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Trading System for Short Inefficient ETFs – part 4 – call or put?

26 Apr 2018,

In the previous part of the educative series, we have explained how the trade length affects the potential probability of success and we have also pointed out that there is a relatively direct relation between holding time and profitability. Of course – it is very important whether we choose an aggressive approach (we expect a significant decline of the underlying market) or a more conservative concept (we expect moderate decline).

I also mentioned that the more conservative approach (expressed with contango of about 2%) would have survived the crisis in 2011 and the pre-crisis development in 2008 (of course not a massive fall in the autumn of that year). Even this would be undoubtedly sucess, because in that period stock indices were already 10-20% in red numbers.

Therefore, it is clear that the contango between the two nearest futures contracts (months) (in the case of volatile ETFs it is VIX futures index) has a very important role in the drop of the underlying ETF. It is precisely this contango that is a very important element that we use in our model where we work with the implied-expected contango to consider a level where we expect the underlying market to be situated within a certain time period (which is logically dependent from the expiration of the option) – up to where it can fall.

If we consider volatile ETF / ETN, then logically, the lower is predicted contango, the closer will be the level where we assume the markets like VXX, UVXY, … could fall. On the contrary, with higher expectations – implied contango, we speculate on a more significant decline in the market.

We will explain the exact parameters and the schema of the model we use later. It is still a relatively advanced topic that deserves more space. However, the basic logic is clear. Trading is a game of alpha, expectancy – in essence, it is nothing but searching the right balance between the probability of success and the RRR. It is precisely the optimal variant that our model searches for.

For more conservative traders and especially new traders, it is advisable to start trading this strategy through vertical option spreads.

It is therefore a strategy with clearly defined maximum profit and loss. Even if volatility would have jumped by tens of percent per day (as we have witnessed this February), we always know that our risk is limited to an acceptable level (of course, while keeping basic money-management rules). It is also very positive that option spreads and its strategy can be opened even on very small accounts, (units of thousands of dollars). If we would take the smallest difference of strikes, ie 1 point, then the margin (for call spreads), respectively the opening cost (for put spreads) will be only a few tens of dollars.

Let’s say we open a vertical bear spread, expiring in 2020, on the UVXY instrument – I choose strike difference 5 points, eg strikes 5 and 10.

Now I have to choose whether to select a call or put spread. The graph of their development is identical, in both cases we want a drop in the market. However, on closer look, the numbers are different.

For comparison:

Obr.1: Bear call spread (5-10 JAN2020) (zdroj: TD Ameritrade)

Figure 1: Bear call spread (5-10 JAN2020) (source: TD Ameritrade)

 

Obr.2: Bear put spread (10-5 JAN2020) (zdroj: TD Ameritrade)

Figure 2: Bear put spread (10-5 JAN2020) (source: TD Ameritrade)

 

CALL (bear call spread):

  • sell 5 Call JAN2020 + buy 10 Call JAN2020
  • Bonus Received: 2.39 = Maximum Profit $ 293 per 1 contract
  • Potential Max Loss: 5 – 2.39 = 2.61, ie $ 261 per 1 contract

 

PUT (bear put spread):

  • buy 10 put JAN2020 + sell 5 put JAN 2010
  • Potential Max. Profit: 5 – 3.03 = 1.97 = 197 USD per 1 contract
  • Given premium: 3.03, which means a maximum loss of $ 303 per 1 contract

 

Clearly, call spread variant looks much better. But there is one thing. In the case of a call option, there is a risk of so-called assignment to the underlying market (opening a direct short position x100 units per 1 option on your account). There is nothing wrong in it, as the trade is covered by a higher-strike call option. However, as I have already mentioned here, while holding a short position, you pay very significant holding fee associated with short position borrowing.

Assignment usually occurs when the sold lower-strike has a zero time value.

In the trading platform, this information is visible in the extrinsic column

Obr.3: Opční striky - ETF:UVXY a expirace JAN2020, včetně vnitřní a časové hodnoty - extrinsic value (zdroj: TD Ameritrade)

Figure 3: Option strikes – ETF: UVXY expiration JAN2020, including internal and time values ​​- extrinsic column (source: TD Ameritrade))

 

Therefore, when choosing strikes for a given strategy, I highly recommend monitoring this figure and choosing an option that has a time value (the specific value is very individual based on the selected market, option liquidity, … in the case of volatile ETFs at least 0.5). Even though it is certainly a good strategy to open up at the higher values ​​of the underlying market (as we have already clarified here), of course it is necessary to expect that the underlying market may grow even higher. In this case, the time value of listed ITM call options will decrease further, so the growing market against our position means an increased assignment risk. It is therefore necessary to take this into account and to buy such strikes where, on the one hand, some time value is now present and where some time value will remain in the case of another – even a short – growth.

Alternatively, it is of course possible to choose put spreads where the risk of assignment is practically not present. Of course, it is clear that their potential profitability is significantly lower, but we can quietly sleep being sure assignment will not occur.

Therefore, when creating a trading system, it is necessary to include in the trading plan whether to open spreads through call options (higher reward, but also the risk of potential assignment)

In one of the other parts we will explain what to do when the assignment occurs. It’s basically nothing tragic, just you need to keep a cool head and knowing what to do in such a situation.

 

 

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