Shorting Index Futures Options

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A complete trading system is described comprising methods of shorting options on various underlying instruments including the S&P 500 futures, e-minis, ETFs and cash indexes. Entry, exit, …

A complete trading system is described comprising methods of shorting options on various underlying instruments including the S&P 500 futures, e-minis, ETFs and cash indexes. Entry, exit, position sizing, risk management and adjustments are addressed.

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  • 1. Atlanta Technical Analysts Society Re-Visiting “ Profits & Probabilities Shorting Futures Options©“ (One Year Later) In Volatile Markets Eric Hartford american_eric@hotmail.com 2 July 2008 Disclaimer – The markets are an expensive place to learn. Don’t even think about trading with money that you cannot afford to lose; in fact, kiss off your entire trading account before your first trade- it’s gone! What were you thinking? All trading systems involve losses. Past performance means nothing. Don’t believe anything you can’t prove. Eric Hartford is not a registered security representative nor financial advisor, bears no responsibility for you or your actions, has obvious trust issues, and laughs at; efficient market theory, bipartisan commissions, soft landings, mutual funds, dollar cost averaging, self- regulation, the SEC, buy and hold, corporate integrity, BLS statistics, CPI calculation, petroleum reserve estimates, re-stated earnings, & the Laffer Curve. Of course, the market is rigged against you, but you can’t win if you don’t try.
  • 2. Last Year • A Complete Trading System – Short Index Futures Options – Scalable • Rules – Position Sizing, Heuristics • Entry – 4 ways to figure Probability • S&P 500 Digression – 3 charting packages • Expectancy - Profitability • Exit – 8 ways out of credit spread stress Creative Destruction Company All Rights Reserved 2
  • 3. System Elements • Underlying • Pit traded Options on S&P 500 Futures - – Favorable margin (SPAN) – Favorable taxation 60:40 Long Term Short Term Cap Gains – Favorable liquidity at strikes far out-of-the- money • Trade Duration – 5 – 10 Weeks before expiration • Position Sizing – 1 short strangle/condor per $5K margin – 10% Value at risk requires exit at twice premium collected, per side • Entry – Premium writing, short strangles, iron condor • Exits – 8 techniques for positions under pressure Creative Destruction Company All Rights Reserved 3
  • 4. Strangling the S&P 500 • Write premium on 20-pt credit spreads – Both puts and calls, – Legging in – better fills, higher risk of no fill • Short OTM option strikes – Probability < ~ 10% finishing ITM – Probability < ~ 20% contacting – Minimum range based on volatility, duration • 45% minimum annualized return initially Creative Destruction Company All Rights Reserved 4
  • 5. Trade Vehicles vs. Leverage • SPY (I Share) 1 S&P 500 pt approx = $0.10 • $SPX (CBOE Index) 1 S&P 500 pt = $1.00 • ES-U07 (e-mini) 1 S&P 500 Future pt = $50.00 • SP07 (CME Full) 1 S&P 500 Future pt = $250.00 • EV07 (End of Month) S&P 500 Fut pt = $250.00 & • OPTIONS on all of above Creative Destruction Company All Rights Reserved 5
  • 6. Range vs. Duration & Volatility Time to Expiration ~ weeks VIX 5 6 7 8 9 10 NT 150 160 170 180 190 10 145 155 165 175 185 195 12 180 190 200 210 220 NT 14 210 210 220 225 NT NT 16 Wait for reversal before selling puts >18 Creative Destruction Company All Rights Reserved 6
  • 7. Other Considerations • Frequency – Rate trading opportunities occur is generally 1 per day – Conditions change, but generally can initiate 60% annualized return trade when VIX is over 14.5 • Reliability – Only matters wrt Expectancy & to Trader’s personality, goals – As you’ll see in Expectancy, generally 83% of trades win • Costs – Commission/fee is $16.65 round turn on full CME S&P 500 – Psyche tested often, Bid/Ask widens from 0.20 pts to 2.00 pts – Opportunity – entry during low volatility foregoes better returns later Creative Destruction Company All Rights Reserved 7
  • 8. Heuristics ~ Rules of Thumb • 5 pt move in the S&P futures fills at net settlement in the direction of the move • Collect >one point on put & call spreads – Puts typically 4 pts short, 3 pts long – Calls typically 2 pts short, 1 pt long – 8.7% initial net on maximum exposure – 90% initial annualized for 35 days, 45% at 70 days • Enter trades in multiples of 2, 3, 4, 6 • Generally 12 – 24 positions per expiration cycle Creative Destruction Company All Rights Reserved 8
  • 9. Probability Finishing ITM vs. “Touching” before expiry • Standard Deviation – I use 1.6 std dev – IV ATM Call x underlying x sq rt DTE/365 – (ATM Put + ATM Call) x 1.25 • Log Normal – see formula on handout • Delta is + or – 3% approximation for: Volatility< 50 Time to expiration < 70 days • Monte Carlo Simulation Creative Destruction Company All Rights Reserved 9
  • 10. Option Greeks – Futuresource.com Option Call Strike Delta Gamma Theta Vega Last SPQ07 0.359 0.006 32 181 15.40 1550 0.291 0.006 28 166 10.80 1560 0.247 0.005 26 153 9.00 1570 0.184 0.005 21 129 5.80 1580 0.143 0.004 18 109 4.20 1590 0.097 0.003 13 83 2.50 1600 0.068 0.002 10 63 1.60 1610 0.046 0.002 7 47 1.00 1620 0.030 0.001 5 33 0.60 1630 0.016 0.001 3 20 0.30 1640 0.013 0.001 2 17 0.25 1650 0.008 0 2 11 0.15 1660 0.010 0 2 13 0.20 1670 Creative Destruction Company All Rights Reserved 10
  • 11. McMillan Monte Carlo Simulator Probabilities Historical Volatility: 13.07 JULY (10) AUGUST (38) SEPT (72) CALLS 1670 3 11 1660 4 13 1650 6 15 1640 1 7 18 1630 1 9 22 1620 1 12 25 1610 1 16 31 1600 2 21 35 1590 4 26 41 1580 7 33 47 1570 12 41 53 1560 20 48 61 1555 25 54 64 Creative Destruction Company All Rights Reserved 11
  • 12. Other Entry Considerations • Support and Resistance • Fibonacci Levels • Andrews Pitchforks & Channels • Daily Pivot limits for order pricing • Degree & Duration of Trends • Average True Range, Rate of Change • 20-, 50-, 200-Day, Trend Support MAs • And now, a digression on the S&P w/charts… Creative Destruction Company All Rights Reserved 12
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  • 16. Expectancy Expectancy = %wins x avg. win – %losers x avg. loss Actual results $262 = 0.83 x $464 – 0.17 x $723 • Theoretical Expectancy – For credit spread systems Probabilityw (Credit) – ProbabilityL (Loss Limit) • Theory is not Fact – Market distributions have fat tails • Summation of 300+ trades over the last 24 months • POSITIVE EXPECTANCY DEFINES A WINNING SYSTEM ! Creative Destruction Company All Rights Reserved 16
  • 17. Profit • Nearly 800 trades • From Aug 03 – June 07 • Not using CAGR- uncompounded 2004 – 63% annualized returns 2005 – 61% annualized returns 2006 – 23% annualized returns • Expectancy based on rolling 24 month results - of 40.7% annualized returns Creative Destruction Company All Rights Reserved 17
  • 18. Exit Guidelines • Close position if; – Underlying crosses strike intraday – Delta exceeds 0.400 – McMillan probability exceeds 75% – Annualized return remaining < new position -Typically 85% target reached w/ > 20 DTE – Expiration • Strong Move right after entry = worst case Creative Destruction Company All Rights Reserved 18
  • 19. 8 Exits for Stressed Spreads 1) Do nothing 2) Exit to close 3) Roll away strikes same month 4) Roll out in time at same strike 5) Roll out and away 6) Jump in front with an options hedge 7) Jump in front with a futures hedge 8) Jump in front with synthetic futures Creative Destruction Company All Rights Reserved 19
  • 20. What has changed since then? • One year older ( wiser? ) • Existing Trends Extended – Suburban Housing continues to lose value – Energy Doubles – Demand exceeds Supply Q4 ‘07 – Wars continue – millions of lives ruined • $30 per capita/per month indefinitely • Congress approves $300M to “prepare the battle space” in Iran – Growing Debt (Personal, Corp, Govt) destroys Dollar and Banks – Banks Reluctant to lend. Rinse, Repeat… • Globalization continues • Jobs dwindle – everyone’s a contractor • Competition for Resources must price out demand • Per capita GDP shrinks Q4 ’07 and Q1 ‘08 • Market conditions … changed… Creative Destruction Company All Rights Reserved 20
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  • 24. USA - Housing Index Creative Destruction Company All Rights Reserved 24
  • 25. Oil • Supply Constant 3 year 86.6 MBD May 2005 86.7 MBD Jan 2008 •USA uses ~21 MBD •Inventories declined 19.1MBD over 4 weeks below Aug ’05 levels • Price out 5% USA Demand? Creative Destruction Company All Rights Reserved 25
  • 26. USA Finance – Pre-Collapse or Pre-TakeOff ? Creative Destruction Company All Rights Reserved 26
  • 27. US Dollar Index Creative Destruction Company All Rights Reserved 27
  • 28. So, what did I do about all this? • Read a couple books by Taleb – Fooled by Randomness – The Black Swan • Coin Flip • Returns – not normal, the past is no guide, luck matters • Absence of Proof is not Proof of Absence • Fat Tails & 100 year floods and Marginal Effects • Narratives • Quit trying to pick up all the nickels in front of the steamroller, at least not all… Creative Destruction Company All Rights Reserved 28
  • 29. What I did about what I learned • Expanded the volatility/duration – Traded Volatilities up to 24 on VIX • Traded shorter durations – Used new instrument – EoM Options • Traded directionally – Coin flip correlation • Traded Broken Wing Condors – Unbalanced, Long option NTM option – Profit probability at exit before expiry Creative Destruction Company All Rights Reserved 29
  • 30. Constructing Condors Creative Destruction Company All Rights Reserved 30
  • 31. Results • Got hammered last August – Spent on long positions – Went to bed deep ITM – Fed intervention cost me 40 pts • (@ $250 per) • Closed out Jan put positions at a loss - Got worse even faster than my bearish view - Rolling 12 month returns ~ 12 % - Now buy options, new issues - Timing, Profit Targets, Reward:Risk Creative Destruction Company All Rights Reserved 31
  • 32. THANKS ! Any Questions ? Creative Destruction Company All Rights Reserved 32