Analyzing an Index Option Write

Because I'm bored, I thought I'd go through a way to choose an option write on the SP 500 via SPY(AMEX)

As the december expiry is upon us, I am looking for a new option write.

With Xmas and everything, there are less than 20 trading days till the Jan expiry, so that is the analysis period.

In the last 20 days, the index has risen 12% from a major low.

Since 1990 the index has only ever exceeded a 12% move up in 20 trading days rise on 5 occasions. On each occasion it has been from a major low, never from a high or intermediate move.

Since 1980 the index has only ever exceeded a 12% move up in 20 days, anytime ending in January, once. That was in 1988 after the crash of Oct 1987.

Since 1990 there has never been a 12% move up in 20 trading days, after the index has already moved up 12% or more in the preceeding 20 trading days.

Implied volatility at OTM call strikes is 35%, but that is artificially low because of the days missed due to xmas, new year etc.

SPY is currently trading at $91.10

Based on IV, 1 standard deviation higher takes us to ~$100

12% higher takes us to the ~$101 strike.

We can get $60 per contract in premium at the $101 strike

That is a return of > 4% on margin for a naked call write for the month if it expires worthless. (~50% annualized).

Worth it?

I think so... as part of a portfolio of writes and with a defense plan, definitely. I believe that the probability of this trade is much higher that the statistical and implied volatility numbers suggest, given the raw numbers above, perhaps 95%.

Cheers

wayneL said:

Worth it?

I think so... as part of a portfolio of writes and with a defense plan, definitely. I believe that the probability of this trade is much higher that the statistical and implied volatility numbers suggest, given the raw numbers above, perhaps 95%.

Cheers

Click to expand...

However:

Murphy's Law
Section 36, Subsection(c), paragraph(2)

Any trade posted publicly on a forum must fail. Furthermore, it shall be the only losing trade on the trader's books, and all other unposted trades on the trader's books shall be deliriously successful. Only the posted trade must fail. This law is absolute and no exceptions are allowed.

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wayneL said:

... as part of a portfolio of writes and with a defense plan, definitely....

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Interesting Wayne! In addition to the probability analysis you have already done on this, IMHO the defense plan would be essential to successful management should Mr Murphy stick his nose in How would you go about defending a position like this?

eg. do you have a stop loss - or just roll up and out until the market eventually reverses - buy the underlying, etc, etc ??? If you don't want to go into details, just a general idea would be great.

Hopefully you've had your turn with Murphy and he will leave you alone this time. However it turns out, it will be interesting to follow this trade.

Cheers

It makes sense to me mathmatically and I like the R/R, however in these times I don't like writing anything less than a month or so out, nemesis gamma has hurt me too many times & mr murphy seems to hold a grudge.

Like sails, Im interested to see the defense.

Some delta hedging perhaps...??
Overlaying other positions on top....???


Grinder, Short Gamma always strikes below the belt....
:run:

I know! Does'nt like to play nice.

Grinder said:

It makes sense to me mathmatically and I like the R/R, however in these times I don't like writing anything less than a month or so out, nemesis gamma has hurt me too many times & mr murphy seems to hold a grudge.

Like sails, Im interested to see the defense.

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Grinder,

Yep gamma can be like having a tiger by the tail near expiry and near the money... can be bloody uncomfortable... and difficult to defend without potentially locking in losses or reducing profit.

You can perform the same type of analysis for the February (or later) strikes. Of course you're not getting as much help from Sister Theta so to my mind it becomes a little bit more of a directional bet. But if you let it go to expiry, you still potentially have to face nemesis gamma.

In the end, with this trade, I don't believe there is a high probability of having to defend (but still laying out burnt offerings to the market Gods ).

sails said:

I How would you go about defending a position like this?

eg. do you have a stop loss - or just roll up and out until the market eventually reverses - buy the underlying, etc, etc ??? If you don't want to go into details, just a general idea would be great.

Hopefully you've had your turn with Murphy and he will leave you alone this time. However it turns out, it will be interesting to follow this trade.

Cheers

Click to expand...

mazzatelli1000 said:

Some delta hedging perhaps...??
Overlaying other positions on top....???

:run:

Click to expand...

OK let's look at where this position can hurt us. Essentially, it is the short delta running away with us if the strike is threatened, due to the high gamma.

Therefore, defense should revolve around taming, neutralizing or reversing delta, but without leaving the back door open for the market to tank and punch our eyebrows off.

Rolling up this close to expiry is to be avoided because you'll get screwed on premium and contest risk. I would prefer to stop out than do that, which is a perfectly valid defense in itself.

You could roll up and out as well, but I'd prefer to stand my ground and face off the enemy. I will typically defend well before the strike is ever threatened, because defending later, when gamma is trying to cut your liver out and eat it for lunch, is not fun.

So if the index breaks up from this little pennanty/flaggy/microconsolidation thingy it's in, in the near future, I'll start defending a little.

This could be done with a little bit of stock, just to add some deltas for a bit and re-evaluate as we go along. I wouldn't go too far with this or we'll end up too much like a short straddle... no thanks.

We can also do it with long calls at a strike lower than the sold strike. Buy the same number of calls and we've flipped the delta and we now have a bull call spread. The index can go up all it wants and we're safe, but opened up the door for a limited loss assault on the downside. We only want to do this if it looks like running away to the upside, because it messes up the who probabiltiy basis for entering the original trade.

But we can buy calls a bit at a time, creating a ratio spread. Each call we buy will push the break even point just a little bit further out, increase potential profit, but also start introducing risk to the downside. Half the number of bought calls makes a standard 2:1 ratio spread. But we don't ever have to stick to that ratio, we can do whatever we want depending what we think is going to happen.

That's my plan, but everything depends on when an upside move is put on and whether I think it's possible for an assault on my sold strike.

Defense is not without risk as a whippy move back down can hurt profit, or create a loss, or make us start trading like a freakin day trader on 'roids, and we have to be cognizant of that when putting defensive positions on.
The idea is to watch premium slowly sink beneath the waves while we sit on our @ss watching, laughing maniacally... then go and have a festive dinner with friends and family after the third friday of every month.

That's what we're trying to achieve with these trades.

Hi Wayne,

Your first post has added another piece to the puzzle.

I just wanted to confirm that you converted IV to monthly IV by dividing 35 by the square root of 12, and if you wanted to calculate 3 months would you divide 35 by the square root of 4? Or is that of the mark.

cutz said:

Hi Wayne,

Your first post has added another piece to the puzzle.

I just wanted to confirm that you converted IV to monthly IV by dividing 35 by the square root of 12, and if you wanted to calculate 3 months would you divide 35 by the square root of 4? Or is that of the mark.

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I work out the number of trading days till expiry and use this formula:

(IV/100 * sqrt(Trading Days/252))*C

Just thought I'd add that the defensive call buys mentioned above, need not be the same expiry as the sold position. You can go out a strike or two to reduce the short theta (but also reduces gamma and increases vega).

Thanks for the detailed post on your defense strategy, Wayne.

Interesting that you wouldn't roll up and out - and yet that is what I was taught to do as the first step in defence by a seminar/broker team! Interesting to see other ideas - thanks

Looks like the trade is doing OK at this point in time - hope it continues to behave!

sails said:

Thanks for the detailed post on your defense strategy, Wayne.

Interesting that you wouldn't roll up and out - and yet that is what I was taught to do as the first step in defence by a seminar/broker team! Interesting to see other ideas - thanks

Looks like the trade is doing OK at this point in time - hope it continues to behave!

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I have heard of this defence before from Dan Sheridan
BUT Wayne explains it much better!!! but with less jokes

So is rolling up and out an acceptable form of defense? its probably what i'll be inclined to do, although reluctantly because of the additional month added to the position.


Thanks for the IV conversion tip Wayne.

mazzatelli1000 said:

I have heard of this defence before from Dan Sheridan
BUT Wayne explains it much better!!! but with less jokes

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Yeah, at least Wayne's theory is in nutshell form - Dan could take at least an hour and a half to give out the same information I haven't done Dan's courses, but have heard him on TOS a couple of times. Have you done his mentoring course? I've heard he's pretty good if you can put up with the drawn out sessions!

sails said:

Yeah, at least Wayne's theory is in nutshell form - Dan could take at least an hour and a half to give out the same information I haven't done Dan's courses, but have heard him on TOS a couple of times. Have you done his mentoring course? I've heard he's pretty good if you can put up with the drawn out sessions!

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Hahaha, agreed!!! I have listened to alot of Dan's free webinars on CBOE and most of it repeats the same thing over and over and over again. But in amongst them there were some great tips I picked up!!!

Sails, I did contemplate doing his course or Cottles course, but both were pretty heavy on the pocket - Dans being 7k and Cottles being much much more - he charges by the hour I believe.

So sorry I can't comment on how good his course is, but I have heard from traders over at Elitetrader forum (back in the day when I hung out there) that he is very one-on-one, hands on and runs through lots of live trades.

There was a forumite over at Elitetrader "theoptionccoach" who knew Cottle personally, who provided free mentoring to some newbies. I jumped on that offer for a while - was very good!!!

cutz said:

So is rolling up and out an acceptable form of defense? its probably what i'll be inclined to do, although reluctantly because of the additional month added to the position.


Thanks for the IV conversion tip Wayne.

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Well, yes if you don't believe the market will reach your strike

mazzatelli1000 said:

Hahaha, agreed!!! I have listened to alot of Dan's free webinars on CBOE and most of it repeats the same thing over and over and over again. But in amongst them there were some great tips I picked up!!!

Sails, I did contemplate doing his course or Cottles course, but both were pretty heavy on the pocket - Dans being 7k and Cottles being much much more - he charges by the hour I believe.

So sorry I can't comment on how good his course is, but I have heard from traders over at Elitetrader forum (back in the day when I hung out there) that he is very one-on-one, hands on and runs through lots of live trades.

There was a forumite over at Elitetrader "theoptionccoach" who knew Cottle personally, who provided free mentoring to some newbies. I jumped on that offer for a while - was very good!!!

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Yes, have read many of OCs posts, not only at ET but also at optionetics where he posted as "spudbarge". He had a huge thread at ET on Iron Condors on the SPX (by memory now). Didn't pick up on his offer for free mentoring - might have been a time when I had other things and wasn't keeping up with the posts because I probably would have gone for it! I did buy his book though.

I must admit that beyond the utter basics (that's being generous actually) I have no clue about options. Which has prompted me to go back and start your options course...thankfully it's all still there, gotta love the Internet.

Looking forward to trying to follow along on this one.

like the thinking.. maybe later months though. Probs go with picking up some extra calls along the way as IV has come of it's recent highs. Not a fan of up & out late in the game, would prefer somekind of ratio that creates a slingshot or even an IC where I could then defend along way out, taking smaller incremental profits as I go & close out before gamma starts to take effect.