Thursday, September 29, 2011

nearly naked diagonals

Me: Mom, the rolls are gravy!
Mom: Well, which is it, dear. Rolls or gravy?
Me: No, no, the rolls are gravy!
Mom: (sigh)
Back in June I wrote about a strategy I call the nearly naked put - a vertical spread with the twist that the long option is purchased WOTM (way out of the money,) a measure that conserves buying power. This is an effective strategy for a non-margin account (but not limited to) where you want to sell a naked-put but want to reduce the allocation of buying power to be more in line with a margin account.

So, now I evolve this strategy a little - I purchase more time on the long option than the short option. See, I want to repeat the NNP on the next cycle but that would mean purchasing yet another WOTM option and while they are cheap enough out there, the repeated commissions and purchase price do reduce profitability a bit. The evolutionary idea here is that by purchasing the WOTM option a couple or three expiration cycles out I get a kind of two-fer, I pay 1/2 to 1/3 the commissions on it and I get the bulk-rate discount on time according to the well-known mathematics of option pricing (whereby price is proportional to the square-root of remaining time e.g. one can buy 4x time for only 2x price.) I call this strategy the nearly naked diagonal or NND.
The Rolls Are Gravy
The goal of the NND is to use time as an edge to produce reliable profits, even (nay, especially) in very difficult trading conditions. This is accomplished as time is winding down on the short options in a trade called a calendar roll. As I discussed previously (in the twilight zone roll) the calendar roll almost always generates a credit due to the mathematics of pricing time into options. The NND goes on for a small credit or debit but then every roll is pure gravy.

Tell that to your Mom at dinner.



(tbc...)


_

Sunday, September 11, 2011

The Twilight Zone Roll

Heaven? Whatever gave you the idea that you were in heaven, Mr. Valentine? This IS 'the other place!!
There's a famous episode of the Twilight Zone (A Nice Place To Visit, season 1, episode 28) in which a gambler, who thinks he has died and gone to heaven, walks into a casino and can't lose. Every time he plays a hand of blackjack he's a winner, every time he pulls the handle on the slots he hits the jackpot and every time he plays roulette the ball lands on his number.

Now imagine that you walk into the Twilight Zone Casino and put a Benjamin on number 19, say, on the roulette wheel and the ball lands on 22. You feel a momentary pang of loss for having played a sucker's game, maybe even a little duped by having watched too much late-night TV .... but then the Twilight Zone Casino croupier offers you a deal: "I'll give you your Benjamin back from the previous spin plus an extra buck or two for your trouble if you play your number again.

Madness, no!? Never happen, right!?

Well, this very deal plays out every week in options trading and its why I'm changing my trading style. The analogous transaction to the Twilight Zone croupier's deal is called a calendar roll. In a calendar roll you buy back the near term short option and sell a longer term option at the same strike price, in a single transaction. Due to the fact of option pricing, in which options with more time are more highly valued, this roll transaction is certain to generate a credit (well, almost certain)* - no matter how badly the position has gone against you prior to expiration. Moreover, you can perpetually roll that loser short option to generate a credit every cycle.

To be eligible for this Twilight Zone Roll you must enter your position by short selling or "writing" an option. You can sell a put option or a call option or both even, it doesn't much matter. Then you wait.

There are four possible outcomes, three of which can always be handled positively and the fourth almost always positively:
  1. Your short option is out of the money at expiration. You buy back your short option for pennies on the dollar, you win the maximum gain.
  2. Your short option is slightly in the money at expiration but worth less than what you sold it for. You buy back your option for a relatively modest gain, you win.
  3. Your short option is deep-in-the money at expiration and is worth a lot more than what you sold it for. You buy back your option and sell next months option at the same strike price for even more money, you win. This is the Twilight Zone Roll. You were losing but you still win.
  4. Your option is exercised early and you now have an equity position. This is low probability and I will address this at length below but can be handled analogously to #3 - immediately close the equity position put to you and sell the same option option again -or- the same option in the next expiration cycle. I will argue that this almost always results in the same positive outcome as #3. You still win.
So firstly, you must convince yourself that options with more time to expiration must command a higher price than nearer term options, given the same strike price. I argue that this is true by virtue of the fact that if you ever find it not to be true then you can create a riskless calendar trade - selling the nearer term option for more money than you purchase the later term option - which is certain to net at least as much money as the net credit going into the trade and possibly much more. There are electronic arbitrageurs that constantly scan option-chains for these rare occurances and it is unlikely that a smallDogInvestor would ever encounter one.

Even knowing this, it has taken me some years of option trading experience to really be convinced that this TZR "out" can't be magically taken away at expiration like Lucy holding the football for Linus to kick. This is because when a short option position is running against you, its just unnerving to eyeball the red ink. One must resist the temptation to pre-empt the trade by closing it out and walking away. Hold it and roll it. Then roll it, til you make it.

As for the early exercise scenario, #4, the incentives for the option owner are against early exercise. This is because the exerciser of an option is foregoing the time-value of the option that he would have gained by simply selling the option. Furthermore, the time value of the cash obtained by exercising a put is almost nil these days because of the low interest rate environment we are in (least to mention you give up 3 days of interest clearing the trade.) The possible exception to this observation is for a dividend paying stock. A call option owner might decide to exercise on the last day of the dividend period (1 trading day prior to the ex-div date) in order to capture a dividend payment. Even still, said dividend must be larger than the time-value on the option (+trading fees) to make the exercise a profitable proposition. However, it is not difficult for the option obligee to evaluate this and roll early.

On the other side of the exercise, the option obligee gains this time-value in the event of an exercise because the contract ended early without him having to pay-up the time value that he would have otherwise had to pay to be released early from the contract. This time-value at the time of exercise provides monetary leeway for the obligee to dispose of the equity position, if desired. Immediately selling the same month's or next month's option will realize this time-value back to your account.

Now, the only real gotcha in this strategy is a total Lehman-like crash and burn, where a respectable $50 stock suddenly and permanently stops trading over the weekend. In the case of Lehman, put obligees that were not exercised, would not have been able to roll perpetually because the option makers stopped creating new options for Lehman. While this is an ever-present risk for the premium seller, it is never-the-less extremely rare. For this reason, and other motivations, I do engage in protective option buying in a strategy called a diagonal that would limit the downside of such an adverse event. However, the existance of a reliable Twilight Zone Roll has redirected my trading focus. This is a fact-based strategy so I know I am not in that other place.

*Since I wrote this blog entry I have actually encountered a situation where I was quoted a small debit on a calendar roll. I believe this to be the work of dividends. In the particular case, the roll to the nearest next weekly option on SPY from SEP4 to SEP5 on the 134 strike puts was quoted as a debit of 5 cents or so. This time period spanned the ex-dividend date of SPY. However, I was able to roll to the OCT monthly expiration for a credit.

Thursday, September 8, 2011

sdi_yesterrange - overlay yesterday's price range on today's intraday chart

The high and low of the previous day are often reversal levels. The trading action tends to be choppy when price action stays inside of yesterdays range; outside the tendancy is toward's trending. sdi_yesterrange helps the intraday trader stay vigilent about yesterday's high and low by displaying a clouded range representing yesterdays price action on the intraday chart as shown below:


SPY with sdi_yesterrange.
By enabling the sideline parameter the range cloud can be thrown off to the right-extension area where it won't crowd your chart drawings. Also, the range cloud will automatically hide when you increase your aggregation period to DAY or larger.

Here's the code:
#########################
# sdi_yesterRange -
#hint: Display yesterdays range as a clouded area. rev: 1.0.0
# source: smallDogInvestor.blogspot.com
# author: allen everhart
# date: Sep 8, 2011
# copylefts reserved. This is free software. That means you are free
# to use or modify it for your own usage but not for resale.
# Help me get the word out about my blog by keeping this header
# in place.

declare upper;
#hint sideline: Set to Yes to display the range cloud in right extension area; No to display range cloud overlaying main chart.
input sideline = no ;

def _ph = high(period="DAY")[1];
plot ph =
  if isNaN(close) && !sideline then
    double.NaN
  else if !isnan(close) && sideline then
    double.NaN
  else
    _ph
;
def _pl = low(period="DAY")[1];
plot pl =
  if isNaN(close) && !sideline then
    double.NaN   
  else if !isNaN(close)&& sideline then
    double.NaN
  else
    _pl
;
addCloud(ph,pl,color.RED);
ph.setdefaultColor(color.RED);
pl.setdefaultColor(color.RED);
ph.setStyle(curve.lonG_DASH);
pl.setstyle(curve.LONG_DASH);

def agHide =  if getAggregationPeriod() >= aggregationPeriod.DAY then
    yes
 else
   no
;
ph.sethiding(aghide);
pl.sethiding(aghide);
#########################################

Friday, September 2, 2011

Pre-Presidential Update

Here's a chart on the pre-presidential cycle update. The blue line is the projection from the beginning of the year, the magenta line is the projection from the current week. The oval is the range of divergence for the end of year time-frame that existed last month.

SPX weekly with Pre-Presidential cycle projection.
This is uncharacteristically bearish for a pre-presidential year. The year open price has become a broken support. This level should then become a resistance level. In my opinion this bodes ill for an up-year, unless the market can break above with some energy.