Watch HowardCohodas Trade Index Options Credit Spreads

[HowardCohodas]

BTW - I just missed a short posting this... grrrr...

Ouch! I'll bet that hurt. It's the price you pay for my education. I thank you.

 

[Martinghoul]

Howard, I think your process is sound. I don't believe your current strategy is, but I think your methods make sense. My 2c...

 

[scose-no-doubt]

That's not enough detail, MG. You need to pick it apart and say why

 

[HowardCohodas]

Howard, I think your process is sound. I don't believe your current strategy is, but I think your methods make sense. My 2c...

Please elaborate. I having trouble separating what you mean by process vs. strategy vs. methods.

P.S. I guess Scose and I were posting simultaneously.

 

[MrGecko]

Could one of you option-bods set me straight please?

The way I understand it, Howards current returns are what you would expect with a strategy ike this, only to give them back when an unexpected move comes (the old penny vs steamroller cliché). But the only way it can have any real "edge" is if the implied volatility of the options he sells is consistently above the volatility that is realised.

Have I got the gist?

 

[meanreversion]

There are two types of so-called digital options. Those that pay off if the barrier is touched at any point during the life, and those which pay off at expiry if spot is beyond the chosen level.

As a very crude approximation, the "one touch binary" usually has a premium equal to twice that of the "at expiry digital" (where the premium is expressed as a percentage between 0-100).

Based on the underlined section, are you using the one touch binary price as a proxy for the odds of finishing beyond the strike at expiry?

What do you reckon on this one Howard, you might have missed it?

 

[Martinghoul]

By process I mean your overall approach to a) finding what you perceive as opportunities; b) risk management. By strategies I mean the particular types of trades you're doing, i.e. selling call/put spreads (you call this "credit spreads") and doing iron condors. Without a much more detailed description of how you calculate the probabilities of "hitting the barrier" I can't meaningfully critique what you're doing. However, I think your description of your edge occurring because there's, effectively, a systematic mis-pricing of spreads suggests to me that you're confused, as I know this isn't the case. However, you're clearly a bright guy (with a sense of humor, which is important), so I'm sure you'll get to the bottom of it.

 

[Martinghoul]

Could one of you option-bods set me straight please?

The way I understand it, Howards current returns are what you would expect with a strategy ike this, only to give them back when an unexpected move comes (the old penny vs steamroller cliché). But the only way it can have any real "edge" is if the implied volatility of the options he sells is consistently above the volatility that is realised.

Have I got the gist?

Yes, apart from the fact that Howard's drawdowns are capped (or floored, whichever way you look at it), given that he doesn't do nekkid options.

For the same reason, it's not so much about implied vs realized generally, but rather implied vol for specific strikes you're going short vs implied vol for ones you're going long vs the realized vols experienced when you get to the strikes. So it gets rather complex, 'cause in many cases you're betting that the implied skew doesn't get realized.

 

[amit1986]

By process I mean your overall approach to a) finding what you perceive as opportunities; b) risk management. By strategies I mean the particular types of trades you're doing, i.e. selling call/put spreads (you call this "credit spreads") and doing iron condors. Without a much more detailed description of how you calculate the probabilities of "hitting the barrier" I can't meaningfully critique what you're doing. However, I think your description of your edge occurring because there's, effectively, a systematic mis-pricing of spreads suggests to me that you're confused, as I know this isn't the case. However, you're clearly a bright guy (with a sense of humor, which is important), so I'm sure you'll get to the bottom of it.

Agreed. I'd also like to know a little more details regarding the models you are using to compute your probabilities. On the other hand, I'd completely understand if you prefer to keep that to yourself as it seems to be the most important component in your system.

 

[HowardCohodas]

What do you reckon on this one Howard, you might have missed it?

Nope. Didn't miss it. Still working it through.

 

[HowardCohodas]

Agreed. I'd also like to know a little more details regarding the models you are using to compute your probabilities. On the other hand, I'd completely understand if you prefer to keep that to yourself as it seems to be the most important component in your system.

I don't know of anything I have hidden from this thread. The links in my signature take you to significant posts in this thread where I have described all the elements in my strategy. The FAQ link specifically discusses probability of touching.

 

[MrGecko]

I think Howard said he is using TOS as his broker, so I perused their website (lots of good stuff there, like some of the chats) for more on Probability of Touching and Expiring...

First video is a little intro on Iron Condors, second is transcript of a chat about Prob. of touching, third is about how TOS prices the options and stuff... the third one is interactive, hover your mouse over the "contents" bar and a meny will pop up.

Enjoy!

Intro to Iron Condors

Probability of touching pdf

Theoretical pricing and Probability

 

[HowardCohodas]

Without a much more detailed description of how you calculate the probabilities of "hitting the barrier" I can't meaningfully critique what you're doing.

The third FAQ (link in signature) describes how I came to the concept of probability of touching, how I calculated it and why I now rely on the TOS model.

However, I think your description of your edge occurring because there's, effectively, a systematic mis-pricing of spreads suggests to me that you're confused, as I know this isn't the case.

On the contrary. I have on several occasions declared that I did not believe the spreads are mis-priced.

So far, all I can come up with is that these profits are built in. But so are the risks. The steamroller analogy is quite accurate. I control the losses as described in the Risk Analysis link in the signature.

 

[arabianights]

Could one of you option-bods set me straight please?

The way I understand it, Howards current returns are what you would expect with a strategy ike this, only to give them back when an unexpected move comes (the old penny vs steamroller cliché). But the only way it can have any real "edge" is if the implied volatility of the options he sells is consistently above the volatility that is realised.

Have I got the gist?

I would actually disagree, despite not being an options bod... the price of the spread is the estimated cost of hedging it... both the seller and the buyer can win

Obviously it requires a market that is efficient in some dimensions and inefficient in some others, but this could be the case...

 

[HowardCohodas]

Of course, you picked a bloody awkward instrument to trade when it comes to understanding the relationship between the derivative and the underlying. The indices have both options and futures to consider when looking at the underlying. Obviously the futures volume overshadows the options volume completely and so does their impact.

I completely forgot about the futures contributions to these issues. My head hurts again.

 

[Martinghoul]

Reading this TOS doc, it seems that they're doing this based on a simple BSM (or should I say, Bachelier-Thorp) approach, which is known to have some, potentially meaningful (depending on your position) flaws. For example, they use a flat ATM vol for the expire ITM/hit probabilities (which, of course, is unavoidable in the BSM world). Given that you're buying/selling spreads, which are priced the way they are due, among other things, to skew, I would treat the results of the calculation with a large grain/pinch/teaspoon of salt. Furthermore, I would question the unequivocal assumption of lognormality, not to mention the real big one that undermines it all, the assumption of mkt completeness.

 

[scose-no-doubt]

What I don't understand is how come this implied skew can be so far out as to offer consistent 10% per month. Does that mean pricing is buggered or that there's expectation of something coming or what?

 

[HowardCohodas]

Based on the underlined section, are you using the one touch binary price as a proxy for the odds of finishing beyond the strike at expiry?

There are already models for estimating the probability that the option will expire OTM. TOS calls it probability of expiring.

As I thought about how to manage the spread, I concluded early on that I would be unmoved by the probability of the options expiring OTM. What would cause me to take action was the underlying price nearing or hitting the short option. When I did my work before discovering TOS, I called it the probability of reaching.

 

[HowardCohodas]

Reading this TOS doc, it seems that they're doing this based on a simple BSM (or should I say, Bachelier-Thorp) approach, which is known to have some, potentially meaningful (depending on your position) flaws. For example, they use a flat ATM vol for the expire ITM/hit probabilities (which, of course, is unavoidable in the BSM world). Given that you're buying/selling spreads, which are priced the way they are due, among other things, to skew, I would treat the results of the calculation with a large grain/pinch/teaspoon of salt. Furthermore, I would question the unequivocal assumption of lognormality, not to mention the real big one that undermines it all, the assumption of mkt completeness.

When I did my calculations using Monte Carlo methods, of course a distribution must be chosen. I experimented with several as I read the academic papers on modeling option prices.

I studied mathematics in college and practiced as an engineer most of my career. The biggest difference in the two professions is their view of math. This can be summarized by the phrase, "however, for all practical purposes."

 

[MrGecko]

This can be summarized by the phrase, "however, for all practical purposes."

I used to call this "hand-waving"... in that you wave goodbye at any and all factors over x^3 :cheesy: