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Question on FX options & time-decay

  • #21
  • Oct 31, 2009 1:13pm Oct 31, 2009 1:13pm
Quoting RiverTrader
scattergood,

I will need to read your posting over and over to understand it all.
My worst nightmare is that Short Strangles are unlimited lost if strike price going outiside of this strangle set.

So, I am looking for a way to calculate out when is my maximum lost = 0, then I will simply close them all out, before expiration.

Can you show us how to calculate out the pips we can tolerate for maximum lost = 0, while the strike passes each option? (before expiration)

RiverTrader
RiverTrader--yes options in general, and strangles in particular are very different and difficult to understand compared to other forms of trading. I will try to address your points:

1) Worst nightmare -- your fear about the price spiking well beyond either strike of a strangle is the #1 issue about trading short strangles. However there are a number of things that make this fear not as big compared to traditional directional trading:

a) With the underlying at your strike (At the Money or ATM), the delta on the option is only .50. Meaning that for every 10 pips above your strike for a call or below your strike for the put, you only lose 5 pips of value. The delta for the option becomes higher the futher In the Money it becomes. Delta doesn't approach 1, where for every pip you lose a pip on your option, for hundreds if not a thousand pips ITM.

b) Forex options are European options, meaning you cannot be exercised against until the day of expiration. This means you are never forced to take a position and realize the full loss, it is always a paper loss until you close the options position or until the day of exercise.

c) You can always realize your loss and roll out the position, which is what I do. Let's say I sell a 1.5000 EURUSD 30 day Call for 25 pips, when the EURUSD is at 1.4500. Then let's say the EURUSD shoots up to 1.5000 in one week. And the option is now 100 pips to buy back. I am 75 pips down.

Well all I need to do is buy it back, netting the 75 pip loss and then sell another EURUSD call further out it time and price. I could sell the 120 call 1000 pips away for 100 pips possibly, and just wait for the time to give me back the value. What happens in this case is you just delay the realization of your 25 pips from 30 days to 150 days. But, do you really care? No, because the margin utilization is so good you are making $250 on $1000 over 5 months instead of over 1. You are still up 25% over the longer time frame, is that so bad?

The key is that whether you can depend on the liquidity to get you out. Certainly at the sizes we trade that is possible.

2) As to your comment "maximum lost = 0", I don't think I understand. You are NEVER not at risk until the option expires, theoretically. What I mean is that let's say you have a 1.5000 / 1.4000 strangle on the EURUSD. If there is 1 day left and the EURUSD is at 1.4500, it is THEORETICALLY possible for the EURUSD to spike 500 pips in 1 day and hit your strike, not likely but possible.
  • #22
  • Edited Nov 1, 2009 8:11pm Oct 31, 2009 10:22pm | Edited Nov 1, 2009 8:11pm
Quoting scattergood
RiverTrader, I have been trading Short Strangles on the equity indexes starting in February. I am happy to report that I am up about 18% so far, with only two months in the red, each one less than 2%. I moved this strategy over to Forex and have been selling strangles for about 2.5 months. Here I am up about 28% in those two months. The difference being mainly the extra leverage.

What you are asking doesn't quite make sense. A short strangle shouldn't have any of the legs exercised. You want to keep the premium and have everything expire...
scattergood,

I searched PowerXL, can't find it.
Do you have a link?

Or, you may already have a spreadsheet with a black scholes formula in it.
Can you post it here for me?

By the way, the maximum lost = 0, was a misunderstanding.
What I really meant was, the breakeven underlying price.

I am looking for a spreadsheet (calculator) to find out the breakeven underlying price for my short strangles.

Thanks ahead !


RiverTrader
Simple is powerful all the time.
  • #23
  • Nov 2, 2009 11:26pm Nov 2, 2009 11:26pm
Quoting RiverTrader
scattergood,

I searched PowerXL, can't find it.
Do you have a link?

Or, you may already have a spreadsheet with a black scholes formula in it.
Can you post it here for me?

By the way, the maximum lost = 0, was a misunderstanding.
What I really meant was, the breakeven underlying price.

I am looking for a spreadsheet (calculator) to find out the breakeven underlying price for my short strangles.

Thanks ahead !


RiverTrader

Here's the link: http://www.power4xl.com/index.html
  • #24
  • Nov 3, 2009 10:45pm Nov 3, 2009 10:45pm
Quoting scattergood
If you want I can post some charts of some of the trades I have done to explain my thinking.
That would be cool, this is a fascinating subject.
I'm currently trying to grind my way though one of the 'Wilmott' books, it's not easy going but it does open ones eyes to the different types of non-TA analysis that are possible.
The breaking of a wave cannot explain the whole sea.
  • #25
  • Edited 12:28pm Nov 4, 2009 11:19am | Edited 12:28pm
Quoting Craig
That would be cool, this is a fascinating subject.
I'm currently trying to grind my way though one of the 'Wilmott' books, it's not easy going but it does open ones eyes to the different types of non-TA analysis that are possible.
OK, here is a chart with information about a USDJPY strangle I have legged into. I sold the put first, then after a few days sold a call.

Here is a legend for the chart:

1) The left most vertical red line is the date I sold the first leg, the put in this case on 10.16.09.

2) The right most vertical red line is the date of expiration of the put (and call) that I sold, which is 11.19.09.

3) The lower black line and text show the put sale. There is a description of the sale and the start of the line is the day I sold it and the end of the line is the day it expires.

4) The upper black line and text show the sale of the call. There is a description of the sale and the start of the line is the day I sold it and the end of the line is the day it expires.

5) The thin blue line is a resistance line I saw being rejected which was one indication for me to now sell the call.

6) The bottom panel contains a custom indicator that measures the internal strength of each individual currency of a pair. The red line measures the strength of the front currency, the USD, and the green line measures the strength of the back currency the JPY. The histogram is the difference between the red line (USD) and the green line (JPY). PM me if you are interested in the indicator.

OK, now here is the thinking behind putting on each leg of the trade:

A) On 10.16.09 you can see about 8 previous days of rise in the USDJPY, including a small retracement from 90.50 to 88.50 in the middle of the 8 days.

B) Further you can see a falling JPY in the Multibar indicator on the bottom panel, and a flat USD. The difference, or histogram, has been steadily rising after an extended month+ of negative values.

A + B indicate that there is significant likelihood of continued rise in the USDJPY. So I selected a Put strike well below the swing low. In fact 86 is below the December 08 and Jan 09 lows of 86.50 or so. This seems like a reasonable lower strike as it has shown itself to be below significant support in the past.

C) 12 days after selling the 86 put, there was a significant decline from 92.25 down to 90.25.

D) This decline started very close to a previous swing high of 92.50 or so as indicated by the blue resistance line.

E) Further, the internals indicator at the bottom shows the JPY has turned up as the green line moves up, and the histogram difference has started to turn down from a small positive value.

C + D + E indicate that a swing high may be in place and that we have started the down, in a down up down move before we get good direction again. So I put on a short 94 Call above the swing high above resistance line the price just moved away from.

All combined, I collected 39 pips on a 2 lot, or around $800. The max margin I would ever have to have on is around $2000 if the USDJPY ever got to either strike.

The max amount of loss I would have to absorb is around $2500 before rolling things out. If the USDJPY shot up to 94, the upper Call strike, the Call I sold for 15 pips would be worth about 135 pips. This 125 pip loss on 2 lots would have to be absorbed, and then rolled out into the future.

So, worst case is I need 2000 + 2500 = $4500 to collect $800. That's a 17% return. I may get that return in 30 days if both options expire. It may take 6 months if I have to roll one of the options out and eat the loss but sell another option.

Either way, 17% on 30-180 days seems pretty good to me. If you have any questions, I am happy to address them, just let me know.
Attached Image (click to enlarge)
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  • #26
  • Nov 4, 2009 11:44am Nov 4, 2009 11:44am
Cool, thank you for that. If could ask a question, forgive me if I am off the mark as I am new to the terminology, so you are not making a 'volatility call' because you are not 'delta hedging' with the underlying, is this correct?
The breaking of a wave cannot explain the whole sea.
  • #27
  • Nov 4, 2009 12:17pm Nov 4, 2009 12:17pm
Quoting Craig
Cool, thank you for that. If could ask a question, forgive me if I am off the mark as I am new to the terminology, so you are not making a 'volatility call' because you are not 'delta hedging' with the underlying, is this correct?
The answer is a yes and a no. Part of the issue is how you intend to exit the strangle. But let's back up a little first.

Let's assume I sell a 30 day EURUSD strangle with the 1.5500 and 1.4500 strikes when then EURUSD is at 1.5000, and collect a net of 40 pips.

There are three things that we really care about that effect the cost of buying back the options:

1) Distance to Strike. == delta
2) Volatility == vega
3) Time to expiry == theta

At the moment the strangle is sold, the net delta on the position is basically zero. Any move in the EURUSD up creates a higher price on the Call to purchase it back, but a lower cost on the put to purchase it back. However if the EURUSD moves significantly higher, then the delta on the call moves up much higer than the delta on the put and any increase in the call repurchase price overwhelms the decrease in the put repurchase price.

At the moment the strangle is sold, the vega is whatever the vega is. If the price shoots up and down and up and down for three days but ends at the same price, volatility may have increased significantly and the repurchase prices of both the put and the call may have increased, thus putting the position into a loss.

Some people look at the strangle and say, hey delta at zero or near zero, and the thing that really affects the price of the strangle is vega. Thus for a short strangle they want vega to decrease so the repurchase of the options is cheaper and they can make money on the movement of the vega.

I however, don't look at it that way. Because what I really care about is theta, or time decay. Vega will go up and down and I have no control over it. Delta will go up and down and I have no control over it. But theta only ever increases. Meaning, the rate of decay of the value of an option only ever accelerates. I can control how much time I want to be in the market, and how much time I am willing to wait on an option. Every day that passes brings the options repurchase lower and lower constantly.

This fact, combined with the higher spreads means I want to avoid as many transactions as possible. I want to sell everything, and then have it expire. So my focus is on time, not volatility.

What you are talking about in regards to delta hedging is actually something that never happens. In order to be a a net delta of zero, you have to constantly change the amount you have hedged. As the call delta increases you have to be long the EURUSD and as it decrease you have to lighten, or go into shorting the EURUSD if the put delta goes to high. This is really gamma scalping. Gamma being the rate of increase in delta. Given the transaction costs on the option side, I am not sure gamma scalping is a good idea or forex.
  • #28
  • Nov 4, 2009 12:36pm Nov 4, 2009 12:36pm
Cheers for that, I'm going to have to think about this for a while!
The breaking of a wave cannot explain the whole sea.
  • #29
  • Nov 4, 2009 7:26pm Nov 4, 2009 7:26pm
Quoting Craig
Cheers for that, I'm going to have to think about this for a while!
No worries if you have any questions I am happy to try to help answer them.
  • #30
  • Nov 4, 2009 7:52pm Nov 4, 2009 7:52pm
Quoting scattergood
No worries if you have any questions I am happy to try to help answer them.
Cool, I think I need to go away and study composite options positions (like 'the strangle'), it's a very hard (for me anyway) thing to hold in ones head as you are not simply dealing with price and time, but many other variable on top of that. Sorry if this has already been asked, but can you recommend any good books?
The breaking of a wave cannot explain the whole sea.
  • #31
  • Nov 4, 2009 8:06pm Nov 4, 2009 8:06pm
Quoting scattergood
OK, here is a chart with information about a USDJPY strangle I have legged into. I sold the put first, then after a few days sold a call.

Here is a legend for the chart:

1) The left most vertical red line is the date I sold the first leg, the put in this case on 10.16.09.

2) The right most vertical red line is the date of expiration of the put (and call) that I sold, which is 11.19.09.

3) The lower black line and text show the put sale. There is a description of the sale and the start of the line is the day I sold it and the end of the line...
Nice strategy, I have to read it over again, and demo it.
Not long ago, I was trying to use monthly chart pivot to set short strangles. Haven't figured it out, yet. Have you done that before?


RiverTrader
Simple is powerful all the time.
  • #32
  • Nov 22, 2009 10:59am Nov 22, 2009 10:59am
Quoting scattergood
OK, here is a chart with information about a USDJPY strangle I have legged into. I sold the put first, then after a few days sold a call.

Here is a legend for the chart:

1) The left most vertical red line is the date I sold the first leg, the put in this case on 10.16.09.

2) The right most vertical red line is the date of expiration of the put (and call) that I sold, which is 11.19.09.

3) The lower black line and text show the put sale. There is a description of the sale and the start of the line is the day I sold it and the end of the line...
I haven't forgotten this, I'm currently grinding my way though Natenberg, so I finally understand 'sell put', 'sell call' & 'short strangle', whew...getting there. I might be able to ask an intelligent question in a week or two
The breaking of a wave cannot explain the whole sea.
  • #33
  • Nov 23, 2009 6:35pm Nov 23, 2009 6:35pm
Quoting scattergood
Spreads on options on index ETFs == $0.01 to $0.05
Spreads on options on forex ETFs == $0.01 to $0.05
Margin for ETFs == Lots x 100 x Strike x .2 - (Lots x 100 x (Strike - Underlying)

Lets say you sell the 1 lot of the SPY (S&P 500 ETF) Call at 100, with the underlying at 95.

Margin at time of purchase = 1x100x100x.2 -(1x100x(100-95)) = 2000 -500 = 1500.
Margin if SPY is at 100 = 2000 -...
Nice coach, scattergood. I have heard of ETF two times in this week, I got to find out what is ETF? Someone told me a Iron Condor is good for trading the Index.
Has Index to do with ETF as well? Apology, if my question is too stupid.
Simple is powerful all the time.
  • #34
  • Nov 24, 2009 12:18pm Nov 24, 2009 12:18pm
Quoting Craig
I haven't forgotten this, I'm currently grinding my way though Natenberg, so I finally understand 'sell put', 'sell call' & 'short strangle', whew...getting there. I might be able to ask an intelligent question in a week or two
No problem, looking forward to your questions when you are ready. Until then here is a short primer that may be helpful. Note, since we are using forex options which are European style options I will define things with that in mind:


American Style Option = An option that can be exercised any time BEFORE expiry.
European Style Option = An option that can be exercised AT expiry.
Option Premium = The price an option is bought or sold for.

Buy / Long a Call = The right but not the obligation to buy the underlying asset at expiry for the strike price of the option.

Sell / Short a Call = The obligation but not the right to sell the underlying asset at expiry for the strike price of the option.

Buy / Long a Put = The right but not the obligation to sell the underlying asset at expiry for the strike price of the option.

Sell / Short a Put = The obligation but not the right to buy the underlying asset at expiry for the strike price of the option.

When you sell an option or a combination of options your max profit is the premium you collect, and losses can be much higher.

When you buy an option or combination of options your loss is the premium you pay and the profits can be much higher.

A strangle is the purchase (long) or sale (short) of the same number of Out of the Money (OTM) calls and puts on the same underlying with the same expiry.

Assuming the EURUSD is at 1.5000 then:

Buy a Strangle
==========
Buy 100K EURUSD Calls at 1.5500 strike, 12.17 expiry
Buy 100K EURUSD Puts at 1.5000 strike, 12.17 expiry

You hope for the EURUSD to either go above 1.5500 or below 1.500 by more than the total premium to make money, otherwise you lose your premium.


Sell a Strangle
==========
Sell 100K EURUSD Calls at 1.5500 strike, 12.17 expiry
Sell 100K EURUSD Puts at 1.5000 strike, 12.17 expiry

You hope for the EURUSD to not be above 1.5500 or below 1.5000 at expiry, an you will keep all the premium.

Hope that helped.
  • #35
  • Nov 24, 2009 12:19pm Nov 24, 2009 12:19pm
Quoting RiverTrader
Nice strategy, I have to read it over again, and demo it.
Not long ago, I was trying to use monthly chart pivot to set short strangles. Haven't figured it out, yet. Have you done that before?


RiverTrader
No I don't use Pivot Points, as I find them better for intraday trading. I use Support / Resistance, Point and Figure, and my own Forex Internals indicators that I find useful.
  • #36
  • Last Post: Nov 24, 2009 12:32pm Nov 24, 2009 12:32pm
Quoting RiverTrader
Nice coach, scattergood. I have heard of ETF two times in this week, I got to find out what is ETF? Someone told me a Iron Condor is good for trading the Index.
Has Index to do with ETF as well? Apology, if my question is too stupid.
An ETF = Exchange Traded Fund. It is really a stock tracker for some underlying instrument. The symbol SPY tracks the S&P 500. The symbol FXE is a stock that tracks the EURUSD. The problem is that it is a stock, has lower liquidity than the cash EURUSD market and is subject to the margin requirements of a stock.

An Iron Condor is a 4 legged options trade:

Sell an Out of the Money Call
Buy a more Out of the Money Call
Sell and Out of the Money Put
Buy a more Out of the Money Put

Let's assume the EURUSD is trading at 1.500:

Sell the 1.5400 Dec 17th Call
Buy the 1.5500 Dec 17th Call
Sell the 1.4600 Dec 17th Put
Buy the 1.4500 Dec 17th Put

Let's say the whole thing, the buying and the selling, will net you 20 pips. That's the max profit you can make.

However, you losses are capped to 100 pips. If the price is below 1.4500, for every pip you lose on the 1.4600 put you sold you make on the 1.4500 put you bought.

My issue with condors and forex options, is that the transaction costs / spread is so high, it tends to make them less attractive.
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