Low Risk Options Trading Strategy - Option Spreads

[scorpio77]

Thank you AW10 & LT for your valuable inputs. I am beginning to get a hold on this!

I quote today's ET Investor's guide:

" The development in the open interest of the September options also validated why crossing over the barrier of 5000 would be a difficult task. For starters, September 5000-5100 calls experienced a continuous build of open interest since Tuesday causing 5100 strike to gain the maximum open interest for the week. For most part of the week while the 5000 calls held the maximum open interest, as on Friday, 5000 calls experienced the highest build up, for call side.
To add to this, the persistent rise in the open interest of in-the-money 5000 puts since Tuesday, encountered a heavy build up of 28 lakh shares in the last two trading sessions of the week.
This huge rise in the option interest on the puts side caused the September Put Call Ratio (PCR) to rise from a robust 1.68 at the end of the week before last to 2.46 at the end of the last week. This is the highest PCR a near term series has shown from the year 2008.
Such high level of PCR reflects excessive optimism and could lead to a significant correction."

Do you agree with this?

Can you pls explain in layman's terms how the author arrived at his conclusion?

Thanks,

Scorpio

Scorpio,
IMO, PCR is just another way of reflecting OI data at a strike price.

I use PCR data (and few derivatives of them) just as one of the input in decision making while selecting particular option strike.

I chk PCR at each strike price, OI of PUTs and OI of CALLs at each strike price, PCR of all strike prices, and in last week of the month, USE OI of current month + next month in PCR calculation.

OI of PUTs indicates bullish sentiment of Market partcipants at that level. And OI number of CALLS indicate the bearish sentiment. That means, we can use this data to get rough idea about support (PUTs OI) and resistence (CALLs OI)

eg - if 4800 has Puts OI of 3 lacs, 4700 has PUTS OI of 2lacs and 4600 has PUS OI of 5 lacs. then more mkt participants have written 4800 put and hence they are bullish at this level. So 4800 shd act as first support. If this is broken, then next stronger support comes at 4600 cause 4700 PUTs are less in number hence less people are bullish at that level.
So lets say if I have to create spreads, or sell option, then I prefer to sell the strike which has higher OI.

PCR gives wrong info as we near the expiry cause contract gets closed in near month and new contracts are opened in Next month. So we have to be a bit careful while using these numbers.

As market moves in either direction, smart option traders keep shifting the position of their strikes as well (rolling up /down).

Hope this helps.

Happy Trading

 

[AW10]

Definitely in BULL spread, but what about the BEAR spread...in which this gentleman expects market to expire below 4900 (in BEAR speard case 1) and below 5100 (in BEAR spread case 2) for earning max profit.

If my understanding is correct then, unless market expires below lower strike price(as he is here buying/selling puts), he 'd not be able to make max profit.

Yogesh, As far as the Bull/Bear SPREAD is concerned, all 4 examples are correct.. along with BEP, Max Risk, Max Reward calculations.
I think you are confused with the title line given for each case..

Bear Spread - view is that market will stay below 4900

You are looking at the title as the price that will give MAX REWARD. If that is the case, then u are right. the title both Bear spreads should say the last number as the strike price of Sold option.
Lets not forget, Max Reward is just one of possible Outcome from the spread.. You start making money as soon as the price crosses Breakeven point.

So you should consider breakeven point in making the decision, and the chance that market will cross this breakeven point. Next comes the thought about market crosses the Max Reward point i.e strike price of short leg.

Hope it is clear now.

Happy Trading

 

[AW10]

Scorpio, I am trying to read between the lines from TRADERs perspective and interpret this text written by an ANALYST (who is paid to write).

" The development in the open interest of the September options also validated why crossing over the barrier of 5000 would be a difficult task. For starters, September 5000-5100 calls experienced a continuous build of open interest since Tuesday causing 5100 strike to gain the maximum open interest for the week. For most part of the week while the 5000 calls held the maximum open interest, as on Friday, 5000 calls experienced the highest build up, for call side.

OI in 5000 calls has gone up in September, that doesn't mean that professionals are paying 100 Rs and taking bet on level above 5000 in next 4 days.
It could be very well risk mgmt buying by them to safeguard against earlier written call on 47 /48/ 49. Probably they had written the previous call that gave them breakeven point near 5000 and now when
market has reached near their breakeven points, they are taking action to limit their possible loss.

There could be another set of people who have bought 5000 Sept call to protect their currently open September position. At the same time, they might have sold 5000 OCT calls so that if market falls for next 3 days and closes below 5000 then their loss on purchased 5000 call is compensated by short 5000 call of OCT.

A novice traders will jump in and start buying 5000 calls cause OI of a call has gone up which is bullish sign.. But they are just trading the news/analyst statement without understanding the underlying here. This is one of the reason that makes trading on OI difficult.

To add to this, the persistent rise in the open interest of in-the-money 5000 puts since Tuesday, encountered a heavy build up of 28 lakh shares in the last two trading sessions of the week.
This huge rise in the option interest on the puts side caused the September Put Call Ratio (PCR) to rise from a robust 1.68 at the end of the week before last to 2.46 at the end of the last week. This is the highest PCR a near term series has shown from the year 2008.

Comparison of 1.68 with 2.46 makes no sense to me. Here again the author is focusing on Sept PUT/Call data and ignoring the picture of What is happening at PCR of October series.
This PCR might have gone up due to closure of SHORT call positions. Even if same number of puts are existing in the market, the lower number of open calls may result in showing higher PCR.
This being quarter end, I wouldn't be surprise if mkt remain in short range till monthend. Atleast that way, MFs can show another month/quarter of great performance.
At this point, IMOs, it is important to monitor the picture painted by Next months OI/PCR data.

Such high level of PCR reflects excessive optimism and could lead to a significant correction."

Makes sense. Infact, PCR is one of the tool used by Contrarian trader. High PCR can be when (a) Put OI is high, i.e. there are lot of PUTs bought by people and they all are bearish.
(b) Call OI is low i..e less number of people feel that they can make money going long at this time. Both these points indicate bearish views.. So if you just know PCR then this sentiment can
be interpreted.

You know that market is known for catching people on wrong side. So when we have excess of bullish/bearish sentiments, it is just matter of time that this excess need to disappear.

Happy Trading

 

[lazytrader]

Definitely in BULL spread, but what about the BEAR spread...in which this gentleman expects market to expire below 4900 (in BEAR speard case 1) and below 5100 (in BEAR spread case 2) for earning max profit.

If my understanding is correct then, unless market expires below lower strike price(as he is here buying/selling puts), he 'd not be able to make max profit.

Ah, now I see what you are pointing at..

You're right about that. The max profit for the bear spreads should be below 4700 and 4900. To stay consistent with the views of above 4900 and 5100 as mentioned in the case of bull spreads for the bear spread 4700,4900 should have been mentioned.

 

[scorpio77]

Thank you AW10 for the wonderful explanation. :clapping::thumb:

Scorpio, I am trying to read between the lines from TRADERs perspective and interpret this text written by an ANALYST (who is paid to write).


You know that market is known for catching people on wrong side. So when we have excess of bullish/bearish sentiments, it is just matter of time that this excess need to disappear.

Happy Trading

 

[simu2004]

Hi,

Please confirm if below are the correct examples for Bear Spread & Bull Spread

Corrections made: Thanks AW10,LT & Yogesh.

Bull Spread:view is that market will remain above 4900
Buy 4700CE=357 (for Oct series - as of 18th Sept)
Sell 4900CE=227 (as of 18th Sept)
Net Cost=357-227=130
Max Risk=130 if expiry is below 4700.
Max Reward=200
Net profit = 200-130=70
BEP=4700+130+2=4832

Bull Spread:view is that market will remain above 5100
Buy 4900CE = 227
Sell 5100CE = 121
Net Cost= 94
BEP=4900+94+2=4996
Net Profit = 200-96=106

Bear Spread - view is that market will stay below 4700
Buy 4900PE - 136
Sell 4700PE - 75
Net cost = 61
Max Risk = 61
Reward=200
BEP=4900-61=4839+2=4841
Net Profit=200-61=139

Bear Spread - view is that market will stay below 4900
Buy 5100PE = 230
Sell 4900PE = 136
Max risk= 94
BEP=5100-94+2=5010
Net Profit=200-94=106

 

[DanPickUp]

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[pasha]

Hi Dan,
Would be nice if you could start a new thread on ratio spreads to keep continuity of posts.
As I recollect, you sold 1 ATM call and bought 2 OTM calls. If the index went opposite you would do the same wih a put ratio spread to neutralise deltas.
This position could become dangerous on a big gap up/down.
Wastej had started a similar thread on Delta neutral however profits seemed to be tiny, about 0.5 to 1% for the entire month.
In al fairness, it must also be said that his risk was equally small.

 

[AW10]

As I recollect, you sold 1 ATM call and bought 2 OTM calls. If the index went opposite you would do the same wih a put ratio spread to neutralise deltas.
This position could become dangerous on a big gap up/down.

Pasha, Dan was buying Ratio spread, with very little of his money. 1 ATM short call, pays for 2 OTM calls. If market opens gap-down, all calls go worthless and u don't loose anything here
cause ur investment is Zero or very low. If mkt opens gap up.. you are happy cause thats what u want to see..

When market goes up and this ratio position is in the money, he was adjusting it with a bearish spread, that too credit spreads so that he doesn't have to shell out his money to protect
profit.

Wastej had started a similar thread on Delta neutral however profits seemed to be tiny, about 0.5 to 1% for the entire month.
In al fairness, it must also be said that his risk was equally small.

As far as I understand, his was not trying to make it delta neutral. The poisition started with +ive delta, and later it was adjusted to reduce delta (which might result in delta neutral).
A delta neutral strategy, will attempt to be neutral right from initiation stage till close.
Welcome your /Dan / others views on this.

Happy Trading.

 

[pasha]

Pasha, Dan was buying Ratio spread, with very little of his money. 1 ATM short call, pays for 2 OTM calls. If market opens gap-down, all calls go worthless and u don't loose anything here
cause ur investment is Zero or very low. If mkt opens gap up.. you are happy cause thats what u want to see..

Agreed, if the gap is in our direction. Lets assume we start out with a put spread 1:2. The market goes up so we remove one OTM put and place the call spread.
An unexpected drop down the next day would open up a 100 point loss if it keeps going down.
The whole point of the Paul Forchione method is to keep the trade delta neutral, however I was unable to find any protection against unexpected gaps against the position which could be it's weak point.
I do think Dan is referring to a delta neutral position however more info is reqd to be able to better assess it's potential.
If you read through the Wastej thread you will find that there is no mention of profit% or how he arrived at the adjustment points of 2461, etc. Somehow, nobody asked these critical questions which could have multiplied the thread value.