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Premium Selling in Low IV Environments

I've received a few questions about selling option premium when IV is low.  This is one example:

Mark,

For approximately 1 month stocks have gone up without the volatility that we had become accustomed to in the fall.  At the same time the vix has gone down to approximately 16.

It pays to look at the multi-year picture to get a better feel for what can happen to implied volatility.  We are indeed below long-term averages at this level, but as recently as Jan 2007, VIX was 10.  The point is that we may look back at these IV levels and think of them as being relatively high. I have no idea which way IV will be trending in the coming months.

I usually sell option premium and with such low implied volatility on individual stocks, it has become very difficult to sell premium without being exposed to higher touching or expiring risk to get the same premium.

Those last four words describe the problem.  Whether you are trading credit spreads, iron condors, or even selling naked options, the decision on which options to trade MUST be based on something other than option premium.  Premium is one of the important consideations, but allowing that to be the one and only factor is a big mistake, in my opinion.

I urge you to think seriously about collecting the same premium when that involves taking greater risk.

When IV is low, it's low.  You must accept that fact and adapt your trading habits.  If you want approximately the same level of risk as your previous trading, then there is no alternative: you must accept a reduced premium.

Taking on more risk is always wrong – unless the extra reward more than compensates.  If you must take more risk, trade smaller size.  You are dealing with statistics. Unlikely events will occur at random times.  If you do not trade as if that fact were the gospel, then you must get rich quickly (and then retire from trading) because you have almost no chance of surviving over the longer term.

Positions that originate when already outside your comfort zone have too much probability of not working.  You may not like my answers, but I implore you: 'Please' do not take more risk just because the markets have not been volatile. 

This is a different market, and perhaps a different strategy should be used during these times.  Positive gamma can be added to your premium selling portfolio, but that would cost some cash, and your note tells me that spending money for any options is not something you are anxious to do.

In your webinar (at Trade King, on debit spreads) you discussed how the debit spread was very similar to the credit spread with a small advantage to the credit spread as you can do whatever you want with the cash.

In times of low volatility such as this holiday season how does it impact the strategies?  Selling credit spreads with such low volatility is very likely to result in problems with vega increasing faster than theta decay making it an unattractive strategy.  

More than similar, it's equivalent when the trades are initiated at equivalent prices, using the same strike prices and expiration dates.

You have drawn incorrect conclusions: It's not 'low volatility' that is 'very' likely to result in problems.  It's your personal need to collect the same premium.  You are increasing substantially the probability that those 'problems' will arise.  It is not mandatory to do that.

Remember that premiums are smaller for a good reason.  The market has not been volatile and thus, the expectation is that low volatility will continue. In fact, the market has been less volatile than predicted by VIX, and that's one reason VIX is still trending lower. 

You could be happy with a non-volatile market.  You could look at it as a less-risky situation.  Yes, it offers less profit potential per spread, but it also increases the probability of earning a profit.  What's so wrong with that?  You may prefer the higher risk/higher reward scenario, but that is not what this market is offering.  You have chosen the higher risk/SAME reward strategy.  Surely you must understand that this may work for you, but it is not wise and it fights those statistics mentioned earlier.

One reasonable solution is to alter your methods.  My solution to these 'IV is too low' situations may not suit you, but I try to own positions with less negative vega.  Thus, if I trade iron condors (I do), then I may add some OTM call and put spreads – just to add positive vega and gamma.  That reduces risk. But be sure to add positions that reduce risk, and do not add to it.

Or I may add diagonal or double diagonal spreads to an iron condor portfolio, making it more vega neutral.  You may decide to go long vega – if you expect that IV will increase quickly.  There are alternatives to your chosen methods.

More often I do not sell credit spreads but sell uncovered options further out of the money and this too is very unattractive with low volatility.

This is a strategy with higher risk.  I have nothing extra to say about this except that moving strikes nearer to the stock price is not the way to go. 

Another possibility for careful traders is to sit on the sidelines until finding something comfortable to trade.  You are not forced to trade right now.  As a compromise, trade one half as many contracts as you do now.

We must be prepared to modify our strategies when market conditions make those strategies less comfortable to use.  Flexibility – not increased risk – is the way to prosper.

Please explain your spread strategy preferences pro and con for very low volatility. 

This is more of a 'lesson' than a quesion, and I respond to questions such as this in the comments area (nor via e-mail.

Answer: I trade iron condors in smaller size – i.e., I trade fewer spreads and just accept that I'll try to make less money.  If you are successful, if you are making money, then it has to be okay to earn less when you feel risk is too high.   I also consider owning a portfolio that is far less vega negative.  I also consider buying insurance (naked strangle)

And please explain your spread strategy preferences pro and con for very high volatility.

Again, this reply required a book chapter, and I cannot go into detail here.

Answer: As an iron condor trader, or credit spread seller, I go farther OTM when IV is high.  I do not go after the higher premium.  I anticipate more volatility and move farther OTM to accept the same, or even less credit.  I like being farther OTM and will take 10% less premium to move another strike OTM.  I trade negative vega strategies and  recognize that some months afford larger profit opportunities than others.

For spreads one is always buying and selling volatility.  For deep in the money there is little impact for volatility as there is no time premium, but in most other circumstances one option is being sold and one is being bought and it seems to me that a change in volatility will have in general a similar impact on spreads of nearby strikes.

Similar, yes.  Nearby strikes and DITM strikes, yes.  But when selling OTM spreads, there is enough difference that the spread widens as IV increases.  This is more obvious with put spreads, where the skew curve plays a larger role.

There is no best answer to this situation and there is no set of rules to follow.  There is only good judgment and risk management. 

There is a lot of hit and miss when trading – it is not an exact science.  I suggest avoiding extra risk, even when that means trading less size.  I advise accepting smaller premiums, and maybe taking a trading break.  However, there are appropriate alternative strategies when you believe IV is moving higher. When it is low and you don't know where it is headed, it seems to me that vega neutral trading is the safest path. I know safety is not your current concern.  It's not too late to reconsider.

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If you are interested in writing an article for ExpiringMonthly:The Option Traders Journal, send an e-mail to me at: mark (at) expiringmonthly (dot) com with a proposal for an article.  This is not a contest and there is no guarantee any ideas will be accepted.  Nor is here a limit on how many may be accepted.  Any topic relating to options meets the initial conditions for acceptance. More detials available.  Just ask.

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Trade like a market maker?

Visit the new home page for Options for Rookies


Mark,

The problem with my spread order is that it is sent to the
market maker who supposedly provided the best price.

On the retail
front end, I can't see the market makers' quotes. Do you know how to
connect directly to liquidity (in a way that I can see MM's quotes)?

Another method I can think of is to come out with a good algorithm for
legging in. This is much complicated and I hope I would not need to go
this route. My opinion is, in order to get into more liquidity, I may
need to learn how to trade like a MM.

John

***


Hello John,

It's difficult to know where your orders are sent without asking your broker.  However, they are never sent to 'a market maker.'  The orders are send to an exchange, and that should be the one displaying the highest bid (or lowest offer).  Sadly that is not always true because some brokers accept bribes payment for order flow.

If you trade enough size, your broker will (gladly?) get a quote for your order.  When I was trading 100-lots of iron condors, I found that the people who provided those quotes were, to put it simply, out to cheat me.  In other words, when I tried to find liquidity, my broker (IB) could not have done me any worse than sending the quote request to the people they chose.

I no longer have access to such quotes (I trade much smaller size), nor would I seek them.  I know they are useless to me.  I blame IB for that (they asked the wrong 'liquidity suppliers' for quotes).

I look at the bid/ask spread for each leg of the iron condor as well as the bid/ask for at the iron condor itself. I then decide if I want to play.  If yes, I enter my order at a price I will accept.  If I don't get filled, so be it.

A few years ago, whenever I entered an order, the IB software showed (for 2-3 seconds only) a counter offer.  In other words, I had the ability to see the true market.  That allowed me to enter a low-ball bid to see the true offer.  That service is no longer available, and we are flying blind when entering orders.

I complained to IB that in reality, I am the market maker.  I am posting a bid (or offer) with no ability to see the true market.  "That's not fair" I tell them.  "Too bad" say they. 

So, I play market maker and hate it.  To  make matters worse, IB charges a fee to cancel an order and replace it with a better order.  Imagine – they charge me, the true market maker in this scenario, to make a better market.  It costs me cash to raise my bid or lower my offer.  It's an obscene system, but I don't see how I can do anything about it.  The overall cost to trade at IB remains untouchable for me.

If readers have suggestions or a work-around, please share.

IMPORTANT: 

1) You will not find a good algorithm for legging in.  In my opinion, there is no such thing.  You would have to know which way the market is moving to leg the first side of the trade.  And if you can get that part right, why would you 'waste' a good trade just to complete the iron condor?  Use that (impossible to build) algorithm to day trade and make millions.

2) You cannot trade like a market maker.  You are never aware of large orders that are being quoted.  You don't know anything about large spreads that are being shopped or sitting with the specialist.  Many times just knowing an order is there allows you to make a trade and then go get a piece of that large order.

You never get to buy on the current bid – and if you do, you will discover that it is no longer the bid and may even be the ask price when you are filled.

There may be books that explain how a market maker trades, but the MM's advantage is not available to you.

792


Em_1009 

September 2010 issue now available

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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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Contest: Suggest a Slogan that Promotes Options Trading

Encouraged by a recent blog post by Michael James (Michael James on Money), I've been looking for just the right term to describe a style of options trading that could receive positive attention from the media. However, the term must be original and not be used elsewhere.

The first term that occurred to me was SmartOptions.  Alas, it's already in use as the title of a newsletter published
by Big Trends. 
I don't have access to their track record, but the methodology used to
make option trades does pass my 'smart idea' test.  In fact I blogged
about the methodology they use (when buying options choose ITM).

I'm looking for a phrase that may make the use of options as a risk-reducing tool ('OptionHedge' is available) more attractive to the huge segment of the population that either ignores options or has a negative attitude towards option trading.  Many have no idea why they distrust options or why their feelings are negative.   I'd suggest that most of those impressions are based on media stories.  Over the past couple of years, all derivatives and derivative trading stories involved financial disasters, making bad press well deserved.

However, using options as we do at Options for Rookies bears no resemblance to the trades made with credit default swaps or other newly invented derivatives.  It does not make use of 40:1 leverage that makes a financial collapse far more likely than the use of a sane amount of margin.

I'd like to restore options good name, but it probably never had one.  Thus, my goal is to find a way to present options in a favorable light.  The primary goal is to attract new investors into the options arena.

Most of the older brokers do not encourage options trading , and one (Raymond James) forbids its customers from using options.  In recent years several new brokers opened for business, and each is dedicated to educating option traders.  Some have the word 'options' in the corporate name; others don't.  But the success of these brokers has not been enough to overcome the bad image that options still have among the trading public.

The few of us who play the no-hype game when writing about options attract a loyal readership.  But the huge majority of people who have money in the stock markets of the world are, and remain, options illiterate.

I'm hoping to make a dent into that situation.


The next phrase/name I considered was TradeSmart, but there is a 'university' and software using that name.

Then I thought that the whole negativity behind options trading is that too many people compare options trading with gambling.  By that I mean making a blind wager with no idea whether it's a good or poor bet. So I tried 'Safe Options.'  When I searched for that word pair, I discovered a web site by that name that recommends safe option strategies.  Sounds good.

When I took a look, and noted that the primary strategies are covered call writing and its synthetic equivalent, the sale of cash-secured puts, I was again discouraged.  I have nothing against these strategies.  In fact, I believe in using them as an educational tool for people who are first learning how options work.

And it's true that these methods are safer than owning stock (buy and hold).  But, 'safer' is  not 'safe.'  These strategies provide plenty of risk when markets fall.

Even eHow.com got into the act.  This site that tells visitors how to 'build just about anything,' had an article on 'safe options.'  Once again it discusses covered call writing.

I admit that my first book was subtitled A Conservative Strategy for the Buy and Hold Investor, and it is about writing covered calls.  But I never called the strategy 'safe.'  It is what it is, and it is safer, or more conservative than buy and hold.  It increases the chances of having a profitable trade and cuts the frequency and size of losses.  But the risk of a large-loss is always present, and I would not want to get my investment advice from anyone who considers covered call writing to represent a 'safe' way to invest.

So here I am with no satisfactory idea.  Thus: a contest.

Contest

Suggest a name, phrase, or ? that I can use to describe option trading that satisfies these criteria:

  • It's honest.  No hype allowed ("Win with Options" is hype)
  • It's not trademarked or copyrighted
  • It reasonably short
  • It presents options in a positive light
  • It makes a good 'slogan' or tag line

If possible, but not required, use the phrase in an appropriate manner:  In a sentence, as a tagline, as a headline etc.

I have no idea how I will
judge this contest, but I want the phrase to appeal to me.

I'll keep this contest open for 10 days.  Entries must be submitted before midnight CT on Sunday, June 20, 2010.  The only way to enter is to post your idea as a comment on this post.

Prize: One year subscription to Expiring Monthly magazine.

If the winning idea turns out to be something that is of practical value and can be used as hoped, I'll try to find a suitable bonus prize.

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