Conservative Options Strategy

Ok, here is what I'm talking about. Historically, when markets form TA indicators such as double tops ( NAS 200)or head and shoulder patterns (S&P 2008) odds are they fall. If you 've $200,000 worth of long positions on individual stocks you don't want to cash out of, puts on the general market might be money well spent to protect existing profit. I favor the OEX. I blew it this time as I expected most of the fall to happen by September and took a small loss on my Sept put spreads and didn't roll them out to October or Nov.

 

This is a lessons learned AND SOLUTIONS FOUND final chapter to this journal. The cost of this lesson has been dear, but the cost will end up being recovered, without doubt. The solution to the problems I had is so simple, yet no one suggested it in any of the previous responses, at least not in any meaningful way. Amazing. If I had known back in July what I know now, my losses would have not exceeded 20% and would likely not have occurred at all.

Now I will state that experienced options traders all know this. And if there are responses to this post, no doubt they will all say well of course, it’s so obvious, any fool knows this. But don’t let them fool you, if you are learning about trading options, they were unwilling or unable to pass on the simple lessons you will find on this page.

Don’t be lazy, those of you how want to learn. This one post will not teach you all that has appeared in previous posts, and there is damn little from my previous posts I would want to retract. So starting at the beginning of this thread is not a bad approach.

My mistakes stemmed from two main short-comings:
My mistaken belief that fundamentals are stronger than (or will overcome) price action.
My lack of knowledge of the little “trick” I’m going to show you.

I’m going to show how those mistakes can be avoided. Also I believe that most of the stress and much of the close monitoring of the positions will go away. Allows the retired among us to enjoy vacations without worrying about internet connections in strange parts of the world. We are going to learn how to instantly and painlessly switch back and forth from bull to bear to bull markets.



So there is going to be an amended guidance to the methodology.

RULES:

Short term spreads cannot be repaired. When they go bad sell them quickly and take losses. 3 to 4 month spreads are short-term, 9 to 24 months are long-term.

Put on vertical spreads that will yield about 70 to 100% over the time on the spread. This means we will be looking for in or near the money BULL CALL DEBIT VERTICAL spreads. They don’t have to be as deep ITM as I originally believed. I still HATE credit spreads using puts.

We will enter the spreads ONLY when the MARKET is down. Use MA crossovers, stochastics, MACD, whatever the hell you like. We do not have to find a bottom, but we will use fundamentals to select the SECTORS and we will use PATIENCE to wait for downturns in the market. BTW the market is down NOW if you haven’t noticed.


DISCOURSE:
The spreads will be much less volatile in the first half, and management is certainly not needed on a weekly basis. As the underlying begins to move, we can leasurely manage the spreads based on prevailing market and sector conditions. We look as charts varying from 3 to 12 months to determine prevailing trends. We don’t need to daytrade and we don’t react to situations immediately.

During the second half of the spreads, last few months before expiration, we have to pay closer attention. Like weekly. And then in the final 3 months I think I would be inclined to put a stop loss like 20% more or less.

This all assumes the spreads do not need to be “adjusted”.


MORE RULES:
We will manage the spreads as follows:

We will need to maintain a 50% cash or equivalent position in the trading account. We need operating capital. It IS a business.

If the spread continues to gain or maintain it’s value as time passes we do not need to make changes as long as we are 3 months or more away from expiration.

If the spread reaches around 80% of it’s expected gain, we probably exit and take our profits.

IF THE SPREAD LOSES VALUE in the early months we use the TRICK!

Here is a trade I did today as an example of the “trick”, which is, of course, simply a diagonal trade of the short leg of the spread.

The original spread was:

5 DBA JAN10 30/35 @ 2.4

The value of the spread today was about .9. So I was down $150 times 5 spreads. DBA closed today at 23.5. Expectation is that the spread will be good by Jan 2010. But who knows? So I bought a diagonal spread of JAN10 35 BTO and STC the APR 30.

Here is the math at the time of the transaction.
The JAN10 30 call cost 6.39 now worth 2.1
The JAN10 35 call was 3.92 now worth 1.25
Buying back the 35 call showed a profit of (3.92-1.25) = 2.67 profit.
I adjust the new basis (or adjusted cost) of the long call: 6.39 – 2.67 = 3.72.
So after buying back the short call my long call JAN10 30 has a cost of 3.72.
Now I sell (STO) the APR 30 call for .65.
Now I have a calendar spread long JAN10 30 and short APR 30.
My expectation is to book the .65 premium to offset the 3.72 long call, assumes the apr call expires worthless.
In april I will then sell another call against the long JAN10 30 call.

I will eventually turn my $750 paper loss to a profit.
I committed 1.25 -.65 = .6 more funds. $300.
I expect to make 325 as the april calls expire.

Now this example is real world and I made a decision to do this based on current information about the market, which must certainly be more accurate than a forcast for JAN 2010. If the market conditions were different, I could have sold any month prior to JAN10 or any strike. I could have made the spread into a bear spread. So essentially I can (AND DO) adjust my spreads from bull to bear and back selecting any strike I want from month to month. That is the “trick” That is the flexibility of options.

So as long as you have a choice of strike months to select from, you can stay very flexible. When you can no longer be flexible, set a stop loss on the spread.

If I can’t make money now, I deserve to be broke.

 

Thank you for your journal.

I wish you a profitable 2009.

 

Hi Yucca,

As you have found out,your strategy is simply a diversified portfolio of shot put verticals in various equities..In a flat to up market you will do fine,in a down market you will get your head handed to you..You are a premium seller who has limited risk,and it appears you do employ leverage.I used the word "appears" as i simply read the first 2 pages of your journal and the last..

With that said,there is nothing inherently wrong with your strategy,but there is something very wrong with your management of an option portfolio..

Your first deadly sin is

"It doesn't make sense to hedge positions that you think are good going into them."

You need to get over this mentality,or go the way of the dinosaur.

I will tell you right here and now that you need to understand options at a higher level,and you need to have a far better trading plan than you currently have.

To arbitrarily start employing MA's without somewhat extensive backtesting and simulations will just complicate matters...Do you have any idea of the accuracy of the 5/20 Ma X over??Is it right 25% of the time?? 35%?? Are you going to liquidate the hedge on Xovers?? Would an oscillator type indicator fit better with your style of trading??

Have you simulated your portfolio and broken it down to see what index it most closely tracks?? Do you know the Beta of your portfolio relative to your chosen index to hedge with?? If so,are you aware of the "downside" beta??

Would you hedge with an index spread or naked index option??
I can only assume you are 100% aware of how a 10,20,30% move impacts your portfolio.

These are just a few of the things you better know..If you dont,you better have that hedge on from day 1..

Tao

 

Taowave mis-understands my post.

By “hedge” I mean maintaining your present position and adding a second position to protect your first position from (further?) decline. In the post he refers to, I was searching and failing to find an answer to my dilemma. In my last post, I propose a solution that has nothing to do with hedging.

Lest I be mis-understood, let me make it clear that the solution I now propose is a “reaction” to underlying price action, not an anticipatory strategy. I respond to what has happened already to the spread. It is only that the spread has declined that has given me the opportunity to use profits accumulating in the short leg to actually lower the basis of the long leg, and put of a new spread that allows me to sell more premium (now adjusted to present stock price and expectation), and eventually overcome the loss in the position.

I only use this strategy when I continue to think that the long call will finish ITM or if I believe that selling this new premium will allow me to work off the position loss within the time allowed. Otherwise, I don’t put on a hedge, I just sell the spread and take my losses.

No TA required, No alpha, gamma, sigma, delta analysis required. Just a general knowledge of near-term price action to decide what new option call to sell now that will give me the most yield in the shortest time, and will have the likelihood not to be ITM at expiration (or at least show a profit from time-premium ).

The only time I am suggesting using TA is to help determine when to enter the spread to begin with (to enter at at lows in the market, and to maintain an understanding of where the market is. I am NOT suggesting we use TA to make changes in spreads based on what we “expect” to happen in the future, that is “trading” and requires much skill and some luck to be successful

Tao says:
“Your first deadly sin is

"”It doesn't make sense to hedge positions that you think are good going into them."”

You need to get over this mentality,or go the way of the dinosaur.”

By my understanding, I stand by my statement. But that doesn’t mean I shouldn’t modify my spread as needed in reaction to what has already occurred. No hedging required!

 

Yucca,

I understand everything you wrote.

I understand your trick very well.

You are simply rolling down and out,and now you are short time spreads.

Every trade you put on,whether rolling or not has to stand on its own merits.

Simply rolling for the sake of rolling is not the way to go..

There are no tricks

 

tao - Thanks for your reply. I agree 100% with your last post. It's not a "trick", but a technique that allows you to adjust a long term spread to take advantage of current market conditions. If you are not aware of the technique it just seems like a trick, but you do need to know how to use it properly.

If used properly the technique allows you to take an active role to fix a wounded spread instead of just selling it or hoping it fixes itself. You don't roll the short leg just for the hell of it.

When a spread goes bad the short leg (of a bull spread) always shows a profit while the long leg shows a bigger loss. Take advantage of that short leg profit (a built in hedge is the benefit of the spread so to speak) to lower the basis of the long leg. The new lower stock price alows you to select a different, more profitable call to replace the short call you buy back.

It only works if the spread has lost significant paper value. Like when the market turns bearish, for example. It is a judgement call to decide when or if to roll the short leg, and what to replace it with. That judgement call should be based somewhat of what the chart looks like.

 

Yucca,

I know what you are doing,as I have been there myslef...

So lets say you buy back your short call at a profit,and roll down and out..You are now short the calender,and short deltas...

Is that the position you want to be in with a beaten up stock that you were initially bullish on??

 

In the example I posted, a spread on DBA. DBA is an commodity ETF that I do think will be above $30 to 35 by Jan 2010. So I am bullish for the long term, and I think it is reasonable to take this action under the present volatile market. I think it is very reasonable to take the approach that this strategy (after the initial spread gets it trouble) is similar to a covered call strategy where the long call subs for the long stock position, and you sell calls agains it to enhance your profit and/or provide downside protection. This is the best approach I can find.

Please tell me what you would do with the example spread.

 

Hi Yucca,

Lets simplify life and see what our "options" are...We are in agreement that you are buying deep in the mony verticals which is the equivalant of selling OTM put spreads(I am ignoring dividend risk)...

If I am not mistaken,you are fundamentally bullish on your stock selection.

In your followup you responded to me

My main point to you is you are apparantly bullish,got long in the 40's,and now when the stock is trading in the 20's,you are establishing a bearish position buy rolling down and out.Do you see your inconsistincies?? If you are right and DBA rallies,you are going to lose even more money,quite possibly more than the initial debit of your spread...That is a disaster..

If you are going to roll the short call out and down,you better consider rolling the long call as well.If you put a gun to my head,I would probably roll the long Jan call down to a lower strike in January.Off the top of my head,I would roll down to the 25 strike,and hopefull not have paid to roll both options...

This is not the approach I would have taken.I am just giving you food for thought.As the stock has moved from the 40's to the 20's,we are obviously late in the game to be rolling.We didnt manage our risk properly and now we are essentially locking in losses or making a "desperation"directional bet.You should have taken premptive action sooner(stock higher than 32),and you may have been able to roll the Jan 35 to the Apr 35 for a 1.20 credit.

I have other thoughts which I will share later.In the meantime,you should fully understand calenders,and diagnol spreads,inside and out.Understand the gamma/vega relationship.Hope this helps a bit

Tao