Hello Margaret,
Sounds like we’re on the same page for a lot of options approaches you’ve covered.
I certainly agree you really need to consider how far OTM to go. The usual rule of thumb I use is to set a target time you expect a movement to happen, and add to it (say 14 days or more), and buy with enough time to ensure there is still at least 30 days to expiry past the most conservative/worst case time projection, this way you can avoid a lot of theta decay. This has to be balanced though with the raw exposure to strong adverse movements, and spread risk exiting when the market makers hit you exiting on weakness/stop.
You are quite right about the delta reducing as an OTM option moves further out of the money. This is an advantage and helps to reduce risk, although the spread in lower volume traded options is the real danger.
Interestingly, I think that you can actually do quite well on longer dated trades in a strongly trending market. My shorter term trades are either counter trend plays, or playing blow off moves after a confirmed breakout – but this is highly T/A oriented.
The counter trend plays I have executed are quite risky - like buying puts against a strong bull market. I’ve done a lot of these successfully taking advantage of the low IV for entry, and the IV rush on exit for fast moves down – you really have to take profits to work these effectively I have found (say half at key prices, exiting on strength), and gingerly winding them out since there is so much upside risk when adverse T/A indicates a good chance of a bullish resumption.
Bull Call spreads:
I have found these are pretty lame in most market conditions, and discarded using them a while ago. When I did these initially, so many times my T/A target would be reached, and like you, the IV would kick up in the sold position, either negating most of the profit, or sometimes resulting in a loss.
The core idea of the Bull Call spread (and Bear Put) is to limit risk through selling a higher strike, but I found you really had to watch the IV since the further OTM call often had a lower IV, which characteristically increased while ATM or more so ITM. They were really designed for mildly bullish markets to avoid theta decay and exposure.
I found that trading these in the US was suicide. I don’t know how many of these I tried (I think about 10 overall) unsuccessfully around 2003-4 for a variety of reasons – adverse IV skews (sold call appreciating more in IV than the bought one), unable to exit either on profit or on stop (since the exit order was often 5 cents short of transacting while I slept since my IV calculations were sometimes fractionally out, or the US market moved against me so violently even the spread couldn’t reduce the loss).
I remember getting my T/A projections spot on with one bull call spread, but I never got to exit it for about 3 nights in a row, until I stayed up one night to force it to fill because of adverse skews, and my orders not filling. By this time I went from a potential 100%+ gain to a substantial loss.
I quickly learned that single option positions were much more effective, especially in strongly trending markets, and that uncapped profits from OTM single series positions greatly outperformed the capped/brokerage riddled Bull Call/Bear Put spreads.
Key disadvantages/dangers are:
• Brokerage: 4 legs – 2 to open, 2 to close
• Adverse IV skews against your position
• Difficulty winding out the position
• Capped profits
• Unfavourable theta decay
Bull Put spreads and Bear Call spreads:
I found that Bull Put spreads and Bear Call spreads are generally much more effective than Bull call/bear put spreads because you only need the market to go sideways or mildly in your favoured direction to make reasonable profits. If you’re lucky you can just let the spread expire worthless and avoid the 2 extra legs in brokerage when the sold strike is OTM at expiry.
Also, you tend to be selling better IV returns ATM or slightly ITM to the OTM bought position on average. For example, theoretically the idea is to aim for a 1:1 Ratio for maximum risk to maximum reward. You can sometimes get 30-40 cents premium for a 50 cent spread if you’re lucky in the day when volatile movements are occurring in the Australian market, and it skews in your favour, leaving only 10-20 cent exposure for the maximum risk.
Theta decay usually works in your favour, especially with ATM/slightly ITM strikes sold with around 25-40 days time value (aiming for 30) – the theta decay over 14 days is usually profitable if you have to wind out the spread on technicals, and if you can hold for longer, the last few days to expiry are vicious on the sold position’s value. I think this is a huge advantage over Bull Call spreads, especially in a higher volatility environment.
But, just like any of these kind of positions, they need to be managed, and wound out either in profit or at a protective stop – I don’t agree you just set them and forget them (although if your T/A’s any good you can sort of do this when there are good moves in your favour in your timeframe).
Key advantages are:
• IV skews tend to be in your favour
• Capped loss
• Favourable theta decay
• Sideways/ favourable movement usually ends up profitable
• Can sometimes let the spread expire worthless for maximum reward
Diagonal Spreads:
These are fun. You are right Margaret, these are combinations of calendar spreads with bear call/bull put elements, but the idea is you want to buy an OTM position, and finance it on the way up/down (usually up since downward moves are usually faster if strong).
The idea is to sell closer to the money for the current/front month if you’re very confident it will expire worthless on a mildly trending underlying. Sell at the same strike if there is some risk of the sold strike expiring ITM. Sell away from the bought strike (if there’s sufficient premium – often not worth doing) when there is a real risk of a move too fast putting the sold position well in ITM at expiry.
The use of ratios gets a bit complex, but you can use ratios of 2:1, 3:2, 5:3 for instance. This could be 5 bought and 3 sold for instance, or the other way around (but quite risky since there is an unlimited risk component involved – but usually good premium if you set it up right), with sold positions in the current month, at the same strike, close to the money, or further away – whatever corresponds to your T/A target, and your skew/hedging objective. These can be morphed too by buying back positions, or selling, or both… this is a whole area of finesse though, and needs more than this cursory description.
The diagonals that work the best tend to be in a mildly trending market, and when there is sufficient premium to sell with 30 days time left, usually not too far from the money, but not too close to it. If worried by the prospect of ITM expiry, you could consider making the position a ratio back spread by selling less contracts than the bought position, but the rules I’ve developed for this are quite involved, and very dependent on my T/A projections.
Fully agree that this is the time to be selective right now – a very volatile and hard to read market – for the shorter term. As for butterflies, I’ve never done one, considered it, and modelled it for other people, but just don’t like the high brokerage, and the limited reward, especially when there’s better pickings to be had, but may use these in a sideways market if it eventuates.
Wow, that’s a lot of page space above, and I still haven’t covered half of what I set out to say… But I’m happy to go into more detail at some point in the future, but I hope this illustrates some of the points you were looking for me to cover.
Regards
Magdoran
Terms:
OTM = Out of the Money
ATM = At the Money
ITM = In the Money
ROI = Return on Investment
T/A Technical Analysis
Skew – where the volatility level/effect is different between different strikes in time or price, or both – where the natural readjustment of this can be advantageous or disadvantageous.