Sunday, July 6, 2014

how i'm trading psar-psearch

in this crazy market the implied volatility is nearing record lows and seems like it will be there forever ... or at least longer than my sanity can hold out. when iv gets this low the direction-neutral credit strategies stop being a good reward for the risk. i feel that i need to choose directions in this market and i am not good at that and i am worse at recognizing when to change directions. this is why i latched on to the psar-psearch idea because it gives me a reasonable way to pick direction and when might be good time to re-evaluate.

now, one can trade the psar-search optimized signals as a pos (plain-old-stock) trade but i prefer the option debit spread because it is a more efficient allocation of capital. in a debit spread one is usually buying an itm option and selling an otm option and paying upfront for it. here's how i pick strikes and manage the entry:

  1. look for a 70'ish delta strike to buy. the range is flexible it can be 60, it can be 80 but a strike or two in the money. the expiration can be 2 weeks to 2 months away. note the extrinsic value of this option.
  2. look for a theta neutalizing option to sell. i look for an otm option that prices closest to the extrinsic value of the long strike. this is usually a strike that is about 30 delta.
  3. buy the spread for 50% of the strike width. i buy the spread if it prices for something like half of the distance between the strikes. a percent or two on either side is fine but more than that means i need to pick different strikes.
  4. 1% per trade. i size the trade to be at most 1% of my available option buying power. this is probably less than an optimal kelly-size but i need to sleep at night.
when executed properly i have a position that is approximately equivalent to owning or shorting about 40 shares of the underlying equity per spread but purchased for far less. this is because .4 is roughly the difference in delta between the long strike and the short strike and each option controls 100 shares of stock. to be sure, the upside is capped but i will almost always realize a large percentage gain in the spread long before i would see the same percentage move in the underlying.

managing the trade is simple:
  1. target 50% max gain. i rest a gtc order to sell the spread when it appreciates to 50% of the maximum possible gain. this should be a price that is about 75% of the distance between the two strikes.
  2. stop out on a psar reversal. don't go against the psar! it may or may not be chop, you just don't know. if one is looking at the psar when the market is open then the the psar stop that is in effect is on the previous candle to the forming candle.
  3. maybe reload the trade. if i made the target and the move is young and the psar dots are doing their parabolic thing and are something like an average-true-range away then i think about reloading the trade but i would hate to give back any part of a 50% gain chasing money left on the table.
  4. maybe take a reverse direction trade. reversing direction is a case-by-case decision. in this bulls-on-parade market i wait for confirmation to take a bearish reverse. by confirmation i mean i wait for a candle that undercuts the low of the reversal candle. fyi, this is how the acceleration part of the psar works, the psar stop gets more aggressive only when there is extension of range in the trade (and only up to the acceleration limit.) 
  5. two stop-outs and done. if i am stopped out twice in a row then i look for a different equity to trade. something is changing to cause excessive choppiness and it is best to let that sort itself out. possibly, the psar-search acceleration parameters are in flux as well. i could conceivably switch back to a neutral strategy but i would need to see the iv sufficiently high (>30% in my experience) to make that work.

1 comment:

  1. I really appreciate all the detail you have put into this post!


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