JW: I'm currently using SPX for my IC's, despite their wide bid-ask spreads. I use them mainly because they offer many strikes spaced at $5 intervals, which makes adjustment pretty straightforward. Other indexes can be used such as the RUT and the NDX, but then you need to make broader adjustments or use other instruments which are essentially the same (such as the QQQQ, etc.) to do the job. With SPX, you can use exactly the same instrument-with a different strike price-, and you don't have to buy large numbers which saves on commissions. Without going into the specifics of my current position, since you can't establish the position at the same prices I did, here's how you might set up the insurance spreads. I'll just do one side (puts) and explain a couple of possible ways to adjust the position that you can use (and there are quite a few possibilities). You can set up an IC for the front month, or you can go out to the second month. Either way is reasonable, but I personally don't like going beyond the third month because you gain very little, but add risk especially if the market is moving strongly or whipsawing. I prefer the second month personally, but I think month 1 or month 3 are also very viable. I usually setup my IC's so they are in the 10 delta range (TOS gives this information in the options chains), but will go a little higher or lower based on the VIX, which is currently in the mid 30's. The higher the VIX, the more conservative I am, but I'm also looking for a reasonable premium. I will not write either side unless they offer a decent risk-reward scenario, based on my market judgement. In January and February, I was very reluctant to write calls, because I felt the premiums were unnaturally low, and I'm glad I didn't. I also try to balance both sides somewhat, but they don't have to be perfectly alike. This helps with adjustment somewhat. Here's an example of what I might do: Put side only--July SPX quotes from May 1 close Sell 10--700 Puts for 9.30 (midpoint) Buy 10--675 Puts for 7.00 (midpoint) Net premium= 10X100X2.30= $2300.00 Then I would buy some closer for insurance, perhaps 2 or 3 --740/720 spreads..in this case I'm using July for protection, but you can also use May or June. If you do, go much closer to the money. You have to gain protection from steep moves in order for the insurance to have merit. Buy 2-- 740 Puts for 14.40 (midpoint) Sell 2-- 720 Puts for 11.60 (midpoint) Net cost= 2X100X2.80= $560.00 Comments: A 25 wide spread is arbitrary. More than 25 might be OK. 10-20 apart is fine. I tend to prefer a little wider because you can trade less spreads, saving on commission and the bid-ask spread will be less as a percentage of the trade. A really wide spread will act more like a naked position, so I avoid getting too far apart. You now have more than $1700 in credit, which can be used to defend the position, as well as your margin money, which you should have plenty of. I never use all of it, and try to keep a very good reserve just in case. If you think an explosive move is more likely based on technical indicators or your intuition, then you can buy more insurance, and you will have less credit to work with. Now let's explore a scenario or two, remembering that we also have calls on the other side of the transaction, which will help in many cases. Case 1: the market is basically flat, meandering around moderately, but not moving strongly in either direction. In this case, you insurance is spent in vain, and although it helps protect you in many cases, it will be wasted in this case. Your overall position would expire worthless, but you should close it early. I wrote another post on this just recently, so I won't repeat it. You pay perhaps $0.20 to close the 10 credit spreads for a cost of $200, and an overall profit of $1500 or so on your margin of less than $25000. Case 2: the market falls. Before you begin, you need to decide when you will adjust. It should be a combination of how many weeks you have run and how much the market has moved. Obviously, in this case, you have 177 points before disaster, but you must choose to adjust before you get to that point. You might say 30 points a week, or 20 points a week for movement, but it is dependant on your risk tolerance and view of the market somewhat. Let's say for the sake of argument that 40 points against you in less than two weeks is your trigger point. At that point, you will want to shift either your whole position (both puts and calls) down, or just those pesky puts. The put adjustment is the critical one in this case, but the profit from shifting the calls can help make the decision easier to swallow. I'd suggest in this scenario that you move the whole put position down by say 25 points to a 675/650 spread. This means you do not adjust down as far as the market has fallen, but try to move along with at least some of the move, and keep a relatively "safe" distance away from the current position. Here you now have 137 points of space, but less time to expiry. Err on the safe side if anything!! Now if you have shifted your calls down as well, you will spend some of your original credit, but usually not that much. Your original debit spread is now much closer to the money than your credit spread, which means that the delta/gamma is now quite a bit higher for that spread, which works in your favor and will protect you even more effectively if the market continues to move. You also have the choice to buy more debit spreads or widen them if you are really concerned. This might mean spending a bit more of your credit if necessary. Other possibilities include pregnant butterflies, regular butterflies, rolling out a month, etc. depending on the timing and prices of various instruments. Options do give you many choices! The interersting thing in this scenario is that if the market continues to fall, you shift both your puts and calls again, but now you are getting even closer to your debit spread, which will now be increasing in value noticeably. Under the right conditions, which won't happen all that often, you may have to adjust a few times, but your debit spread could actually get close to the maximum value, which would be significantly more than your original credit. There are a lot of judgment calls that you have to make along the way, which I won't get into at his time, but they are interesting ones because there are quite a few profitable possibilities and some nasty pitfalls, too! CAVEAT!!! No strategy is FAILPROOF!!!! You can lose money on ANY options strategy no matter how complex, and despite the exotic names!!! There is no substitute for careful money management and a sensible approach to risk. I know from experience what can happen.
It is easier to invest via IC's (look for your absolute returns) than it is to make a living trading them. I have a certain goal each month to obtain for income purposes. It is easy to go 2SD OTM on the call and the put side, enter a ton of these IC's, and just sit tight. If this trade works out, I wouldn't make enough money to live on. So, obviously, I have to move a little closer. In addition, even if you're 2SD OTM and you see an upward explosion, your calls will kill you both financially and psychologically. So, again as Mark says, it is all about comfort zone. As I have said, you can't use the same strategy for every situation and expect to max out your returns--true of investing and trading.
Thanks Johngreen and jwcapital for your explanations. It seems to me that the true edge in this method comes from making the adjustments properly and with some sense of timing, even if it is a crude timing (market direction, or volatility levels, or a combination). Otherwise, over the long run, the plain IC strategy is about a breakeven or small loser on average, when considering commissions and bid/ask spreads. Would you guys mostly agree or mostly disagree on the above paragraph/statement?. Thanks again, and good trading. JW
1) Agree that risk management - adjusting - is far more important that initial strategy selection. I blogged abut the need for a trader to be flexible this morning: http://blog.mdwoptions.com/options_...sential-when-choosing-trading-strategies.html 2) Disagree that on average, IC is a small loser. Too many options are overvalued - and that means the implied volatility turns out to be less than the realized volatility - and thus, I anticipate profits over the long term by selling vega judiciously. Mark
Money management, and hence the adjustments, is more important than the original strategy, although the initial strategy selection narrows the scope and sets the framework for the adjustment stages. If you are holding for two months, you will probably have to make many more trades as adjustments than just holding the initial position for the whole time. Even with insurance, adjustments are necessary to keep things relatively balanced, and minimize the potential for large losses, although good gains are also a possibility. With the continued strong upward performance of the S&P, I have moved my call spreads upward, and increased my insurance a little. Time will tell if that strategy will be effective! I have also shifted my puts upward, collecting profits on the closed spreads, and writing new ones a little closer to the money. Mark, did you mean to say the IV was(is) higher than the actual realized volatility?
Does anyone ever hedge with ES futures, such as watching your total position delta and when it gets up to +-50 (or less, maybe 25 makes you comfortable), sell/buy an emini?
I normally don't do adjustment but just let my IC either hit my profit target or stop loss. The reasons - more adjustments mean more commissions + bid/ask spread, and the market could reverse after you make the adjustments and in this case you will get double hits (see the March/April). Bottom line is that I don't think i can time the market precisely.. My IC positions are not doing well for the past two months, mainly due to the one directional movement of the market (which is crazy as seemed the market is only "allow" to go to one direction with some mystery reasons ! !) and I have to admit that I am lossing money in my IC (although I manage to cover the loss from my other strategies). These two months are really a hard time for most IC traders, but you have to give back some money after you profits for several months since last year, rght ?..
Pismo, I have thought about the emini solution, and am playing with Ninja Trader on simulation to learn how to do futures effectively as a hedging tool. My current thinking is the most effective time to use the ES would be in a situation where you were holding overnight on expiry night hoping to collect the remaining value of your spreads, but very concerned about a sharp move overnight. Then, you could use them if you needed to defend in one direction against a move that would go into the money against you. You would have to watch and buy(or sell) just as it crossed the threshold, but it could be a powerful cancel defence against a catastrophic loss. Of course, you just might have a sleepless night! Right now, I just avoid this situation altogether, rolling out to the next month or closing the position entirely. Gap openings on SET day are not worth the risk!