Intro to Options. Part III : Designing Option Strategies

[Versiunea romaneasca] [ in romana] [English edition]

I could have entitled this article simply “Option Strategies”. But it’s not the case. This article will not be a presentation of option strategies, as it might have been normal, after the presentation of the greeks. Rather, we will outline the process of thinking and designing option strategies , with accent on a few elements that will be the building blocks of tomorrow’s generation of EAs.

There are two major classes of option strategies, derived from the basic ones:
– first, the ones that aim on winning on movements of the underlying asset , which have as risk underlying movements in the wrong way, and the decay;
– second, the ones that aim on preserving premium and use also the decay, which have as risk underlying movements in the wrong way as well as their strength;

There are more tuned strategies that derive from gamma trading:
– first, the ones that aim on winning from ranging markets;
– second, the ones that aim on trending markets;

And finally, pure implied volatility strategies that aim on relatively high/low implied volatilities. But this is another game ; it is a double edged sword, affecting all strategies in both ways.

It seems that underlying movements in the wrong way are a quite common risk of option strategies derived from the basic strategies, as well as in simple underlying trading. This happens because these strategies, which are many, are directional themselves.

However, what has to be clear in mind, first is how much are we prepared to lose?
If a trader would view the entire time to expiry, he would see the premium as maximum loss/maximum gain.

However, if trades are going to be kept only for the lifetime of a signal, we must have a clear image on what may happen with the option price. Some factors are harder to account for, others are more easy to see.

Study case: we have a bullish volatility signal on the underlying

We could buy a straddle.

A long straddle strategy consists in the purchase of a Call and a Put on the same underlying, having the same strike and expiry.

To have a balanced delta effect , we will pick an ATM strike, where deltas are similar as absolute value;
To give the strategy more time to have effect, we could pick a far expiry, where thetas are minimum ; this will expose us to vega .
It will be extremely indicated an implied volatility analysis ; this is a good go if implied volatility for chosen options is relatively low, as profits will be more probable, in the case of an increase ; it will not be indicated to do it in the case of a relatively high volatility ; because there would be the danger of an implied volatility going down, pulling down option prices with power, because for far expiries vega may be more powerful than delta.

The most interesting case is what happens if our signal is for instance on H4 ; if we are supposed to have powerful underlying movements over the next bars, with a maximum of 2-3 trading days, then probably we shouldn’t be too afraid of implied volatility. And if implied volatility will move too slow and decay will not have too much effect either, then we will be insulated from these effects, there will remain only delta effect. But remember, we didn’t have a directional expectation , as we intentionally picked similar deltas in absolute value. But remember the charts of delta versus the underlying (it’s easier to understand than gamma). Click here for a link to my previous article, in a new browser window, and look on the charts.
So, if the underlying is going quickly up, the delta of the Call will grow in size, making it more valuable, while the delta of the Put will fall in absolute value, insulating the Put price more and more. This will create an accelerating profit on the Call side, at the same time with decelerating losses on the Put side. If implied volatility doesn’t ruin the game, our profits will start forming up from the acceleration difference between Call and Put, that will have to finance spreads and decay. Got the catch? (N.B. There are also Option Spread strategies. When I write about this kind of strategy, I will write “Spread”, and when I write about the bid-ask difference, it will be “spread”).

Study case: we have a bearish volatility signal on the underlying
Side note: bearish volatility may not be necesarilly bearish; if a powerful counter-trend forms on the chart, our BBoverStdDev indicator will plot it as bearish volatility, because it reads “the return of the price to the average of the last values”. If prices return for good, the indicator will continue plotting bearish volatility for real, but if prices continue trending, the indicator will turn again to higher volatility plots. A bearish volatility signal would be then the intersection of the standard deviation with the lower Bollinger Band. Click here for the article in a different browser page.

Supposing that the signal is correct,
We could short a straddle.

A short straddle strategy consists in the sale of a Call and a Put on the same underlying, having the same strike and expiry.
The delta considerations should be the same, as for theta, we are now interested in decay. We will pick first expiry month. This will make the vega effect to be smallest in comparison to delta, throwing vega out of the picture. If the signal is correct, and what follows is a ranging market with a lower and lower volatility, we will have a hedge between the Call and the Put, as deltas will – first have not too much effect because the underlying itself doesn’t move too much, second, due to up/down movement , transfer profits/losses from the Call to the Put and viceversa – have no effect overall, being hedged. As time passes until signal clears out, the decay produces its effect , financing spreads and minor losses by delta unhedged deviations, thus generating profit.

Just a short parenthesis about hedging. You can see in this strategy that we emphasized accelerating profits versus decelerating losses. When you do the “hedging” as it is widely accepted by forex communities, by going long and short at the same time, that’s not really a hedge. It is a pause. It pauses any results until hedging is removed, by closing or adding trades that un-flatten the resultant position. Whilst the real hedging, the one that amounts to arbitrage, will insure that there will be accelerating profits versus decelerating losses (as in the first case), or keeping losses steady (as in the second case) of course, in such conditions that the trades have enough time to profit until outside parameters will produce their effects, meaningly implied volatility and decay.

These are just two examples. We will return to these examples as soon that both Strategy Tester and options will be available. Remember however that option traders don’t have proper tools on their hand. For this reasons, they invented strategies that put the accent on reducing payed premiums while capping maximum payout. Why ? Because there isn’t going to be any unlimited market action for unlimited profits, so there is no reason in paying full premiums.

Options are themselves hedged instruments. Especially the buyer has this feeling, that he uses a hedged instrument : unlimited upside potential, limited downside potential. However, a lot of option strategies will cap the upside potential and reduce costs of the downside potential. These strategies make up classes like Spreads (Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread) and Collars (Collar, Costless Collar, Fence). Strategies that aim on decay are Calendar Spreads and Iron Condors mostly.

You can read about these strategies on several option sites, including : , , ,, etc.

However, the point is not to know the strategies themselves. They are around for some time and can be found on Internet. Strategies should be played function of what you can analyse better: Straddles or Condors, if it’s underlying volatility, basic strategies or Spreads, if it’s underlying direction, or long term expiry options, if it’s implied volatility.

Sure, there is also possibility of option arbitrage. An arbitrage in the underlying market would mean to simultaneously buy and sell the underlying at different prices. Both buying and selling the underlying can be emulated with options, by the use of synthetic positions. For instance, Synthetic Long is composed by Shorting a Call and Longing a Put with the same strike and expiry.. The reverse, Synthetic Short is composed by Longing a Call and Shorting a Put with the same strike and expiry.. You can obtain the equivalent of an arbitrage thru a Conversion, which is long underlying and Synthetic Short or by a Reversion , done by Short Underlying and Synthetic Long. Another arbitrage is a Box , which is made by a both synthetics at the same time. But remember you work with options. When it comes to arbing this way, it’s about expiry, while what happens until expiry, a stretch/skew in profit, is dependant on the market and the greeks. As author Sheldon Natenberg says in his book, “Option Volatility & Pricing: Advanced Trading Strategies and Techniques” , there are no riskless strategies : there are strategies with greater or lesser risk.I recommend you read this extraordinary book when you will have options available, cause it has a lot of information there, accentuating this theme, the strategy option design side, rather than a presentation of option strategies.

However, I am pretty doubtful that option arbitrages will be possible rightaway under MT5. Option trading should be regarded in the same context as the multiasset trading. If you can arb between fx and fx futures, then surely one of them can be replaced with a synthetic, which may create extra opportunities due to lower option markets liquidity and higher latency.

Now, due to MT5’s extended capacities, option trading can gain new meanings, such as pair trading with options or gap trading with options. Possibilities are limitless, but they depend on the capabilities of the Strategy Tester as well as option spreads, that have an influence, more or less, depending on chosen strategies. We are hoping to record some option data until MT5 is completed with Strategy Tester and options, so strategies could be analysed more in-depth even without the help from MT5.