Challenge and scrutinize this options strategy!

Hi All,

I have been working on testing and perfecting this strategy for a few years now, ON and OFF periodically and can't for the life of me find a losing scenario over a 12-month or longer term period.

I'm thinking this can't be, so I'm turning to you guys if you can tell me if I am missing anything in this "too good to be true" strategy.

It's an options strategy that involves the following:

*Tested primarily on index etf's such as SPY,QQQ,IWM etc.
*Even tested the strategy for it's performance using an options simulator, however using real life historical prices for SPY along with appropriate volatility to get accurate option pricing into the simulation and period of test was 2007 July through 2009 February, during which the biggest drop occurred and my strategy came up with a 79% return for the period mentioned, which annualized is 45% (this is net profit, after deducting commissions round trip).

Here is the strategy:

1.Buy deep in the money CALL option (approx. 30-35% in the money from current price) with an expiration of 1 year (LEAPS)
2. Buy a PUT option at the money with an expiration of 1 year also (LEAPS)
3. Every month, sell a CALL option At-the-money.

I have a few variations in mind, but let's start with the "basics" and hear your thoughts, please challenge it and say under what scenario this strategy would lose money during a 12-month or longer period time frame?

I am very analytical by nature, but have not found any glaring weaknesses in this strategy for producing +20% returns year after year, regardless of market direction.

Thanks for all your feedback in advance.

 

Your long a 1 yr strangle. And selling a call each month. Or your long a put and short timeapreads. What happens if the underlying goes up 10000%? You basically have a short call time spread and you lose AND you lose on the put value going down too

 

A few years and you still can't see the short fall of this strategy ?

 

If you use current values of SPY for your 'strategy':
SPY at 213.10
long Mar '16 150 call (63.66)
long Mar '16 210 put (11.90)
short Jun '15 213 call 2.75

Breakeven at 139.02

at June expiration you would lose at any price above 139.02

 

I don't have time or interest in running the backtest, but I would imagine during a strong bull market you'd see losses. Those LEAPS just won't have the protection you're expecting against your monthly call. Just look at the delta's of those strikes. No matter how you look at it, your vulnerable to an up move in the underlying, and the longer the LEAPS are let run the more vulnerable you'll be.

If you stuck to stop-losses I'm sure you'd be profitable in the long run, but profitable doesn't really matter. It's more important to try to maximize your risk / reward profile. In my mind there's dozens of strategies that will have a better return on risk than this one.

Why not just ditch the LEAPS altogether and find a method you're comfortable with to short the ATM and hedge it enough so you can make reasonable stop-losses when it goes against you?

 

You are paying for protection at 15 vol, and selling protection at 10 vol, but you are locally short more 10 vol than you are long 15 vol.

So if the markets move more than 10 vol and less than 15 vol over 1 month, you will start to bleed money (especially to the upside).

You want the markets to carry much more than 15 vol to the downside (as you are long skew) or carry virtually nothing so that you make more on the front month leg than you will lose in decay and vol slide on the back months. Or you want the back side to get bid enough that the vega pnl offsets any gamma losses on the front side.

Also, instead of doing the ITM call vs the ATM put, do the strangle. It will be a tighter market but keep your gamma, vega, and delta profiles.

Finally, there is no fool proof option structure. If you think you have found a fool proof strategy, then you haven't tried hard enough to break it.

 

Here is the deal, the deep ITM LEAP call that I would be buying would have about 75-85 delta, and which basically mimics a covered call from the onset with a lower capital requirement of actually having to purchase the stock/etf, however I have tweaked it slightly instead of buying an ATM LEAP put option, I changed the put option to purchase at the exact strike price as the ITM call purchased with the same LEAP expiration period and still selling the ATM 1 month out call option. I have tested this strategy under three distinct environments: 2008 during which SPY dropped by 38.9% while the strategy produced over 100% Net of commission gains. Then I tested the same strategy under 2011 Beginning of March through 2011 end of February during which the SPY gained 47.1%, during which this strategy had gains of 30% net. So to me this proved that under a rapidly upwards/downwards moving environment, this will produce worthy gains but I had to test it under an environment during which the SPY would make practically no gains/losses and found 2011 beginning of Jan through 2011 end of Dec to fit such descriptions, where the SPY gained only 2% while the strategy produced gains of 18% Net of commissions.

Notice that from the onset the strategy is essentially a delta neutral strategy and sudden strong movements will indeed either erode the purchased call or put, producing temporary losses for the front months of the period, however once the impact of losses is increased, essentially strong moves upwards will turn the strategy into a delta positive (hence adapting) and in cases of strong moves downwards, the strategy will turn into a delta negative, once again adapting.

I do understand the old saying there are no free lunches and would like you and/or anybody else to give me a scenario where this strategy would be weakest and turn losses over a 12-18 month time frame overall.

I also realize that under certain circumstances there strategy may "under-perform" the market but that is not the point, the point is to deliver solid growth under any circumstance regardless of market direction.

Again your response/s are much appreciated.

 

I'd be interested to know how much you need to pay up to get a MM to sell those 85 delta calls. Markets must be very wide and have zero customer flow.

 

I don't know how you get 100% return over that time period. You must be employing some leverage. So you should consider that in your comparison.

Secondly, if your goal is to reduce margin. SPY is 25% maintainence margin in a reg-t account. Options are 100% the cost of the option (in this case 35% of the value of the index for the call + the time value of the put).

Your backtesting dates don't make sense. the SPX didn't rally 47% from March 2011 to end of Feb (presumably 2012).

If you drift lower 30% over the course of a year, you can lose a lot of money because your 1Y options will expire worthless and you won't make enough premium to cover it.

If you sell off initially and then continue to sell 1 month calls at the new level and then rip, you can lose money.

If you want to grow as an options trader, you should do this analysis yourself. Don't focus on the backtest. Focus on the what-if's. See if you are okay with those scenarios.

 

What you will do if your short call is in the money at expiration? Buy it back with a loss?