Monday, August 13, 2012

DN Options... Part 3 8.13.12

Let me just expand on some statements from last week's delta neutral options study and the use of the momentum matrix.  First... we looked at 2 approximating a delta neutral position, the other reflecting a delta positive position.  Our goal was to generate low risk capital appreciation using an options strategy either by itself or in conjunction with holding underlying equity positions. 
In the case of the delta neutral model we simply sold at the money calls against out equity positions and collected premium.  The utility of the momentum matrix in this scenario is minimal and is limited to assessing the risk for undertaking new option positions independent of the Mosaic delta neutral portfolio.  This matter was not addresses in the previous posts and reader enthusiasm for learning more details will drive any further explorations down this wormhole. 
In the case of the delta positive model we can expect that at the money option positions will be regularly exercised (called away) and must be re-established immediately in order to preserve the Mosaic balance.  An alternative approach involves selling the slightly out of the money calls (shown above) and letting price come to the strike.  This strategy knocks down our premium income and relies more on the underlying positions' appreciation to drive our income stream.  In this case the momentum matrix does provide greater utility in targeting how far out the option chain we want to set the OTM strike and is still useful in setting up option positions independent of the Mosaic portfolio.
What are the inherent dangers of the delta neutral model?  Since the income stream is premised on maintenance of a steady state of long/short balance.... if the equity side of the equation (QQQ for example) runs up way past the target strike we are suddenly running a deficit position in which we must cover the called option at a net loss.  At this point it becomes a question of whether we want to play the mean reversion game, re-establish the position and hope for a retracement.  Hope is never a good strategy and this becomes a very dangerous game of wait and see....and is completely contrary to the low risk goals of Mosaic so I don't recommend it to any thinking trader or investor.
On a side note ... XLK traded 67,000 calls at the September 31 strike today, with a total open interest of 140,000 contracts.  This is a huge position and looks like a hedging trade rather than a breakout bet.