How To Trade Options – Part 4: Comparison Strategies (Loss)
After defining and detailing the fundamentals of options trading, we can move ahead with comparing and contrasting trading results. We’ll now take a look at what could have happened if we used options in place of SPY stock, using a strategy loosely based on the one Larry Connors presented in his preview of the upcoming Quantified Options Trading Strategies Summit 2013:
- Entry: SPY 2-period RSI < 5
- Exit: SPY 2-period RSI > 70
There were 3 consecutive trades starting in late July 2011 that should prove illustrative and will be covered throughout the next 3 installments of this series- a loser, a winner, and a break-even trade if SPY stock were traded. Since the strategy was based on the SPY 4PM EST close, I simulated option prices for 3 strikes with the Black-Scholes model, inputting that day’s implied volatility (IV) for the middle (ATM) strike, 4% higher IV for the lower (ITM) strike and 4% lower IV for the higher (OTM) strike. This should give us a reasonable approximation of comparative results.
The first trade we’ll look at had an entry on July 27, 2011 and didn’t exit until Aug. 15, 2011.
Anyone who was trading mean-reversion strategies at that time will remember that period all too well. The results based on using Aug. 2011 monthly options are shown below (no commissions/slippage):
The first group of results reflects using 1 option contract as a replacement for 100 shares of SPY. The long calls had a smaller loss in dollars although in percentage terms took a 100% loss. This should reinforce the notion that a 100% loss is a very real possibility when trading options. The short puts lost much more than the long calls. Essentially they did better than long SPY because of the premium collected, where a covered call would have given the same results. The bull spreads, even the $4 spread, fared the best. This can be attributed to the much lower market and dollar exposure (if you compare the deltas on the spreads vs. the single options). Also, notice that there was no real difference between the long call (debit) spread vs. the short put (credit) spread.
The second group of results shows what happens if you increase the contracts so that the market exposure is equivalent to SPY stock.
Number of contracts * Deltas = SPY equivalents
Long calls continue to lose less than SPY stock. Short puts do worse, since as the trade goes bad the market exposure gets bigger. The bull spreads perform in between, not surprising considering their long/short options structure. What is somewhat alarming is how many $2 spreads were needed to establish the same market exposure as SPY stock — commissions and liquidity would certainly become a factor.
Most of these results show reduced losses in what was a very bad trade, so using options would have been preferable. In the next installment of the series we’ll look at a winning trade and see if the same impression is true there as well.