An Overview of the Non-Directional Trading with OptimalTrader

Editor's Note: Wow! It has been three years since this article was written. OptimalTrader has changed quite a bit since then. We are in the middle of re-writing this article to show the new screen shots and use more up to date knowledge that we have gained over the past three years. Now,... on to the nostalgia...

OptimalTrader is designed for use by directional as well as non-directional alike. We have covered in other articles how to use it in conjunction with AdvancedGET to do directional trades in my article titled, Where is the DOW Going? This article will focus on features built into OptimalTrader for the non-directional trader.

First of all, it is a known fact that as an option trader matures in their career that they will be bruised quite a bit from trades that have gone the wrong way. This can do a lot of psychological damage to a trader and many quit being option traders at this point. The lure of doubling your money every six weeks gives false hope to traders and this greed blinds them. If they want to survive, they eventually start looking at non directional techniques in order to make smaller, but more consistent profits.

The non-directional trader must create trades in which an equal profit can be made whether the stock price goes up or down. However to get right to the point, these types of trades work really well when the stock is going down, but when it goes up, they start to fall apart. Why does this happen? Because of the implied volatility collapse that frequently occurs when a stock finds a support level and starts going up. The implied volatility going up, accelerates your profits, puts you in a state of euphoria. But then the stock starts to turn upward, and implied volatility crashes, and even if you are delta neutral, you will lose money. Does this story sound familiar?

Here is the chain on events. As excitement in a stock grows, the options volume increases. As the demand for options increase, due to people running for protection, or mass speculation that a stock is going to make a fast run up, the price of the options go up.

So what we need is a way to balance our trade based on the assumption that IV will go up when the stock price goes down, and IV will go down when the price goes up.

First of all, realize that this effect is short term only. If I try to draw a risk graph that is accurate a month from now, I cannot assume that just because the stock price is lower that IV will be higher. That is because the stock price could have been even lower in the interim, and it has since found a support level and has started to go back up. So even though the stock price a month from now is lower, I cannot tell you if IV will be higher or lower. But in the short term, for less than a few days we can form a relationship between stock price and implied volatility.

Okay the theory is over. Let’s start with a hypothetical trade. We want to create a non-directional trade using low volatility stocks. The IV collapse risk, or “vega risk”, is the hardest to overcome. So we find stocks that we hope will not lose implied volatility in the future.

One of the best ways to do this currently is to use ivolatility.com tools. Here is a screen shot of stocks with low implied volatility. We will pick one of these for our trade.

And here is a partial list of the results:

Of course implied volatility could even go lower than the current levels.

I am going to pick Halliburton (HAL) because it is an oil stock and at the time of this writing, I believe that oil prices could either go much higher, or much lower depending on what happens with the prospects of war.

So we don’t know what direction the stock is going. We expect future change. So we need a delta neutral type strategy.

So let’s build a trade. Notice that if I were directional in the stock that I would use OptimalTrader’s search capabilities to find the best trade. With non-directional it is easier to build it by hand.

Step one in this task is to create a delta neutral strangle. I am going to make this a huge trade and use this as a paper trade. I intend to follow this trade on a day by day basis over the next few weeks and show you how I go about making adjustments to the trade as it progresses.

I take a quick look at the stock chart to see what it looks like.

The red and blue lines are the 50 and 200 day moving averages. Option trading is fluid. I am going to pick strikes above and below the current stock price, but these will change as the trade progresses. I want options that don’t have a lot of time decay in them, so they must be at least 90 days away.

Here is what I start with:

I entered 1000 contracts for each with the strikes and expiration I have chosen. From this starting point I will enter in .51 for the Implied Volatility because that is what ivolatility.com showed me. We will adjust this if necessary. Then I click on Update Prices.

OptimalTrader automatically filled in the CostBasis and CurrValue fields based on the prices as of the close of trading on Friday, the 3^rd of January. As you can see, I have a position delta of 2,470.7. That means I need to either buy more puts or buy less calls. It doesn’t matter which for the purposes of this paper trade. I want to adjust the number of puts so that my position delta is as close to zero as I can get.

So I use the Ratio Finder tool to do this task for me.

Ratio Finder told me that 1117 puts will balance the 1000 calls.

It looks nice. The current stock price looks like it is fairly well centered in the bottom of the curve. If it wasn’t then we could make some adjustments to eliminate any bias to one side or another.

Now here is the next problem. If the stock continues to go up, then implied volatility could even go lower, but if the stock goes down then IV will go up in the short term.

So let’s make up some assumptions. They will probably not be exact, but the current risk graph is far from being accurate. Let’s say that implied volatility will go up to 61% if the stock goes to 16, and it will go down to 41% if the stock goes to 21. Here is the OptimalTrader screen for this:

And a close-up of the section we have entered our numbers into.

Let’s see what our Risk Graph looks like now.

Yikes!! That no longer looks like a balanced trade any longer. Wouldn’t you agree? But we have a problem here. The position delta is still where it was -6.8 shares. And that is as close as you can get without adding a few shares of stock to the trade.

So what can we do? Obviously we need to buy some calls or sell some puts. But we can no longer use position delta as our yardstick to see if we are balanced.

What are we really after? To balance our greeks or to make the same amount of money if the stock goes up or down? Our greeks are balanced, but our reward is not.

So here is a new plus in the program. See the number to the left of Position Total called RN? That stands for Reward Neutral. When that number is zero, then we have a trade balanced on how much money we make if the stock goes up or down. Maybe there is some magical formula in a book somewhere. But I have chosen to keep it simple and so I want to know that if the stock goes up or down 5% whether I am perfectly hedged or not. Of course then assumes that our IV Profile is close to being correct. And if it is not, it is a lot closer to being real than the earlier risk graph.

Adjusting to be Reward Neutral is just as easy as adjusting to be delta neutral. We use the Ratio Finder again.

The results are terrible.

If our IV assumption is right, then we need to use different strikes so that we have a curved line instead a flat one on the right side. The call strike needs to be much closer to the stock price.

Playing around, I finally arrive of something that looks decent by using calls that were slightly in the money. Since this is still a new tool, we will have to learn and adjust as we go.

Today’s blue line is now balanced to have an equal reward for a 5% move in the stock up or down. I will click on some of the dates and remove the other three lines and just show the graph with today’s line on it.

You can see the background behind Expiration , 5/14/03 and 3/10/03 is no longer dark. This indicates that it is in the off position.

So now, theorectically, we should have a balanced trade. You might have noticed another feature on the IV Profile screen allows you to alter the IV for changes over a period of time, such as the period before earnings. You may have also noticed that each option line also has a dark background behind them. They can be toggled on and off also. This is helpful when trying to balance those calendar strangle trades, where both halves of the trade should be reward neutral. Let’s look at that briefly.

Let’s say we want to reduce our theta on this trade. We still want to take advantage on the big price movement of the stock, but we want to take a little edge off the trade to minimize our time decay losses while we are waiting. Right now our theta decay per day is a loss of $1312. Let’s try to reduce that to 1/3 of that, or a ballpark figure of $400. Let’s sell a short term strangle and try to take in about 900 dollars a day in time decay.

There is no tool to start this with. We will play with the numbers to get our 900 dollars and then use the Ratio Finder later to make sure that it is reward neutral. So we toggle off the first two legs so we can concentrate on the two new legs.

Playing with the numbers I have -200 calls and -500 puts. Then I use Ratio Finder to further narrow this number down. With -200 calls, Ratio Finder says to use -573 puts. Now my theta for my short options is $967. A little more than I wanted. So I can go in and play with the numbers until I get it looking the way I want it. Here is the final resulting graph:

The idea is to keep playing around with the graph until you get something that you are confident in. Then you paper trade it for a while to see how well this type of trade works for you. The trade should be reward neutral even though the position delta is 15,903. The prices shown here assume that you can’t shave anything off of the bid/ask spread. In reality you should be able to do better than the model risk graph.

I hope you see that it is not easy to create a trade that will stand up to the rigors of real trading. I hope that this has shown you that you can’t just create a delta neutral trade and expect to make money if the stock goes up or down. That just isn’t the case. Without the ability to apply volatility to the risk graph, you are taking a lot of risks with your money that you may not be aware of.

Please see our web site for further details on how to obtain our analysis software.    

Rick Fortier

rick@deltaneutral.com