Methodology...Mindset Part 1
Initiating New Positions
When inititating new positions, or hedging/rebalancing the entire portfolio, the first thing I look at are the overall deltas of my portfolio. I beta-weight all my positions to the SPX to give me a good idea about how much money the portfolio has at risk in absolute dollar terms with respect to every 1 point move in the S&P500. Since I trade only the Russell 2000 (via IWM) and the S&P500 (via SPY), beta-weighting to the SPX works well for me. Since I have a good feel for trading (ie: predicting) short-term 1 to 3 day moves in S&P500 via the futures, understanding risk in dollars vis a vis a 1 point move in the underlying SPX index allows me to associate my qualitative trading feel (on market direction) with quantitative options trading methods and technical indicators. Say what you want about trading off of "feel"--after you've watched the daily movements of a market for years (even down to the very last tick sometimes) you get a really good "feel" for what kind of market you're in--bull/bear, high/low volatility, breakout/breakdown, whether its good to follow the crowd or be contrarian. It works for me, and when it stops working, I'll look to try something else or go straight "quant" and relatively delta-neutral until I get my feel back. (Obviously, no model, quant or otherwise, will predict 2 airplanes running into buildings like on 9/11, and that type of event really is the *only" type of event I'm worried about when trading these methods of mine.)
I would say my trading of these methods tracked on this website is about 75% quant driven (managing greeks) and 25% qualitative. When the market is at extreme overbought/oversold levels, I'll qualitatively trade market direction either through the deltas of my options, or simply via going long/short S&P futures contracts.
The Delta-Neutral Basics
Managing a large options book dedicated to milking time premium across 3-6 expiration months can be quite a daunting task if you don't distill all your contracts down to the bare bones--the greeks. Since my main intent with this strategy is to always be net short option premium (ie: my total portfolio theta is positive at all times.), it is also usually my intent to also be as delta-neutral as possible, within reason (I won't "overtrade" just to achieve neutrality). But just because I'm always net short options premium, doesn't mean I never buy options! The portfolio is not leveraged in any way, and every short option position is always hedged at some level by an option I've bought (ie: making a vertical/calendar/diagonal spread). In my mind I have a comfort zone associated with how much delta exposure I'm comfortable having at any given time--usually the maximum exposure I want to any 1 point move in the S&P is about 0.25% of my total portfolio value. In the scope of this paper trading portfolio I'm running on this website, this 0.25% equates to about $350. Remember, this is $350 at risk for every 1 point the S&P500 moves *AGAINST* me. (ie: Assume I'm starting a new options portfolio with $100,000. So, 0.25% of $100,000 equates to $250. So, if my SPX beta-weighted delta ever got to +/- $250 I would look to rebalance/hedge.) This is quite a bit--at least for my conservative trading nature--as it's very common for the S&P500 to have 10 point swings intra-day and a 10 point move against me with an absolute delta equating to $350 would be a loss of $3500, or in terms of percentage of the portfolio that I used before 10*0.25%=2.5% of the total portfolio! (Generally, I would ensure my other greeks would "back up" my delta exposure--ie: if I have a lot of short deltas, I'll make sure I have a lot of positive vega exposure--more details on this later), so this 2.5% wouldn't actually be the case, and but I'll get into the details of using back-month vega and front-month gamma to help manage delta exposure later. Still though, I don't want to even come close to the 2.5% drawdown because of some mismanaged deltas--this is quite a bit, and is why this is my absolute maximum delta exposure I will usually have at any given point and time. The only time I would embrace this type of "risk" is when I actually want to take a short-term directional stance, which would only be at a significantly overbought/oversold time and when multiple technical indicators are indicating either a huge breakout, or swing in trend is imminent in the very short-term (ie: intra-day, up to 3 days). Below, I will discuss how (and why) I chose to trade directionally at times, given the overarching idea of managing a delta-neutral portfolio.
Intelligently Rebalancing to Delta-Neutral
In my mind, it's easier to trade the volatility of the S&P500 than it is to trade outright directional movement of the S&P500. (Forget that I also trade the Russell 2000, and remember that I beta-weight everything to the S&P500 for purposes of efficiently managing my greeks in a very short period of time.) The VIX is the easiest way to see how the market is viewing S&P500 volatility, and since the VIX is priced through backing out the volatility premium priced into SPX options, understanding what the VIX is trading at is of huge importance to me when trading my options for this portfolio. Remember, when the market is highly volatilie (ie: a high VIX), people are willing to pay more for insurance in the form of options contracts. The willingness to pay more will cause options premiums to increase relative to what they would be if the market were less volatile. Therefore, generally speaking, the higher the VIX is, means the more I will be able to take in from selling options, and the more I will have to pay for buying options.
When inititating new positions, or hedging/rebalancing the entire portfolio, the first thing I look at are the overall deltas of my portfolio. I beta-weight all my positions to the SPX to give me a good idea about how much money the portfolio has at risk in absolute dollar terms with respect to every 1 point move in the S&P500. Since I trade only the Russell 2000 (via IWM) and the S&P500 (via SPY), beta-weighting to the SPX works well for me. Since I have a good feel for trading (ie: predicting) short-term 1 to 3 day moves in S&P500 via the futures, understanding risk in dollars vis a vis a 1 point move in the underlying SPX index allows me to associate my qualitative trading feel (on market direction) with quantitative options trading methods and technical indicators. Say what you want about trading off of "feel"--after you've watched the daily movements of a market for years (even down to the very last tick sometimes) you get a really good "feel" for what kind of market you're in--bull/bear, high/low volatility, breakout/breakdown, whether its good to follow the crowd or be contrarian. It works for me, and when it stops working, I'll look to try something else or go straight "quant" and relatively delta-neutral until I get my feel back. (Obviously, no model, quant or otherwise, will predict 2 airplanes running into buildings like on 9/11, and that type of event really is the *only" type of event I'm worried about when trading these methods of mine.)
I would say my trading of these methods tracked on this website is about 75% quant driven (managing greeks) and 25% qualitative. When the market is at extreme overbought/oversold levels, I'll qualitatively trade market direction either through the deltas of my options, or simply via going long/short S&P futures contracts.
The Delta-Neutral Basics
Managing a large options book dedicated to milking time premium across 3-6 expiration months can be quite a daunting task if you don't distill all your contracts down to the bare bones--the greeks. Since my main intent with this strategy is to always be net short option premium (ie: my total portfolio theta is positive at all times.), it is also usually my intent to also be as delta-neutral as possible, within reason (I won't "overtrade" just to achieve neutrality). But just because I'm always net short options premium, doesn't mean I never buy options! The portfolio is not leveraged in any way, and every short option position is always hedged at some level by an option I've bought (ie: making a vertical/calendar/diagonal spread). In my mind I have a comfort zone associated with how much delta exposure I'm comfortable having at any given time--usually the maximum exposure I want to any 1 point move in the S&P is about 0.25% of my total portfolio value. In the scope of this paper trading portfolio I'm running on this website, this 0.25% equates to about $350. Remember, this is $350 at risk for every 1 point the S&P500 moves *AGAINST* me. (ie: Assume I'm starting a new options portfolio with $100,000. So, 0.25% of $100,000 equates to $250. So, if my SPX beta-weighted delta ever got to +/- $250 I would look to rebalance/hedge.) This is quite a bit--at least for my conservative trading nature--as it's very common for the S&P500 to have 10 point swings intra-day and a 10 point move against me with an absolute delta equating to $350 would be a loss of $3500, or in terms of percentage of the portfolio that I used before 10*0.25%=2.5% of the total portfolio! (Generally, I would ensure my other greeks would "back up" my delta exposure--ie: if I have a lot of short deltas, I'll make sure I have a lot of positive vega exposure--more details on this later), so this 2.5% wouldn't actually be the case, and but I'll get into the details of using back-month vega and front-month gamma to help manage delta exposure later. Still though, I don't want to even come close to the 2.5% drawdown because of some mismanaged deltas--this is quite a bit, and is why this is my absolute maximum delta exposure I will usually have at any given point and time. The only time I would embrace this type of "risk" is when I actually want to take a short-term directional stance, which would only be at a significantly overbought/oversold time and when multiple technical indicators are indicating either a huge breakout, or swing in trend is imminent in the very short-term (ie: intra-day, up to 3 days). Below, I will discuss how (and why) I chose to trade directionally at times, given the overarching idea of managing a delta-neutral portfolio.
Intelligently Rebalancing to Delta-Neutral
In my mind, it's easier to trade the volatility of the S&P500 than it is to trade outright directional movement of the S&P500. (Forget that I also trade the Russell 2000, and remember that I beta-weight everything to the S&P500 for purposes of efficiently managing my greeks in a very short period of time.) The VIX is the easiest way to see how the market is viewing S&P500 volatility, and since the VIX is priced through backing out the volatility premium priced into SPX options, understanding what the VIX is trading at is of huge importance to me when trading my options for this portfolio. Remember, when the market is highly volatilie (ie: a high VIX), people are willing to pay more for insurance in the form of options contracts. The willingness to pay more will cause options premiums to increase relative to what they would be if the market were less volatile. Therefore, generally speaking, the higher the VIX is, means the more I will be able to take in from selling options, and the more I will have to pay for buying options.
posted by Justin @ 8:42 PM
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