Day trading with buy-writes?

A good friend once suggested that my propensity to do buy-writes was silly (he might have used a stronger word). Since covered calls are a bullish strategy, why not just go long, instead of messing around with options strategies that strongly limit the upside and only give a moderate amount of downside protection?

The reason I don't follow my friend's advice is that if I'm in a short term timeframe, and just long with a stock I turn into a day trader. And I don't have the time, temperment, or track record pursue day trading. With covered calls the pace slows down, and I make better decisions. My other rational is that markets go side-ways a lot more of the time than they go up or down. Getting time premium from being short options is a good deal--most of the time.

Upside opportunity vs downside risk in the market is one of the qualitative measures my brain generates. Right now I see quite a bit more upside than downside, and the market has been making big positive jumps. To try and take advantage of those jumps (without day trading, and with some downside protection) I did a buy-write of SPY with Aug 99 Calls for an overall debit of 96.79. SPY was at 98.86 and the calls were at 2.07. I immediately put a close out order in for a net credit of 92.28 -- a .49 gain. I choose this strike price because it was just a little out of the money. The amount of premium starts dropping off as soon as the underlying increases past the strike price--assuming the IV stays constant. After I put in the credit order SPY moved up to 99.46, a 0.60 move and the resultant available credit moved up .29, very close the .5 delta behavior you would expect from an ATM buy-write combination. A short term move of 1.2 or so in the underlying should trigger this credit order.

Will the financials continue to claw back?

Sold Aug 13 calls for XLF at .24, currently XLF is 12.56 -- I guess I'm feeling a little optimistic about financials.

Back into XLK -- two weeks late...

As usual my crystal ball is broken, so after my XLK was assigned two weeks ago I waited while it gained 5% before I jumped back in. Did a buy-write XLK at 19.56, sold the Aug 19 call XLKHS at .82 for a net debit of 18.74. I tried debit orders at 18.69 (.31 premium) and 18.72 (.28 premium) before this order went (.26 premium) --and it went immediately. While .26 isn't much, it is still 1.3% for a maximum 26 day investment-best case of course. Break even is at a 4.3% drop, so there is a fair amount of downside insurance in this position.

Aug SPY Buy-Write

SPY buy-write on Aug 96 Calls, one more dollar in the money cost only .4 in premium--seemed like reasonable insurance. Bought SPY at 97.43, sold Aug 96 Calls at 3.12, for net debit of 94.40. I screwed up with the debit order, incremented the wrong way (debit = debt dummy!) -- cost me around .12 -- argghh.

Dipping a toe into Small Cap Buy-Writes

I bailed out of some small cap mutual funds that my broker had me in and switched over to a buy-write on IWM (Russell 2000). Volume on both the ETF and the options looks good (strikes at every dollar) , with bid/ask spreads of 1 cent and 1 dollar respectively. Bought IWM at 54.30, sold Aug 54 calls (IWMHB) at 1.82 for a net debit of 52.48.

VIX options expiration day and a VXX collapse

On Monday I created a Pseudo Buy-Write position with VXX as the underlying and selling VIX July 25 options. Even with VIX at 23.98 the options did not trade below 0.10 on Tuesday, the last day to trade them. I thought about just letting the options expire, but two things deterred me: 1. the recent weird behaviours in VIX on their expiration morning, and 2. the potential for VXX to drop dramatically. Number 1 did not happen, the VIX opened at a very reasonable 24.05, number 2 did happen, although if I had sold VXX at opening I would have been ok with a .3 overall credit (excluding commisions). However throughout the day VXX dropped like a rock, closing -4.24% lower, a much more significant drop than the VIX's 1.68%.

On Tuesday afternoon I was thinking about the people that run the VXX. They have stated that their goal is to track a very short term index, the VIX--on the other hand their primary tool as market makers are the two short term contracts of the S&P 500 volatility futures. The literature I have seen claims that the VXX will roll over the VXX position, perhaps daily to decrease their position in the near term contract, while increasing their position in the next month contract. So, the day before July VIX option and S&P 500 voltatility contracts expire you would imagine that the VXX folks would be almost entirely invested in August contracts.

The fly in this ointment, is that the August Volatility futures have been runing considerably higher (~17%) than the July Volatility futures. The VIX/VXX ratio was running at around .3711, which is less than 5% away from its average value of .395 --so the simple rolling position approach doesn't match up to the reality of a full August based position. If the VXX market makers were just selling relatively cheap July Futures contracts and buying expensive August contracts the value of VXX relative to VIX should have been dropping all month--which it wasn't.

I managed to scare myself into thinking that this correction in VXX value might happen on today, on options expiration day morning --the only time ever where the VIX and the July Volatility contracts have to line up--by definition. To avoid taking the risk on VXX I closed out the position for a net loss of 0.02 per contract. A very small price to pay for a good night's sleep.

The VXX did take a big hit, but the supposed underlying, the Aug futures dropped almost the same amount (-3.78%). The next mindbender is whether this drop might have been driven by the VXX folks selling August futures contracts today, either to close out open positions, or to take short positions to hedge VXX against possible drops in August futures relative to the VIX index. With high volume days running in the million share range ( > $60Million worth) there may be enough money to trade a lot of contracts). The futures chart shows a lot of open interest creation in the last few days.

There was certainly nothing noteworthy in the behavior of the $SPX index or VIX that would suggest the market or these indexes drove the major drop-off in the August volatility futures today.

My guess is that there is more going on under the hood of VXX than just rolling futures contracts day by day...

Don't trust the Greeks with Fear!

Update:  Chris McKhann commented on a recent post of mine, that  LIVEVOL provides free delayed quotes that include correctly computed greeks for VIX options. 



The broker quoted Greeks associated with VIX options are worse than a stopped watch. At least a stopped watch is correct once per day. The Greeks associated with the VIX options can only be counted on to be right once a month, the day you can't trade them--expiration day.

Computing the delta, gamma, and implied volatility of a option doesn't require much information, and most of it is common across whole families of options (days till expiration, cost of money, dividends) while one piece, strike price is static and specific to the option in question. The one remaining required piece of information in the price of the underlying--and our brokers thoughtfully provide us with the wrong number -- the VIX index value.

You can't buy or sell the VIX index, even if you have lots of money and brains. The best you can do so far is VIX futures--which settle once a month--based on the future value of the VIX index at one point in time. The rest of the time the VIX future wanders above and below the VIX index depending on how the futures market predicts the future, not current value of the VIX index.

The VIX option values track the VIX future value as the underlying not the VIX index. For example, if the VIX future value is higher then the index then deep in the money calls look outrageously expensive--with IVs on the bid side of several hundred. This suggests going short on the options while hedging with futures or VXX. On the other hand if the VIX future value is below the VIX index then IVs look very low. Any trading strategy based on these bogus numbers is asking for trouble.

You can compute reasonably accurate Greek values for VIX options yourself. You don't even have to get a futures quote (although you can get delayed quotes for free). It turns out that if you split the bid/ask price for the 10 strike VIX option and add 10 to it you can get close, usually within +-.15 to the true underlying price for the VIX options. You can then use freely available options calculators to compute your IV based on the underlying price and option price and then your Greeks. For example, today's ending prices:

True VIX Option Underlying (VOU) :

VOU = 10+ 14.55 (bid/asked split of VIX GB is 14.20/14.90) = 24.55

Closing price of 22.5 Call 1.85/2.2 (assume 2.10) for value

___________ VIX index __ VOU

Underlying ____ 24.40 ____ 24.55

Delta _________ .86 ______ .91

Gamma _______ .11 _______ .09

IV ___________ 143 ______ 82 (very close to the actual 20 day historic volatility)

Normally the VIX index and the VOU are further apart, so the Greek / IV differences are even larger, but there is only one more trading day for July options so the VIX index and VOU are converging.

So beware of broker quoted VIX option Greeks -- they are usually lying about the underlying.

Will Oil mix with Fear?

Today did a buy-write of USO (Crude Oil ETF) and $35 Aug options UBOHI net debit 33.04 USO at 34.63 and UBOHI at 1.59

Also did a Pseudo buy-write of VXX (VIX volatility ETN) with $25 July VIX options (expire on Wednesday) net debit of approximately 24.42. VXX at 65.75 , July VIX futures at 25.2, VIXGE at 0.78. I assumed 40 shares of VXX will hedge one VIX option (based on its historic ratio). To keep the brokers happy I created the VIX option position as a vertical bear spread with the long calls at $32.5 (.03 each).

There is very little downside protection here if the VIX continue to drop as it did last week, but I am betting that the market will at least pause a couple of days to digest last week's surge. Assuming the VIX July future as the underlying I compute an IV for the option to be 77 -- which is consistent with what it was doing last week. I am looking for a volatility collapse today or tomorrow--I would rather not depend on the VIX options expiration process, which looks pretty flaky to me (prone to manipulation). I also might roll the spread to August, where the Aug 25 option is showing a 16%! premium relative to the underlying.

On to August 09 Options -- except for VIX

Thanks to the nice little rally last week almost all of my options were assigned. The only exceptions were a position in USO that I don't want to close out yet, so I rolled those to August 34s and I closed out a SPY position with 91 calls for a 90.92 credit--8 cents seemed like a reasonable price to pay for not having to worry about the market last Friday. In these bullish situations it is tempting to lament the loss of upside potential due to the short calls in the covered call positions, but I try to remember those flat periods where owning the equity doesn't net you anything.

Overall I see more downside risk than upside for next week because of the big run-up last week, but if I could consistently pick market direction I wouldn't need my day job! I probably won't write many August calls next week because August 22nd (the next expiration date) is a long ways away. Some things that are interesting:

• USO (Oil ETF) is relatively low, I don't see the price of oil dropping much
• VIX options expire on Wednesday. There was an interesting amount of premium on the ITM calls last week as the VIX swooned. I would hedge with VXX, even though it is behaving strangely (its "historic" relationship with the nearest S&P volatility future has been running at .39 to .395, away from its normal .41)
• Fidelity allows trading on weekly SPX options it appears. I would have to do a bear spread with the long side way out of the money--and long SPY, the effective underlying
• Colgate and Proctor & Gamble are going ex-dividend this week. The options probably have too much time value to be an effective hedge--might be interesting to hedge by going short on the the sector for a day.

Abbott Labs Dividend Capture

Update: My options were not assigned. I talked to options specialists at both Schwab and Fidelity and neither one could offer any opinion other than the options owners were not on the ball. The open interest did not drop much either, so I don't think it was a case where I just didn't draw the short straw.

I closed out my position early on the 10th. The IV on the options was up significantly (to prevent the people short the options from profiting immediately from the dividend.) With Abbot Labs scheduled to report earnings in two days I wasn't in the mood to take chances, so when I was able to get out with an 0.12 overall profit (including dividend) I did. This was before the big run-up the following week when many people were forecasting a big drop. If I had stayed in the reward would have been substancial ( .4 from the dividend plus 0.14 ) but betting direction on individual stocks I barely know is not my game.

Original Post

I did a ABT buy-write this morning. Bought the stock at 45.42, sold to open July 44 calls at 1.56 for net debit of 43.86 (Debit order was 43.88 so it filled at.02 better than my order). Ex-dividend date is 13-July, with a dividend of $0.4 per share. Since the premium on the options (.16) is less than the dividend value today (Friday) and the ex-dividend date is Monday I expect the options to be assigned tonight. If so it will be a .36% return for one day's investment.

I put in a 43.85 debit order initially, which did not fill in the 20 minutes I left it open. It appeared that the market fluctuations justified a fill, but these orders are handled manually and oftentimes don't catch the best case combinations. I debated doing sequential market orders instead of the debit order (with the options having to go last to avoid a naked call situation), but getting the option order executed at a good price looked tricky. I was not sure at all if I could get execution splitting the bid-asked prices. The spread was 0.1 most of the time, so this was 30% of the profit potential at risk if the order would only go through at full asked price. The options at that strike price were pretty active, with a cummulative volume of around 400 when my order when through.

The risk profile of this investement is pretty low. If the ABT - ABTGR call combination stays above 43.6 then the options will probably be called, closing the position tonight. This .3 drop in net credit would require a large drop in ABT, because the delta on the option is -.83 currently (of course the delta shifts as the stock price changes relative to the strike price.) If the option is not called then the .4 dividend per share will lower the break-even point of the position to a credit of 43.46, an almost 2 point drop in a stock that has not been below 43.46 since May 22nd.

Headed for a "W"? Maybe not

6-July-2009

I was impressed that the market rallied at the end of the day today. The market direction has been slanting downward, many people are saying that a sell-off is coming, and last week ended with some fairly decent drops. Yet in spite of a scary fall-off first thing, the market did not panic. VIX levels (Fear Gauge) popped up some to reach over 30, but didn't exceed the level we had a few weeks ago while in the middle of a pretty strong bear run. Today's volume was a respectable 175M on SPY. If today is any indication we won't be in for a "W" bottom to this bear market--A "L" looks more likely.

For the first time in quite a while (maybe the last VIX options expiration), VIX climbed to exceed the July VIX future value (the true underlying of the VIX options). As a result the greeks on the VIX options were realistic (the VIX option greek calculations normally assume the VIX index is the underlying). For example the IV (Implied Volatility) of the 30 call was 87, much lower the 110 we had last Thursday, and the deep in the money calls show no significant premium as they should.

Day Two -- Paper trade-- attempted Delta neutral SPY IV drop capture

Hold on for the ride! See this post, for the beginning of this exercise

Instead of a quiet prelude to the July 4th holiday weekend, the market decide to open sharply lower. Instead of a expected drop in IV, it went up instead. Assuming I was lazy and didn't rebalance the delta hedge at the end of day one the result was a $377 loss, 0.3%.

Specifics:

SPY 89.81 off 2.58 (- 2.8%)

SDS 57.84

91 July Call 1.20 (start 2.97) Delta .38 IV 24.5

93 July Call .54 Delta .22 IV 23.05 (up 0.55)

VIX 27.95 (up 1.73)

DISBA 29.25 (up 1.65)

VXX 71.58 (up 3.82)

DISBA / VXX = .408

Net Debit = 1000*89.81+430* 57.84-540 (93 July calls) = 114141 (Loss of $377 from the start -- .3% loss)

If I had delta rebalanced at the end of day 1, buying 37 more shares of SDS the loss would have been $250 instead.

Lessons learned: While the damage was limited, this example shows that pre-holiday action can be tricky. A deeper in the money option would have probably suffered about the same amount (more money gained on the option value decrease, but less SDS hedging). Since the options still had 18 days to go at the beginning, it was probably too early to try this sort of game. Re-adjusting the delta through the two days would have reduced the losses, but commission costs would probably been prohibitive.

Paper Trade -- Delta neutral SPY IV drop capture

Simulated trade to capture pre-holiday volatility drop in SPY

SPY 92.95 1000 shares

SDS 54.09 (2X short S&P500) 430 shares (see delta neutral calculation below)

SPY July 91 Call 2.97 Delta .68 IV 23.24

SPY July 92 Call 2.29 Delta .6 IV 22.07

SPY July 93 Call 1.69 Delta .51 IV 21.39 (this is the one I selected--has the most premium)

VIX 25.06

DISBA 27.45 (Deep ITM Split Bid/Ask VIX) -- VIX true underlying price

VXX 66.86 DISBA/VXX = .4105

Net Debit = 1000*92.95+430* 54.09-1690 (Sell 93 July calls) = 114519

In the absence of other market dynamics the $SPX option IV drops significantly on Friday, or the day before a long holiday weekend. If the options are not expiring that weekend any sort of trade needs to be delta neutral, otherwise the normal move of the underlying would dominate the P/L of the position. This position should be delta neutral--but would need to be rebalanced if the underlying moves.

When figuring out what the SDS position remember that the SDS tracks 2X the percentage move not the point move of SPY. Since the 93 call is providing -.5 of the delta and the SPY is providing +1.0 delta we need another -0.5 delta to be neutral. I think it is easiest to do the SPY --> SDS conversion in dollars -- we need the equivalent of 0.5*1000 = 500 short shares of spy for the hedge, which is 500*92.95= 46475. Since SDS gives us a 2x move we divide that by two = $23237, and then we divide by the SDS price, 54.09 to get the number of shares to buy = 429.6, rounds to 430 shares.

End of Day 1 results

The market sagged some. Final prices:

SPY 92.39 off 0.56 (0.6%)

SDS 54.8

93 July Call 1.45 Delta .446 IV 22.5 (up 1.11)

VIX 26.22 (up 1.18)

DISBA 27.60 (up .14)

VXX 67.76 (up 0.9)

Paper value of the position at day end was $114504 (down $15) -- the hedge worked well! It looks like the time decay of the option contributed about 0.05 per option $50 total to this result. In addition the SDS was short about 0.2% in achieving the ideal 2X move. Finally the move away from delta neutral as the call delta shifted things to a net loss for the day.

Because of the market action the option IV went up, overwhelming the time delay factor that would make it go down. The IV on the option moved almost as much as the VIX -- which is what you would hope would happen, this is the intent of the VIX index calculation, to show the IV on S&P500 calls.

To adjust the hedge: We now need -(1-.446) = -0.554 in SDS to balance the lower delta of the option. 554*92.39= 51184.06, divide this by 2 and divide by the SDS price of 54.8 = 467 shares of SDS.