Systematic Options Writing

Discussion in 'Options' started by Painkiller, May 13, 2005.

  1. Anyone have any links or resources about systematic options writing and trading strategies. They would be dynamic and involve reactions to directional moves in the underlying with appropiriote action in options to offset losses or hold onto gains.

    Here would be an axample of what I'm talking about, though I didn't write this:

    The systematic writing recipe:

    Step 1:Start by writing puts on half the amount of shares in which you are willing to buy (for example, if you are willing to buy 1,000 shares, write 5 puts).

    Note: Repeat step 1 until you are assigned. Again, it is very important to use this strategy only for stocks you would be willing to buy at the strike price regardless.

    Step 2:Once you are assigned in step 1, write covered straddles (sell a call and sell a put). In this example, the investor will write 5 calls and 5 puts. The position is considered covered, because the investor can always deliver the shares if assigned on the short calls.

    Step 3:If the investor gets assigned from the calls in step 2, start with step 1 again. If assigned on the puts again, write covered calls against the entire position.

    Investor B uses the systematic strategy. He will write puts on one-half of the position he would be willing to buy, to represent the 500 shares he's willing to purchase. The stock is currently at 50, so he writes only 5, 50 put contracts for $8 each.

    At expiration, the stock is trading for $35. Because B is using the systematic principle, he bought only 500 shares from the put assignment. Now he enters the second step of the strategy: writing covered straddles. Investor B will now write 5 $35 puts (assume they are $5) and 5 $35 calls (assume they are $6).

    Investor B will bring in an additional $2,500 for the puts and $3,000 for the calls.

    At this point, two only two things can happen for the stock: It will either be above or below $35 at expiration. If the stock is above $35 (the strike price) at expiration, B will have his shares called away due to the short call option. But that's okay, as we will see shortly that his average cost is only $33, and he will make 2 points profit. But, let's assume the stock is down again to $30. Investor B will buy his second lot of 500 shares at a price of $35, the strike of the short put. Investor B's cost basis is effectively $42-1/2 for the purchase of stock alone (500 shares at $50 and 500 shares at $35). But in addition, B took in $4,000 for the original put sale, and $5,500 for the covered straddle (500 * $5 for the puts and 500 * $6 for the calls). The total proceeds from the options is $9,500, for a total cost basis of $33,000 or $33 per share for investor B. Now, investor A has a cost basis of $42, and B has one of $33 with the stock trading at $30. The third step for the systematic writing would require B to write 10 calls (covered call position) against his 1,000 shares. The market is at $30 and his average cost is $33. Say he can sell 10 $30 calls trading at $5 to bring his cost basis to $28 per share. If he gets assigned, he will sell 1,000 shares at $30. If not, he will continue to write calls against the entire position until called out. At that point, he will look to start with step 1 again in the strategy.

    Notice too that, although a two-point profit may not seem like such a big deal, the stock has fallen 34% from $50 to $33. There is not much an investor who paid $50 for the stock can do at this point. But our systematic writer is able to potentially capture a two-point profit despite the fall.

  2. lar


    You'll find a systemic writing system much like you described in the book "LEAPS" by Harrison Roth. McGraw-Hill Page 77 - 79, including Figure 13.1

    Peace and gtty,

  3. alassio


    Why writing initially only half of the amount of puts and later writing straddles instead of alternating between puts and calls with the full amount?

    Is this intended to reduce risk? (such that you are only fully invested in the stock when it already has fallen some amount)
  4. johnk49


    Sounds good on paper but to get an ATM $6 premium on a $35 stock it would have to be a pretty wild stock!

    The premiums on less volatile stocks are hardly worth bothering with,if you look at GE currently at 35.80 the June 35 is only paying $1.30.YHOO is paying $1.05 etc.

    The other poster mentions Harrison Roth(whose book I have)but he's applying it to Leap options where the premiums are naturally higher,probably ok for the longer term investor.

    Good idea anyway.
  5. MTE


    The reason for this is that it allows you to write straddles if the intial put is assigned, so you can bring in more premium. In fact, it doesn't have to stop there. That is, you can keep writing straddles as long as you're willing to purchase additional shares.

    In other words, if you start with the maximum amount you're willing to buy then after the put is assigned you can no longer write puts, but have to wait for your calls to be assigned.
  6. alassio


    Such a strategy should be fairly easy to backtest, provided you have the necessary option prices available.

    I remember having seen a similar backtest in McMillan's book "New insights on covered call writing" showing better results than buy and hold.

    Has anybody the means to backtest such a strategy?
  7. Unrealistic strategy that was somewhat OK in 1999-2000 (huge premiums) and is completely useless today. You don't have to back test it because its basis is theoretically wrong even without taking in the account "Fat Tails" that will kill you instantly. A typical newby's revelation that is based on a book for housewives. Ridiculous! :cool:

  8. :D

    well why not just say the put is $25 or 60? I mean to illustrate something shouldn't one use "realistic" values for the puts and calls they propose to sell?

  9. Choad


    So, MAESTRO, how do you REALLY feel about the strategy? :D

    This can be a good strategy, but like every other option strategy you MUST define where the edge is. No edge - little or no gains over time.

    But just like continous index "covered calls", you may be able to capture 5-20%/year over time. However, if you can identify which stocks, for example, will "bounce" after a big drop, then do the short straddle/strangle, you might have a decent system.

    The big question is, can you control your losses well enough to prosper? And why wouldn't it be better to just buy/sell the underlying (not saying it is, just that you must be sure).

    Good luck to all.

  10. man


    ... you probably find numerous superior strategies. ask an individual "metooxx" ...

    #10     May 13, 2005