Weekly options: A business approach
Dan Sheridan has seen the options business from both the institutional and retail sides. After 24 years as a Chicago Board Options Exchange market-maker and another 10 years as a options mentor for private traders, his approach has remained consistent: To be successful, you must treat options as a business.
“This is a craft,” he says. “We practice it daily. For those with the consistency and discipline, it becomes a good business.”
More recently, the practice has had a weekly focus. Weeklies have been the growth end of the options business. More contracts have come on board, and more volume is being traded. There are compelling reasons why:
Less capital: “You can achieve higher yields with less capital. If someone is seeking to make $500 per week, or $2,000 per month, with weekly iron condors, it takes $10,000 capital earning 5% per week. If someone wanted to achieve the same $2,000 per month via monthly iron condors with a duration of 30 days from expiration, it would take capital of $40,000 getting 5% per month. That’s four times more capital,” Sheridan explains.
Less risk: He also points out that some weekly strategies call for the trade to be on only two or three days. The trader is then out of the market two or three days and faces no exposure. Contrast this with a classic monthly option trader who is taking on 30 to 40 days of market risk.
Options decay: Sheridan is an option seller. He does this in different ways. For example, his favored vehicles include calendar spreads, butterflies and double diagonals--no naked options. He makes money by the decay in the options he sells. These strategies all have one thing in common: They work from faster decay in short options relative to long options.
Statistical probability: If you are selling out-of-the money (OTM) options that consistently carry a 70%, 80% or 90% statistical probability to expire out of the money—and are not exposed to naked risk—over time, you’ll win. Sheridan does this using iron condors.
Consistency: To make statistical probability work, though, you’ve got to be there, week in and week out. Sheridan is in the market every week, not just for the occasional speculation that may or may not work. He knows if he takes a loss this week, most likely he’ll see a profit the next, and the next, and in the long term, his winners will overtake his losers because the statistical probabilities are in his favor.
“If we can have a year-end weekly iron condor record of 40 wins and 12 losses, and keep losses to a level not much higher than the wins, you will be successful,” he says.
Management: Finally, he has predetermined contingency plans for market moves, both up and down. In a word, he adjusts the trade to stay near “delta neutral,” meaning that if the underlying moves $1, the value of the options position changes little or nothing. Ideally, at a particular point in time, the beginning of the trade, you are not leaning long or short. Once the market moves up or down
$1, the “gamma” (acceleration of change in the delta) makes you long or short.
$1, the “gamma” (acceleration of change in the delta) makes you long or short.
There are myriad ways to do this, including rolling up or down, adding options, subtracting options, etc. But the goal usually is to put the position back to neutral. This allows for the inevitable zigzags of the market, such as market regression, and maximizes time in the trade, which in turn, allows the magic of theta (options decay) to accrue. The concept of adjustments also includes the concept of maximum loss: exiting the trade when a pre-determined loss level is hit.
“If I’m putting on 50 weekly calendars a year, I’m not going to let one wipe out three or four weeks of profit,” he says.
Sheridan also teaches “no touch” versions of most strategies, where you simply exit a position when a profit target or loss target is reached, no adjustments.
“This is more of a couch potato approach,” he says. It is popular among some of his students for its simplicity.
Sounds simple enough, but the real world application can be a bit more daunting. For example, while profits can accrue more quickly in weeklies, so can losses. One’s “technique” and strategy must be in place before the trade is put on. Here’s a close look at one of his favored vehicles.
Weekly options: A business approach
Nine-day rut iron condor
The nine-day RUT iron condor is one strategy that facilitates trading options as a business (see “Visualizing the condor,” below). RUT is the Russell 2000 index. An iron condor is a four-option strategy that can be conceptualized as a put credit spread on the bottom and a call credit spread on the top. Ideally, the RUT just sits in the middle and the trader keeps all the premium he collected when expiration comes and goes. Life usually is not that simple, however, and this is where the craft (and a bit of art) come in.
The trade is put on each Wednesday morning. Sheridan suggests 10:30 a.m. as the best time.
“This lets the market settle a bit before entering, gives you some idea of how crazy the day might be and most importantly, avoids big potential gap openings,” he says.
It is conducted as follows:
- You sell the put strike that carries a (negative) 14 to 16 delta and buy the put that is five points lower. The long strike caps the loss in case of market plunge. It is insurance.
- On the call side, you sell the call that carries an 8 to 11 delta, and similarly, buy the call five points higher. This should deliver a credit of 80¢ to $1, against a total risk of $5.
Sheridan explains: “The reason I sell higher delta in puts versus calls is to get position deltas close to zero and let theta do its job. In SPX and RUT, selling the same delta on the put and call side will get you out much further on the down- side and much closer on the upside. This is because of the high volatility in OTM puts and lower volatility in OTM calls.”
The profit target is 10%, figured against total risk. The maximum loss is 15%. The maximum days in the trade are seven. Do not take the trade into expiration as market whipsaws can turn profits into losses in short order, and neither time nor adjustment can recoup the losses.
The adjustments would then be preordained as follows:
First upside adjustment: When the delta of the short call option increases 12 to 14 points, and is now 20 to 25, roll up the put side to short with 14 to 15 delta, similar to the initial put side. Achieve a minimum net 40¢ for the roll. If the market moves big on the first day of the trade, the delta of the short call shoots up by eight delta points. Make the adjustment then; don’t wait.
Second upside adjustment: When delta of short call is 30, roll put side up again to 14-15 delta for the short strike.
First downside adjustment: When the delta of the short put option increases 12 to 14 points, roll down the call side to short with a 10 delta. Achieve a minimum net credit of 40¢ for roll. If lightning strikes, and the market moves down big on day one and short put delta increases by eight or nine points, adjust at that time.
Second downside adjustment: When the delta of the short put hits 35,
roll the call side down again. Achieve net 40¢ on roll.
roll the call side down again. Achieve net 40¢ on roll.
Cutting the strategy’s risk with an adjustment is shown in “Position management” (below). If the market reverses, when the short delta increases by 10, adjust or just take off at max loss. When the max loss is hit, get out.
After an adjustment is made, the profit target is decreased from 10% to roughly 7%. That is typically the net cost of the adjustment.
In this example, the adjustment is by “rolling up” or “rolling down” the credit spreads. There are many other ways to adjust. Examples are adding a long option, adding a vertical credit spread, a vertical debit spread, adding another kind of delta neutral strategy on top of the iron condor, such as a calendar spread, butterfly or double diagonal. The possibilities are myriad. None is right or wrong, but is important to keep things simple. However, the most important aspect of adjusting is the timing; that is, when you adjust, not how. Too complicated? Explore the four-day iron condor, a popular strategy because you are only at risk two days per week.
Weekly options: A business approach
No-touch condor
The Sheridan four-day no-touch iron condor is designed to let the trader profit from the same concepts as the nine-day RUT iron condor but with less active management.
Here’s how it works: On Monday, at 10:30 a.m., after the market finds its equilibrium from the opening, put on the position. Sell call strikes with a 7 to 11 delta, put strikes with a 15 to 18 delta. In SPX, buy long strikes 10 points further out from short strikes.
Exit when either target is hit. The profit target is 7% to 9% and the maximum loss is 12% (see “Initiation and targets for no-touch condor,” below).
To exit, simply take off the “bad side” of the position. If the long option on the bad side is less than 25¢, just leave it on. There are no adjustments.
However, consistency is key. There will be losers. You must do this trade every week to be in position to take advantage of the probabilities. The “four-day” part of the name comes from the fact that the maximum duration of the trade is four days. Sheridan usually exits by Wednesday, but always by Thursday.
Sheridan has similar sets of rules for trading weekly calendars, butterflies and double diagonals, but the principles are the same: When delta is moving against you, take action to reduce it. When max loss is hit, bite the bullet, take the loss, regroup and return for the next week. Alternately, there are the “No-touch” methodologies for those that aren’t ready for adjustments or simply want less work.
Whether you are adjusting or “no- touching,” the strategy requires the trader to be there each and every week. This is just as simple, then, and as difficult, as marathon training. It may even be better than building a business because that’s what the strategy is designed to help traders do. Just like any business, it requires consistency, coming back each day, not quitting. That’s how you turn options trading from a series of speculations into a consistent, profitable business.
There is lot of strategy and a lot of rules and regulations, but it does work.
“It’s a matter of first learning, then applying the craft, day in, day out, week in, week out,” Sheridan says. “That’s how the consistent profits are made.”
John A. Sarkett is the author of several books on options, including “Option Wizards: Real Life Success Stories from the Financial Markets.” His e-mail is jas@option-wizard.com. Dan Sheridan can be reached at dan@sheridanmentoring.com.
Three pages included and copied from Futures Magazine
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