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Selling Options on Futures?
Started:July 19th, 2011 (06:16 PM) by ron99 Views / Replies:569,446 / 5,734
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Selling Options on Futures?

Old July 15th, 2014, 03:08 PM   #3481 (permalink)
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k20a View Post
Hi all, new here. This thread is simply epic.

I have been selling options on etfs for a few years and have been testing futures options with small amount for the past few months. I was mainly involved in weeklies so fops are a little different. my style is a bit more "unorthodox" and probably contradict what some of you guys do. I will summarise it and state my opinions on them.

Time
I am much more experienced in weeklies so I always go for only 1 month until expiry. Actually I prefer weeklies but theres no volume at the moment on the weekly fops. My reasoning is, say a stop loss is 3x the premium, with a monthly option, it takes 2 months to make it back (assuming you win). With a weekly, it only takes 2 weeks to make it back. A big move against you will most of the time result in a loss, either you are in monthly or weekly. It's almost always the "tail" end 2 std+ moves that get you. It is better for this to happen on a weekly than a monthly. Rarely do you get consecutive losing weeks as after the big move, volatility adjusts premium for the next period or you moved onto another market.

Also weekly compound over the long term makes a difference. For example 1% per week compounded against 4.33% per month (52%/12weeks) results in a 20% difference over 3 years.

Strike selection
I have tested alongside each other a few different methods and my conclusion is: sell as godamn far away as possible for an acceptable return. Go as far away where the premium:margin gives you the return you desire. I have had 2 times where a decent move against me, I had both 0.03 delta entry and as far as possible positions on. The delta strike premium went against me about double the premium. The far option the premium was lower than entry price. Further strikes helps,p remium decay works more

Expire or close early
This goes along with time and strike. Low time and far strikes means low premium. I usually enter for around $30/contract on a few hundred margin. Doesn't make sense to close it for $10. Expire, and repeat, I have already made the target amount for the period. Selling option should NOT be like trend following pyramiding, piling into winning trades (aka selling for 10c and closing for 2c and then selling more). When a big move comes, it will get you bad as you roll closer to extract more premium. Consistent low risk profits is better long run than milking a lot out of trades and then having a big loss as you progressively take on higher risk by rolling.

Margin
Ron's margin rule is absolutely spot on. Having 2x spare margin saved my ass when I entered with 66% free margin and then margin increased resulting in my having only 15% free margin left. Using Ron's words, I rode the position out with the excess margin as premium had not reach my stop yet. Coming from equities where margin barely changes I was always using upto 90% of margin. For naked selling on fops having spare margin is a must.

Diversification vs Concentration
I think almost everyone diversifies into a lot of different positions. I am of the opposite view. I do not think spreading your eggs out in multiple baskets should apply to selling options. We lose by "oh crap" moves. We want to avoid them as much as possible. By having less positions, you automatically dramatically lower the chance of catching one. If you have 10 soldiers and there are 10 different paths but you know for sure that 1 or 2 of the paths have landmines which you cannot possible analyse which one, you should not send everyone to the 10 different paths. I think 2 or maybe 3 different UNCORELLATED (avoid ng and cl @ same time, count them as "one" position) commodities is the max that should be spread.

Our risk to reward is very bad. We have capped profit. You cannot avoid it by selling OTM options. We rely on high probability win to make profits - having too many position simply goes against our edge. I think high diversifications is only for high R:R trading such as trend following, you do not know which market is going to trend hard, so you enter a lot to catch the big one and get stopped out on others. We are the opposite of this. We sell lottery tickets/death insurance ~ we want to sell to as less people as possible for the same profit.

Analysis/Projection
This is probably going to stir some people up, so please note this is only my opinion. Forget all your crystal balls/projections//reports/seasonals. If they work on a VERY consistent basis go trade directional, you will make more money. If they don't ~ sell options and throw it all out. Fundamental has no place for predicting the next 30 days move. It is pure sentiment. Do some very basic TA if you want, trendlines/sup&res. We are just managing the trade and letting time decay work its magic. Van Tharp has stated random entries work - it is in correct trade management that the profit lies. We are simply punting where price will not go and I truly believe a random entry(say when your positions expire), just looking at the numbers and if they add up, trade it and managing it correctly will be enough. You cannot guess where the bloody black swans will pop up - it certainly does not show up in the crop report or your freaking trendlines.

I only use very basic TA on a more macro view. We option sellers are mean reversionists. At whichever point you sell at some point it hopefully will revert back to the mean. You cannot perfect the entry. Selling a bit late or a bit early will result 1 or 2 strikes closer - no big deal.


---

All criticisms are welcome ! Opposing views always gets me thinking more and may open up more breakthroughs, I am ready to change any of my views above with more feedback and evidence.


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Old July 16th, 2014, 11:38 PM   #3482 (permalink)
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k20a View Post

Diversification vs Concentration
I think almost everyone diversifies into a lot of different positions. I am of the opposite view. I do not think spreading your eggs out in multiple baskets should apply to selling options. We lose by "oh crap" moves. We want to avoid them as much as possible. By having less positions, you automatically dramatically lower the chance of catching one. If you have 10 soldiers and there are 10 different paths but you know for sure that 1 or 2 of the paths have landmines which you cannot possible analyse which one, you should not send everyone to the 10 different paths. I think 2 or maybe 3 different UNCORELLATED (avoid ng and cl @ same time, count them as "one" position) commodities is the max that should be spread.

I've had this conversation with a few people outside of this thread, and after studying this a while I have concluded diversification is better, exactly the opposite of what you conclude.


Here is my reasoning:


Trader C is Mr. Concentrator. He has a $100 account. He takes 2 uncorrelated trades per month. He wins 90% of the time. When he wins, he makes $2.5 on his account. When he loses 10% of the time, he loses $10.

In one year, on average he'll win 24*.9 = 21.6 trades at $2.5 each = $54.
In one year, on average he'll lose 24*.10=2.4 trades at $10 each = -$24.

Overall in one year, he'll earn $30.

$$$$$$$$$$$$$

Trader D is Mr. Diversified. He has a $100 account. He takes 10 uncorrelated trades per month. He wins 90% of the time. When he wins, he makes $0.5 on his account. When he loses 10% of the time, he loses $2. Note that his wins and losses are exactly 1/5 of Trader C's wins and losses. This is because he is making 5x as many trades. This is accomplished by sizing his positions.

In one year, on average he'll win 120*.9 = 108 trades at $.5 each = $54.
In one year, on average he'll lose 120*.1=12 trades at $2 each = -$24.

Overall in one year, he'll earn $30.

********************************

OK, so overall, Trader C and Trader D, on average, will both earn the same return over time. Their performance looks equivalent, and it is as far as profits go.

The question is: would you rather be Trader C, or Trader D? Or does it even matter?



I encourage everyone to stop here, and think about the answer to that question. The answer is revealed in the next post.

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Old July 17th, 2014, 12:01 AM   #3483 (permalink)
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Diversification vs. Concentration, Part Deux


The question is: would you rather be Trader C (the concentrated trader), or Trader D (the diversified trader)? Or does it even matter?



Even though both traders, in my example, have the same average annual gain, it turns out it matters a lot, especially if you are concerned with drawdown and downside risk.

The answer has to do with standard deviation of the trade results. All other things being equal, if you want to minimize the downside, you always want to strive for the lowest standard deviation of trade results as possible. This leads to smaller drawdowns, as one tangible benefit. The drawback is that it gives up some upside potential.

If we look at Trader C's trades in one year (24 trades), his trade standard deviation is: 3.53

If we look at Trader D's trades in one year (120 trades), his trade standard deviation is: 0.75


That is a huge difference - almost a factor of 5. That is why it is better to be Trader D - lower standard deviation leads to smaller dispersion of trades, which shows up as smaller drawdowns.


Another way to show this is by running some Monte Carlo simulations, over 1 year's worth of trades. By showing final equity in a histogram, it is easy to see that Trader C has a more widely dispersed set of results than Trader D. Again, if everything else is the same, you want to have a tight distribution of final equity values (unless you are only trying to maximize gain).

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Note that on the far right of the chart above, Trader C has many more occurrences of big profit. So, if you were purely trying to maximize your odds of large final equity, without regards to downside risk, you'd want to be Trader C. That is the only benefit I can see in being Trader C.

If you want steadier results, diversification is the way to go.

*****************************************


End Note:

Of course, this is all an exercise, and makes a lot of simplifying assumptions. For instance, it assumes that both traders have the same win rate. Maybe Trader C, since he only deals with 2 markets, will be able to achieve a higher win rate, since presumably he knows the markets better. That would change this analysis. And I assumed uncorrelated trades for both traders. If Trader C's 2 markets become tightly correlated for a short time, he could be in trouble. Think about the 2008 meltdown, where many things seemed to be correlated.

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Old July 17th, 2014, 08:43 AM   #3484 (permalink)
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Good points kevin, but it assumes a few points I have some concerns with:

- All 10 trades in Diversification being equal only happens on paper theory. I am having trouble finding even 5 liquid enough FOP markets, let alone 10. Also at the same time, all 10 markets will not have the optimum IV/range. Selecting 2 or 3 of the best markets AT THAT TIME (IV moves around..eg. sometimes oil is high, sometimes wheat is), you can be flexible with concentration, you don't have to pick 3 markets out of the 10 and stick with them all year. You move around to where the best opportunities lie. Harder (impossible IMO) to do this with 10 positons.

- You left out compounding in your example. I am going to assume you & some (or most ?) people compound throughout the year, please correct me if I am wrong. If you assume every month is the same then yes the $100 example will turn out to be $30. If you factor compound in, it can be quite different (not so much over 1 year, but 3 years the difference is clear). 10 trades @ 90% win rate assumes a loss every month. This will slowly but "snowbally" bite into compounding and kill off some of its effects as opposed to Concentrated positons, where the chance of loss is just 20%, as opposed to a 100% loss rate. Yes you lose more when you lose but the extra buildup from longer preservation of profits allows compound to work its power.

--
However I must note the advantage of diversifying for people with a history of undisciplined exits. Personally in a few years of selling options I've never had a loss gap through my stop so I do not really see this advantage, but in a period of absolute armageddon this will apply. If you "forget" or "refuse" to close out losing positions that are at your stop, it is less damaging for this to happen to 10% of your account than 33% or 50% of your account, assuming uncorrelated positions.

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Old July 17th, 2014, 10:08 AM   #3485 (permalink)
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k20a View Post
- All 10 trades in Diversification being equal only happens on paper theory. I am having trouble finding even 5 liquid enough FOP markets, let alone 10. Also at the same time, all 10 markets will not have the optimum IV/range. Selecting 2 or 3 of the best markets AT THAT TIME (IV moves around..eg. sometimes oil is high, sometimes wheat is), you can be flexible with concentration, you don't have to pick 3 markets out of the 10 and stick with them all year. You move around to where the best opportunities lie. Harder (impossible IMO) to do this with 10 positons.

The same conclusion holds for any number of markets greater than 2. I could have picked 3, 5, 10, 100 or whatever number of markets - the conclusion is the same. Being diversified leads to steadier returns.



k20a View Post
- You left out compounding in your example. I am going to assume you & some (or most ?) people compound throughout the year, please correct me if I am wrong. If you assume every month is the same then yes the $100 example will turn out to be $30. If you factor compound in, it can be quite different (not so much over 1 year, but 3 years the difference is clear). 10 trades @ 90% win rate assumes a loss every month. This will slowly but "snowbally" bite into compounding and kill off some of its effects as opposed to Concentrated positons, where the chance of loss is just 20%, as opposed to a 100% loss rate. Yes you lose more when you lose but the extra buildup from longer preservation of profits allows compound to work its power.

Again, compounding doesn't change the conclusion. Here are the results for 5000 simulations, for 3 years of compounded trading, of Trader C and Trader D


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Annual Percent Return is roughly the same

Max DD is a lot less for Trader D

Risk Adjusted Performance (Return/DD, aka Calmar ratio) is a lot better for Trader D



Compounding doesn't change the conclusion.


So, does being more concentrated (Trader C) have a benefit? Yes, as mentioned earlier, the upside for Trader C is higher, as shown below. But the downside is also lower. And, the drawdown you have to endure to get the higher returns is much larger

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Old July 17th, 2014, 11:21 AM   #3486 (permalink)
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The same conclusion holds for any number of markets greater than 2. I could have picked 3, 5, 10, 100 or whatever number of markets - the conclusion is the same. Being diversified leads to steadier returns.

Yes I agree with you in theory. But in the real world in which we have to trade in - do you still make the same conclusion, after taking into effect having to deal with liquidity/optimal opportunity. I can only deal in about 3 commodities markets with my account size. Other markets I cannot get any fills.

Being diversified leads to steadier returns if all markets offer the same r:r & volume while all being uncorrelated. Which I believe is not the case in commodity futures.

Anyway we have reached the same conclusion for theory but I still hold my view for real world trading, all good. If can find 4 or more trades of the same high quality(low correlation, high liquidity, optimal iv/range), then diversify. Becomes harder as account grows.

I am getting a different value to you in compounding, I will check those values again.

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Old July 18th, 2014, 09:21 PM   #3487 (permalink)
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Old July 18th, 2014, 10:38 PM   #3488 (permalink)
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While the totals are higher, most of the growth is in exotic options including options that aren't traded on Globex. OI for options on CL, NG, RB, HO, C, S, GC, ES are lower compared to last year. CL is down by over 50% compared to 3 years ago.

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The ones higher YoY are EW, LH, LC, FC, & W.

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Old July 19th, 2014, 05:17 PM   #3489 (permalink)
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Nice post! Have you thought about or perhaps done weekly trades on ES. I personally would probably be uncomfortable with just naked shorts on any weeklies but was thinking more along the lines of horizontal or vertical spread or combination of thereof.

Well as promised, here are some of my recent trades I have done for SPY. With current volatility, they are best used for selling on expiration day. IB uses my timezone for timestamping trades, so all trades are -12hrs for new york time.

-------
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Expiration trade just last Friday. Looking on the chart price basically went sideways after 2.30pm, so at 3.30pm I sold strangle for 7c which is $7 for 25 contracts, minus commissions netting $153 for a 30 minutes trade.

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-------
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Last week's trade..Price was already flat near the open and throughout the day but I still waited until 2.30pm to sell. With price already been flat all day, I went for both strangles and straddles. Went for 10 contracts of $38, and closing it when it about halved for $20, netting total $180. Sold more other puts and calls as the day went on for another $100 or so.

-------
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This was from last month..I had more margin free so took 100 contracts of $4, netting $332 for the day. Price was flatlining all day..

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-------
Have a look at the chart above and look at the strike price range sold. If you take away the horizontal time axis and vertical price axis and I told you it was a daily bar, would you do the trade ? Options decay on all timeframes - you can sell intraday, few days, weeklies, few weeks, few months..all the same to me.

I use the SPY to pick up extra premium on the leftover margin available. Cross margining also reduces the margin a lot which makes this viable. The margin is going to expire at the end of day, maxing out your account has no margining risk - for equities at least..margins are adjusted EOD, at least for IB.

Risk ? I will exit the trade when premium doubles so essentially this is a 1:1 trade with a very high win rate. You are not exposed to overnight/weekend risk. Friday, especially late afternoon trading session, tend to be very quiet. Who's going to schedule for news to be released just before the market closes ? Big instituitions pin option strikes of big caps which makes up the SPY etf putting extra pressure on price flatlining. Unexpected news do pop up, but there is no way for price to gap through your stop for something so liquid like SPY options.

Picking up a $100 or $200 extra per week is potentially $5k or $10k extra a year. I do this every single week I have time to trade the Friday close. There is also Tuesday expiration trade every week too so you can double dip if you are keen on being active.

If I total up all my expiration trades vs monthly/weekly trades my win rate is higher on expiry trades.

Forgive me if this should not be posted in the futures thread, but the exact same method can be used on futures too. But obviously once a month is not as fun and liquidity will probably be a problem.

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Old July 19th, 2014, 06:51 PM   #3490 (permalink)
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k20a View Post

Risk ? I will exit the trade when premium doubles so essentially this is a 1:1 trade with a very high win rate. You are not exposed to overnight/weekend risk. Friday, especially late afternoon trading session, tend to be very quiet. Who's going to schedule for news to be released just before the market closes ? Big instituitions pin option strikes of big caps which makes up the SPY etf putting extra pressure on price flatlining. Unexpected news do pop up, but there is no way for price to gap through your stop for something so liquid like SPY options.

Thanks for sharing your trade. How do you handle stop loss order in IB? Manually or through contingent order?

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