Trend following system w/ Option writes

Discussion in 'Options' started by links, Mar 13, 2003.

  1. links

    links Guest

    In the past I have looked at this idea many times but never had the chance to do any rigorous research. The basic concept is to employ a medium term trend following strategy but rather than buying options when a signal is given, one would sell or write options.

    For example take QQQ, 120 minute bars, a simple 20 period breakout system. So every time the Q's breakout above their 20 period range one would sell puts and if they break below their 20 period range one would sell calls.

    Basically what this strategy is trying to do is to address the two big short comings of the Trend following strategy, one that the mkt only trends 35% of the time and the second that if your exits are not efficient you end up giving up a good portion of the move. This strategy utilizing a medium term trend hopefully will give infrequent signals, so one would capture the time premium even if the mkt is going sideways.

    I wish I knew how to post charts, but if you look at the QQQ 120min chart a signal to sell calls would be given on 1/17/2003 and exit (close the short calls and open a new position by selling puts) was given on 2/18/2003 a month later.

    As you can see if you had traded the underlying Q's you would have made about 1 point. But the hope is that the time decay of the options would be much more; and then if you look at the next signal (sell puts 2/18, exit 3/7) it would have been a small loss trading the Q's but the puts with time decay would result in a small profit. ( These dates/numbers are just approximations to highlight a point, the strategy also is nothing stellar)

    Wondering if anyone has comments or thoughts on utilizing this technique?
  2. ctrader


    I have often thought about this too.... have the time decay work for you instead of against you.

    I am sort of uneasy being short naked options though
  3. I've been trend-following w/ writes for some time and it has been a consistent income generator. Occasionally I'll augment with a direct futures position (Like this a.m. spoos pre-market!)

    My approach is more seat-of-the-pants rather than quantititative so I'll simply suggest that, yes, I believe this strategy can be quite lucrative & would encourage your further pursuit.

    A caveat: One has to be a grown-up, and make an honest assessment of risk in order to pursue this strategy. With this strategy the operative question is 'What risk am I willing to assume?' rather than 'How many pts. my target?'
  4. dis


    I do this by writing ITM covered calls aiming at 1-2% a month.
  5. links

    links Guest

    I agree, this stratergy has the potential to be a consistent income generator. Based on my limited research time premium decay is very forgiving, it will compensate for bad entry/exit points.

  6. A good topic for discussion...I do similar stuff with index options, and I have noticed quite a bit more discussion of this subject in the past month...There is no question that disciplined and selective index options writing coupled with some creative execution techniques can be a relatively "lower" risk strategy when compared to consistent directional trading via the e-minis, or other futures contracts...

    A few observations and experiences that I would make a note of...The one aspect of options writing that is the trickiest, and the only one that has ever resulted in some decent losses, is writing options that either have too little theta, hence large gamma, writing strikes that appear to be far enough OTM, but then having the market "snapback"(a common occurrence in the past 6 months), and putting too large of a position on all at once and therefore having a bad cost basis...

    From my experience, the first problem occurs more often than others...i.e. writing options that are time bombs and begin to trade pure gamma, moving very sharply with any changes in the underlying...These also seem to occur right around the front month expirations, so it should be anticipated...

    I agree that there is a great deal of leeway if your timing is even mediocre...If your timing is WAY off, then the margin of error does not hold up as well, especially if you picked the wrong strikes to "leg" into...

    I don't ever use this strategy on any other markets aside from the index options markets because I find that the price shocks in individual equities puts even the most outlier strikes in jeopardy on some fluke earnings warning, news event, etc...However, with the index options, you can really structure your risk accordingly and always figure out a strike that offers a compelling risk:reward...

    The only caveat is the margin required...So I do believe it is something of a "bigger money" technique simply because even the most outlier strikes require massive margin to hold naked positions...Other than that, it does have a level of consistency and a margin for error that is hard to find on a day to day basis when trading direction in the underlying...
  7. links

    links Guest

    Vulture, you and others have made some good points. I think individual stocks are just too risky for this type of technique unless you do covered writes. For stocks, index options or QQQ are the best vehicles.

    My favorite though is the the 10 Yr T-Note futures market, the options are fairly liquid, the margins are very reasonable, plus futures have the added tax benefits.

    Some of the lessons that I learned is that less is more. This uncovered writing should not be used as a swing trading technique, the slippage and the mental aggravation in putting on the positions is just very taxing. This should be used w/ a medium term trend following system so that the signals are not that frequent. Just put on a position and let the premium erode away. The goal should be modest income generation not trying to earn a living at it.

    Another thing you mentioned about the mkt snapback, this has happened to me as well, for example in the QQQ's, very often I would write an option and collect lets say 2 1/4 points, then it would whither down to a 1/2 or 3/8, only to see the mkt snapback and this option right back up to 1 3/4 again. I think if I were to do it again I would definitely buy it back at a 1/2, the risk/reward is just too great waiting for it expire worthless...
  8. my cousin, who was an options mm, explained this to me once. i didn't really understand it back then, but i remember the bit about premiums coming back. i wondered then why you wouldn't just close the position; it's not like you're gonna miss out on THAT much extra profit by not 'letting your winners run'.

    i think it's something to test. just how much your system suffers by closing them out early. you could probably come up with some improved exit method (rather just waiting for expiration)
  9. Would you give an actual example ? something like XZS at 50, sell 52 call 3 weeks to exp ?
  10. yeah, I definitely think that it's wise to close out positions in the final days prior to expiration, especially if the options you are net short are trading somewhere between .05-.20 cents and you have more risk by sitting on them waiting for them to expire worthless...Since the "envelope" of premiums begins to shrink more and more in the final 10 days of an expiration cycle, it becomes more and more risky to try and sell the strangles on the wings, and that's where the bigger risks come into play...So I definitely agree that it is wise to begin to reduce the exposure once you are in a situation where the risk:reward is diminished greatly
    #10     Mar 15, 2003