Shorting Index Futures Options

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Shorting Futures OptionsShorting Futures Options©©“ “

(One Year Later) (One Year Later) In Volatile MarketsIn Volatile Markets

Eric HartfordEric Hartford

[email protected][email protected]

2 July 20082 July 2008

Disclaimer – The markets are an expensive place to learn. Don’t even think about trading with money that you cannot afford to lose; in fact, kiss off your entire trading account before your first trade- it’s gone! What were you thinking? All trading systems involve losses. Past performance means nothing. Don’t believe anything you can’t prove. Eric Hartford is not a registered security representative nor financial advisor, bears no responsibility for you or your actions, has obvious trust issues, and laughs at; efficient market theory, bipartisan commissions, soft landings, mutual funds, dollar cost averaging, self-regulation, the SEC, buy and hold, corporate integrity, BLS statistics, CPI calculation, petroleum reserve estimates, re-stated earnings, & the Laffer Curve. Of course, the market is rigged against you, but you can’t win if you don’t try.

Creative Destruction Company Creative Destruction Company All Rights ReservedAll Rights Reserved 22

Last YearLast Year

•• A Complete Trading SystemA Complete Trading System

–– Short Index Futures Options Short Index Futures Options

–– ScalableScalable

•• Rules Rules –– Position Sizing, Heuristics Position Sizing, Heuristics

•• Entry Entry –– 4 ways to figure Probability4 ways to figure Probability

•• S&P 500 Digression S&P 500 Digression

–– 3 charting packages3 charting packages

•• Expectancy Expectancy -- ProfitabilityProfitability

•• Exit Exit –– 8 ways out of credit spread stress 8 ways out of credit spread stress


System ElementsSystem Elements

•• UnderlyingUnderlying

•• PitPit-- traded Options on S&P 500 Futurestraded Options on S&P 500 Futures–– Favorable margin (SPAN)Favorable margin (SPAN)

–– Favorable taxation 60:40 Long Term Short Term Favorable taxation 60:40 Long Term Short Term Cap GainsCap Gains

–– Favorable liquidity at strikes far outFavorable liquidity at strikes far out--ofof--thethe--money money

•• Trade Trade DurationDuration–– 5 5 –– 10 Weeks before expiration10 Weeks before expiration

•• Position Position SizingSizing–– 1 short strangle/condor per $5K margin1 short strangle/condor per $5K margin

–– 10% Value at risk requires exit at twice 10% Value at risk requires exit at twice premium collected, per sidepremium collected, per side

•• Entry Entry –– Premium writing, short strangles, iron condorPremium writing, short strangles, iron condor

•• Exits Exits –– 8 techniques 8 techniques for positions under pressurefor positions under pressure


Strangling the S&P 500Strangling the S&P 500

•• Write premium on 20Write premium on 20--pt credit pt credit spreadsspreads–– Both puts and calls, Both puts and calls,

–– Legging in Legging in –– better fills, higher risk better fills, higher risk of no fillof no fill

•• Short OTM option strikesShort OTM option strikes–– Probability < ~ 10% finishing ITMProbability < ~ 10% finishing ITM

–– Probability < ~ 20% contacting Probability < ~ 20% contacting

–– Minimum range based on volatility, Minimum range based on volatility, durationduration

•• 45% minimum annualized return 45% minimum annualized return initiallyinitially


Trade Vehicles vs. LeverageTrade Vehicles vs. Leverage

•• SPY (I Share) 1 S&P 500 pt approx = $0.10 SPY (I Share) 1 S&P 500 pt approx = $0.10

•• $SPX (CBOE Index) 1 S&P 500 pt = $1.00$SPX (CBOE Index) 1 S&P 500 pt = $1.00

•• ESES--U07 (eU07 (e--mini) 1 S&P 500 Future pt = $50.mini) 1 S&P 500 Future pt = $50.0000

•• SP07 (CME Full) 1 S&P 500 Future pt = $250.SP07 (CME Full) 1 S&P 500 Future pt = $250.0000

•• EV07 (End of Month) S&P 500 EV07 (End of Month) S&P 500 FutFut pt = $250.pt = $250.0000

&&

•• OPTIONS on all of aboveOPTIONS on all of above


Wait for reversal before selling puts>18

NTNT22522021021016

NT22021020019018014

19518517516515514512

190180170160150NT10

1098765VIX

Time to Expiration ~ weeks

Range vs. Duration & VolatilityRange vs. Duration & Volatility


Other ConsiderationsOther Considerations

•• FrequencyFrequency–– RateRate trading opportunities occur is generally 1 per daytrading opportunities occur is generally 1 per day

–– Conditions change, but generally can initiate 60% Conditions change, but generally can initiate 60% annualized return trade when VIX is over 14.5annualized return trade when VIX is over 14.5

•• Reliability Reliability –– Only matters wrt Expectancy & to Trader’s personality, Only matters wrt Expectancy & to Trader’s personality, goalsgoals

–– As you’ll see in Expectancy, generally 83% of trades winAs you’ll see in Expectancy, generally 83% of trades win

•• CostsCosts–– Commission/fee is $16.65 round turn on full CME S&P 500Commission/fee is $16.65 round turn on full CME S&P 500

–– Psyche tested often, Bid/Ask widens from 0.20 pts to 2.00 Psyche tested often, Bid/Ask widens from 0.20 pts to 2.00 ptspts

–– Opportunity Opportunity –– entry during low volatility foregoes better entry during low volatility foregoes better returns laterreturns later


Heuristics ~ Rules of ThumbHeuristics ~ Rules of Thumb

•• 5 pt move in the S&P futures fills at net 5 pt move in the S&P futures fills at net settlement in the direction of the movesettlement in the direction of the move

•• Collect >one point on put & call spreadsCollect >one point on put & call spreads

–– Puts typically 4 pts short, 3 pts longPuts typically 4 pts short, 3 pts long

–– Calls typically 2 pts short, 1 pt longCalls typically 2 pts short, 1 pt long

–– 8.7% initial net on maximum exposure8.7% initial net on maximum exposure

–– 90% initial annualized for 35 days, 90% initial annualized for 35 days, 45% at 70 days45% at 70 days

•• Enter trades in multiples of 2, 3, 4, 6 Enter trades in multiples of 2, 3, 4, 6

•• Generally 12 Generally 12 –– 24 positions per expiration 24 positions per expiration cyclecycle


Probability Finishing ITM Probability Finishing ITM vs.vs.

“Touching” before expiry“Touching” before expiry

•• Standard Deviation Standard Deviation –– I use 1.6 std devI use 1.6 std dev

–– IV ATM Call x underlying x sq rt DTE/365IV ATM Call x underlying x sq rt DTE/365

–– (ATM Put + ATM Call) x 1.25(ATM Put + ATM Call) x 1.25

•• Log Normal Log Normal –– see formula on handoutsee formula on handout

•• Delta is + or Delta is + or –– 3% approximation for:3% approximation for:

Volatility< 50Volatility< 50

Time to expiration < 70 daysTime to expiration < 70 days

•• Monte Carlo Simulation Monte Carlo Simulation


167016700.200.20131322000.0100.010

166016600.150.15111122000.0080.008

165016500.250.251717220.0010.0010.0130.013

164016400.300.302020330.0010.0010.0160.016

163016300.600.603333550.0010.0010.0300.030

162016201.001.004747770.0020.0020.0460.046

161016101.601.60636310100.0020.0020.0680.068

160016002.502.50838313130.0030.0030.0970.097

159015904.204.2010910918180.0040.0040.1430.143

158015805.805.8012912921210.0050.0050.1840.184

157015709.009.0015315326260.0050.0050.2470.247

1560156010.8010.8016616628280.0060.0060.2910.291

1550155015.4015.4018118132320.0060.0060.3590.359SPQ07SPQ07

LastLastVegaVegaThetaThetaGammaGammaDeltaDelta

StrikeStrikeCallCallOptionOption

Option Greeks – Futuresource.comFuturesource.com


Historical Volatility: 13.07

JULY (10) AUGUST (38) SEPT (72)CALLS

1670 3 111660 4 131650 6 151640 1 7 181630 1 9 221620 1 12 251610 1 16 311600 2 21 351590 4 26 411580 7 33 471570 12 41 531560 20 48 611555 25 54 64

McMillanMcMillan Monte Carlo Simulator Probabilities


Other Entry Other Entry

ConsiderationsConsiderations

•• Support and ResistanceSupport and Resistance

•• Fibonacci LevelsFibonacci Levels

•• Andrews Pitchforks & ChannelsAndrews Pitchforks & Channels

•• Daily Pivot limits for order pricing Daily Pivot limits for order pricing

•• Degree & Duration of TrendsDegree & Duration of Trends

•• Average True Range, Rate of Average True Range, Rate of

ChangeChange

•• 2020--, 50, 50--, 200, 200--Day, Trend Support Day, Trend Support

MAs MAs

•• And now, a digression on the S&P And now, a digression on the S&P

w/charts…w/charts…





ExpectancyExpectancy

Expectancy = Expectancy =

%wins x avg. win %wins x avg. win –– %losers x avg. loss%losers x avg. loss

Actual resultsActual results

$262 = 0.83 x $464 $262 = 0.83 x $464 –– 0.17 x $7230.17 x $723

•• Theoretical Expectancy Theoretical Expectancy –– For credit spread systemsFor credit spread systemsProbabilityProbabilityww (Credit) (Credit) –– ProbabilityProbabilityL L (Loss Limit)(Loss Limit)

•• Theory is not Fact Theory is not Fact –– Market distributions have fat tailsMarket distributions have fat tails

•• Summation of 300+ trades over the last 24 Summation of 300+ trades over the last 24 monthsmonths

•• POSITIVE EXPECTANCY DEFINES A POSITIVE EXPECTANCY DEFINES A WINNING SYSTEM !WINNING SYSTEM !


ProfitProfit

•• Nearly 800 tradesNearly 800 trades

•• From Aug 03 From Aug 03 –– June 07June 07

•• Not using CAGRNot using CAGR-- uncompoundeduncompounded

2004 2004 –– 63% annualized returns63% annualized returns



•• Expectancy based on rolling 24Expectancy based on rolling 24-- month resultsmonth results

of 40.7% annualized returnsof 40.7% annualized returns


Exit GuidelinesExit Guidelines

•• Close position if;Close position if;–– Underlying crosses strike intradayUnderlying crosses strike intraday

–– Delta exceeds 0.400Delta exceeds 0.400

–– McMillan probability exceeds 75%McMillan probability exceeds 75%

–– Annualized return remaining < new Annualized return remaining < new positionposition-- Typically 85% target reached w/ > 20 Typically 85% target reached w/ > 20 DTEDTE

–– Expiration Expiration

•• Strong Move right after entry = Strong Move right after entry = worst caseworst case


8 Exits for Stressed Spreads8 Exits for Stressed Spreads

1) 1) Do nothingDo nothing

2)2) Exit to closeExit to close

3) 3) Roll away strikes same monthRoll away strikes same month

4) 4) Roll out in time at same strikeRoll out in time at same strike

5) 5) Roll out and awayRoll out and away

6) 6) Jump in front with an options hedgeJump in front with an options hedge

7) 7) Jump in front with a futures hedgeJump in front with a futures hedge

8) 8) Jump in front with synthetic futuresJump in front with synthetic futures


What has changed What has changed

since then?since then?

•• One year older ( wiser? )One year older ( wiser? )

•• Existing Trends ExtendedExisting Trends Extended–– Suburban Housing continues to lose valueSuburban Housing continues to lose value

–– Energy Doubles Energy Doubles –– Demand exceeds Supply Q4 Demand exceeds Supply Q4 ‘07‘07

–– Wars continue Wars continue –– millions of lives ruined millions of lives ruined •• $30 per capita/per month indefinitely$30 per capita/per month indefinitely

•• Congress approves $300M to “prepare the Congress approves $300M to “prepare the battle space” in Iranbattle space” in Iran

–– Growing Debt (Personal, Corp, Growing Debt (Personal, Corp, GovtGovt) destroys ) destroys Dollar and BanksDollar and Banks

–– Banks Reluctant to lend. Rinse, Repeat…Banks Reluctant to lend. Rinse, Repeat…

•• Globalization continuesGlobalization continues•• Jobs dwindle Jobs dwindle –– everyone’s a contractoreveryone’s a contractor

•• Competition for Resources must price out Competition for Resources must price out demanddemand

•• Per capita GDP shrinks Q4 ’07 and Q1 ‘08Per capita GDP shrinks Q4 ’07 and Q1 ‘08•• Market conditions … cMarket conditions … changed…hanged…





USA USA -- Housing IndexHousing Index


OilOil

•• Supply Constant 3 Supply Constant 3

yearyear

86.6 MBD May 200586.6 MBD May 2005

86.7 MBD Jan 200886.7 MBD Jan 2008

••USA uses ~21 MBDUSA uses ~21 MBD

••Inventories declined Inventories declined

19.1MBD over 4 19.1MBD over 4

weeks below Aug ’05 weeks below Aug ’05

levelslevels

•• Price out 5% USA Price out 5% USA

Demand?Demand?


USA Finance USA Finance –– PrePre--Collapse or Collapse or

PrePre--TakeOffTakeOff ??


US Dollar IndexUS Dollar Index


So, what did I do about So, what did I do about

all this?all this?

•• Read a couple books by Read a couple books by TalebTaleb–– Fooled by RandomnessFooled by Randomness

–– The Black SwanThe Black Swan•• Coin Flip Coin Flip

•• Returns Returns –– not normal, the past is no guide, not normal, the past is no guide, luck mattersluck matters

•• Absence of Proof is not Proof of AbsenceAbsence of Proof is not Proof of Absence

•• Fat Tails & 100 year floods and Marginal Fat Tails & 100 year floods and Marginal EffectsEffects

•• Narratives Narratives

•• Quit trying to pick up all the nickels Quit trying to pick up all the nickels in front of the steamroller, at least in front of the steamroller, at least not all…not all…


What I did about what I learnedWhat I did about what I learned

•• Expanded the volatility/durationExpanded the volatility/duration

–– Traded Volatilities up to 24 on VIXTraded Volatilities up to 24 on VIX

•• Traded shorter durations Traded shorter durations

–– Used new instrument Used new instrument –– EoMEoM OptionsOptions

•• Traded directionally Traded directionally

–– Coin flip correlationCoin flip correlation

•• Traded Broken Wing CondorsTraded Broken Wing Condors

–– Unbalanced, Long option NTM optionUnbalanced, Long option NTM option

–– Profit probability at exit before expiryProfit probability at exit before expiry


Constructing CondorsConstructing Condors


ResultsResults

•• Got hammered last AugustGot hammered last August–– Spent on long positionsSpent on long positions

–– Went to bed deep ITMWent to bed deep ITM

–– Fed intervention cost me 40 pts Fed intervention cost me 40 pts •• (@ $250 per)(@ $250 per)

•• Closed out Jan put positions at a lossClosed out Jan put positions at a loss

-- Got worse even faster than my Got worse even faster than my bearish viewbearish view

-- Rolling 12 month returns ~ 12 %Rolling 12 month returns ~ 12 %

-- Now buy options, new issuesNow buy options, new issues-- Timing, Profit Targets, Timing, Profit Targets, Reward:RiskReward:Risk


THANKS !

Any Questions ?

Date post:	31-May-2015
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