I usually use online spreadsheets to run my data when I am working on a new strategy and trying to see the future possibilities based on past performance. This time I have had to use a PC based system as there is just too much processing involved. The online services just cannot handle it. As a result I don't have my spreadsheets with me today, so my numbers are going to be rough generalizations. I also have some more adjusting that I need to do to my entry and exit criteria to get the accuracy that I would like.
Actually, on the entry and exit. This particular strategy does not conform to the typical style of back testing that you might see when trying to buy or sell a stock based on indicators. In those cases the indicators need to be overlaid and entry exit prices determined by using some complicated formula and a charting service that has some level of backtesting capabilities. While there area number they are not cheap and the results are not always exactly what would have actually been traded... for a number of reasons.
Due to that my backtesting has typically been done by hand so that I would see what had gone on and applied my rules accordingly, I got to see exactly where the plan worked and didn't rather than just getting a number at the end of the test. This was necessarily very time consuming and, if a plan did not pan out, it was often frustrating.
This is different. I am not concerned with entry and exit points. I am not overly concerned with the price movements that the underlying security exhibits. I really don't care if it goes up or down or nowhere after a trade entry, only if it goes past my set move allowance from trade initiation to completion. The test is a win or loss determination for each trade based on the particular opening price and the particular price at option expiry (could be Friday's opening or closing depending upon the style of option traded). Each week there are one or two trades made, the allowance is applied for the time period and the result is spit out and tabulated as a total number over whatever time period I am testing for.
Also, unlike many backtesting plans my window tested can go back as far as I have data available. I can easily get free data for about 18 years, run that through my spreadsheet and produce a win rate in moments... just not online. If I want to apply a normal loss allowance I can do that, or I can use the actual closing value of the stock at the expiry of the trade to determine what the un-stopped loss could have been, sort of a worst case let it all ride scenario. I expect to do both methods to see what would have happened.
At this point I am seeing a greater than 96% win rate over all traded timeframes (1, 2 and 3 days). Well above my estimated 80% requirement. This is without any adjustments, just applying an allowable move percentage and making a sweeping assumption that I would have to use that allowance each and every time. In more volatile markets I could use a much wider allowance so the percentage I started with is really a minimum. I would rather not try to guess where the allowance could have been greater so I will just consider this as a worst case scenario. I have always liked to skew the results against me in order to keep the expectations more realistic.
Given such a high win rate and using a loss allowance of 4 times my option value (I may change that for a number of reasons but it is a good place to start) and applying this over the past since 1993 produces some very large numbers. I tend to think that the numbers are large enough that they can be discounted as, more or less, unworkable in a single security option. I expect that, at some point splitting the account into multiple security options would be necessary to not be trading all of the available open interest... that and switching to or adding the larger and more expensive index futures. This would also serve to mitigate any potential single loss. Of course there is always the removing of cash from the plan to use for personal uses along the way. I am not letting these numbers get me too excited as this is a longer term income strategy and I have yet to see what premiums can be sold in various option chains after applying reasonable move allowances to their respective historical data. I also have not accounted for income taxes in any of my math yet.
Even though past results do not guarantee future results I can at least be certain that if a stock or index fund exhibited 96 winning trades for each 100 trades and held this average for 18 years using a single move allowance value I can be pretty sure that some similar result may be reasonably expected to continue, particularly if I can apply varying move allowances to suit the volatility of the market in real time.
Jeff.
Questrade, My direct access discount broker.
Saturday, May 14, 2011
Wednesday, May 11, 2011
Strangling, forecasting the required win rate
Before I get to the backtesting results I figured I should check what might be needed for a win rate in order to produce a profitable plan. If I assume that I use a stock/ETF option produces at least a 10 cent credit each week I was going to setup a spreadsheet to forecast this over a period of time, a few years anyway, but decided that if I applied a very basic ratio of loss allowance against the expectation of profits it is very simple to calculate.
I figured if a 10 cent credit trade provides a $100 profit (10 contracts per side of the strangle, ignoring commissions at this point as they are only worth about 2 cents of the trade and I figure that 10 should be a low enough expectation to accommodate that).
Given the nature of a strangle, limited gain for larger possible loss, I used 4:1 loss over gain on a per trade basis. The 10 cent trade could loose 40 cents (which is actually a 50 cent move but the 10 cent credit gets applied against the loss) or a losing trade would be $400 for a winning expectation of $100.
Given this simple math I would need to see 4 trades to cover the one loss which is actually an 80% win rate just to break even. That's tough in the world of trading in the normal sense of buying and selling based on charts, fundamentals or news.
Keeping this in mind I will run the numbers for trading based on SPY (any index ETF would suffice to see the trend over time). After applying the range of 4% from open to close of the trading period I decided that I should also allow this range to be variable to see how much of a difference it might make on the win rate.
I also noted that I had been using the numbers based on Friday's closing price. there are only a small handful of options that expire in the evening of Friday, most expire based on the opening price on Friday morning. this is calculated based on the first moments of the market so I also need to adjust my spreadsheet test to accommodate this as well. Doing so makes the results more accurate as Friday can move quite a bit from open to close.
Win rates over time coming up.
Jeff.
I figured if a 10 cent credit trade provides a $100 profit (10 contracts per side of the strangle, ignoring commissions at this point as they are only worth about 2 cents of the trade and I figure that 10 should be a low enough expectation to accommodate that).
Given the nature of a strangle, limited gain for larger possible loss, I used 4:1 loss over gain on a per trade basis. The 10 cent trade could loose 40 cents (which is actually a 50 cent move but the 10 cent credit gets applied against the loss) or a losing trade would be $400 for a winning expectation of $100.
Given this simple math I would need to see 4 trades to cover the one loss which is actually an 80% win rate just to break even. That's tough in the world of trading in the normal sense of buying and selling based on charts, fundamentals or news.
Keeping this in mind I will run the numbers for trading based on SPY (any index ETF would suffice to see the trend over time). After applying the range of 4% from open to close of the trading period I decided that I should also allow this range to be variable to see how much of a difference it might make on the win rate.
I also noted that I had been using the numbers based on Friday's closing price. there are only a small handful of options that expire in the evening of Friday, most expire based on the opening price on Friday morning. this is calculated based on the first moments of the market so I also need to adjust my spreadsheet test to accommodate this as well. Doing so makes the results more accurate as Friday can move quite a bit from open to close.
Win rates over time coming up.
Jeff.
Strangling the weekly options, back testing
I downloaded the historical data for SPY from about 1993 to date and ran three checks.
The first compared the opening price on Thursdays to the closing price on Fridays to represent the percentage move over those two days. The second compared the opening on Wednesday and the Third the opening on Tuesday, again to the close on Friday.
These tests would show the number of times that the price of SPY, in my first test, moved 4% over one of these periods. Now this does not reflect the trades being set at strikes that are greater than 4% away nor does it factor times that I might only make one side of a trade to reduce risk during particularly edgy times. I am assuming that I am trying to set this as a, more or less, automatic style of trading where I can place the trades according to strict rules. I would count all the trades, winners and losers, and use the lowest target trade entry price. For a full strangle my lowest acceptable credit would be 10 cents. That may change as I track the current weekly trade possibilities, but it is a good conservative number for now.
These tests would also count a cumulative profit and increase the trade size as the capital base grew. I know that weekly options were not available in 1993, not actually until fairly recently, so the exercise is for interest sake mainly. At least the testing covers the tech bubble and the latest bear market and the infamous flash crash.
More on the results tomorrow.
Jeff.
The first compared the opening price on Thursdays to the closing price on Fridays to represent the percentage move over those two days. The second compared the opening on Wednesday and the Third the opening on Tuesday, again to the close on Friday.
These tests would show the number of times that the price of SPY, in my first test, moved 4% over one of these periods. Now this does not reflect the trades being set at strikes that are greater than 4% away nor does it factor times that I might only make one side of a trade to reduce risk during particularly edgy times. I am assuming that I am trying to set this as a, more or less, automatic style of trading where I can place the trades according to strict rules. I would count all the trades, winners and losers, and use the lowest target trade entry price. For a full strangle my lowest acceptable credit would be 10 cents. That may change as I track the current weekly trade possibilities, but it is a good conservative number for now.
These tests would also count a cumulative profit and increase the trade size as the capital base grew. I know that weekly options were not available in 1993, not actually until fairly recently, so the exercise is for interest sake mainly. At least the testing covers the tech bubble and the latest bear market and the infamous flash crash.
More on the results tomorrow.
Jeff.
Tuesday, May 10, 2011
Strangling Risk Management
First note, weekly options expire every Friday which means they are very short term as the trade is closed as of Friday's closing price. If the price falls short of the call strike and doesn't drop as low as the put strike then I keep all the premium. If I sell options on Wednesday or Thursday I limit my exposure to one or two days, no positions held for a possible weekend move. With the short time to expiry there is not much premium left for time decay so the options are fairly cheap, probably less than 15 cents normally... depending on risk tolerance and volatility at the time.
All that the price needs to do is not go into the money in either direction so I need to set my risk levels wide enough to miss most of the large moves and close enough to still have some premium left to sell. For SPY I tried 4% first. Based on this, as long as the price does not move up or down 4% from the time of the trade then the trade is a winner.
On a stock with a price of $100, just to make the math simple, I would sell the $104 calls and the $96 puts. Calls are usually less risky than puts as a price is more liable to drop faster and farther than to rise far and fast so I wouldn't mind holding the strike a bit closer whereas a put I would sooner leave a little more room. So if the same stock was priced at $100.50 I would still sell the $104 call but if the price was $90.50 I would move the put down to $95 to have AT LEAST a 4% allowance.
4% is just a guideline though. As the market becomes more volatile premiums rise and I could just as easily go to 5, 6, or 7% as long as I meet my target weekly option price. I haven't set targets yet as I need to watch the options for a while to see which ones will be the best for premium vs risk.
Watching the stock for price moves into the money is one way to keep track of the trade. Another is to just set a stop loss. I am not as keen on stop losses on options as option prices can vary widely even though the option is still OTM. Perhaps a 4 or 5 times loss allowance would do it. For example, a 10 cent option sold would have to go to 50 cents to stop out. I am not as comfortable with this as it could lead to some whipsaws so I would prefer, when I can, to monitor the price activity when the option prices get that far out.
Actually, another method of loss mitigation could be to sell the next higher (for calls) or lower (for puts) strikes seeing as the prices are higher. Closing the first trade may not be required but can be part of the plan. While this might not eliminate a loss, selling another 10 cent option farther out can at least cut it by 20 or 25%. Adding the other side of the trade to make a new strangle using the new stock price and adjusted strikes could effectively cut the loss by as much as 50%. Obviously I have not worked this particular trade management out completely as there is only a day or two in the original trade anyway. The worst case would be that one week's loss needs to be recouped over the next three or four weeks. How often can a stock make statistically unlikely moves from week to week? Given the correct analysis and application of the risk management strategy I expect losses to be few and far between even if they are larger relative to the individual gains.
Jeff.
All that the price needs to do is not go into the money in either direction so I need to set my risk levels wide enough to miss most of the large moves and close enough to still have some premium left to sell. For SPY I tried 4% first. Based on this, as long as the price does not move up or down 4% from the time of the trade then the trade is a winner.
On a stock with a price of $100, just to make the math simple, I would sell the $104 calls and the $96 puts. Calls are usually less risky than puts as a price is more liable to drop faster and farther than to rise far and fast so I wouldn't mind holding the strike a bit closer whereas a put I would sooner leave a little more room. So if the same stock was priced at $100.50 I would still sell the $104 call but if the price was $90.50 I would move the put down to $95 to have AT LEAST a 4% allowance.
4% is just a guideline though. As the market becomes more volatile premiums rise and I could just as easily go to 5, 6, or 7% as long as I meet my target weekly option price. I haven't set targets yet as I need to watch the options for a while to see which ones will be the best for premium vs risk.
Watching the stock for price moves into the money is one way to keep track of the trade. Another is to just set a stop loss. I am not as keen on stop losses on options as option prices can vary widely even though the option is still OTM. Perhaps a 4 or 5 times loss allowance would do it. For example, a 10 cent option sold would have to go to 50 cents to stop out. I am not as comfortable with this as it could lead to some whipsaws so I would prefer, when I can, to monitor the price activity when the option prices get that far out.
Actually, another method of loss mitigation could be to sell the next higher (for calls) or lower (for puts) strikes seeing as the prices are higher. Closing the first trade may not be required but can be part of the plan. While this might not eliminate a loss, selling another 10 cent option farther out can at least cut it by 20 or 25%. Adding the other side of the trade to make a new strangle using the new stock price and adjusted strikes could effectively cut the loss by as much as 50%. Obviously I have not worked this particular trade management out completely as there is only a day or two in the original trade anyway. The worst case would be that one week's loss needs to be recouped over the next three or four weeks. How often can a stock make statistically unlikely moves from week to week? Given the correct analysis and application of the risk management strategy I expect losses to be few and far between even if they are larger relative to the individual gains.
Jeff.
Monday, May 9, 2011
Breaking down the naked option income strategy
Well, historical option pricing is a pain to acquire for regular options let alone weekly, so I will just do some tracking this week figuring that the current activity is more or less average.
I ran up a spreadsheet to compare trade sizing vs option pricing to get an idea of how much capital I would need to maximize my returns based on the commission rates that I currently have. The thing about this strategy is that the premium collected from selling an option that is far enough OTM to be relatively safe is relatively small. Selling 5 and 10 cent options means selling enough contracts to make it worth while. For example a 10 cent option selling 10 contracts returns a net profit of $83.05.
An easy method to increase the revenue without increasing the risk is to turn the trade into a strangle. If both sides (the higher strike call option and the lower strike put option, a naked strangle) are taken simultaneously the commissions are less than doubled (with Questrade anyway) whereas the potential profit can be as much as doubled.
Selling calls at $140 strike and puts at $130 strike for a stock priced at $135 might create a 15 cent credit or more (5 cents on the call and 10 cents of the put, but these prices depend on a lot of factors). This particular single contract trade would require a cash balance of $985 to cover the margin requirements, although a single contract is not really worth the effort due to the small credit acquired. Take it up to 10 contracts per side and the margin requirement is $9,850. Profit on this trade would be $123.05 or, based on cash allocated, 1.25% return.
The down side of this is that, in the rare case that a trade goes against me the loss far outweighs the profits. This only means that the trading record has to have a very high win/loss ratio... back to the spreadsheet to create some historical tracking.
Jeff.
I ran up a spreadsheet to compare trade sizing vs option pricing to get an idea of how much capital I would need to maximize my returns based on the commission rates that I currently have. The thing about this strategy is that the premium collected from selling an option that is far enough OTM to be relatively safe is relatively small. Selling 5 and 10 cent options means selling enough contracts to make it worth while. For example a 10 cent option selling 10 contracts returns a net profit of $83.05.
An easy method to increase the revenue without increasing the risk is to turn the trade into a strangle. If both sides (the higher strike call option and the lower strike put option, a naked strangle) are taken simultaneously the commissions are less than doubled (with Questrade anyway) whereas the potential profit can be as much as doubled.
Selling calls at $140 strike and puts at $130 strike for a stock priced at $135 might create a 15 cent credit or more (5 cents on the call and 10 cents of the put, but these prices depend on a lot of factors). This particular single contract trade would require a cash balance of $985 to cover the margin requirements, although a single contract is not really worth the effort due to the small credit acquired. Take it up to 10 contracts per side and the margin requirement is $9,850. Profit on this trade would be $123.05 or, based on cash allocated, 1.25% return.
The down side of this is that, in the rare case that a trade goes against me the loss far outweighs the profits. This only means that the trading record has to have a very high win/loss ratio... back to the spreadsheet to create some historical tracking.
Jeff.
Return to the basics in option trading
I almost called it "Return to Fundamentals" but I am not a fundamental trader, never have been and I don't see that changing. Oh, this involves naked options, not really basic but the strategy is easy and should prove consistently profitable and, overall, relatively low risk.
I still like my latest trading plan but I don't like the need to hold a bunch of stocks in the wings waiting for trade setups. I look at tweaking the system every once in a while in order to generate more trades but I realize that more trades does not equate to more profit, often it is quite the contrary.
So, I return to an option trading strategy that I started a while back and add a few incidental facts that I did not have available at the time. If any were following along then and are still here it was my iron condor option trade strategy. While it happened to produce 100% profitable trades while I worked it, I shut it down as the SPY ETF options were getting rather cheap. This only served to drive the risk up while trying to optimize the profitability as I have to take options that were further away from expiry and closer to the strike prices. Besides, I had another grand trading scheme in mind at the time.
The little fact that I did not have at the time was that weekly expiry options were becoming available for various index ETFs. I had determined that I would need to start trading futures in order to see enough premium in option selling to justify running iron condors but I had tried that using a service already, and it did not pan out very well. Losses were more frequent and larger than I would have figured, but that is sometimes what happens when you work with a service and have less control over the trades directly.
Now, rather than selling options then having to buy the corresponding protective options to look after loss control I can directly sell options and set stop orders to exit for protection.
This allows two things to happen. One, cost savings for the trade overall, no buying and Two, I can take cheaper options which means closer to expiry (days) and/or farther out of the money.
This is where the weekly options come into play. Each week I can place a trade that is one, two or maybe three days away from expiry and select options that are far enough out of the money that the chances of them closing in the money are very very slim, I'll work that one out next post. These options are using the European method where they cannot be assigned prior to expiry so there is zero change of getting stuck with stock pre-maturely and they are traded right through to Friday evening which means I don't have to just sit and wait to see what happens on Friday as the prices could go anywhere. I had that happen where a loss turned into a larger loss over the Thursday night. Not fun.
I know this is an all over the place post but I wanted to get some information down and out of my head so I could focus on the particulars that I need to work out before this actually can be deem ed a workable trading plan. 15 years of backtesting for starters... even though the weeklies have not been around for more than a few years this lets me track the underlying price activity in order to see historically significant moves which provides me some idea of the possible risk involved.
Jeff.
I still like my latest trading plan but I don't like the need to hold a bunch of stocks in the wings waiting for trade setups. I look at tweaking the system every once in a while in order to generate more trades but I realize that more trades does not equate to more profit, often it is quite the contrary.
So, I return to an option trading strategy that I started a while back and add a few incidental facts that I did not have available at the time. If any were following along then and are still here it was my iron condor option trade strategy. While it happened to produce 100% profitable trades while I worked it, I shut it down as the SPY ETF options were getting rather cheap. This only served to drive the risk up while trying to optimize the profitability as I have to take options that were further away from expiry and closer to the strike prices. Besides, I had another grand trading scheme in mind at the time.
The little fact that I did not have at the time was that weekly expiry options were becoming available for various index ETFs. I had determined that I would need to start trading futures in order to see enough premium in option selling to justify running iron condors but I had tried that using a service already, and it did not pan out very well. Losses were more frequent and larger than I would have figured, but that is sometimes what happens when you work with a service and have less control over the trades directly.
Now, rather than selling options then having to buy the corresponding protective options to look after loss control I can directly sell options and set stop orders to exit for protection.
This allows two things to happen. One, cost savings for the trade overall, no buying and Two, I can take cheaper options which means closer to expiry (days) and/or farther out of the money.
This is where the weekly options come into play. Each week I can place a trade that is one, two or maybe three days away from expiry and select options that are far enough out of the money that the chances of them closing in the money are very very slim, I'll work that one out next post. These options are using the European method where they cannot be assigned prior to expiry so there is zero change of getting stuck with stock pre-maturely and they are traded right through to Friday evening which means I don't have to just sit and wait to see what happens on Friday as the prices could go anywhere. I had that happen where a loss turned into a larger loss over the Thursday night. Not fun.
I know this is an all over the place post but I wanted to get some information down and out of my head so I could focus on the particulars that I need to work out before this actually can be deem ed a workable trading plan. 15 years of backtesting for starters... even though the weeklies have not been around for more than a few years this lets me track the underlying price activity in order to see historically significant moves which provides me some idea of the possible risk involved.
Jeff.
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