Short strike indicator

[wayneL]

Been meaning to do this for a while and conversation in another thread has prompted me to put this together.

The general dogma when selling OTM options is to sell them 1 standard deviation of volatility from the current price.

I agree with this, subject to a bit of technical analysis. I will sell puts (and/or spread) when I think a down wave or retracement has concluded, subject to the trend. Visa-versa for calls.

Therefore, what better way to include the short strike selection criteria in analysis, than with an indicator that plots the levels of 1 standard deviation of volatility, above and below the current price on the chart, both in terms of historical and implied volatility?

e.g. Looking at Alcoa (NYSE:AA), the 30 day statistical volatility is 41% , but the implied volatility on April options are around 52% with no earnings announcements due within the time frame, and 24 trading days to go. Not bad option writing conditions.

Now the idea of analysis when writing options is to determine where the price is NOT going to go, rather than where it is going to go. Enter the chart with indicator applied:

The inputs are the number of trading days remaining and the annualized implied volatility (the number your platform shows).

What we have is one standard deviation of volatility, relevant to the time period involved. Pink is statistical vol and yellow is IV.

This analysis is suggesting that if writing calls in the april series, we're looking at the 42.50 strike and if writing puts, 30.00 or 32.50 strikes (or both if doing condors).

Next step is to add your own technical analysis to see if these are reasonably safe strike to write, and place a trade or not.

The amibroker formula I've come up with is:

x = Param("Enter Trading Days Left",20,1,100,1);
y = (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
osda = C + (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
osdb = C - (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
z = Param("Enter Implied Volatility",35,1,200,1);
oiva = C + (z/100 * sqrt(x/256))*C;
oivb = C - (z/100 * sqrt(x/256))*C;

Plot(LastValue(osda),"1SVabove",colorCustom12,styleDashed);
Plot(LastValue(osdb),"1SVbelow",colorCustom12,styleDashed);
Plot(LastValue(oiva),"1IVabove",colorYellow,styleDashed);
Plot(LastValue(oivb),"1IVbelow",colorYellow,styleDashed);

(add your own elegance)

Disclaimer: Writing options can give you herpes, liver damage and warts on your nose, and you might lose money blah blah blah.

Cheers

 

[VolTracker]

Hi Wayne,
Thanks for the example, I can see the logic of being aware of significant technical levels.

For the sake of my liver, is it worthwhile overlaying some prices and probabilities on this:

Assuming for this example that you sell an AA condor made up of the 32.5/30 put & 42.5/45 call credit spread (credit $0.55c, risking $1.95).

Using a probability calculator and entering hist vol (41%) as the volatility forecast you have a 80% chance of making the maximum of $0.55 (AA being between 32.5 and 42.5 at April expiry). 84.5% chance of doing better than breakeven. 5.3% chance of maximum loss of $1.95 etc.

If you multiply them out you get an expected return of around $0.24 on risk of $1.95, or an expectancy of 12%. This looks like a good return but I would play around with higher vol forecasts to get more comfortable. Also assumes normal distribution of returns with no fat tails (ie non-conservative approach).

 

[wayneL]

Thanks Vol,

There is nothing worse than a herpes infection as a result of an option position. As a rule, I don't plonk condors on stocks exactly because distributions are not normal... too much chance of a fat tail whipping out on you.

I'll write one side and if all goes well, that's it. I'll only write the other side as a defence and or precurser to a possible flip or whatever seems appropriate at the time... even a stop out.

I know many who just write and sit. Not this little black duck. If my t/a fails it's a case of "not so fast jack, yer ain't gittin' ma money"... or managing the beast - option metamorphosis as Cottle more elegantly puts it.

As always, use with head screwed on.

 

[chops_a_must]

x = Param("Enter Trading Days Left",20,1,100,1);
y = (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
osda = C + (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
osdb = C - (StDev(log(C/Ref(C,-1)),30)*sqrt(x))*C;
z = Param("Enter Implied Volatility",35,1,200,1);
oiva = C + (z/100 * sqrt(x/256))*C;
oivb = C - (z/100 * sqrt(x/256))*C;

Plot(LastValue(osda),"1SVabove",colorCustom12,styleDashed);
Plot(LastValue(osdb),"1SVbelow",colorCustom12,styleDashed);
Plot(LastValue(oiva),"1IVabove",colorYellow,styleDashed);
Plot(LastValue(oivb),"1IVbelow",colorYellow,styleDashed);

I love you more than Spitzer loves *****s.

:remybussi