Thursday, May 04, 2006

Murphy's Option Law: A Stock will make its big move when you are not net-long contracts!

So I have been playing a simple counter-trend system lately using options. I've been playing it Telab style by using the system's signals to build butterflies with extra wings. Basically it works like this. When the system signals a stock purchase, I would sell a bull put spread with an extra long put (This is actually called a backspread). Then, when the system signalled a sale, I'd sell a bear call spread and buy an extra long call. (Again this is really a backspread) Sometimes I would buy the extra options at the same strike and sometimes I would buy them a little further out of the money. At first, I was very disciplined about buying those extra options every time, but lately I had began to feel like a sucker giving up so much of my premium to buy those extra long options so I had stopped buying them, and was simply building butterflies without the extra wings. This leaves me protected from "black-swan" events, but I was no longer positioned to profit from them.

Well, I had my first really big moves (since I started using this system) in 2 of my positions today...and whatdayaknowit...of the 20 or so positions I had put on using this system, they were in 2 of the 4 where I didn't have those extra wing options! Niether of these were "black swan" moves, but one of them at least was big enough that it would have really made my month if I had purchased those extra calls. The stocks were WFMI which was up 12% and EXPD which was up almost 20%. For the WFMI position, the system had not trigered a sale since the initial purchase trigger so I had not finished building the butterfly and I went into this move with a deep in the money bull put spread,. There was a nice, but limited profit from this move. If I had completed the butterfly with extra wings I probably would have not made much money from this position or taken a small loss, since the 12% move, although large, wasn't enough to produce much of a profit from an extra out of the money call.

With the EXPD butterfly, I definately would have made good money from this position, on the order of several hundred percent return on the capital risked if I had purchased those extra wings, instead of taking a limited loss like I did. As it is, the pnl from both the WFMI and the EXPD positions about cancelled each other out today.

Assuming, I continue to use this system after May expiration, I think I will modify the strategy like this. When I enter the vertical spreads, I will move an extra strike out of the money, and always buy 2 of the long option part of the spread. (Buying 2 of the long options changes the vertical spread into a backspread.) This way I won't have to give up so much premium to buy the extra wings, which will make it emotionally easier to always buy extra wings. This will increase the amount of capital at risk however, so I will have to take less of the trades signaled by the system. This is not a problem, though, because I have allready become more picky about which signals I trade. I would have made money from these moves today (taking a small loss on WFMI, while making large profits on EXPD) had I been using this modification to the strategy.


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