Option income strategies

Hello all,

I have used a lot of investment newsletters, some of them good, some of them not so good. My conclusion: when the times are good, most of them can make money almost with no effort. But in 2009, I didn’t need them – I could just invest in double index fund and make 50-60% a year. The problem begins when bear market comes – and in bear markers, very few newsletters deliver decent results.

My conclusion is very simple: it’s very hard to beat the market. So many experts say: just buy the index and hold. Well, we know what happened to those who just bought an index 10 years ago.

So what's the solution? When buying stocks, indexes etc., the mathematical probability of success in general is 50%. Why not to put the probability to our favor by implementing options income strategies like iron condor, calendars etc.? Stocks and indexes do trade in narrow range 80% of the time. Why not to use this fact in our favor? If you trade Iron Condor for example, the probability of success (depending on the strikes) can be 80-90%, with 4-8% monthly return. Of course those trades require adjustments and constant management in order to limit losses, but so are stocks. We already saw the most “safe” stocks tank by 40-60%. So instead of buying stock/index, watch it to go up 20% only to come back, why not to put time to work for us?

I don’t want to rely on my (or anyone else) ability to predict the market direction and pick good stocks. I want to build my strategy on two well known facts:

1.Most of the time, indexes move in tight range.
2.Options lose value every day.

If I implement market neutral strategies with options, 80% of the time I can just sit tight and make 7-10% per month. If I control risk and cut my losses at those 20% period when indexes move more than 10-12% per month, I should do much better than directional strategies.

My experience with those strategies is still limited. I started using iron condors in April 2009. Despite very strong move since then (rut moved from 450 to 600 – that’s 33% in 7 months, doesn’t happen very often), the results have been very respectful. I made 8 trades, 2 losers (6-7% each) and 6 winners. September was particularly difficult, with RUT moving 18%, but I managed to close the trade with only 6% loss. Overall, I had 14% average gain (including the two losers), with average holding period of 6-7 weeks.

To reduce vega risk, I started using multiple calendars, in addition to iron condors. Iron Condor is vega negative (loses money when volatility increases), while calendars are vega positive. So I’m trying to open iron condors on down days when volatility increases, and calendars on up days when volatility is lower. Combination of those two strategies reduces vega risk.

I would appreciate your opinion about those strategies.

 

It seems to me that you're looking to use option selling strategies as a way to generate income.

There are a couple assumptions you are making. First, that the move in stocks are not going to be volatile; second, the premiums that the option buyer pays is high enough for you to justify selling that option to them.

Options are priced based upon certain models that assume a lognormal distribution. If you think that the odds of an extreme move outside that distribution is overvalued, then you sell options. Conversely, if you think that the options do not have enough premium to justify the large move risk, then you are an option buyer.

In the options market, there's really no "one-size-fits-all" strategy for every single market condition. When we have a period of ever increasing volatility, then option selling was a losing bet (see 2008). So it's dependent on the market environment both in terms of price and vol.

 

No, I'm not looking at option selling strategies as a way to generate income. I want to increase my returns and increase probability of success.

I understand that those strategies are not going to work every month with the same success. However, we know that markets do move in range most of the time. As an example, if I trade Iron Condor with strikes about 1 std, I have about 66% probability of success. So in 8-9 months out of 12 I can just sit and collect my premium. My risk management and my ability to manage the other 3-4 months will determine my success. I watched some Dan Sheridan webinars on CBOE site, and he shows how you could make profit in IC even in October 2008. Sure it’s more difficult than in normal month, but it’s possible.

You are absolutely correct that some option selling strategies like Iron Condors lose money when volatility increases. However, there are strategies (like calendars) that actually benefit from increased volitility.

There are many services that trade those strategies. Most of them don’t have proper risk management and have months that lost 50-60%. This is the main danger. However, I followed two services that are different. One of them sells low credit spreads only (one side of IC), has an average monthly return of 4-5% since 2000 and no losing month since 2005. Second one is using combination of IC and multiple calendars, has an average monthly return of 7-8%, no losing month since 2007. They prove that those strategies can work no matter how the general market is doing. You cannot say the same thing about directional strategis. They lose money in down markets no matter what, unless you are smart enough to go short. I don't want to rely on my ability to predict the market direction.

 

You collect premium upfront, not afterwards, ie. I think you use wrong terminology. You collect premium when you sell a call or sell a put
without owning it yet.

 

You are right of course.

What I meant is sit tight and watch the time working for you. If I collect $2 for an Iron Condor, and I can buy it back for $0.3-0.4, I make $1.6 on $8 margin. That's 20% in 6-8 weeks. In 6 out of 8 my trades since May, this is what happened.

 

If only life was that easy.

Its amazing what 9 months of straight bull market will do to people.

Selling options is great, and market nuetral strategies are great, but it works until it doesn't. You have a very short memory. Remember 12-15 months ago? Those selling options then got crushed. Some of them wiped out. Doing NOTHING BUT selling options and/or nuetral strategies will work fine most of the time, but at some point you will experience a very large drawdown. I'm not saying that what happened last year will happen tommorrow. In fact, I don't think we'll see another 20% or greater downturn for at least another 4 or 5 years when the greed and irrationality of some will once again combine with the natural business cycle to create another inevitable recession that will cause some to think the world is ending.

The problem with selling options is it works great in neutral or bullish markets, which tend to last for a while and make those option sellers complacent. Then that inevitable downturn will happen and many sellers will lose all their gains and then some. And believe me, you (nor I, nor anyone else) has any idea when that next downturn will occur. So it makes options selling very difficult, and by reading your post I deduced that you might think it may not be that difficult.

You are right. It is very possible and not even that difficult to have an 80-90 percent success rate in these ventures. The problem is with that pesky 10-20 percent, which will be swift and painful, and could erase all those little gains you have been slowly collecting

The fact of the matter is you cannot beat the market by just simply selling options or nuetral strategies, at least not consistantly over many years. You have to have skills, or an edge of some sort.

 

This will probably be your or some others reply to my post. Control risk and cut losses sounds great, but its very hard to actually do. Cut losses too soon and you will get whipsawed all the time, and your winning percentage will tank. Let losses run too far and you will watch all your little gains disappear faster than Tiger's wife. You have to find a medium. You have to know when to cut the losses that will eventually become devastating, and you have to know when to just let some losses ride back up to winners. All that is extremely difficult unless you have a crystal ball that can help you time the market. That brings me to my point.

You cannot just sell options and do nuetral strategies and expect to beat the market over long periods of time without

1. Extreme luck.
or
2. Mad skillz

 

Both IC and calendars share the same directional risk. They are both short gamma and will get killed on a large move of the underlying. So balancing vega doesn't make this combination a protected portfolio. BTW, do you mind sharing the websites or identity of those two newsletters you mentioned that boast that impressive trackrecord? (Pls, only if they were active during 2008

 

> One of them sells low credit spreads only (one side of IC), has an average monthly return of 4-5% since 2000 and no losing month since 2005. Second one is using combination of IC and multiple calendars, has an average monthly return of 7-8%, no losing month since 2007.

I'm assuming the latter of these is condoroptions-- very good service, and I know jared personally. I run a trading service as well with a combination of option selling and buying techniques.

You're under the assumption that you can sell options and let them simmer 3 months while you collect premium. I can assure you that this rarely happens (this month did well, however). Consider your risk and reward. If you're in an iron condor that is returning ~30% on your risk, your risk is still substantial if you get caught outside the wings. So if for every 3 I.C.'s that are successful, you have one that goes out for full risk, you're at breakeven. And that doesn't include the heartburn of the gamma you have at the beginning of your position.

So as I said, it depends on the volatility environment on whether it makes sense to take these trades. If the premiums are undervalued with respect to volatility and the market moves faster than what they were pricing in, you can lose more capital than it may have seemed at the outset.

 

I just ran the numbers, and 4% per month is 60.1% per year (with monthly compounding). Is that not good enough for you? I don't know any money managers who do that well consistently. Could your numbers be off?