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I used a similar approach for a while. But after some months I had to find out that I had lost money on the futures. Thus, I stopped buying / selling futures to have a stop loss for short option positions.
So I wanted to put together a quick post talking about the ups and downs of rolling.
During an earlier trade I opened a single position with 50 contracts and afterwards decided the position was too large and would need to be split up. So that's what I did, I converted the single position to 3 positions each one ranging from 10 to 25 contracts. Now, when this happened the original position was in the negative but in my mind I opened positions that kept my cash position the same. So to break this down
Original
ESU6 P1790 -50
ESU6 P1490 100
I opened another position along the way as the market bounced back and added a few extra contracts to cover transaction costs
New:
ESU6 P1790 -10
ESU6 P1490 20
EWU6 P1450 P -25
EWU6 P1700 P 50
EWV6 P1400 -29
EWV6 P1650 58
So the above is where I stand. Now, each position had decayed 50% or more so all seemed great BUT and this is the BIG BUT here my Net Liq is still lower than when I started. Why? I had to spend some time with my spreadsheet and go through the trades only to realize the issue, I never accounted for the loss when I closed out the original position. See, even though you get the same amount of cash from the roll the fact that we're not going to 100% expiration but to 50% means that you'll end up with a net loss overall.
Ex.
1. $100,000 cash balance
2. Original position was opened and gave you a premium of $5,000
3. New balance on the account is $105,000, so far so good
4. Now the position drops and the options premium doubles..and you decide to roll
5. You close the old position and your cash balance is $90,000
6. Open a new position at a lower strike that takes your cash balance back to $105,000 and you think all is good BUT
7. your new 50% value is not $105,000, it's actually $97,500.
There in is the problem. A roll CAN NOT just account for the cash balance but must accommodate the draw down against your Net Liq as well. So now I have these open positions open and all of them have past the 50% mark but I can't close them out because my Net Liq is still in the red.
Does anyone have strategies around this? I'd love to get some thoughts and advice on how to properly manage this situation and potential situations like this going forward.
@rsm005 I think you had an error in the calculation of your premium doubling. If your original balance was 100K and the premium taken in was 5K then the new net liq value would be 95K. The premium went from 5K to 10K and of that amount half of it is your loss (5K) and the other half is your original premium taken in. In your scenario, to go from 105K --> 90K account value, assuming an initial premium of 5K, would require the option premium to have tripled.
EDIT: I reread your original post and think you meant 5K as the premium target of 50% profit taking. i.e., you took in 10K of premium and were targeting an exit with 5K. You're correct that with a 2:1 risk to reward ratio, you can't come out ahead with a roll unless you increase your position size.
With the help of @SMCJB I researched what would have happened last year Aug and Sep if futures dropped more than they did. It did drop from 2091 on 8/17/15 to 1862 on 8/24/15 and 1872 on 9/28/15. I was looking at a total drop from 2091 to 1791, 1691 and 1591. 300, 400 & 500.
The problem is that we have no way to estimate what the margin would have been with those larger drops. I'm guessing that we would have been on margin call with the larger drops. But I wanted to see what shape the account would have been in after exiting.
But we can kind of estimate the option premiums. In order to estimate the premiums I had to estimate the IV. I looked at the patterns involved and what the higher strikes' IV was on 8/24/15.
For example on 8/21/15, the Friday before the crash, the 1675 put had an IV of 30. That same day the 1775 put had an IV of 26. After the futures drop of 101 on 8/24/15, the 1675 had an IV of 33. So the 101 drop should have made the IV 26 (IV gets lower the closer to ATM) but the increased volatility because of the 101 drop added 7 to the IV making it 33.
I then estimated the IV for the 1675 put on 8/24/15 if the futures dropped to 1691 by taking the 1775 IV of 30 and adding 5 to that (7 times 71% (the further drop to 1791 from 1862)) and used 35 for the IV for the 1675 if the futures were 1791 on 8/24/15. I then plugged that into a Black-Scholes calculator to get a premium of 68.39.
Here are the actuals and estimates.
The premiums on the 1440(2) rows are for two longs.
I knew that the 2 longs spread would do better draw down wise on the drops that occurred 7 days after entering the spread. I was a bit surprised that the 2 long spread did equally as well as the closer together 1 long spread at 53 DTE.
The 1675-1575 spread was a 57% draw down at 1791 on 8/24/15. But it was 104% and 129% for 1691 & 1591 futures. Your account would have gone negative.
The 1675-1440(2) spread was never more than a 63% draw down on 8/24/15 even with a 500 drop in futures. But not every huge drop is going to happen 7 days after you entered the trade. So that is why I looked at what happened on 9/28/15 at 53 DTE.
The actual draw downs on 9/28/15 were about the same at 21-22%. When futures dropped to 1691 the draw downs were 86-90%. At 1591 futures and at 53 DTE, both spreads went negative with 110-139% draw downs.
In 2008 there was a 551 point drop in ES in 84 days.
Now remember that these premium estimates are just rough estimates and could be off. Plus every situation is different and the drop could be quicker and more volatile.
Based on this research I am going to go back to the one short two longs spread. Possible monthly ROI is about the same and you get better risk protection if the huge drop comes early and about the same if it happens later.
Just a quick question and I hope you guys won't find it disturbing or stupid
Regarding futures credit spread margin, is there any possible situation that the exchange will require us to put the whole amount of the spread as collateral when things go bad?
For example: currently shorting 1 credit put spread /EW3V6 P2000/P1950 will yield a premium of 275$ (the spread is $5.50) and my broker require me to post a margin of $424 (this is TOS, maybe less with other brokers). I want to know if there is any chance the exchange (yes, the exchange, not the broker) will require us to put the whole amount of spread as collateral (in this case, the amount is $2,225).
In my opinion, I don't think the exchange will ever require us to put the whole amount of the spread as collateral because that would conflict with their preferable method which is to use the SPAN margin. I just want to know if that situation ever happened before?
This situation just popped up in my head so I come here immediately to ask.
Sorry if I confused you guys.
Margins are increased by the exchanges in case of high volatility. Usually margin is significantly smaller than the full value of the spread or outright, but there are exceptions.
When the price of Minneapolis wheat exploded in early 2008 the margin for the commodity was increased to the full value of the contract. There are probably some more examples I am not aware of.
I should have mentioned strongly that I used a margin factor of 6X for these numbers. If you used 3X your account blew up on the actual numbers before I went even lower on the futures than it actually dropped.
