I think your worst case scenario is that the market drifts down to around 1690.01 at the 46 day mark, never hitting your criteria to buy back the spread in the interim. It will cost you more than $10 to buy back the 1700 position at that point since it's not so ITM that it's trading at intrinsic. For example right now it looks like a put that is 10 points ITM and 15 days from expiration is trading at around $25, not $10.xx. Obviously the 1690 expires worthless. Not an unlimited loss, but closer to $2,500-$150 instead of the $1,000-$150 you're thinking. The real loss comes when you don't take the loss right then, and try to hold that naked 1700 short put! My read of the literature is that this strategy has a lower risk adjusted return than you probably think. There is a well-known phenomenon of OTM S&P puts costing more than they should based on realized volatility, one of the few cases where options are provably systematically mispriced. The ATM puts obviously are subject to put-call parity. So, at least when you're close to the current trading price, a strategy of selling the fairly priced put with the higher strike and buying the inflated further out of the money put would be suboptimal. I'm not sure what the research says as you go far out of the money, might be worth looking into if you're going to continue to pursue.
Sig, Thanks for the evaluation. That's pretty much my conclusion too. So lets say you are trading 10 spreads, on a 100k account. Looks like you can make $70 bucks/month/spread roughly. $8,400/year on a 100k account = 8% Now during one of those years that might happen 1 out of every 7 years, you might get nailed... and you lose 10*$2500 = 25% of your capital. It's not perfect, and there are alot of assumptions, but seems to me this is a no brainer. I've been trading it for about 6 years now, and it has worked well. I just have not traded it to the size to look to generate 5%+. This is not my primary method to make money in markets, but a supplement to my directional trading. "The income piece" Anything else I am missing, any other input?
Actually the worst case scenario is not a drift to the 1690 number, but a spike there. The closer you are to the expiration of the 1690's the worse it will be. The spike will blow up the volatility in your short options which will hurt you much more than a drift there. How much is at risk? Hard to say, but assuming you hold to expiration day of your longs, and the index is at 1690, Your shorts could be very very high. The more time that is left on your longs when you exit the position keeps the spread less risky. More risk closer to expiration of longs. Note that this spread is a long delta spread, You will lose money with a substantial selloff.
I agree except the OP said they close out the position sounds like around halfway to expiration. So a drift down that never triggered the buyback followed by a spike just before expiration of the near option?
So overall, is this strategy not worth it? Whats your opinion? Am I a lunatic? I figure if I can make 3% 6 years in a row, and then MAYBE have a 10% loss year 6... this is worth trading. Also, keep in mind this is not my primary way of making money, this is just a supplement.
I personally don't think any "one" strategy is ever worth doing blindly over and over. Whether it be selling iron condors, buy writes, etc. You give up edge getting in the position, and if you assume the options are fairly priced you will lose in the long run. Some strategies will make money for a while then lose a bundle.
Palindrome.. good thread to read! Firstly, KISS... keep it simple stupid! As a strategy I would never make it this difficult. You add a lot of risk by buying the 1690 instead of the 1700 put, and at 400 point out that 1700 put is not that much more expensive. That way, you're not short the 1700-1690 spread and never lose the extra 10. The biggest risk is indeed a drop to 1700-ish and a rise in vol. It will then all depend on how high the vol will be and how close to expiry we are. The further away from expiry the better, but you will still lose, even if it's a 1700 calendar. If you are very late in cutting your losses, this can end up in a drama, this spread could be worth 60, 70 bucks around expiry... if vol would be 50, so losses around 7k. (50 vol sounds like a lot, but not in panic mode). Basically, you're vega short, delta long... even the 1700 calendar spread would be vega short, delta long. Probably even gamma short. So you want it to go up slowly, or stay unch... hence why you've been making money on this, market has been going up. Slowly is good, heavy down costly. Don't think this is my type of trade, since there's not that much beef in it..
I don't think you should look at this as a 3-5% return trade... because you're not using the full potential of your 100k. A single short put would require a margin of about 5k? A calendar spread would be less... (not saying you should go all-in though )
Good Point JackRab. That makes sense about the 1700, instead of 1690. I guess the trade is really a protective trade if an atomic bomb goes off, and the Market drops to 1300 quickly (unlikely)...but if it did, I would be wiped out if trading unhedged.