In last week’s Options Corner (https://itawealth.com/options-corner-24-august-2020/) I started to build a “position” in SPY (S&P 500) Options and, with a ~$10 move higher in the price of SPY I have added a few more “legs” to the “position” over the past few days. In this post I will update the position and introduce you to two other “instrument gauges” that are used to manage these (seemingly) complex positions that have no special “strategy” name.
This is a totally different approach to Option education than we normally see in textbooks or are taught in courses. As one ITA member commented on last week’s post I’m throwing you into the (very) deep end and hoping that I can teach you how to swim – or, at least, to paddle to safety and get an idea of why we might consider including Options in our portfolios. It’s just a different way to add diversification.
As I explained in last week’s post, my objective in the construction of this Options “position” is to create a downside “hedge” to (at least partially) protect my longer term investment portfolios. Since I don’t know where the markets are going over the next few months (specifically through the upcoming elections and into next year). A simple hedge would be to just buy an appropriate number of Put Options. But Put Options are expensive and if we have no “insurance claims” we lose the premium paid to buy the insurance. My approach is therefore to be a (net) seller of premium (act as the insurer) so as to generate credits that can then be used to buy downside protection – i.e hopefully ending up with “free” insurance. However, this cannot be done without accepting some level of risk – so, controlling that risk is important.
As I mentioned in the comment section of the last post, I have added eight (8) new legs to the position that was opened last week. The current “legs” are shown below:
And, as we can see, the “Delta” of the “position is -20.67 i.e. we are bearish to the tune of 20.67 shares in SPY (as explained in the previous post) – being the sum of the deltas in the individual “legs”.
Note the columns labelled Theta and Vega – we’ll be coming back to this figure later.
At this point, with Options at different strikes and expiry dates you might wonder how I can more easily keep track of my Position”. I do this by using a simple spreadsheet:
Where I can see the legs relative to time and price (current price of SPY ~$350). Because I want to cover as wide a range as possible, I want to keep the overlapping to a minimum.
Last week I showed the profit/loss risk graphs using graphics from the ThinkOrSwim (TOS) platform (by far the best platform for Options analysis – even though they’re not in my good books for trading at the moment). However, any readers that have followed my GLD trades will know that I also use the OptionsAnalysis.com website for tracking purposes (this is not a trading platform). Using this software my current position now looks like this:
This view is rotated 900 from the TOS graphs but shows our P/L side by side with the daily candles. Since SPY moved up ~$10 over the past week, and my position has a negative delta (bearish), the position is presently showing a small loss – but this is OK since my portfolios are (hopefully) showing profits that can absorb this.
In tabular format, OptionsAnalysis (OA) summarizes the position like this:
Where, checking the numbers within the red box at the top of the figure we can see that my net “cost” on this position is a $140 credit. This does not mean that I have no risk – risk is currently sitting at $1,860. Because price has gone up (and the position is delta negative) the position is currently showing a $95 (~5% of risk) loss – but that’s ok. The table at the bottom of the figure shows details of the individual legs and (should) match the information shown in the first figure from TOS. However, it does not match exactly because I have not used TOS for my actual trades and the TOS data reflects price fills in a duplicate “paper money” account. The OA prices shown above reflect my real fill prices.
OA is showing a position delta of -14.54 (slightly less that the TOS illustration) and this is a result of the different fill prices and the “models” used to calculate the data. OA and TOS use different theoretical models so there will be differences – but this is not too important, either is close enough for practical position management. If you’re wondering which data is “best” I would probably go with TOS – but they’re all just theoretical models used for analysis – actual prices are set by the “market makers” and determined by market supply/demand conditions – not calculated from a model using fixed/static data.
Now we come to those other columns in the first figure (with equivalent data in the OA red box). The first column shows “Theta” for the individual legs and a total “position” theta of 6.03 (by summing the individual legs). The OA software calculates as slightly smaller Theta of 4.42 (good enough for government work 😊). So, what does this mean? This tells us that, if we hold this position, we will make $6.03 (or $4.42), say $5, per day due to time decay. Nothing is static with Options but, thinking simplistically, the message is that, if price (and other parameters) were to remain unchanged for the next 21 days, then we would pick up ~$5 x 21 = $105 in time decay – and this “covers” the current $95 loss – so, why the $95 loss isn’t a big concern. As stated, nothing is static (e.g. volatility can change and affect pricing) but “Theta” is the second instrument (after Delta) on our management dashboard that we should be watching.
I’ve already hinted that Implied Volatility (IV) is probably the most important parameter affecting Option prices and “position” sensitivity to IV is reflected in the next column, labelled Vega. TOS is showing Vega as -26.84 (note the negative sign) and OA is calculating a -$16.80 value – again, not huge numbers and close enough – the most important point is that Vega is negative. What does Vega mean? Vega is the change in position value for a 1% change in (implied) volatility. i.e. if volatility increases by 1% then our position will decrease in value by ~$22 (somewhere between the TOS and OA calculations). This is due to the fact that our position Vega is negative. If volatility were to decrease by 1%, then our position would increase in value by ~$22 – again offsetting the current $95 loss. At expiration, volatility drops to zero, therefore a position with negative Vega, if held to expiration would increase in value. Since the current position does not totally expire in 21 days, volatility will not drop to zero – but I hope you can visualize how the “greeks” are the instruments that we can use to manage complex Option positions.
Ideally, to establish a position that might achieve my objectives I would like to see a negative delta (bearish bias), positive theta (benefitting from time decay) and negative Vega (benefiting from volatility “crush”). At the present time I have this combination, but the challenge comes as market conditions change. My expectation is that volatility will increase as we approach the November elections (that will hurt me since I have a negative Vega position) but that volatility will drop when the election is resolved (that will benefit the position). In terms of directional risk I am looking for a hedge against my portfolio positions (that equate to positive delta) and my negative delta does this – but has risk if price continues upwards. To compensate for the possible downsides in delta and vega I am relying on the positive theta decay to benefit from the inevitable passage of time. This is how we use the “instrument gauges” (the “Greeks”) to manage any Option position – no matter how simple or how complex the position might look.
To finish this post I will just show another graph that is generated in the OA software:
that shows how the position value might change with a change in Implied Volatility. As you can see in the figure on the right, portfolio value should increase in value as IV either increases or decreases.
The figure on the left shows how uncertainty is already being built into the price of the longer term options (i.e. they are getting expensive) – the 60+ and 90+ day Options are already showing higher volatility than the shorter-term Options – that are currently trading at their 4-month lows.
So what’s so difficult about trading Options? Calls or Puts for direction, Buy or Sell to control risk and an instrument panel to help us drive/manage. Right?
I want to place another “Calendar” trade (preferably leaving me with a long Put Option in the November expiry), but this will cost me money, so, before doing this, I will try to sell something else for a credit (adding to my current $140 balance) to generate more funds with which to finance the purchase. Since I want to try to avoid overlapping positions I’ll wait and see what price movement we get going forward.
A pdf copy of this post is available at https://www.dropbox.com/s/qwtw3cwuylfqnio/Options%20Corner_200829.pdf?dl=0
[Remember – for anyone preferring to go the simpler, more conventional route to using Options, my old “basics” posts can be found in the pdf files at https://www.dropbox.com/sh/3pu80xpnlxoewyl/AADf122Bgx9IFw3utOElxz7Wa?dl=0]