S&P500 Simplified : Historical Odds Are....

In order to prove the efficacy of a plan, some historical context needs to be established... as much as historical performance does not indicate future performance, it is a very good indicator that a plan may have some merit going forward.

Using SPY as the initial test subject and about 10 years of daily open and close prices I set up a spreadsheet to compare various trade periods and strike ranges against the actual price movements. I also ran the numbers for 20 years and trades using every single trading day and the percentages were very close so I have chosen to work with a smaller chunk.

In this first study I used trade periods of between 5 and 40 trading days (not calendar days) and calculated the price move of SPY for each period ending on the option expiry, the third Friday of the month. The October 2013 monthly option expiry was the 18th, so trade start dates would have been August 22, 29th, September 6th, 13th, 20th, 27th, October 4th and 11th.

The percentage price move between the start and end of each period was calculated and compared to various strike distances represented as a percentage lower than the opening start price. I know the resultant "strikes" are not accurate to the dollar so this is more a relative measure to prove a point. If the price move did not end lower than the selected percentage or strike on expiry day, it was considered a successful trade.

Here is the resultant table. The colours represent the success rates up to 80% in red, between 80% and 85% in orange, 85% to 90% in yellow and anything over 90% in green. I figured that anything over 97% or 98% is just the narrow edge of the bell curve and not worth figuring out.

	40 Days	35 Days	30 Days	25 Days	20 Days	15 Days	10 Days	5 Days	Combined
Strike	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate
0%	65.52%	61.21%	60.68%	59.83%	60.68%	63.25%	58.97%	56.78%	60.86%
-1%	69.83%	68.10%	66.67%	67.52%	68.38%	68.38%	66.67%	74.58%	68.77%
-2%	73.28%	71.55%	73.50%	72.65%	73.50%	76.92%	74.36%	83.05%	74.87%
-3%	78.45%	77.59%	78.63%	77.78%	80.34%	82.05%	82.05%	89.83%	80.86%
-4%	82.76%	82.76%	82.05%	81.20%	83.76%	90.60%	91.45%	93.22%	85.99%
-5%	87.93%	87.07%	85.47%	85.47%	88.03%	93.16%	92.31%	95.76%	89.41%
-6%	88.79%	87.93%	89.74%	89.74%	91.45%	93.16%	94.87%	97.46%	91.66%
-7%	91.38%	90.52%	93.16%	94.87%	96.58%	94.02%	96.58%	99.15%	94.55%
-8%	93.97%	93.10%	94.02%	94.87%	96.58%	94.87%	98.29%	99.15%	95.61%
-9%	95.69%	93.97%	95.73%	94.87%	96.58%	94.87%	98.29%	99.15%	96.15%
-10%	95.69%	95.69%	96.58%	96.58%	98.29%	95.73%	98.29%	99.15%	97.01%
-11%	95.69%	96.55%	97.44%	96.58%	98.29%	96.58%	98.29%	99.15%	97.33%
-12%	97.41%	97.41%	97.44%	96.58%	98.29%	97.44%	98.29%	100.00%	97.86%
-13%	98.28%	97.41%	97.44%	97.44%	98.29%	98.29%	98.29%	100.00%	98.18%
-14%	98.28%	97.41%	97.44%	98.29%	98.29%	98.29%	99.15%	100.00%	98.40%
-15%	98.28%	98.28%	97.44%	99.15%	98.29%	98.29%	99.15%	100.00%	98.61%

It is worth noting that all periods hit the 90% range at -7% below the starting price and -4% for anything 15 days or less.

Assuming that there are trades at those 90% plus ranges, I like the odds.

Jeff.

TSLA trade setup using the Simplified S&P500 formula

I know this is jumping the gun, but even though I haven't written all my posts on the S&P500 formula I wanted to apply it to an ideal trade setup today.

Yesterday TSLA had a serious drop in price of just over 10%. Today the price opened under $120 and the put options were priced accordingly.

The Implied Volatility (IV) Rank was over 60, which is a good place for it to be with this sort of spread trading as a high relative IV drives the price of options up, it's one of the factors that directly affect the extrinsic value of a stock.

Here is the historic chart representing the distance from the price for spread strike entry relative to the time until expiry based on trading days, not calendar days and the successful trades... or at least trades when the price ended above the strike price. The pattern suggests that trades longer than 20 days may have crossed the strike then returned above by the end of the period which leads me to use a different strategy here, but the same spread type.

	40 Days	35 Days	30 Days	25 Days	20 Days	15 Days	10 Days	5 Days	Combined
Strike	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate
-5%	71.05%	76.92%	74.36%	71.79%	66.67%	74.36%	72.50%	77.50%	73.16%
-6%	73.68%	76.92%	76.92%	71.79%	69.23%	76.92%	72.50%	80.00%	74.76%
-7%	73.68%	82.05%	82.05%	76.92%	79.49%	76.92%	82.50%	87.50%	80.19%
-8%	78.95%	82.05%	84.62%	76.92%	79.49%	79.49%	90.00%	87.50%	82.43%
-9%	81.58%	82.05%	87.18%	87.18%	84.62%	82.05%	90.00%	92.50%	85.94%
-10%	81.58%	82.05%	87.18%	89.74%	87.18%	87.18%	95.00%	95.00%	88.18%
-11%	84.21%	84.62%	87.18%	92.31%	87.18%	89.74%	95.00%	97.50%	89.78%
-12%	86.84%	84.62%	89.74%	92.31%	89.74%	89.74%	95.00%	97.50%	90.73%
-13%	92.11%	84.62%	89.74%	92.31%	89.74%	94.87%	95.00%	100.00%	92.33%
-14%	94.74%	87.18%	89.74%	94.87%	89.74%	97.44%	95.00%	100.00%	93.61%
-15%	94.74%	87.18%	89.74%	97.44%	89.74%	100.00%	95.00%	100.00%	94.25%
-16%	94.74%	87.18%	89.74%	97.44%	92.31%	100.00%	95.00%	100.00%	94.57%
-17%	94.74%	89.74%	92.31%	100.00%	94.87%	100.00%	97.50%	100.00%	96.17%
-18%	94.74%	89.74%	92.31%	100.00%	94.87%	100.00%	97.50%	100.00%	96.17%
-19%	94.74%	94.87%	94.87%	100.00%	94.87%	100.00%	97.50%	100.00%	97.12%
-20%	94.74%	94.87%	94.87%	100.00%	94.87%	100.00%	100.00%	100.00%	97.44%
-21%	94.74%	97.44%	97.44%	100.00%	97.44%	100.00%	100.00%	100.00%	98.40%
-22%	94.74%	97.44%	97.44%	100.00%	97.44%	100.00%	100.00%	100.00%	98.40%

The trade entry was this morning at the open for the December 21 105/100 put spread (selling the 105 and buying the 100) for a credit of  75 cents.

This is basically making $75 on a $5 spread which is a $425 risk or a Return On Risk of 17.6% if the option is held to expiry... 31 calendar days (23 trading days on my charts). The 105 strike is about 13% OTM which has a historic win rate of almost 90% (the 20 day column above) or 92% (the 25 day column).

I might consider that the bottom of the spread is the determining number for the risk as that is maximum loss, and the 100 strike is closer to 17% lower than the price which pegs the historical odds between 95 and 100%

Strategy 1 might be to hold the trade through to expiry for the full return and take the slim chance that it might not work out OR aim for 50% profit taking which, with the action of the stock, could take as little as a week.... probably whichever comes first. At this writing (almost 3pm on the same day) the value of this spread has dropped to 55 cents, which is 26.6% profit already.

Let's see where this one goes.

Jeff.

S&P500 Simplified : Calls vs Puts

The first item to clarify when it comes to trading anything is that buying a security or derivative (option) involves forecasting the move in price. The move must be in favour of the trade and, with options, must make that favourable move in some chosen time frame. Considering that the price can go up, down or even sideways, a very base assumption is that just buying options I can be correct maybe a third of the time, although with stocks they can be held indefinitely so there is less of a time factor, perhaps it's fair to say that the odds are near 50%. There are strategies that can mitigate and help to produce larger winners than losers but, as I have found out, they are often not as simple as at first thought.

In my last post I had briefly outlined the difference between naked options and spreads, specifically trading the puts which can be a fairly neutral strategy in that the price of the underlying stock can move up, sideways and even down a certain amount and the trade will still produce a profit. This can change the base 33% odds to higher than 50%. Anything over 50% is the edge that can be used to produce more winning trades than losers but even that is often not enough to make a trade strategy profitable. More on the stats in the next post.

The main reason for choosing put spreads instead of call spreads has to do with the price skew between calls and puts. Today SPY closed at $179.87. Comparing the equal (more or less) strike distanced 190 call selling for 9 cents and the 170 put options selling for 51 cents. In the case of the credit spread, the higher priced option produces a higher profit trade.

A note about the pricing structure of the options used in this sort of strategy.

A put has intrinsic value when the stock price is below the strike. This value is equal to the difference between the strike and the price and changes in direct proportion to any changes in the price of the stock. The credit spread uses options that are OTM and do not have any intrinsic value.

In it's simplest form, the extrinsic or time value is a calculated price or premium based on the volatility of the stock (expected and historical range of price moves), proximity of the strike to the price and the time left until it's expiry. This value reduces or decays as the expiry date approaches, as the price wanders higher making the option farther OTM and as the volatility reduces. A credit spread uses this decaying extrinsic value in it's favour as the credit gained at the initial sale is kept as the options expire with a zero value at expiry. The only factor that can produce a losing trade is the price dropping below the put strike so a directional move up is better for the position but isn't critical. Time can only reduce and, while volatility can affect interim trade value, it won't matter as long as the price stays higher than the strike. A sharp reduction in volatility in a few days can turn the trade into a quick winner and can allow it to be closed early... but that is a whole other topic.

Here is the comparison between the two vertical spreads, a call and a put, with the same $5 width or spread, these are based on the SPY December 2013 monthly option prices:

Call Spread				Put Spread
$0.06		Net credit in green		$0.24
$0.03	Buy	195 strike
$0.09	Sell	190 strike
		SPY Price 179.87
		170 strike	Sell	$0.51
		165 strike	Buy	$0.27

In a 10 contract trade the call spread will produce $60 (1.2% Return On Capital, ROC) and the put spread $240 (4.8% ROR). This disparity is typical between OTM calls and puts on most any underlying stock or fund. That's an even 300% higher return.

This pushes me to look for an edge that favours a put credit spread even though I expect that there may be better odds in favour of the call spread, the reduced profitability won't make up for the difference... particularly in a small account..

Jeff.

S&P500 Simplified : Selling Naked Options vs Credit Spreads in SPY

Lately I've been tinkering with credit spreads and naked puts in SPY, more out of curiosity than anything else... that is until I did some extensive studying of the historical SPY data. More on that another time though.

I have dabbled in options before and made out very well.... and not so well in varied proportions. The one strategy that I did have a 100% success rate (albeit with not as many trades as would be needed to prove feasibility) with was the credit spread. It was short lived due to my need for continued testing of other strategies and styles of trading, which is now one of those hindsight stories.

The basic credit spread plan is to sell an out of the money option and buy a further out of the money option with the same expiry. The first is the profit and the second is the protection. The risk is fixed and is the difference in the strike prices less the premium collected. The trouble is getting enough premium difference between the two transactions to be profitable which made me consider the naked option.

Naked option selling looks much more lucrative up front as selling the option without the need for a protective leg purchase means that all of the premium collected is kept. This often allows the sold option to be farther out of the money and still be profitable. The trouble is that the risk is no longer defined.

With a naked put, if the price plummets the loss becomes the difference between the strike price of the put and the price of the underlying at expiry. Not that a stock is going to hit zero but a large down move could be a real problem. This is the point where my SPY study comes in to provide some historical context for the risk involved.

While the naked options look enticing for the reasons mentioned and the credit spreads look to be a safer bet, the upfront account management implications for both need to be considered and compared.

Account size.

A typical broker may have a $5,000 minimum account balance in order to trade credit spreads whereas $25,000 is required to sell naked options. This makes the credit spread more accessible to the small account holder or hobby trader. Anyone halfway serious can probably start with enough to choose either method but only if they are comfortable and confident in the plan and have at least $100,000 would they really be able to use naked option selling.

Margin requirements.

The credit spread requires the entire potential loss to be in the account... so, technically, margin is not even being used. With a spread that covers a $1 strike price range, this amounts to about $100 per contract and the margin does not change with the price of the underlying stock. This is also the entire amount risked, less the premium collected, on the trade. It will vary with how wide the spread is in increments of $100 per strike per contract. Because the protective put will be exercised to offset the naked put in a worst case scenario, there is no chance that there will be any assignment of the stock or ETF.

For a naked option this amount is more variable and is not the entire risk associated with the trade. For a $100 stock the margin required might be in the $1,500 range whereas a $200 stock could be around $3,000. It varies with how far out of the money the option is and how much premium was collected for it. The margin requirements also change with the stock price.

These differences make the credit spread a more viable trading method for those with small to medium accounts as naked option trades will tie up much more cash per transaction.

For example, a naked 140 put for November expiry sold for 19 cents on September 30th. 10 contracts would yield $170 after commissions but based on a margin requirement of $24,860 which is an ROI of 0.68%. That is one trade.

A credit spread between 141 and 135 strikes sold at the same time with the same expiry would yield 7 cents net. It would take 42 contracts in one trade to equal the cash return of the naked option using $25,000. The advantage is that four separate trades could be placed at varied times and dates which could be at different strikes based on the price movement and these can be staggered in a way to reduce the chance of a price move producing a loss. Four trades of 10 contracts each that I am currently tracking are from September 30th, October 3rd, 7th and 8th with 10 contracts per trade which can yield a combined $200 profit after commissions based on a margin requirement of $23,800 or an ROI of 0.84%.

A quick note, both the naked puts sold and the credit spreads that I track are set up such that they have a success rate of better than 98% over 20 years. Even then the few times that they were "losers" appear to have been easy to close before they were a total failure... which is more important with the naked options than the spreads.

(UPDATE: I am investigating strategies based on historical statistics and current data that will serve to increase the returns on risk and maybe even increase the probability of the trades being winners.)

Jeff.

The VTSO trade for SPY, active

If you read my last post it briefly outlined trade ideas based on the McClellan oscillator as a trigger and the chart indicated a trade to open on November 15th.

Here is the oscillator:

...and here is the current SPY daily chart:

Today the adjusted VTSO has the stop at $134.76. While this price is still below the entry price of $135.98 the loss, should the stop be triggered now, is not very great.

I toyed around with the idea of taking profits at 4%, 6% and 8% gains along the way but found that just leaving the VTSO run and adjusting it at those particular points in the trade is more profitable by about 10% overall. While the smaller realized gains serve to give the feeling of success, they are not necessary. Having said that, a target exit of 6 % has the best bang for the buck if I decided to go that route for a smaller sidebar trade.

Jeff.