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Option Strategies for Shorting Inefficient ETFs – Summary

8 Mar 2018,

In this article, I would like to make small summary and comparison of the option strategies discussed so far, and that can be used to short – speculate on the decline (not only) of the inefficient ETFs. I would like to mention their advantages, disadvantages and compare the situations when they can be used.

 

  1. Short call

Opční strategie short call (zdroj: TD Ameritrade)

Figure 1: Short Call Option Strategy (Source: TD Ameritrade)

 

Advantages:

  • Very interesting profit potential – usually very high option premium
  • When selling option (OTM), the market does not have to do anything, and you can make profit
  • There is no borrowing-fee as in the case of classic short
  • Usually less demanding towards margin than the classic short trade

 

Disadvantages:

  • Theoretically Unlimited Loss – You need to follow trade, control it and in case of movement against you, either close it or roll it
  • Each option controls 100 units of underlying asset> large nominal
  • Not all ETFs can be traded through options

 

How to use the strategy:

With regard to the theoretically unlimited loss, a very strict money-management and a clearly defined exit from the position are needed. Also, I do not recommend to use it for leveraged volatile instruments – a few weeks ago, we have witnessed extreme volatility within one day, which would result in very significant losses when using naked calls.

If you really want to trade naked call option, then rather trade commodity ETF, where the risk of movements of tens of percents per day is significantly reduced by the nature of the underlying asset (eg natural gas, oil, …).

Entry: Ideally at higher value, predicting short-term growth of the substrate and then return.

Exit: very much depends on the situation, but usually at 30-50% of the premium received. The big advantage is that profit can be realized very quickly if the volatility of the market drops – this is the valuation factor for the option.

 

  1. Long put

 

Opční strategie long put (zdroj: TD Ameritrade)

Figure 2: Long put option strategy (source: TD Ameritrade)

Advantages:

  • An interesting yield potential
  • Unlike a naked call, there is a clear maximum loss given by the premium paid
  • No additional costs for short (borrowing-fee)

 

Disadvantages:

  • Usually high initial cost for the option purchased
  • Rather a psychological disadvantage – to make a trade profitable, something must happen (the price must go down, vs. the OTM call option description) during the life of the option
  • Sensitivity to volatility – despite the decline in the price of the underlying asset, required profit may not occur if the volatility of the underlying instrument declines too.

 

How to use the strategy:

I am typically buying put options with longer expiration (for several months, even a year) for volatile ETFs, which are for a longer time in extreme values. There it makes sense to buy a distant option (OTM) because it is cheap and offers a very interesting profit potential when the market drops. Usually I “go” for 30-40% appreciation compared to the premium paid.

Even though it may be tempting to use the strategy during the short-term extreme growth of underlying market (for example, instruments such as VXX, UVXY), if the market does not return quickly back, the option – opened with a longer expiration – may even with the correct estimation of the market direction have a slight loss due to the decline in market volatility.

On contrary, during the speculation to a quick turn and a backward decline in the market, I would rather focus on buying short-term OTM (weekly> monthly) options, whose price is usually very favorable, and return to the original values can yield very interesting profits.

 

  1. Vertical bear call spread

 

Opční strategie bear call spread (zdroj: TD Ameritrade)

Figure 3: The bear call spread strategy (source: TD Ameritrade)

 Advantages:

  • Strategies with a clearly defined risk profile, predefined loss and profit.
  • With regard to “built-in insurance”, there is no need to close the trade if the price of the underlying market goes against the position in the unfavorable (often short-term) movement.
  • Very low margin

Disadvantages:

  • Limited profit potential.
  • In the case of bear call spreads, the risk of assignment of the option sold in case of  high price of the underlying market.

How to use the strategy:

The strategy offers an interesting return at the maximum risk limitation. Ideal time for entering the strategy is again during the increased value of the underlying asset. I usually choose the expiration for several months -> 2 years. It is very important how high the market is (if extreme values -> several months to a year, if higher values ​​(eg penetration of moving average 100, etc.) -> max expiry time that spreads offer. It also depends on maximum premiums, that are available for given spread combination.

It is based on the model (which I will introduce you in some other part of the series), which calculates the available premium vs. the probability of success of a particular spread structure.

Typically, I’m out of trade if at least 80% of the premium is reached.

For bear call spreads, it is advisable to keep an eye on the the time value of the (lower) call option, if it is very low (close to zero) then there is a considerable chance that assignment will occur, so instead of the sold option you will have 100 pieces (times number of  the original option contracts) short of the underlying asset. This is not a major problem, the position is still covered by a higher-bought option, but the short itself may already be linked to the borrowing-fee.

  1. Vertical bear put spread

 

Opční strategie bear put spread (zdroj: TD Ameritrade)

Figure 4: The bear put spread strategy (source: TD Ameritrade)

 

Advantages:

  • Clearly given risk / profit profile
  • given the limited risk, there is no risk in case of extreme movement on the underlying market (gaps, limit movements, …) against my position
  • Unlike bear-call spreads, there is no risk of assignment
  • very low cost

Disadvantages:

  • Compared to bear-call spreads, there is lower profit potential (with identical design)
  • for someone the problem is debit strategy = first the payment is required (vs. bear call spread, where the premium is collected first and then I “defend” it)
  • limited defined profit (as any vertical spread)

How to use the strategy:

Basically, it is very similar to bear-call spreads, the conditions are the same. The only difference is the lower profit potential (even tens of%) compared to the same bear call spreads, but there is practically zero assignment risk. It is therefore always a compromise.

 

I personally open bear call spreads on the market that is not in extreme values (for volatile ETFs, if VIX value is below 30) and where there is a relatively rapid chance of returning to normal within max units of months. I open bear put spreads on the contrary (even with regard to interesting valuation) at extreme values and usually with the longest expiration possible.

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