Trading System Design - The Options Selling Reportgotradesignals.com/resources/Trading System Design...
Transcript of Trading System Design - The Options Selling Reportgotradesignals.com/resources/Trading System Design...
The Option Selling Report www.GoTradeSignals.com ©2012 All Rights Reserved
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Trading System Design
The Option Selling Report
And Other Trading System
Analysis
Author: GoTradeSignals
The Option Selling Report www.GoTradeSignals.com ©2012 All Rights Reserved
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U.S. Government Required Disclaimer: Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risk.
You must be aware of the risks and be willing to accept them in order to invest in the options, futures and stock markets. Don’t trade with money you can’t afford to lose. This
training website is neither a solicitation nor an offer to Buy/Sell options, futures or securities. No representation is being made that any information you receive will or is likely
to achieve profits or losses similar to those discussed on this training website. The past performance of any trading system or methodology is not necessarily indicative of future
results. Please use common sense. This site and all contents are for educational and research purposes only. Please get the advice of a competent financial advisor before
investing your money in any financial instrument.
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Introduction
Welcome to the Option Selling Report. With this model
you, the trader, will be able to do what many successful
traders are already doing, extract money from the
financial markets. This model is not rocket science, or
the most complex strategy you can find in some of the
outstanding books out there. But having a clear cut, and
expressed, trading plan is most of the reason traders are
successful. And success is what you want.
This report culminates with an explanation of the GTS
Method for iron condors. The method generates a similar
credit to an iron condor, and has a similar expiration
graph (red line), but the active risk profile is more
favorable at initiation, as well as long vega at the put
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wing, which would aid with a sharp market move lower.
However, the iron condor strategy outlined in this report
will do well on its own in most market years. Below is
the risk graph of the GTS Method for the iron condor.
The www.ThinkOrSwim.com platform is a great
platform and provides some of the images in this report.
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This report can be grasped by anyone with an interest in
trading. However, the more versed one is in the
terminology, the easier read it will be. If someone has an
interest in trading, but not sure of an interest in learning
to trade, they can trade hands free with
www.GoTradeSignals.com.
By working with our approved brokers, trading can take
place with no effort by the account holder. The account
is funded in the trader’s name, and
www.GoTradeSignals.com publishes the signals to the
broker; the broker takes care of the rest by autotrading
for the account holder.
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www.GoTradeSignals is not an investment advisor but is
an autotrade publisher of trading signals. No specific
advice is given, signals are available to all subscribers.
From a mathematical perspective, the terms which
describe the inner working of options are referred to as
the Greeks. While the option Greeks are not referred to a
great deal in this report, there are some options
terminology which may be unfamiliar. But if you are just
starting out, a quick glance at some of the tools out there
will make this an easier read than it is. If you need a
primer, drop us a line, www.GoTradeSignals.com.
This options trading technique, as presented, takes as
little as $2000 to implement. There are many ways to
trade with less capital, but commissions become more
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consequential, and this drags on expectancy. Expectancy
is the calculated mathematical conclusion of a series of
trades.
When trading equities, more contracts per position will
mitigate the impact of commissions further. In our
examples, and for simplicity, we will trade one contract
at a time. This sets margin requirements at
approximately $2000 to get started with this model.
The target profit potential per month is approximately
8% on margin before transaction costs. The average
monthly potential will be much lower when factoring in
losing months, likely closer to 4%. Winning every
month will not occur, so be prepared to take some
managed losses.
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Margin rates for short equity option spreads are fairly
easy to calculate as the spread amount minus the credit
received multiplied by $100. For simplicity the spread
can simply be considered the margin requirement.
www.GoTradeSignals works with great brokers who
autotrade for their account holders, and can answer any
questions you may have.
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The Debate
Option selling vs. buying can often be a volatile debate.
The debate is likely not about agreeing if most out of the
money options expire worthless or not. It is actually a
question of options being efficiently priced or not. From
an objective standpoint, a case can be built for both sides
of the discussion.
The parallels between the options selling business and
the insurance business are numerous. Option sellers are
essentially selling insurance. Insurance companies, as a
whole, can do very well with forecasting and actuary
tables if the premiums are rich enough.
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If insurance premiums were priced efficiently, and net
revenue matched net insurance claims, plus the cost of
doing business, the incentive to be in the insurance
business is greatly reduced, if not completely eliminated.
Therefore, insurance premiums are modeled with the
ability to generate a profit over and above what their
actuary tables indicate is needed to cover claims, and
thus, the incentive for the insurance provider, and their
respective shareholders, to continue in business, remains
in tact. This is part of the rational of proponents of some
options being regularly mispriced.
On the other side of the coin, many argue there is no
expectancy for options, and they are priced efficiently.
Therefore, if options were randomly sold over a long
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enough period of time, the expectancy would be $0, less
transaction costs. This would exclude any trade
management or exit techniques. If options prices are
always efficiently priced, then trade management is the
main potential edge for the trader, and that can be a
daunting thought.
The question to be returned to, then, is whether or not
there is a long term profit built in for the option seller,
similar to what the insurance companies are pursuing.
There are many factors to this answer in terms of the
trader, strategy used, exit techniques, hedging techniques,
market used, and more. We’re going to let the debate go
on without us for now, and dive into the model.
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Objective
The objective of this report is to introduce a systematic
options selling model, which can be used by most traders
with a basic understanding of options, for a U.S. equity
index, or a derivative thereof.
A brief note on system traders. We are an affectionately
dysfunctional bunch, methodical and analytical, and
often isolated due to our trading style. Many of us are
hardwired to feel more comfortable trading with
quantified rules, but will hopefully loosen up when
needed. Discretionary traders are probably less enthused
by systematic rules, and they might be better suited
viewing the system as a guideline.
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As with the last report on Trading System Design, this
report will be short, even shorter actually. In this case
this is likely positive, as some traders do not make good
writers. The information in this report is far from
exhaustive, and there are some great books out there with
much more advanced concepts and definitions which are
truly enjoyable to read.
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Markets
The underlying instrument used in this report is the ticker
SPXPM. SPXPM is the newer underlying related to the
SPX, but the options are electronically traded, and appear
to have significantly smaller spreads when compared to
the SPX. SPXPM options expire the evening of
expiration day, and not at the open. This gives the
options essentially one more day of life, but there are no
surprises as to where the market is when the options
expire. And this is an issue with the SPX as the set price
can be over one daily average true range away. The
process of establishing the set price is one of the biggest
ways in which large players manipulate the market and it
likely should be changed.
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However, other instruments can be used as a proxy for
the S&P, such as the ES, SPY, the mentioned SPX and
others. But the trade structure should look very similar
across the board. Compared to these other markets,
commissions incurred using the SPXPM can be lower
and the bid/ask spreads are typically lower than the SPX.
For now there is much lower volume options volume on
SPXPM than on the SPX, but fills don’t seem to be an
issue.
As mentioned, SPXPM is electronically traded and
maintains the same size of the SPX. We are somewhat
averse to pit traded markets in general because they can
often take a long while to get a fill, and some of those
fills can be unfairly poor. The electronic markets are
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actually improving spreads and liquidity in all markets.
There are times, however, when pit traded vehicles are
more than viable and are the best vehicle to use, it just
depends on the preference of the trader.
The options world has changed so rapidly recently with
the advent of end of month options, weekly options, and
now weekly options available more than a week out.
With so many tools available, adjustment possibilities
have really multiplied.
At the time of this writing, SPXPM only offers serial
options, which are the options which expire on the third
Friday of the month. However, SPX offers weekly and
quarterly options and these can always be used for trade
initiation and adjustments as well.
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Options with less than a week of life left have theta levels
of nearly violent proportions. If weekly options are
viable, it would offer 52 expirations per year. The trade
off would most likely be the lack of a cushion from a
strong market move. Some traders achieve impressive
weekly results by selling options, and every once in a
while there can be a big hit to performance.
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Trade Structure
There are many ways to trade. And just about any way
can be tweaked to be successful as it really depends on
what works for the individual. In terms of attempting to
make an attractive absolute return in equity markets,
spreads can be used similar to the technique presented
here.
The reason spreads are utilized is because of reduced
margin and defined risk. The margin requirements for
uncovered option selling in equity markets are
substantial, and the risk is much less defined. Some
traders using spreads refer to it as a bribing of the margin
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gods, as the lower margin requirements are so significant
compared to uncovered margin requirements.
However, uncovered option selling is much more viable
in futures markets, like the ES, SP and others, where
margin requirements are based on probability and risk
utilizing SPAN. Selling uncovered premium is the most
efficient way to produce a credit, and the most risky, in
terms of theoretical max loss, and vega (implied
volatility) exposure.
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The particular strategy in this report uses vertical spreads.
A vertical spread is buying and selling different strike
prices in the same month and underlying. It is often used
as a risk management tool and either generates cash into,
or depletes cash from, the account.
As discussed earlier, uncovered option selling is usually
considered more risky than selling premium via vertical
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spreads. Covered calls, a fairly well accepted strategy,
has a very similar risk profile to a written uncovered put
option, and yet bafflingly, it is encouraged by many
brokers. This is likely because the broker has no
perceived risk. Regardless, if leverage is used, extra care
is necessary, and all trading should be taken seriously.
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Technology
There are some great trading platforms available to the
independent trader, many at no cost. There are also a
number of charting websites which stream at no charge.
For quick static charts on the fly, I have used
www.Bigcharts.com for over a decade. Some of the
images in this book are from Bigcharts and for this
reason we are recognizing them.
To actually trade well, tools with more features need to
be used. We use other platforms for real time trading and
streaming data. Drop us an email and we may be able to
steer you in a direction for various tools. If you have a
great tool, we would like to hear about it as well.
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The Options Selling Entry
The basic building block of this strategy on the SPXPM
is the Iron Condor. The Iron Condor requires a vertical
spread with calls, and a vertical spread with puts, and
combines them to complete the condor. They share the
margin requirement, and only one side can be at risk at a
time. The spread distance is 20 points for both vertical
spreads, which is what enables the sides to share a
margin requirement.
To find which strikes are to be used for the Iron Condor,
find the vertical spread for the calls or puts which nets
approximately .90 per side. This will net a combined
credit of approximately 1.80 for the complete Iron
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Condor. This will generate $180 on approximately
$2000 in margin, resulting in generating 9% on margin.
Because actual prices are used to discover which strikes
are used for the entry, the trader is not using probability
analysis, or a multiplier of the standard deviation, or delta
etc, to choose the short strike price. But in all reality,
those techniques should result in very similar strikes with
short strike deltas at approximately .16. For this
technique, choosing of the strike price is purely based
upon the price of the options, which is not uncommon.
The goal is to set up both a call and put vertical spread
with 45-60 days left before expiration.
Options can be written with less of a duration before
expiration. But because U.S. equity markets tend to fall
significantly faster than they rise, it is not advisable when
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considering put exposure. Put another way, when a sell
off does occur, a 1.5-2 standard deviation move from
when the put option was sold is very possible.
When trading iron condors, the trader does not want the
underlying anywhere near their strike price. Gamma (the
rate at which an option’s delta will increase with a move
of the underlying) will simply grow too rapidly with a
severe market drop. Some traders refer to this as gamma
gearing. The GTS Method attempts to compensate for
this potential move by being long vega at the wing.
The steps to develop the trade structure are the following:
Pull up an option chain on www.Bigcharts.com, or
another site, for the SPXPM. Look at the options
expiring in 45-60 days. Find the 20 point put spread with
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a value of at least .90, usually about two standard
deviations away.
The call entry uses a similar concept. Look at the calls
on the SPXPM options chain with the same expiration
date. Find the 20 point spread with a credit of no less
than .90. The calls will likely be set up approximately
one standard deviation away.
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Here is how the numbers line up trading 1 contract:
Vertical Put Spread credit = .90
Vertical Call Spread credit = .90
.90 x 1 contract (puts) = $90
.90 x 1 contract (calls) = $90
Total premium = $180
$180 / $2000 (premium / margin) = 9%
Courtesy of www.ThinkOrSwim.com, the following
image is how the trade visually appears at initiation.
Notice the time laps lines showing the profitability due to
time decay. Upon initiation, the trade has a profitability
range of 240 points. As time decay (theta) occurs, the
range of profitability grows:
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Later in this report we will be discussing the GTS
Method of modifying an iron condor to improve the
risk:reward characteristics. It transforms the risk graph
to look like this:
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With some slight modifications, the trade is long vega on
the put side, giving the trade staying power for a large
move lower. Max risk is also greatly reduced. Be sure to
read the section on the GTS Method for more info.
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Exit
The exit for the vertical spread is also price based. If the
vertical hits either four times the entry, in this case 3.60,
or the combined iron condor drops in value to .10, then
buy it back.
If the trade is bought back at a loss, wait and set up the
trade for the next month according to the entry rules.
Remember, volatility often follows volatility, so don’t be
over eager to reenter.
Some deviation from this exit is allowed, but if the
spread is allowed to more than quintuple, when taking a
loss, expectancy is hindered.
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Also, unless a trade goes significantly against the trader
immediately, the trade could very well need to quintuple,
or more, to reach a price of four times the entry. This
idea greatly increases the odds of the trade winning, but
emphasizes that a good entry is key.
Our probability analysis suggests the odds of the price of
an option spread quintupling is low, even more so when
time has passed. But if the spread price does quintuple,
the option spread value will probably keep growing, so
be mindful of the low of the trade since entering.
If a position is under pressure, and the trader believes a
reversal is about to take place, they will be tempted to
wait the position out. However tempting it may be, it
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would probably be better to take the spread flat, and roll
it out to keep gamma (the rate of the change in delta) in
check.
Once in a great while it is prudent to allow options to
expire, but it is rare. Typically, we divide the number of
days left before expiration into the value of the spread,
and if the quotient drops below the desired theta (time
decay) per day, the position is no longer worth holding.
This ensures the most efficient use of risk and usually
requires positions to be closed before expiration.
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Adjustments
Adjustments are double edge swords. Unless the trader
has an edge in picking short term direction, we suggest
not adjusting trades in general. However, there are times
when exiting at a very clear support or resistance point is
not advisable, and an adjustment to buy more time makes
sense. There are many ways to adjust a trade, one
technique is presented here.
When looking to use an adjustment technique instead of
an outright exit, the trade has to be adjusted well before
the traditional price based exit of a quadrupling of the
entry of one of the vertical spreads.
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One adjustment technique is to wait until one vertical
spread increases to 2.5 times the entry. At this time the
entire iron condor is purchased back. Then, a new iron
condor is established using options which expire further
out, and are sold for a slightly higher credit than the debit
to close the original iron condor. The vertical call and
put spreads are reset at nearly equal prices with the hope
of the market stabilizing. This will very often work, but
if the market continues to move directionally, or snap
back, there will likely be slightly larger loss taken.
Running through adjustment scenarios is a great exercise.
Just use great care in putting them to work as they nearly
always complicate the strategy.
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Calculating Expectancy.
Average winning month = 170 170 / 2000 = 8.5%
Average losing month = 190 190 / 2000 = 9.5%
Win Rate = .75
Loss Rate = .25
Expectancy = (.75 x 170 = 127.50) – (.25 x 190 = 47.50)
= $80 per combined call and put spread (iron condor).
$80 / 2000 = 4% per month average.
4% per month compounded is well over 50% per year.
4% a month is an average, but the equity curve will not
be smooth as it will experience winning and losing
months, multiple losing months are very possible. A
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strategy such as this needs a minimum of 12 months for
statistical tendencies to materialize.
These numbers presented are raw and do not include
transaction costs. Short term expectancy is probably
higher; some positions will be shut down early at a
smaller loss or even a small gain. There will be larger
losses due to gaps and trading errors, long term
expectancy could be lower as a whole as the likelihood of
a rare event becomes higher.
By pulling in the short strikes slightly closer to at the
money (current market price) the average trade profit and
loss will increase. For smaller returns and lower risk,
push the short strikes out further.
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The major criticism about the deep out of the money
(strike prices far away from the current market) iron
condor is the large loss which can be incurred with a rare,
but enormous, move in the market. If the short strike
goes at the money, the spread will, on average, be worth
about 10 points. Even if two points were collected for
the position, that is a risk reward of 5:1. The
mathematical max risk for the trade is 10:1.
The trader simply cannot allow these trades to get away
from themselves, especially with the short vega trade
structure. If the exit price is hit, exit early and move on.
At the end of this report a modified iron condor method
is described transforming this trade from short vega to
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long vega, offers a better absolute risk:reward, and still
maintains a short theta posture.
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When Not to Sell
With the entry and exit rules in place, we may want to
explore when not to sell options. Evaluating market
environments is notoriously difficult to do. We have
developed different ways of measuring the behavior of
markets, and, how accurate implied volatility readings
may be at predicting future movements of the underlying.
What we have found is, over the long term, and by
averaging the number of excursion violations as
measured by our criteria, implied volatilities are largely
accurate.
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For example, when selling an options one standard
deviation out, with 30 calendar days left until expiration,
the underlying will hit the strike price before expiration
an average of 16% of the time. If naked strangles were to
be written, with call and put strikes one standard
deviation out, over the long term, one of the sides would
be violated, before expiration, 32% of the time.
Coincidentally, there will not be an excursion violation
68% of the time, which represents a 1 standard deviation
figure.
However, there are a select few years in the U.S. equity
markets when the trend is so relentless, often to the
upside, that the occurrence of a pre-expiration excursion
violation was in excess of 50%. These are the times you
simply have to get out of the way of the train.
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A vertical spread on its own can have positive
expectancy, but it is usually on the put side due to skew.
Short calls are fairly well priced but they can often be
exited early for a gain when given the opportunity.
A way to mathematically define when not to sell
premium is difficult to develop. From using historically
low VIX levels to attempt predicting sell-offs, to using a
price regurgitating trend indicator when trying to stay on
the right side of the market, systematically predicting
when to avoid selling options to steer clear of dangerous
waters is challenging to accomplish. Many say to simply
buy cheap volatility and sell expensive volatility.
However, volatility trends can clearly continue much
further than anticipated.
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The Slope Indicator
Through continued collaborative efforts, we have
developed a proprietary indicator which measures the
steepness, or slope, of a market relative to implied
volatility. We simply refer to it as the slope indicator.
In short, this indicator attempts to define when the
market is more prone to committing an excursion
violation. It defines when the market is trending more
than implied volatilities are predicting it will. With a
high enough reading we will buy back month strangles
with small size and sit on our hands.
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The formula is proprietary, but it is available to use for
free at our site: www.GoTradeSignals.com. My talented
webmaster has constructed an interface to view the
indicator over any daily time frame desired, beginning in
1990.
Using the Slope indicator is simple. A reading under 6 is
usually a market environment conducive to option
selling. A reading of 6 to 6.5 indicates some moderate
volatility, sell options carefully. With a reading over 6.5
we would be very hesitant to enter new positions.
With readings over 7, we’re usually buying back month
strangles with small size. Once the strangle becomes
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front month, and our exit price has not been hit, which is
5 times the entry price of one leg, we are unwinding the
position. No need to be on the wrong side of accelerated
theta.
The Slope Indicator is not flawless, but if there is a
prolonged imbalance of trendiness, it will keep us from
selling options. In 2008, we saw some of the largest, and
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most well known, premium sellers experience severe
drawdowns in excess of 50%, in very short time frames.
Some of the losses were due in part to reentering
positions too quickly when the worst of the volatility was
not over. Revenge trading has been the downfall of
many a short options trader.
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Summary
The iron condor options system presented is a viable
means for a trader to have a system with clearly defined
entries and exits. Although different strategies may be
better suited in different market environments by an
experienced trader, this system can get the trader well on
their way. www.GoTradeSignals.com trades the GTS
Method of the iron condor for autotrade subscribers.
Some discussion on that method follows.
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GTS Method
The GTS Method is a way to establish a position with an
expiration graph very similar to an iron condor and yet be
long vega on the put side, have the potential for windfall
profits in a crash scenario, and still maintain the positive
theta posture. The risk graph at initiation looks similar to
this.
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Although the trade structure continues to utilize 20 points
spreads on the SPXPM, the trade structure is slightly
modified. The trade is long vega on the put side which is
a tremendous advantage over the long term. Below is the
represented risk graph with an 11% increase in volatility.
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Here is another look with the graph expanded. As can be
seen, a market crash could actually be fortuitous.
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The emphasis of being long vega is placed on the put side
as an implied volatility explosion will most assuredly
take place with a large move down. With a spike in the
VIX of more than 20 points or more, the vega response is
even more pronounced.
The GTS Method is a way to sell option premium while
still having protective positions at the wings. The put
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vertical spread is converted to long vega with the
potential for a benefit from a crash. The call vertical
spread uses the reverse skew of calls against itself. Short
call spreads are notorious for their drawback of
accelerating gamma with a smaller spike up in the
markets. The GTS Method takes much of the bite out of
those relentless moves up in the market, especially at
trade initiation.
The other major piece of the GTS method is
diversification of the model itself. Instead of trading the
model on a single stock, the model is traded on an index.
This eliminates company specific risk and allows the
underlying to be more statistically viable. One top of
using an index as the underlying, the model is split into 2
to 3 positions on the index where the trades entreies and
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exits are staggered. This enables a shift in the market
environment to be accommodated. This theory can also
be applied to all iron condor traders as well.
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Conclusion
There are no secret option positions out there, just
different ways of constructing risk graphs with known
tools. The iron condor position laid out in this report is a
great way for a trader to begin trading with a high win%
strategy. The pace of the trade is also low with decreased
gamma levels, allowing a trader more time to evaluate
necessary adjustments. If iron condors are utilized, make
sure the entry credit is adequate, and honor those stops.
High probability iron condors very often take care of
themselves.
The GTS Method is a unique way of maintaining a
positive theta stance for the iron condor and defend