Sunday, September 16, 2012

my etf universe

in my previous blog on stock-straddles i mentioned criteria for finding appropriate etf's. so i have prepared a list of the etf's that satisfy my criteria and i share it with you now:

nonlevered, liquid etf's with liquid options

this was created by scanning all etf's for those that have greater than 600,000 shares traded daily and are optionable. then i winnowed out all leveraged etf's and those whose options were not liquid and added vxx which falls under the designation of etn. i think this list of 35 etf's is surprisingly short considering the thousands of etf's that are clamoring for investor dollars but that is to where i want to shrink my universe. i am currently running stock-straddle trades on the first four.

Friday, September 14, 2012

new rules: stock-straddles

  • initiate stock-straddle trades only. that is, long stock and short the straddle  (short the call and short the put at the same strike.)  i sell the straddle in the back month.
  • trade only unlevered, liquid etf's with liquid options. unlevered etf's have low risk of going to zero and other adverse corporate events. this strategy relies on future expiration cycles perpetually being available.  levered etf's suffer from the death spiral syndrome whereby they never seem to recover in price even though the underlying index does. the back month atm options must have a narrow (like 15 cents or less) bid-ask spread and must have a couple hundred or more contracts of open interest. the underlying etf must trade 500,000 or more shares/day. it is interesting to note that most etf's satisfying the volume requirement also satisfy the liquid option requirement.
  • prefer etf's with a high volatility index. the emphasis is to make money on selling premium and the options aren't going to sell for much if the vol is low. although, low vol is not a reason to quit one of these trades.
  • roll eligible options as soon as the extrinsic value is worth less than the roll value. the options become eligible for rolling when they age into the front month. this way the extrinsic value is constantly being tacked on to the back month and the risk of early exercise minimal. this rule applies equally well to both the itm as well as the otm options.
  • keep a gtc order to buy-back the options for a nickle. if these execute then sell the 30 delta options to complete a vertical roll. the trade may evolve into a stock-strangle trade but that's ok.
  • control the beta-weighted delta with stock-straddle trades on sh and vxx. stock-straddle trades are neutral-bullish so a portfolio of these can cause your net-liq to sag when the market retreats. sh is a bearish etf on the s&p 500 which meets my selection criteria. vxx is an etf that trades vix futures and though it is not explicitly a bearish etf, it does create negative beta-weighted delta.

the first principle that makes these stock-straddle trades work is the statistical fact that the highest probability of future price is the current price. thus the probabilities favor time-decay of the short options. being short a call and a put guarantees that at least one of the options will be profitable.

the second principal stock- straddles stand upon is the addage: time-is-money. thus, a short option that has appreciated can be rolled to some future expiration for a credit in all but the most extenuating circumstances. such circumstances could only occur in a stock paying a large one-time dividend and that is a rare occurrence for stocks  and more so in the etf world.

Saturday, September 1, 2012

a new trade on my favorite etf ...

iwm, the russell index etf, of course!
this week i put on a frank walsh style trade on iwm. frank is a frequent commentator/educator on the thinkorswim chats (what's frank thinking?). he has been advocating a trade that is combination of a covered-call and a naked put. if you understand the concept of put/call (call=stock+put) parity then you will immediately say, ah, but those are the same thing! true dat! if one plots the p&l graph for a covered call and a naked put at the same strike one gets the same hockey-stick graph with a fixed max profit on the upside and a long handle down to zero underlying price on the downside.
the same, but different! 
the difference is in how one thinks about and manages the trade. here's my full iwm position:
iwm full position
if i let this ride to expiration then there is a 65% chance of profit, which is very good. however, notice though that if i expire under the $81 strike then the call will go out worthless and leave me with a stock position (assuming i roll the put position.)
my goal is to set up a monthly trade like this. so i like to think differently about this position and another totally equivalent way to think about this trade is as a stock - straddle (long stock/short straddle) trade. if i buy back the options every month then the stock will persist in my account unless i am exercised early (not a terrible result actually.) so what i am left dealing with, month-to-month in the options, is a short straddle position (short a call and short the put.) the straddle has this p&l:
iwm straddle
here i have unchecked the stock position from the analysis and redrawn the break-even lines.  thus, there are three outcomes: <76, between 76 and 86, >86. here's my action plan for these three expiration-week outcomes:
  • <76. the call should be nearly worthless so i will roll the call to the same strike in the back month. if there is not sufficient value to call roll then i will consider a roll diagonally down but only to a 20 delta option. alternatively, i evaluate whether rolling further out in time is a better value. the put will be itm (in-the-money) and my action plan calls for rolling the put too. yea verily, this does write-down a loss but time is money, the roll, most often, generates a net credit. i will evaluate the roll value on the put when the time comes to see if maybe rolling deeper in time is a better value. with two-year leaps trading on iwm there is no shortage of deep-time options available.
  • between 76 and 86. in this range both options expire profitably and i simply roll them to the back month at the same strikes.
  • >86. same as <76 but reverse the logic for call and put.
in a nutshell that is it.
the tricky part is coming to grips with rolling the itm options. it's all in the way that one thinks about it. if you feel that buying back the itm option is a loss, and a loss is a loss, period, then maybe you need to follow a trade like this in a practice account first. there are always future months to roll to (otherwise we have bigger problems), thus, i have come to view the roll on the itm option as a loan. i am loaning the market some money and receiving what is usually very generous upfront interest payment on the loan in the form of the roll credit. i compare the roll credit to the size of the loss i am writing down, many times it is in excess of 30%. why would i eat the loss and throw away the opportunity!?
of particular note, in the case of an itm call, i am loaning out unrealized profits on the stock. the underlying might double or triple but i will always be able to roll that itm call because i have the stock. almost inevitiably the postion will retrace in some future month when stock holders get impatient or worried and i get to collect on my loan, keeping the "interest payments" of course. likewise for the itm put, but here i am loaning out cash from my account. that should be no problem though because otherwise my broker would not have let me sell the put in the first place and the most cash i would be loaning out is the strike price x 100, the cost of the shares.
all-in-all this trade strategy is heads i win, tails i win later.

dave says: true dat!