Lohit from New Delhi asks:
What in your experience is the best options strategy all said and done? I traded straddles for many years, but have gone back to being naked long or short, albeit with smaller bets.
Ed Responds:
Lohit,
In order to answer your questions properly I will assume you have risk capital and no strong directional opinion of the market. Our trading style is not to take large risks in the market or be subjected to huge margin calls; instead we attempt to receive consistent returns.
We trade with the proven assumption that most options expire worthless. Therefore we want to be net collectors of premium. Insurance companies became some of the wealthiest entities in the world by collecting premium, not paying premium.
An example of a strategy we employed for our clients this week in the Standard and Poors 500 is as follows:
Sell 1 March S & P 1200 Call
Buy 1 March S & P 1225 Call
Sell 1 March S & P 975 Put
Buy 1 March S & P 925 Put
Total premium collected prior to any commissions or fees paid is $1850 (3.7 points x $250 = $925, on the call side and 3.7 points x $250 = $925, on the put side) with a total initial margin of $2045. Downside risk is $10,650 while upside risk is $4400.
All margins on the Chicago Mercantile Exchange are based on SPAN (Standardized Portfolio Analysis of Risk). Unlike the equities markets, where this type of trade would require margin for the call side and margin for the put side, SPAN recognizes that risk can only exist on one side of the trade. Calls and Puts cannot get in trouble at the same time and therefore margin must be met only for one side. If you meet the margin for the put and subsequently implement the call side of the trade your margin will not increase.
If on expiration, the third Friday of March, the S & P 500 is between 1200 and 975 all options will expire worthless and all collected premiums will be retained. Prior to commission this is a return of over 90% on margin.
The credit-spread is turned into a naked strangle by not purchasing the long call and the long put. Although the margin jumps to $9659 from $2045 the amount of premium collected only increases from $1850 to $4775. By collecting $4775 on initial margin of $9659 the best the naked writer can obtain is a return of $4775/$9659 = 49.4% on margin. Also detrimental to the naked strangle is the loss factor. Instead of the loss being a known limited component it becomes unlimited. Selling naked calls, puts, straddles or strangles can have better short term results but in the long run credit-spreads are far superior.
I have found that the investment field is saturated with people who can formulate and enter a trade which on the surface appears strong. But, in the event the market starts to move against their position whether slowly or in gap fashion the vast majority of traders lack the knowledge or experience to exit properly or adjust the position.
Depending on volatility, time to expiration, delta of existing options, proximity of the underlying futures market to options and margin restraints, numerous adjustment strategies can and should be implemented. Over the long run a trader's success will depend on his ability to adjust or reconfigure when the market is moving against him.
Besides being financially and psychologically suitable before entering any positions you should have an exit or adjustment strategy. Credit-spreads can provide you with staying power while limiting the total risk they can be used in all of the financials.
A prime example occurred after September 11th, 2001. We established our credit-spreads in July of 2001 by selling the December 9500 puts and 11500 calls in the Dow Jones Industrial Average. We also purchased as insurance the December 9000 puts and 12000 calls. After September 11, 2001 the Dow bottomed at 7850. The put spread was fully in the money. At 7850 a naked 9500 put would have been worth $16,500 per position. In all likelihood you would have been forced out of the market because of a huge margin call with large losses. Our clients were able to stay in because the credit-spreads peaked at $3800 and had limited risk of $5000. Not being forced out of the market meant the staying power to maintain the credit-spread on expiration. At expiration the market closed at 10,045, making all options worthless and turning a loser into a winner because the correct strategy was implemented. Hopefully this helps with your question.
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