Keep in mind part of Karen's edge was/is that she biased her shorts based on market expectation. Essentially her delta was skewed bullish in a bullish market (she even says it herself in one of her videos where she talks about selling more puts than calls). I have traded options since the late 90's and have pretty much settled on just the $RUT to simplify my life. But I can tell you that there is no edge in just selling options without some kind of bet on volatility or direction. The thing about selling premium is that you may be successful for a number of years, but eventually the market will do something you thought would never happen and you are in a huge hole. Hedging with futures is a great idea someone mentioned earlier, it will really help you sleep at night. Not to beat a dead horse, but 20-30% returns with minimal leverage would put you in the realm of elite hedge funds and people would be beating down your door to manage money.
Hi. I have periodically used the VAR analysis from with IB (and their stress test reports in the management view) to help me get an assessment of what my margin & net liquidation risk for extreme moves. I don't always run it each week before I make my open. I have primarily used it historically when I was back testing various extreme market conditions with sample portfolios. For the specific scenarios that I trade against, in a portfolio that currently has $1.1M net liquidation value, if I opened my standard positions today AND attempt to collect .39% weekly return, then the VAR for 1 day with 99.9% confidence is -231K. The 4 day risk (to expiration) is -$475K. 99.0% confidence over 4 days is -$182K. These are the standard naked positions without any long legged hedges.
Have you ever considered spending a small percentage of the total credit (premium) on buying “units”? Units are very inexpensive options (normally PUTs in equity) purchased in the front-month that go bid in the event of a rapid (semi-black swan) down move. One of my core short option positions is in natural gas (NG), its major risk is to the upside and if you look at a 25 year historical chart you will see what I mean – it almost resembles the VIX in its spikes and mean-reversion attributes. I normally spend around 10% per month (of the total possible credit, not AUM) on PUT and CALL units based on whatever position(s) I plan to have on during the month going forward. Almost all will expire worthless, but I don’t see it as money wasted – one day, they will pay out, and more importantly give me some flexibility to manage the short tested side.
I've heard of the following hedging strategies: 1. Buying outer period ATM or OTM puts with a % of credit collected. 2. Buying VIX and VXX call options 3. Offsetting with ES futures 4. Position sizing 5. Long positions creating vertical spreads - or a ratio IC. I am sure there are others. I think spending 10% of the collected credit is a fine amount to spend, but I think you have a couple choices here. 1. Do you buy 1 closer to the money put? In my model, I'd be able to buy 1 put for every 10 puts opened (and every 50 calls opened) that is one month out, which is 8% OTM at current volatility. I could open this put each week creating a ladder. After 4 weeks of doing this, I'd have only 10 short puts opened and a ladder of various long puts at different strikes, with different expirations, all about 8% OTM. Of course, this 10% isn't really wasted, as if I wanted to go all cash, I could sell some of them back for a profit. This sort of scenario would let a black swan happen, and instead of surviving a 40% drop before a first margin call, I'd get about 58% drop before my first margin call materialized. There may be some positive short term gains that come from markets that are having a normal 5-10% correction as both the short and long puts could show gains. 2. The other choice is to go far enough OTM to buy enough coverage puts each week. We'd have to go about 15% OTM to buy these puts. If you applied the same ladder strategy, after 4 weeks, you'd have about 40 long puts for the 10 short puts that you are carrying. In this black swan event, you'd like end up with a positive net liquidation overall if you deleveraged the short puts and sold all of the long puts. I may take some time to run some simulations if the market drops 20% and VIX goes to 150% with a ladder of options like this.
I ran this scenario and got nice results for the cost of the hedge. Buy long puts with 10% of credit each week. Buy long puts, 15% OTM 28 days to expiration. Market crashes 20% in single day, IV spikes to 150%. Assume market had been flat each week prior to insurance puts are same cost & strike. On a $1.1M portflio where there are 4-5x as many naked calls as naked puts, am able to buy about 2x long puts in a calendar ladder over 4 weeks vs. the # of short puts opened. If the market crashed 20% in a single day and you could get liquidity at these prices, then the position would be showing a $260K gain overall once the calls expired. At the moment in time, the overall position would have an $82K gain as the short calls would have $-180K cost to them, but those naked calls are 25% OTM with <7 days to expiration, i wouldn't be letting go of those. If you are trying to hedge against a black swan event like that to the downside, seems that spending 10% of your collected credit each week could pay off nicely with this sort of structured ladder. Close out all of the put positions immediately, ride the naked calls to expiration and have a 1 week gain of nearly 25%.
Yes, You’re getting the idea. I go 1:1 on my CALLs, but that’s because I choose to also do the same on the PUT side, which traditionally has not been a problem – but again, this is to protect against the unexpected so you never know. I wouldn’t naturally profit on a spike, unless I buy back the tested (or already ITM) short CALLs and ride further momentum and volatility upwards. The same would obviously apply going downwards, but they are both designed to give me flexibility once the move has already started, compared to having to react after the fact which would be very expensive in some form. Since you’re going one side only, you can have >1:1 ratio which could potentially give you a profitable move depending on its strength and volatility effects. I would treat your account as trading two core positions – the primary, trading short weekly latter’s, and the secondly, looking to profit on market dislocations (aka black swans). Important Note: Creating such a position under SPAN (and most likely PM) would allow you to really leverage up for the shorts – don’t – model the short latter’s first, base it on that margin, then apply the longs after. I’ve seen traders buy units, only to sell more shorts, then sometimes buy even more units and so on. It ends badly.
I think a combination of all above methods could work. The hedging comes into play when you have a position that's going against you and looks like it's going to continue going against you. Rather than rolling options and all that, just cover your delta with the underlying and try to balance transaction costs against rehedging frequency while hopefully not getting caught up in a back and forth volatility storm. The futures come into play because their margin is cheap and leverage is high - allowing you to more efficiently hedge deltas without having to lay out a ton of capital on SPY or similar. Also, using futures keeps you "1256 contract clean" just as trading SPX options does (SPX opts are considered broad based index options). The popular ETFs which track indexes (SPY, QQQ, IWM, etc) are not 1256 safe for tax purposes (atleast for options, not sure about the outrights).
Obviously you need to start hedging your positions more, you're just putting far too much at risk. It's like other people have said, you can do what you're doing likely for years without it being a problem and make a nice tidy profit doing it, but the day will come when the unexpected really hurts you. It's like in Terminator... You're dead already, it just hasn't happened yet. So you need to hedge. The issue with hedging is to get the most bang for your buck right? People have floated some good ideas already, futures, VIX options, volatility products like VXX for short term, etc. If I could I'd like to give you another one for you to explore on your own. VXUP and VXDN are new ETF's. Rocky start, and are still kind of a mess with very few data points, but they are interesting. You may want to start looking into them, and if it makes sense within your current trading strategy, possibly holding and adding to a position week after week.
NPTrader, there is a message group on Yahoo groups ( supertraderkarenstudy) that has been testing Karen's strategy for 2 years now, you might want to subscribe to them....
+1 to this idea. Always try to have extra units on the downside. If you have portfolio margin it can do wonders for margin control too. If you don't like paying for them, try backspreads. Another consideration is to spend some of the credit you earned on debit spreads in front of your shorts. Besides testing your model based on one day drops you also need to test it against large sustained moves. This might open your eyes to some of the fundamental flaws with rolling down and out. This hasn't been an issue for the past 6-7 years, the market has always come back. But I think what you will find is that the IV in your short options you have to buy back will have exploded compared to the longer dated months you are trying to roll in to. In a panic, everyone is buying what you already sold driving your buy back cost through the roof. The best hedge/adjustment is to position yourself so that you can ride out the storm knowing what your max loss is no matter what happens in the market.