Position Sizing in Options

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Gherkin
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Position Sizing in Options

Post by Gherkin » Wed Jul 14, 2004 12:06 am

I have been trading a trend following sytem using bought options for leverage with medium success. i.e barely profitable after 1% commisions or $160 round trip commission. I have been testing both a fixed fractional betsize strategy and a volatility based one (20 ATRs @ 3.5% risk). Thus far, all I've done to convert to option contract size is: when I get a position size in shares, I just divide by 1000 (1000 shares per option contract in Australia). I am also buying one to two strikes in the money to gain leverage, without time decay and changes in vol getting me. This produces quite volatile results, and sometimes (in the volatility based position sizing) tells me to bet up to 19% of my equity on one trade!! Obviously this is not risk management. The smallest (volatility based) bets are around 2%, so the variation is quite marked. Does anyone here experience similar issues? Is there a solution other than reverting to fixed fraction of my bank at risk? This is a complex problem (to me, anyway), and I believe the only thing holding back a very profitable system. Any ideas or suggestions would be very welcome, and I am at wits end, so I will consider just about anything. I know I am doing something wrong, but what?

P.S. This is a terrific forum.

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Post by Gherkin » Mon Aug 02, 2004 4:07 am

Actually, problem solved. It was nothing to do with MM. Now it is a very profitable system. Fixed fraction is less volatile, and still generates the return results that I was hoping for (albeit slightly less than volatility position sizing). Now, to raise money...

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Post by Forum Mgmnt » Mon Aug 02, 2004 1:40 pm

Gherkin wrote:This produces quite volatile results, and sometimes (in the volatility based position sizing) tells me to bet up to 19% of my equity on one trade!!
What was the exact formula you used to get this type of trade? You stated 20 ATRs at 3.5% risk. Is that 20 ATRs of the underlying asset or ATRs of the option price itself?

It seems to me that perhaps in this instance the option premium was too high relative to the underlying volatility measured by ATRs. As most option pricing models tend to use standard deviations of price there might have been a strong divergence in the volatility as measured by standard deviation and the volatility as measured by ATR.

- Forum Mgmnt

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Post by Gherkin » Tue Aug 03, 2004 4:01 am

Hi Forum Mgmnt,
I was simply using the 20day ATR of the underlying and then allocating that amount of capital (3.5%) to paying for premium in the spot month, 1st strike in the money option. Very little volatility and time but plenty of leverage. I was actually using the formula in your turtle rules pdf on the website. I just set it at 3.5% instead of 1%. It's still much more volatile than fixed fractional, but it outperforms it by a 5th. To be honest I think I will just use the FF approach as it produces fewer, smaller drawdowns and a smoother equity line. As I am seeking to raise money now, this will be desirable. Any thoughts?

Craig.

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Post by s-a » Tue Aug 17, 2004 5:52 am

Hi Craig,

I know that the near month options are cheaper, but have you thought of giving yourself more time? I use a similar system to determine my position size with options except I also account for a 20 day average of IV and I use options that are at least 2 months out in time (pref 3-4 months). I don't hold long options with less then 30 days unless they are deep ITM or are hedging shorts.

Just another perspective, maybe it gives you an idea.

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Post by Gherkin » Tue Aug 17, 2004 7:33 pm

I have tested using longer expiries on them, but the numbers were not as good. Probably because there was too much vol + time in the options. The real reason I buy spot month in the money is not because they are cheap in absolute terms, but cheap in vol terms. I basically only pay the in the money price plus less than 10% of that for time and vol. I am after leverage at little extra cost, not cheaply priced options. And I can always roll them over if the trend continues strongly after expiry.

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Position sizing in options

Post by raymcboyd » Wed Aug 18, 2004 4:49 pm

Gherkin:

Have you considered factoring in the delta of the option when you determine bet size?

If, for example, your fixed fractional worked out to 20 shares and your option delta were 0.5, then 40 options would be the equivalent of 20 shares.

That having been said, there is another risk aspect that you'd need to look at. Since options buying is a 100% risk of capital, you'd need to make sure that you can handle a potential loss of the entire investment. If not, you'll have to scale back

Ray

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Post by William » Thu Aug 19, 2004 11:28 am

Gents,

To avoid asking the obvious questions in this new area for me...

Are there any books,articles...that discuss how to use options in the overall scheme of trading systems and trendfollowing? Thanks

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Post by GammaTrader » Thu Aug 19, 2004 6:01 pm

First of all, let me say that I can't believe how great this site is compared to anything I've seen so far on the net. Thanks to the creators and maintainers. The civility and balance of the participants is welcome.

I've been a confirmed weekly lurker here for over six months. This is my first post because I'm primarily a futures only option trader. I traded on the floor in Chicago (Eurodollar options) for a few years, went off floor 4 years ago. I'm willing to learn anything to help myself get a better edge, and having a trend bias makes sense and more money if you hit a big trade.
William wrote:Are there any books,articles...that discuss how to use options in the overall scheme of trading systems and trendfollowing?
None that I'm aware of, and I've read just about everything there is having to do with options. There are sporadic mentions of the situation in various dedicated options courses or books, and the same in systems books and courses. I've never seen a mechanical option trading system that didn't require "professional" handling.

I think that there would be a great market for a good book on the subject. As far as I can tell, a few hedge funds have done research in this exact area, but they are keeping their discoveries to themselves. I can't blame them much, as handling option derivative risk well can be very lucrative.

I have found some useful books on options which deal with handling real market risks written by traders instead of the academics who talk about theoretical money. Most of these are found on Amazon or other online book sellers. Hope I got the links correct.

1. Dynamic Hedging : Managing Vanilla and Exotic Options---by Nassim Nicholas Taleb (I agree with and love Taleb's ideas, I just don't like his superiority complex)

2. The Option Trader Handbook : Strategies and Trade Adjustments (Well written book by a decent trader)

3. Option Volatility & Pricing: Advanced Trading Strategies and Techniques-----by Sheldon Natenberg (If you only buy one book on options, this should be it)

I personally settled on a turtle-type breakout using my own version of a vertical call spread as my method of trading options with an uptrend. The initial position is delta neutral. I sell some puts and some calls and buy some calls on a buy signal. Reverse for a sell.

Cheers---

kianti
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Post by kianti » Fri Aug 20, 2004 1:24 pm

I used to trade options long time ago and I also liked
Option Volatility & Pricing: Advanced Trading Strategies and Techniques-----by Sheldon Natenberg (
I also tried the demo of a quite interesting excel software called Optionstar
http://www.optionstar.com/


best regards, as ever

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Post by wonkabar » Mon Sep 20, 2004 7:35 am

I think the position sizing for buying options is relatively easy since the max risk is predefined as the price of the option. It is then up to the trader to determine how much they want to risk which can be based off of several well known methods.

What about when selling options though? What is the right way to position size a portfolio of, say for example, short spx strangles?

here is a fund that just sells s&p options: http://www.ansbacherusa.com/D-Doc.html

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Post by wonkabar » Mon Sep 20, 2004 3:36 pm

that's not right at all. selling a put is the same as selling a call and buying the underlying and selling a call is the same as selling a put and selling the underlying.

The trick is the optionality. If i am short puts and the market goes down I get longer and if i am short calls as the market goes up i get shorter. It is not a linear relationship like trading futures.

If I want to just sell options and not trade the underlyings how do I size the positions?

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Post by kianti » Fri Sep 24, 2004 10:25 pm

On Delta Neutral Options Strategy: http://www.allin.net/dn/pages/dnos.pdf

Shorting options is a non-trendfollwing strategy, i.e.
(limited profit = premium received) vs unlimited loss theoretically.
Long options is a trend-following strategy,
i.e (premium paid=stop-loss) vs (high reward = the trend !?!)

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Post by wonkabar » Mon Sep 27, 2004 6:29 pm

thanks Kianti but I was not looking for a delta neutral strategy but rather a short premium strategy. Somethink like,say, selling 10% out of the money calls and puts on the SPX. How best to position size and manage exposure?

Ron, your example is confusing to me. If an at the money put is -50 delta than selling this will make you +50 delta worth of the underlying. Buying a put gets you short and selling it gets you long. Buying a call gets you long and selling it gets you short. How much long or short depends on the delta of the options which depends on all if the inputs in the BS formula. The gamma of the option is how the delta changes in regards to movements in the underlying only. All underlyings are 100 delta.

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Post by kianti » Tue Sep 28, 2004 12:21 am

Buying a put gets you short and selling it gets you long. Buying a call gets you long and selling it gets you short.
When you buy a put,call or future you're always long, when you sell a call,put or future you're always short.
selling 10% out of the money calls and puts on the SPX. How best to position size and manage exposure?
You're basically not managing exposure, you get a theoretically unlimited risk for a very small reward (OTM options premiums);you're exposing yourself to big risks like 'black swans'.

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Post by Gherkin » Tue Sep 28, 2004 12:37 am

I've been trading options for the last 7 years and personally can't stand selling premium. And that was even before I read "Fooled by Randomness". I like the psychological lure of "being right" a lot, but hate losing money.
As to the position sizing of selling options, because the largest extreme move to occur is still out there waiting, and as a seller you are exposed to this in the form of unlimited risk, you cannot safely size selling options based on anything sensible. There is no absolute stop loss for you. 1 contract is too much for infinite variance samples (or fat tails, leptokurtotic distributions). You will have to just "average" a lot of data and hope you are out of the market on all the days of extreme price moves against your potential sold position. If Victor Niederhoffer couldn't make it work, who can?
This strategy is horrible, and responsible for more option losses than anything else you can think of.

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Post by wonkabar » Tue Sep 28, 2004 11:29 am

Kianti, you are correct that buying/selling options makes you long/short vega and gamma but I am talking about just the delta or directional market exposure which i thought you were to since you mention futures. simply buying a put is getting you short the market.

Gherkin, selling options is no more right or wrong than buying options. There are plenty of worse straegies that will lose you money faster. Buying options the day before equity earnings announcements is just one example. There is a price and quantity where each is more favorable. Neiderhoffer blew out because he didn't position size himself properly and manage his risk which is what i am trying to stimulate discussion about. He also was selling options to raise premium to pay for a losing Baht trade. This is idiotic and has nothing to do with options but rather reckless behavior. I do not think there is any nobility in bleeding to death like Taleb or others that say buying volatiltiy is the only way to go. Anyone that trys to make this a black and white issue such as selling=bad buying=good is missing a lot. there is a time and place for both.

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Post by kianti » Tue Sep 28, 2004 12:20 pm

wonkabar wrote:Kianti, you are correct that buying/selling options makes you long/short vega and gamma but I am talking about just the delta or directional market exposure which i thought you were to since you mention futures. simply buying a put is getting you short the market.
You're also correct but margin requirement for long or short options are different.

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Post by jankiraly » Tue Sep 28, 2004 12:28 pm

I had avoided options because I'm a mechanical systems trader and I found it difficult-to-impossible to obtain and organize options pricing historical data for backtesting. Then a friend made a remark that I consider brilliant:
Maybe you can't backtest options systems but you can backtest managers who trade options systems
I poked around on the web and found several hedge funds and money managers and CTA's who trade options exclusively, and who have long track records. A representative example is http://www.iasg.com/SnapshotPT.asp?ID=36 . The track record goes back ten years, and the manager has delivered net profits in nine of those ten years, after deducting fees and incentives. This particular manager ONLY sells options (sometimes outright, sometimes credit spreads). If you dig around on the net you'll find lots of other specialists.

Eventually I picked a manager whose minimum account size is $250K. He's traded options for me and so far, I've been happy. Your mileage may vary.

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Post by fcarlson » Sat Jan 01, 2005 8:17 am

Gherkin wrote:I've been trading options for the last 7 years and personally can't stand selling premium. And that was even before I read "Fooled by Randomness". I like the psychological lure of "being right" a lot, but hate losing money.
As to the position sizing of selling options, because the largest extreme move to occur is still out there waiting, and as a seller you are exposed to this in the form of unlimited risk, you cannot safely size selling options based on anything sensible. There is no absolute stop loss for you. 1 contract is too much for infinite variance samples (or fat tails, leptokurtotic distributions). You will have to just "average" a lot of data and hope you are out of the market on all the days of extreme price moves against your potential sold position. If Victor Niederhoffer couldn't make it work, who can?
This strategy is horrible, and responsible for more option losses than anything else you can think of.
First thing I want to say that this board is an answer to my prayers. This looks really really great. Thanks c.f.!! :)

Second thing is that I am a newly minted MBA and I have taken every class I could on this. That said, reading and getting tested on Hull and Bodie is not the same, by a longshot, as practice. That is why I am here.

Third thing is that I don't understand Gherkins post. I use options tactically backed by cash to put in buys (by writing slightly out of the Money puts) and sells (covered calls). I tend to write puts on stock that have the combination of high vol. and decent fundementals as a business. The part I don't understand is the claim that you are exposed to "unlimited risk" by selling options. If you are selling naked calls (or calls where you have insufficent backing), this is true, but it is the only case that I know where you have unlimited risk.

Forth thing is Gherkin's very smart statement about fat tails which is the bane of anyone playing this game with levered portfolios. There is a HUGE battle brewing in mainstream finance that Mandelbrot just started about the assumptons of price independence and lognormally distributed returns in the holy grails of finance (MPT, CAPM, and the 50 or so variations on Black-Scholes/Binomial Models). Stay tuned.

Fifth thing is a question about the use of Delta as an "in the money" probablity estimate. I have been using Delta to give me a clue to the probablity that the position will land in the money. I hear that this is a disputed technique, but I don't know why.

Glad to be here!!!

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