Wednesday, June 04, 2008

Asynchronous Diagonal Put Spread Trading

I'm now at the second stage in my new U.S. based options trading strategy. I'm trading QQQQ options at the moment. I'm short 4 June $48 puts and long 4 September $49 puts. This is a "diagonal put spread". A horizontal spread is the same strike in different months and a vertical spread different strikes for the same month. The asynchronous bit means that I didn't trade the two options at the same time, but allowed the market to move in between the two trades.

We know that ">put selling is extremely profitable. We also know that it can be extremely dangerous. For example, Victor Niederhoffer sold a large amount of out of the money S&P 500 puts in 1997. When the market fell the value of these puts rose partly due to the fall in the market and also due to the accompanying rise in implied volatility and his fund got a margin call that blew it up. This is despite the puts still being out of the money at that point. So I was interested in selling puts, but wary of the danger, and that led to the development of this strategy which I am beginning to implement. Another reason that I am interested in trading options, is that gaining from the time erosion of sold options means that I have to be less accurate in my trading in order to make money than is the case with futures. This is useful as I can't watch the US market all the time.

This is the strategy:

1. When my trading model gives a buy signal I short just out of the money puts for the current month. These puts have the largest time value of the current contract and the current month has the fastest time decay of all months. It makes no sense that I can see to ever sell anything but the current month (especially when spreads and commissions are low). I only sell a small number of puts - only as many as I am willing and able to buy stock in the event of being exercised at expiry. This is the first safety provision.

2a. Hopefully the market rises and the value of my puts falls rapidly. When my trading model generates a sell signal I buy a put. This put is for at least 3 months out - which has half the theta - sensitivity to time erosion. 6 months out has a third of the sensitivity but the bid-ask spread can be sufficient to negate the advantage. This means that the spread gains value over time ceteris paribus. The later option also has a greater vega - is more sensitive to volatility - which tends to increase when the market declines. Ideally, I buy this option a little in the money, but even if it is out of the money the delta (sensitivity to market movement) of this option is greater than that of the sold option. These differences in delta and volatility mean that if the market declines the spread increases in value. By not buying back the sold option I continue to gain from its time erosion and to save on commissions and spread - if the market is trending upwards it will likely expire worthless. It also partly hedges my bought put if I'm wrong about the market going down.

2b. If the market goes sideways, I just wait for the sold option to expire worthless.

2c. If the market goes against me - the model is wrong and I buy a later option to create a calendar spread to protect me against a crash and potentially benefit from rising volatility. When I think the market has bottomed, I'd probably just sell the bought option and redeem the sold option closer to expiry unless it was now very much in the money and had little chance of expiring worthless.

3. If 2a happens and we now have a diagonal spread, I wait for the model to generate its next buy signal. I then sell the bought put and hold the sold one and either it expires worthless or I buy it back closer to expiry. If the market has risen considerably since I first wrote the put, I will consider buying it back and writing a new one at a higher strike. And if the market has declined considerably, buying it back and writing a new one at a lower strike.

We are now just past 2a with the value of the spread increasing as the market declines.

I think this strategy cleverly exploits the advantages of put selling while mitigating some of the risk, exploits my model, and takes into account my location far from the U.S. time zone. I still need to be available either at the beginning or end of a US market session to make trades when neccessary.

Trading options in Australia has several disadvantages:

a. Very big contract sizes for the SPI futures options. I could write options more out of the money to reduce the risk, but that has Black Swan (i.e. tail event) risk.

b. The SPI futures options only exist for each quarter - my strategy is far more effective with monthly options.

c. There are also "XJO options" traded on the ASX 200 Index on the ASX. These are for 40% of the size of the SPI contract. Still big for me at the moment, but more manageable and these are monthlys. Problems with these are the very wide bid-ask spreads - SPI futures options have a tight spread (though you can't see bid ask quotes on IB's TWS...). If can get Interactive Brokers to approve me to trade them,* I can get low commissions - compared to CommSec's very high commissions. It's likely I will try trading these at some point.

Another possibility is futures options on the Nikkei traded on the Osaka futures exchange. These are also a big contract size but they are monthlies. The spread is 10 points, but so is the spread of the underlying contract. Commissions with IB are low and I already have the trading permission.

* I signed up for my account in the US and US residents are banned from trading options on foreign exchanges by the SEC. Futures options are OK because they are regulated by the CFTC. I've told IB I now live in Australia but regular Australian options are still blocked.

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