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Writing Calls Against LEAPS. Vega Risk

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Hi Mark,

OK I did my homework on the following scenario and I am
confused.

My original idea was to buy
LEAPS VLO Jan 15 @ 4.35 and short Sept 18 Call at .40. You said:
"The volatility is more than a consideration. This trade is very vega
sensitive and I believe that if you make this play repeatedly, your
results will be based on IV."

I compared the HV [MDW: Historical volatility] and IV and they are relatively close at this point. [MDW:That tells you that IV may be at a reasonable level, but does not describe potential risk.]

I ran the numbers with IV decreasing and it does affect LEAPS pricing.  However, doesn't that imply the stock price is more
stable because IV typically decreases on rallies?  [MDW: Not always.  IV does rise and fall for reasons other than how the market has been recently trading.  And IV for a single stock can easily get separated from 'market IV']

I went to the CBOE site and ran the numbers, but my more important question is
this: I purchased the 15 strike LEAPS.  Let's
go worse case to the upside and assume company is a takeover target @30.00, with the deal closing before my short options (Sep 18C) expire.

This is how I am viewing the trade:
My long 15 call is worth 15+ any time value. [MDW: There will be zero time value if the takeover is for cash]
My short 18s  cost 12 and the loss is $11.60.
Although not profitable at this time [MDW: 'at this time'?  There is no other time.  You will shortly have cash and no investment], my net cost for the investment is 3.95 (4.35 – 0.40)…

My cost at
this point is 3.40 (15-11.60) exposing me to a .55c loss  [MDW: This is not an accurate calculation.  Your cost remains $3.95, per the previous paragraph,  The position is now worth $3.00. That's a 0.95 loss]

[MDW:Please let me know what part of the trade I am missing.

Don, You are missing the fact that a 95-cent loss on a $3.95 investment is a very bad result.  A 24% loss is significant.

You used a single, low-priced stock, trading with a 33 IV and want to discover generic rules that apply to all situations.  You see the dollars lost as a number, and not as a percentage of the investment.  That's not reasonable.  Try this with AAPL and consider the results.

As we know there
is no reward without risk but I see the two risks: 1.
Stock sinks;  2. Dramatic upside
move.
I am interested in hearing your thoughts. 

Yes, those are two of the risks.  Add another: an IV decline not related to a rally.

b) "Do you understand that by the time the stock hits 19, you are short
delta and continue to lose money on a continued rally?"

I don't get this
part and I am really trying to understand.  [The delta of your short option becomes higher than the delta of your long option.  Hence, you are net short delta and lose money on a price increase]


c) Look at the stock trading at 20. Drop IV by 25%. How does the trade
look now? How about 21 on the stock and IV down 50%?
I have not made any of these calculations. That's your assignment.  When
trading LEAPS, you want to know, not guess, what happens in a bunch of
'what if' scenarios.


OK, I did this hundreds of ways so that other readers and you can pick
apart my thinking:
I used 40% IV and then reduced it to 20% for VLO. 
I set up the trades as mentioned above.  [MDW: Don, The assignment was to help you decide if you really like this type of trade. My looking at the numbers does not help you develop a plan.

Is the risk/reward reasonable?  Can you make a wild stab at the potential reward?  What if IV declines and you must sell options @ 20 cents instead of 40 cents?]

[Don goes on to offer data, if you care to see the details, click here]


Thanks for reviewing this.  Hope I set it up in a way that makes sense.

Don

Yes, it makes sense.  But the data is for you to review

The bottom line remains.  When you own LEAPS, a plan such as yours is not unique.  Many try this plan, and everyone who adopts it owns the LEAPS for a long time.  The price of that option is very susceptible to changes in IV because these options are rich in vega. 

The other factor that followers of this strategy ignore, is the possibility that the monthly income stream can be cut in half or worse, when IV drops or the stock price declines.

This strategy can prosper.  But it has more risk than you see. 

760

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Loving Positive Theta and Trading Calendar Spreads II

Part I

Follow-up: I did not mean to sound naive when I said that I don't care about short term movements.  I
tend to take a macro view of my positions.  I trade options just on
index options or index ETFs and I filter out the daily "noise."  I let the market ebb and flow and don't make too many
adjustments.

If the number of adjustments is sometimes > zero, then you are in the game.

I am conservative with the # of contracts so that a big market
swing is not going to cause much damage to the overall account.

Good. Position size is the #1 step when managing risk

In response to your comments about what would I do if the market
increases and my long put loses value: I would roll up my short position
to create a bull spread, presumably collecting enough premium to offset
the decline in the long position.

If I understand your plan correctly, the newly opened short put has a higher strike than your long put (hence you are now short a put spread). 
Roll too far and you suddenly have nightmarish downside risk.  Do you
really want (for example) to own a Dec 800 put against a Nov 850 put? 
How is that a calendar spread?

Be careful when adjusting. Do not own a new
position when that position has far more risk than you prefer.  It's
better to exit, take the loss, and begin again.

I would not allow my short position to get too far ahead of my long position so that the position became too risky.

OK. 
That's the goal.  Not so easy to do when you want to 'roll up' the put
to recover enough cash to cover the loss from your long LEAPS put.

 
I did a 6-year back test of this strategy from 2004 – 2009 following this basic criteria:

1) buy 2-3 year Put ATM or slightly ITM.

This is a HUGE vega play, and to me, dwarfs your theta play.

[Side comment:  IV
skyrocketed during 2008-9.  If you  already owned your long-term put
before the IV rise, you fared far better than if you had to buy the put
when IV was near 90.  Consider the effect of this on the back test
results]

2) sell 1 month ATM, allowing myself to roll up my short position each month so that I'm selling ATM. 

Problems:
This ignores how far ITM or OTM your long option is.  Thus, it ignores
all Greeks. This may be a viable play, but it is NOT trading calendar
spreads. In a calendar, strikes are identical.  You are trading a
variety of diagonal spreads.

3) If the market declined to the point that I couldn't get $1 or so
rollover for each short put, I would close both legs and
re-establish the spread using ATM prices.  This happened during the 2008
crash.

Closing
both legs and opening a new ATM position during the crash means you had
to buy LEAPS puts when IV was HIGH.  All time record high (excluding
Oct 1987).  How could you convince yourself (in the real world, not in a
back test) to pay such a gigantic price for LEAPS puts?  How can anyone
anticipate a profit knowing that IV is going to decrease?

How can you earn a profit buying ATM puts in
a volatile market?  The strike you own soon becomes far OTM, reducing
the value of the time spread.

4)  As the market increased, I would increase my short strike price
to be ATM but would not let my short position to get more than 20
strikes ahead of my long position.

Twenty
strikes?  20 SPY points is a 20% market move. Near the bottom it was > 20%.  

Please understand:  I find this far too
risky.  You may find it a great strategy, especially when you have back
tested it.  But know this:  This is not a calendar spread
This is not a theta play.  This is a play on vega. Plus, you are seldom
near delta neutral – and negative gamma continuously makes that worse. 

How can you own,
for example, a LEAPS 85 put and sell an ATM, front-month 100 put and
feel hedged?  You lose money on a big downside move and lose on a rally
with an IV crunch.

I must be missing something here.

This caps the risk.

The question becomes: Is that cap at an acceptable level, or is it too high? 

If the market increased substantially from my strikes, I would close both positions and re-establish.

Based on your comment, it seems to me that 'substantially' means more than 20 strikes.

Do
you recognize that selling ATM options gives you the maximum + theta that you
seek, but that it comes with maximum negative gamma?  This is not a conservative
play.


5)  I did one spread for every $2,500 of cash in the account,
thereby having enough cash on hand to handle adjustments and lower the
risk of the overall account.

I
see the possibility of losing half of that $2,500 overnight.  Obviously
that did not happen.  How big was the largest draw down?

This 6 year back test netted performance of approximately 25% per year.

Nice result. Do
you trust that period of time as being typical? 

Because I was satisfied with the back test, I started trading this
with real money in January of this year.  YTD, I am up almost 10%
compared to a down S&P 500.

Your benchmark is not the S&P.  Your trades have nothing whatsoever to do with market direction.

The important question for you: Is this return sufficient to justify the risk?  You may feel there is little risk, making this question easy to answer. Because nothing
terrible seems to have happened during very turbulent markets, the risk
may be less than I fear.

There is no reason to abandon a
successful strategy.  But be careful: Overconfidence can be a killer.

My
question remains:  Why are you making money?  It is truly from theta? 
Is it from vega?  Is it from lucky market moves?  Is it from making
skillful and timely adjustments?

This strategy is not a 'set it and forget it.'  Thus, it's important to know from whence come the profits.

 

Anyway, thanks again for your feedback.  I look forward to learning
more through your book which I just bought.

Thanks

752



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Loving Positive Theta and Trading Calendar Spreads

Another good set of questions

1)  I am a big fan of calendar spreads because I like the idea of selling time value.

I'm sure you are aware, but other strategies allow time value to be sold, including covered all writing and credit spreads.

The definition of a calendar spread includes the requirement that both options have the same strike price.

All other variables of option prices are unpredictable, but the
passage of time is something you can count on.  Most books
describe calendars using calls, with the long position expiring only a few months after the short position.

It seems to me that using puts is more
advantageous: I can get more
for an OTM put than I can for an OTM call, therefore I'm selling more
time value.

You are also pay more for the long puts. 

An important decision: – Calendars perform poorly when the market
moves far away from the strike.  Thus, choosing OTM calls vs. puts
should be partially concerned with getting the strike price right.

Also, I have been buying LEAPS as my long position.  I look at my long put position as a life insurance policy,

That is NOT realistic.  No one hedges a life
insurance policy by selling short term policies against the main
policy.  If the market makes a gigantic move through your strike price,
you no longer have any insurance.

and I want the cheapest per month premium I
can get.  For example, this Jan I bought a Dec 2012 SPY 115 put
for approximately $19.  The cost of this insurance is just
over $.50 / month.  If I bought a 6-month put, the cost per month
would have been substantially higher.

I understand your plan.  But what are you going to do with that $19 put when the market moves much higher, IV gets crushed, and the put has declined to $8?

Am I missing something here?

You are
ignoring gamma risk – i.e., the BIG move.  Obviously calendars do best
when the market does not make a giant move.  But the market must remain sufficiently volatile such that IV
(implied volatility) doesn't decline by enough to destroy the
value of your LEAPS or severely diminish the price of the short-term puts – the options you sell every month.

This idea is so dependent on IV that it is really a vega play and not a theta play.  At least, that's how I see it.

So far, this strategy has proven to work pretty well,

Over what period of time?

but I'd be interested in hearing your opinions on using Puts and also using LEAPS.

Puts
are okay – but please evaluate how much extra you must pay for the LEAPS puts to determine whether this idea is truly better than using calls.

LEAPS are
not for me – unless IV is very low.  Buying LEAPS options is a big play on
vega
and future IV.

Question: Are you playing calendar spreads to play theta (as you said), or vega?  How much vega risk are you willing to take?  Only you can answer.

 

2)  My understanding is that
the Greeks help you understand short term movement in your overall
position.  If you set up a position with an eye towards the profit/loss
graph at expiration, the Greeks will only help you understand how your
position will react short-term.   When I set up a position, I'm not too concerned with short term movement, but only focus on the ultimate profit/loss potential….so if that's the case are the Greeks less important? 

IMHO, this is a naive and dangerous question.  Fortunes are made and lost before expiration arrives.

The
Greeks serve one purpose.  They allow you to measure risk.  Then, the trader accepts that
risk or reduces it.

My philosophy is that a
trader must avoid the big hit.  If you ignore
everything that happens between today and expiration, how can you avoid
that occasional big loss?

What if the
market rallies and your $19 put loses value day after day.  At what
point to do stop that bleeding?  Never?

If you plan to hold positions through expiration, regardless of risk during the interim
(I shudder at the thought, but understand it's your decision) I
believe the strategy is doomed to failure because the most important factor in your future success is how well you manage risk.

Take the gambling aspect out of the equation.  I recommend considering position risk, defining your comfort zone, and trading accordingly.  That is risk management.

 

3)  Finally, another question about the Greeks:  I understand Delta, Theta and to a lesser extent, Vega. 

Nutshell version:  When IV increases by one point, option prices increase by their
vega.  The more vega you own, the better you do when IV increases.

But I have a lot of trouble wrapping my mind
around Gamma.  I know the definition that it measures the change in
Delta, but how does one use Gamma to structure a position? 

It measures the rate at which delta changes. If
you are selling gamma – and you are – you want to know how much money
you anticipate losing if the underlying moves X points.

Let's say you lose $1,000
on a two point move (delta ~ -500).  Then lose $1,200 on the next
two points (delta ~ -600) and $1,500 on the next two (delta ~ -750).  If the rate at which those
losses are accelerating is too high – if the risk is outside your zone – then you are short too much gamma. 
'Structure' your trade differently.

One way to do that is to
reduce position size.  Trade 10 or 20% fewer spreads. 

Or own some
protection (buy something useful (not father OTM than your short option)
that has + gamma, even though it is going to cost some of that precious
time decay).  Even a 1-lot pays dividends on a large move.

The point is to be aware of gamma, decide if it's too high, and adjust the trade accordingly.

I need to continue studying Gamma. 

When
replying to questions such as you raised, it's very helpful to have an
idea how long you have been using options.  I'm sure you can see that my
reply to a brand new option trader would not be the same when the
questioner has been trading for 5 years.  If you are a 5-year trader,
I's a bad idea to not know more about the Greeks.

If new to
options, I'd encourage you to spend some time in learning to understand what the Greeks
can do for you (even though it is only to measure risk; this is
important).

For example, Delta is easy to remember
because it's always positive for Calls, negative for Puts.  How Gamma
works is not as intuitive as the other Greeks.  I will continue my
reading on this area.

Gamma is the same for the
put and the call (same strike and expiry).  Gamma is always +.  If you
own the option, you get + gamma.  If you sell it, you accumulate negative
gamma.


Vega is always +.  All options increase in value when the
implied volatility rises.  Own an option, you have + vega.  Sell it,
negative vega.

Same with theta.  All options decay.  Options have negative theta.  Sell the option, and you have + theta.  Own it and it's negative.


Tomorrow, a follow-up conversation.  To be continued

751

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