The next step in the evolution of BoomBustBlog research

Tuesday, 04 August 2009 00:00

The next step in the evolution of BoomBustBlog research ^Featured

Written by Reggie Middleton

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The second quarter + has been a hard time for fundamental investors. The market has literally disengaged itself from all fundamentals (and apparently even technicals). Although I clearly anticipated a strong bear market rally in March, the last 4 months or so have been ridiculous, bringing to mind all sorts of market manipulation theories (and some not so theoretical explanations).

I have decided to supplement both my proprietary trading regimen and consequently the research and opinion offered via subscription, since this site is basically a digital diary of my investment opinion and actions. Please keep in mind that this site's contents and offerings are NOT investment advice and should not be considered as such. With that in mind, I am going to post some empirically derived, direction neutral strategies that I either have used or plan on using, wrapped around the forensic and fundamental research. This is a lot of work, and goes considerably beyond the scope that I planned to offer via subscription, but these are very difficult times from an investment perspective and since I am putting the resources in to generate the material, I am (for the time being) going to share it with professional subscribers. I will post the initial introductions to all subscribers, though.

To determine the best market neutral option strategy during periods of increased volatility (and by volaitility, I mean significant price movement in either direction) for the time being we have considered 3 option strategies – straddle, strangle and put ratio back spread with different strike prices. We have empirically back tested these strategies for the period January 2009 – March 2009 assuming an investor enters an option strategy on January 2, 2009 based on 3 month expiration schedule and closes out his position at the end of the trading day on expiry (in reality, this may not be the optimal method but it was simplified for backtesting purposes). Currently, we have analyzed these strategies for the period January-March 2009 as historical volatility of S&P 500 index in 1Q09 was nearly 40% compared with long term historical volatility of approximately 20%.

The table below shows option trades for each of the three strategies at various strike prices, the initial investment, theoretical maximum gain and loss for each of the strategy, maximum and minimum payoff at any point during the three month frame under analysis (Jan-March 2009) and payoff at expiry.

	ATM Long Straddle	OTM Call Long Straddle	ITM Call Long Straddle	ATM Long Strangle	OTM Long Strangle	ITM Long Strangle	Zero cost Put ratio back spread	Net credit Put ratio backspread	Net debit Put ratio backspread
Ratio							1.48 : 1	1.30 : 1	1.75 : 1


Underlying (Jan 02)	931.8	931.8	931.8	931.8	931.8	931.8	931.8	931.8	931.8

Long Put Strike price	930.0	950.0	920.0	930.0	900.0	970.0	925.0	925.0	925.0
Long Call Price Price	930.0	950.0	920.0	930.0	1,000.0	900.0	na	na	na

Long put value	27.8	37.7	23.5	27.6	16.1	49.3	25.4	25.4	25.4
Long call value	40.9	31.1	46.5	40.6	13.8	58.8	na	na	na

Short Put Strike price							950.0	950.0	950.0
Short put value							37.6	37.6	37.6

Breakeven point above	998.7	1,018.8	990.0	998.3	1,030.0	1,008.1	955.0	949.4	n/a
	7.2%	9.3%	6.2%	7.1%	10.5%	8.2%	2.5%	1.9%

Breakeven point below	861.3	881.2	850.0	861.7	870.0	861.9	872.7	856.7	882.4
	-7.6%	-5.4%	-8.8%	-7.5%	-6.6%	-7.5%	-6.3%	-8.1%	-5.3%

Theoretical maximum gain	Unlimited	Unlimited	Unlimited	Unlimited	Unlimited	Unlimited	Unlimited	Unlimited	Unlimited
Theoretical Maximum loss	(6,870)	(6,881)	(7,001)	(6,825)	(2,997)	(10,809)	(2,500)	(2,048)	(3,192)

Maximum profit during the period	18,316	20,301	17,187	18,361	19,194	18,370	9,300	5,362	15,328
Maximum loss during the period	(417)	(221)	(1,075)	(373)	(150)	(251)	(54)	(23)	(102)
Payoff at expiration (March 20, 09)	9,276	11,265	8,145	9,321	10,149	9,337	4,976	2,646	8,543

Initial Investment	(6,870)	(6,881)	(7,001)	(6,825)	(2,997)	(10,809)	0	452	(692)

We shall extend the analysis for other strategies and extend the time horizon (staring October 2007, or, 3Q-07) in our subsequent subscription reports.

Read 4991 times Last modified on Tuesday, 04 August 2009 08:05