Trading System Design

Trading System Design
The Option Selling Model
And Other Trading
System Analysis
J. Murakami
The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
1
Headings
1. Introduction
2. The Debate
3. Objective
4. Markets
5. Trade Structure
6. Technology
7. Entry
8. Exit
9. Calculating Expectancy
10. When not to sell
11. The Slope Indicator
12. Conclusion

2
RISK STATEMENT: The trading of stocks, futures, commodities, index
futures or any other securities has potential rewards, and it also has
potential risks involved. Trading may not be suitable for all users of this
Website and book. Anyone wishing to invest should seek his or her own
independent financial or professional advice.
The Information, Forms and other resources available on or through this
Website and Book and received from or through this Website and Book
such as e-mails and/or newsletters are provided for education and
informational purposes only, without any express or implied warranty of
any kind, including warranties of accuracy, completeness, or fitness for any
particular purpose. The Information contained in or provided from or
through this Website and Book is not intended to be and does not constitute
financial advice, investment advice, trading advice or any other advice. The
Information on this Website and Book and provided from or through this
Website and Book in the form of e-mails and/or newsletters is general in
nature and is not specific to the User or anyone else. USER SHOULD NOT
MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR
OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED
ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES,
INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT
DUE DILIGENCE AND CONSULTATION WITH A COMPETENT
FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that
any and all use of the Information and Website and Book which User
chooses to utilize, is completely at User's own risk and without any recourse
whatsoever to GoTradeSignals, its associates, subsidiaries, partners or
content Providers. User understands that User is using any and all
Information, Forms and other resources available on or through this
such as e-mails and/or newsletters AT USER'S OWN RISK.

3
Introduction
Welcome to the Option Selling model. With
this model you, the trader, will be able to do
what many successful traders are already
doing. It may not be 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 writing is probably best for the novice
options trader. While the greeks are not

4
referred to a great deal, there is 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 easy read for you too. And,
this is a very easy read. If you need a
primer, drop us a line,
pinvestments@hotmail.com.
This trading technique, as presented, takes
as little as $700 to implement. Yes, there
are ways to trade with even less. It might be
suggested one use at least 5 contracts to
mitigate the impact of commissions when
using this system on the SPY. In our

5
examples, we will trade 5 contracts at a time.
This increases margin requirements to
approximately $3500 to get started with this
model.
The target profit potential per month is
approximately 5.5% on margin before
transaction costs. Margin rates vary, as well
as commissions…but you already knew that.
5.5% compounded for a year is nearly 100%.
But, winning every month is difficult to do, so
be prepared to take some losses.

6
The Debate
Option selling vs. buying can often be a
volatile debate. For the author, the debate is
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. If one is an objective individual, both
sides of the discussion can be seen. But in
the end, the trader has to make a choice.
The parallels between the options business
and the insurance business are numerous.
Option sellers are essentially selling

7
insurance. Insurance companies, as a whole,
can do very well. If the 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.

8
The question, then, can possibly be reduced
to 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.

9
Objective
The objective of this book is to introduce a
systematic options selling model, which can
be used by a common trader, with a common
understanding of options, on a U.S. equity
index, or a derivative thereof.
A brief note on system traders, I would like
to say affectionately, we’re an interesting
bunch. On average, we’re very methodical
and analytical, often isolated due to our
trading style, and hard working. Many of us
are hardwired to feel more comfortable

10
trading with quantified rules, but we’ll keep
trying to loosen up…☺. Discretionary traders
are probably less enthused by systematic
rules, and they might be better suited
viewing the system as a guideline.
As with the last book, this one will be short,
even shorter actually. ‘Probably a good
thing, considering my writing abilities. The
information here is far from exhaustive.
There are some great books out there, with
much more advanced concepts and
definitions, and are truly enjoyable to read.

11
12
Markets
The underlying instrument used in this book
is the ticker SPY. However, other
instruments can be used, such as the ES,
SPX and others, but the trade structure will
be slightly different. Commissions incurred
using the SPY will likely be higher but the
bid/ask spreads are typically narrower than
the SPX.
I’m somewhat averse to pit traded markets
in general, because it can often take a long
while to get a fill, and many of those fills

13
have been unfairly poor in my experience.
There are times, however, when pit traded
contracts are more than viable and are the
best vehicle to use. For years I used the
CME SP pit, and the SPX is also pit traded.
Many think the electronic markets are
actually improving spreads and liquidity in all
markets.
A benefit of using the ES is the availability of
End of Month options. This potentially offers
24 expiration opportunities a year, instead of
the normal 12. ES EOM options do have
wider bid/ask spreads with less liquidity but
they are viable. ES options are also

14
electronically traded and available nearly
24/7. ES weekly options for week 1 and
week 2 are also available, albeit with low
volumes and open interest, but obtaining
data for them can be challenging as some of
the vendors are still working to avail the
data.
The SPY and SPX both have End of Month
options available during the serial months
(quarterlies) so this enables 16 expiration
periods. The SPX also has weekly expirations
and the volume and open interest is growing
quickly. Options with less than a week of life
left have theta amounts of nearly violent

15
proportions. If weekly options are viable, it
would offer 52 expirations per year. The
trade off in selling weekly options would most
likely be the reduced cushion from a six
sigma market event.

16
Trade Structure
With regard to this system, in terms of
making an attractive absolute return in
equity markets, vertical spreads need to be
used. This option selling model uses vertical
spreads because the margin requirements for
uncovered option selling in equity markets is
substantial. Many traders simply call using
spreads a bribing of the margin deities.
However, uncovered, or naked, option selling
can be utilized using the lower margin
requirements of futures markets, as in the ES

17
and SP. Selling uncovered premium is the
most efficient way to produce a credit, and
the most risky, in terms of theoretical max
loss, and vega exposure.

18
A vertical spread is established by buying and
selling different strike prices in the same
month and underlying. It is often used as a
risk management tool. Uncovered option
selling is usually considered more risky than
selling premium via vertical spreads, and
most spreads in general, although covered
calls, a strategy accepted fairly well, has a
very similar risk profile to a written
uncovered put option. Again, this system
uses vertical spreads. Either way, if leverage
is used, positions need to be taken seriously.

19
Technology
There are some great trading platforms
available to the independent trader, many for
free. There are also a number of charting
websites which stream at no charge. For
quick 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 I want to thank them for their
content.
Drop me an email, I’d be happy steer you in
a direction for website tools, or trading

20
platforms etc, if I can. If you have a great
tool, I would like to hear about it as well.

21
Entry
The put entry does not use probability
analysis, or a multiplier of the standard
deviation, to choose the short strike price.
This 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
put vertical spread with 30-45 days left
before expiration.
Every once in a while, a put can be written
with less than 30 days left before expiration.
But, because U.S. equity markets tend to fall

22
significantly faster than they rise, it is not
advisable. When trading in this fashion, the
trader does not want the underlying
anywhere near their strike price. Gamma
(rate at which an option will increase) will
simply grow too rapidly with a severe market
drop. One associate on a popular forum
referred to this as gamma gearing.
Pull up an option chain on the SPY and find
the put with a value of at least .50, usually
about two standard deviations away. An
option chain can be found at
www.Bigcharts.com, but they are not
streaming option chains. If possible, find a

23
streaming option chain. The short put is
usually sold for about .50 and the long put is
usually bought for about .25. The minimum
points the spread should be sold for is .25
and not for more than .30. There are usually
7 to 8 strikes between the puts in the vertical
spread.
The call entry uses a similar concept. Eligible
calls have 21-35 days until expiration.
Typically, the trader is looking for a 3 to 5
point call spread with a credit of no less than
.25 and no more than .30.

24
For the beginners, 1 options contract controls
100 SPY shares. So if we sell one option
share for .25, we multiply it by 100 for the
contract value, which is $25. When trading 5
contracts at a time, we multiply $25 by 5 for
a product of $125.

25
Here is how the numbers line up trading 5
contracts:
Vertical Put Spread credit = .25
Vertical Call Spread credit = .25
.25 x 5 contracts (puts) = $125
.25 x 5 contracts (calls) = $125
Total premium = $250
$250 / $3500 (premium / margin) = 7%

26
Exit
The exit for the vertical spread is also price
based. If the vertical hits either 3 times the
entry, in this case .75, or drops in value to
.05 or less, then buy it back. If a 5 contract
vertical spread is sold to open for .25, and
bought to close for .05, the winning trade has
a $100 profit (500 x .20). Conversely, if the
same trade is bought back for .75, the losing
trade has a $250 loss (500 x .50). Since
there is a call and put vertical spread on, and
only one side can lose at a time, the average
winning month is $200.

27
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 the market. But, it will sometimes
be tempting.
Some deviation from this exit is allowed, but
if the spread is allowed to more than triple
when taking a loss, expectancy is greatly
hindered. Also, unless a trade goes
significantly against the trader immediately,
the trade could very well need to quadruple,
or quintuple, to reach a price of three times

28
the entry. This idea greatly increases the
odds of winning, but a good entry is key.
Our probability analysis suggests the odds of
an option quintupling is fairly low. And if it
does quintuple, the trade will probably keep
going against the trader, 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, and if the
trader must reenter, it would probably be
better to take the spread flat, and roll it out

29
to keep gamma (the rate of the change in
delta) in check.
One of the few times to deviate from the exit
technique is if there is significant long term
support or resistance backing up the position.
Markets have an uncanny knack of gunning
for those nice round numbers, and then
reversing.
Once in a great while, we will allow options to
expire, but it is rare. Typically, I divide the
number of days left before expiration into the
value of the spread, and if it drops below the
desired theta (time decay expressed in

30
dollars) per day, the position is no longer
worth holding. This ensures the most
efficient use of capital and usually requires
positions to be closed before expiration. If
the position is not ready to close, the market
is closing in on the position, and gamma is
most likely higher than I would like.

31
Calculating Expectancy
Average winning month = 200
200 / 3500 = 5.7%
Average losing month = 250
250 / 3500 = 7.1%
Win Rate = .80
Loss Rate = .20
Expectancy = .80 x 200 - .20 x 250 = $110
per combined call and put spread (condor)
$110 / 3500 = 3% per month average.
3% per month compounded is 42% per year.

32
…Minus transaction costs, of course. Short
term expectancy is probably higher; some
positions will be shut down at a smaller loss
or even a gain. There will be larger losses
due to gaps and trading errors, long term
expectancy could be lower.
By pulling the short strikes closer to at the
money (options at current market price) the
average trade and risk will increase. For
smaller returns and lower risk, push the short
strikes out further.

33
When Not to Sell
With the entry and exit rules in place, we
may want to explore when not to sell options.
Evaluating and quantifying market
environments is notoriously difficult to do.
By collaborating with some very talented
traders, 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.

34
What we found was, over the long term, and
by averaging the number of excursion
violations as measured by our criteria,
implied volatilities, which are, in short, what
the market is predicting the future range will
be, are pretty accurate.
For example, when selling an option 1
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 a naked strangle were
to be written, with call and put strikes 1
standard deviation out, over the long term,
one of the sides would be violated, before

35
expiration, 32% of the time. Coincidentally,
there will not be an excursion violation 68%
of the time, which represents our 1 standard
deviation figure. The numbers line up.
However, there are some 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. A vertical spread, on its
own, has positive expectancy, but it is more
pronounced on the put side, due to skew,
which in this case is the relatively high prices

36
of puts. Stand along vertical call spreads do
very well sideways and bear markets.
A way to mathematically define when not to
sell premium is difficult to develop. From
using historically low VIX levels to try and
predict sell-offs, to using a price regurgitating
trend indicator to stay on the right side of the
market, systematically predicting when to
avoid selling options, and steer clear of
dangerous waters, is challenging to
accomplish.

37
The Slope Indicator
Through continued collaborative efforts, we
have developed a proprietary indicator which
measures the steepness, or slope, of a
market. We’re so creative, we decided to call
it the Slope Indicator, only because
steepness is harder to say, with more than
one syllable and all.
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

38
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.
As the formula is proprietary, I put it in my
temporary memory bank so I cannot be
tortured for it. At this time, however, 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.

39
Using it 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 I 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 front month, and my
exit price has not been hit, which is 5 times
the entry price of one leg, I’m unwinding the
position. No need to be on the wrong side of
theta.

40
In terms of the SPY, we are using short
vertical spreads, albeit large ones. But, there
is still some reduction in vega exposure (risk
of loss due to implied volatility increasing).
The VIX and VXO are implied volatility
indices. With a back month long strangle on,

41
vega exposure is reduced even more.
Sometimes having long exposure comes in
very handy.
The Slope Indicator is not perfect, 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 most well
known, premium sellers experience severe
drawdowns. Some 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.

42
Conclusion
Presented was an options system with clearly
defined entries and exits. Clearly, different
strategies can be employed in different
market environments by an experienced
trader, but this system can get the trader
started. If you have any questions, feel free
to drop us a line. Good trading to you.
RISK STATEMENT: The trading of stocks, futures, commodities, index

futures or any other securities has potential rewards, and it also has
potential risks involved. Trading may not be suitable for all users of this
Website and book. Anyone wishing to invest should seek his or her own
independent financial or professional advice.
The Information, Forms and other resources available on or through this
such as e-mails and/or newsletters are provided for education and
informational purposes only, without any express or implied warranty of
any kind, including warranties of accuracy, completeness, or fitness for any
particular purpose. The Information contained in or provided from or
through this Website and Book is not intended to be and does not constitute

43
financial advice, investment advice, trading advice or any other advice. The
Information on this Website and Book and provided from or through this
Website and Book in the form of e-mails and/or newsletters is general in
nature and is not specific to the User or anyone else. USER SHOULD NOT
MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR
OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED
ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES,
INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT
DUE DILIGENCE AND CONSULTATION WITH A COMPETENT
FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that
any and all use of the Information and Website and Book which User
chooses to utilize, is completely at User's own risk and without any recourse
whatsoever to GoTradeSignals, its associates, subsidiaries, partners or
content Providers. User understands that User is using any and all
Information, Forms and other resources available on or through this
such as e-mails and/or newsletters AT USER'S OWN RISK.

44

Trading System Design - The Options Selling Model

Загружено:

Сведения о документе

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Trading System Design - The Options Selling Model

Загружено:

Авторское право:

Доступные форматы

The Option Selling Model

And Other Trading

The Option Selling Model - J. Murakami

10. When not to sell

11. The Slope Indicator

The Option Selling Model - J. Murakami

The Option Selling Model - J. Murakami

Welcome to the Option Selling model. With

this model you, the trader, will be able to do

what many successful traders are already

doing. It may not be 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 writing is probably best for the novice

options trader. While the greeks are not

The Option Selling Model - J. Murakami

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 easy read for you too. And,

this is a very easy read. If you need a

primer, drop us a line,

This trading technique, as presented, takes

as little as $700 to implement. Yes, there

are ways to trade with even less. It might be

suggested one use at least 5 contracts to

mitigate the impact of commissions when

using this system on the SPY. In our

The Option Selling Model - J. Murakami

This increases margin requirements to

approximately $3500 to get started with this

The target profit potential per month is

approximately 5.5% on margin before

transaction costs. Margin rates vary, as well

as commissions…but you already knew that.

5.5% compounded for a year is nearly 100%.

But, winning every month is difficult to do, so

be prepared to take some losses.

The Option Selling Model - J. Murakami

Option selling vs. buying can often be a

volatile debate. For the author, the debate is

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. If one is an objective individual, both

sides of the discussion can be seen. But in

the end, the trader has to make a choice.

The parallels between the options business

and the insurance business are numerous.

Option sellers are essentially selling

The Option Selling Model - J. Murakami

can do very well. If the 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

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