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The Option Selling Report www.GoTradeSignals.com ©2012 All Rights Reserved

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Trading System Design

The Option Selling Report

And Other Trading System

Analysis

Author: GoTradeSignals


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U.S. Government Required Disclaimer: Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risk.

You must be aware of the risks and be willing to accept them in order to invest in the options, futures and stock markets. Don’t trade with money you can’t afford to lose. This

training website is neither a solicitation nor an offer to Buy/Sell options, futures or securities. No representation is being made that any information you receive will or is likely

to achieve profits or losses similar to those discussed on this training website. The past performance of any trading system or methodology is not necessarily indicative of future

results. Please use common sense. This site and all contents are for educational and research purposes only. Please get the advice of a competent financial advisor before

investing your money in any financial instrument.


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Introduction

Welcome to the Option Selling Report. With this model

you, the trader, will be able to do what many successful

traders are already doing, extract money from the

financial markets. This model is not 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 report culminates with an explanation of the GTS

Method for iron condors. The method generates a similar

credit to an iron condor, and has a similar expiration

graph (red line), but the active risk profile is more

favorable at initiation, as well as long vega at the put


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wing, which would aid with a sharp market move lower.

However, the iron condor strategy outlined in this report

will do well on its own in most market years. Below is

the risk graph of the GTS Method for the iron condor.

The www.ThinkOrSwim.com platform is a great

platform and provides some of the images in this report.


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This report can be grasped by anyone with an interest in

trading. However, the more versed one is in the

terminology, the easier read it will be. If someone has an

interest in trading, but not sure of an interest in learning

to trade, they can trade hands free with

www.GoTradeSignals.com.

By working with our approved brokers, trading can take

place with no effort by the account holder. The account

is funded in the trader’s name, and

www.GoTradeSignals.com publishes the signals to the

broker; the broker takes care of the rest by autotrading

for the account holder.


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www.GoTradeSignals is not an investment advisor but is

an autotrade publisher of trading signals. No specific

advice is given, signals are available to all subscribers.

From a mathematical perspective, the terms which

describe the inner working of options are referred to as

the Greeks. While the option Greeks are not referred to a

great deal in this report, there are 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 easier read than it is. If you need a

primer, drop us a line, www.GoTradeSignals.com.

This options trading technique, as presented, takes as

little as $2000 to implement. There are many ways to

trade with less capital, but commissions become more


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consequential, and this drags on expectancy. Expectancy

is the calculated mathematical conclusion of a series of

trades.

When trading equities, more contracts per position will

mitigate the impact of commissions further. In our

examples, and for simplicity, we will trade one contract

at a time. This sets margin requirements at

approximately $2000 to get started with this model.

The target profit potential per month is approximately

8% on margin before transaction costs. The average

monthly potential will be much lower when factoring in

losing months, likely closer to 4%. Winning every

month will not occur, so be prepared to take some

managed losses.


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Margin rates for short equity option spreads are fairly

easy to calculate as the spread amount minus the credit

received multiplied by $100. For simplicity the spread

can simply be considered the margin requirement.

www.GoTradeSignals works with great brokers who

autotrade for their account holders, and can answer any

questions you may have.


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The Debate

Option selling vs. buying can often be a volatile debate.

The debate is likely 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. From

an objective standpoint, a case can be built for both sides

of the discussion.

The parallels between the options selling business and

the insurance business are numerous. Option sellers are

essentially selling insurance. Insurance companies, as a

whole, can do very well with forecasting and actuary

tables if the premiums are rich enough.


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If insurance 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. This is part of the rational of proponents of some

options being regularly mispriced.

On the other side of the coin, many argue there is no

expectancy for options, and they are priced efficiently.

Therefore, if options were randomly sold over a long


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enough period of time, the expectancy would be $0, less

transaction costs. This would exclude any trade

management or exit techniques. If options prices are

always efficiently priced, then trade management is the

main potential edge for the trader, and that can be a

daunting thought.

The question to be returned to, then, is 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, and dive into the model.


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Objective

The objective of this report is to introduce a systematic

options selling model, which can be used by most traders

with a basic understanding of options, for a U.S. equity

index, or a derivative thereof.

A brief note on system traders. We are an affectionately

dysfunctional bunch, methodical and analytical, and

often isolated due to our trading style. Many of us are

hardwired to feel more comfortable trading with

quantified rules, but will hopefully loosen up when

needed. Discretionary traders are probably less enthused

by systematic rules, and they might be better suited

viewing the system as a guideline.


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As with the last report on Trading System Design, this

report will be short, even shorter actually. In this case

this is likely positive, as some traders do not make good

writers. The information in this report is far from

exhaustive, and there are some great books out there with

much more advanced concepts and definitions which are

truly enjoyable to read.


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Markets

The underlying instrument used in this report is the ticker

SPXPM. SPXPM is the newer underlying related to the

SPX, but the options are electronically traded, and appear

to have significantly smaller spreads when compared to

the SPX. SPXPM options expire the evening of

expiration day, and not at the open. This gives the

options essentially one more day of life, but there are no

surprises as to where the market is when the options

expire. And this is an issue with the SPX as the set price

can be over one daily average true range away. The

process of establishing the set price is one of the biggest

ways in which large players manipulate the market and it

likely should be changed.


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However, other instruments can be used as a proxy for

the S&P, such as the ES, SPY, the mentioned SPX and

others. But the trade structure should look very similar

across the board. Compared to these other markets,

commissions incurred using the SPXPM can be lower

and the bid/ask spreads are typically lower than the SPX.

For now there is much lower volume options volume on

SPXPM than on the SPX, but fills don’t seem to be an

issue.

As mentioned, SPXPM is electronically traded and

maintains the same size of the SPX. We are somewhat

averse to pit traded markets in general because they can

often take a long while to get a fill, and some of those

fills can be unfairly poor. The electronic markets are


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actually improving spreads and liquidity in all markets.

There are times, however, when pit traded vehicles are

more than viable and are the best vehicle to use, it just

depends on the preference of the trader.

The options world has changed so rapidly recently with

the advent of end of month options, weekly options, and

now weekly options available more than a week out.

With so many tools available, adjustment possibilities

have really multiplied.

At the time of this writing, SPXPM only offers serial

options, which are the options which expire on the third

Friday of the month. However, SPX offers weekly and

quarterly options and these can always be used for trade

initiation and adjustments as well.


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Options with less than a week of life left have theta levels

of nearly violent proportions. If weekly options are

viable, it would offer 52 expirations per year. The trade

off would most likely be the lack of a cushion from a

strong market move. Some traders achieve impressive

weekly results by selling options, and every once in a

while there can be a big hit to performance.


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Trade Structure

There are many ways to trade. And just about any way

can be tweaked to be successful as it really depends on

what works for the individual. In terms of attempting to

make an attractive absolute return in equity markets,

spreads can be used similar to the technique presented

here.

The reason spreads are utilized is because of reduced

margin and defined risk. The margin requirements for

uncovered option selling in equity markets are

substantial, and the risk is much less defined. Some

traders using spreads refer to it as a bribing of the margin


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gods, as the lower margin requirements are so significant

compared to uncovered margin requirements.

However, uncovered option selling is much more viable

in futures markets, like the ES, SP and others, where

margin requirements are based on probability and risk

utilizing SPAN. Selling uncovered premium is the most

efficient way to produce a credit, and the most risky, in

terms of theoretical max loss, and vega (implied

volatility) exposure.


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The particular strategy in this report uses vertical spreads.

A vertical spread is buying and selling different strike

prices in the same month and underlying. It is often used

as a risk management tool and either generates cash into,

or depletes cash from, the account.

As discussed earlier, uncovered option selling is usually

considered more risky than selling premium via vertical


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spreads. Covered calls, a fairly well accepted strategy,

has a very similar risk profile to a written uncovered put

option, and yet bafflingly, it is encouraged by many

brokers. This is likely because the broker has no

perceived risk. Regardless, if leverage is used, extra care

is necessary, and all trading should be taken seriously.


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Technology

There are some great trading platforms available to the

independent trader, many at no cost. There are also a

number of charting websites which stream at no charge.

For quick static 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 for this

reason we are recognizing them.

To actually trade well, tools with more features need to

be used. We use other platforms for real time trading and

streaming data. Drop us an email and we may be able to

steer you in a direction for various tools. If you have a

great tool, we would like to hear about it as well.


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The Options Selling Entry

The basic building block of this strategy on the SPXPM

is the Iron Condor. The Iron Condor requires a vertical

spread with calls, and a vertical spread with puts, and

combines them to complete the condor. They share the

margin requirement, and only one side can be at risk at a

time. The spread distance is 20 points for both vertical

spreads, which is what enables the sides to share a

margin requirement.

To find which strikes are to be used for the Iron Condor,

find the vertical spread for the calls or puts which nets

approximately .90 per side. This will net a combined

credit of approximately 1.80 for the complete Iron


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Condor. This will generate $180 on approximately

$2000 in margin, resulting in generating 9% on margin.

Because actual prices are used to discover which strikes

are used for the entry, the trader is not using probability

analysis, or a multiplier of the standard deviation, or delta

etc, to choose the short strike price. But in all reality,

those techniques should result in very similar strikes with

short strike deltas at approximately .16. For this

technique, 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 call and put vertical spread

with 45-60 days left before expiration.

Options can be written with less of a duration before

expiration. But because U.S. equity markets tend to fall

significantly faster than they rise, it is not advisable when


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considering put exposure. Put another way, when a sell

off does occur, a 1.5-2 standard deviation move from

when the put option was sold is very possible.

When trading iron condors, the trader does not want the

underlying anywhere near their strike price. Gamma (the

rate at which an option’s delta will increase with a move

of the underlying) will simply grow too rapidly with a

severe market drop. Some traders refer to this as gamma

gearing. The GTS Method attempts to compensate for

this potential move by being long vega at the wing.

The steps to develop the trade structure are the following:

Pull up an option chain on www.Bigcharts.com, or

another site, for the SPXPM. Look at the options

expiring in 45-60 days. Find the 20 point put spread with


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a value of at least .90, usually about two standard

deviations away.

The call entry uses a similar concept. Look at the calls

on the SPXPM options chain with the same expiration

date. Find the 20 point spread with a credit of no less

than .90. The calls will likely be set up approximately

one standard deviation away.


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Here is how the numbers line up trading 1 contract:

Vertical Put Spread credit = .90

Vertical Call Spread credit = .90

.90 x 1 contract (puts) = $90

.90 x 1 contract (calls) = $90

Total premium = $180

$180 / $2000 (premium / margin) = 9%

Courtesy of www.ThinkOrSwim.com, the following

image is how the trade visually appears at initiation.

Notice the time laps lines showing the profitability due to

time decay. Upon initiation, the trade has a profitability

range of 240 points. As time decay (theta) occurs, the

range of profitability grows:


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Later in this report we will be discussing the GTS

Method of modifying an iron condor to improve the

risk:reward characteristics. It transforms the risk graph

to look like this:


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With some slight modifications, the trade is long vega on

the put side, giving the trade staying power for a large

move lower. Max risk is also greatly reduced. Be sure to

read the section on the GTS Method for more info.


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Exit

The exit for the vertical spread is also price based. If the

vertical hits either four times the entry, in this case 3.60,

or the combined iron condor drops in value to .10, then

buy it back.

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.

Some deviation from this exit is allowed, but if the

spread is allowed to more than quintuple, when taking a

loss, expectancy is hindered.


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Also, unless a trade goes significantly against the trader

immediately, the trade could very well need to quintuple,

or more, to reach a price of four times the entry. This

idea greatly increases the odds of the trade winning, but

emphasizes that a good entry is key.

Our probability analysis suggests the odds of the price of

an option spread quintupling is low, even more so when

time has passed. But if the spread price does quintuple,

the option spread value will probably keep growing, 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, it


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would probably be better to take the spread flat, and roll

it out to keep gamma (the rate of the change in delta) in

check.

Once in a great while it is prudent to allow options to

expire, but it is rare. Typically, we divide the number of

days left before expiration into the value of the spread,

and if the quotient drops below the desired theta (time

decay) per day, the position is no longer worth holding.

This ensures the most efficient use of risk and usually

requires positions to be closed before expiration.


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Adjustments

Adjustments are double edge swords. Unless the trader

has an edge in picking short term direction, we suggest

not adjusting trades in general. However, there are times

when exiting at a very clear support or resistance point is

not advisable, and an adjustment to buy more time makes

sense. There are many ways to adjust a trade, one

technique is presented here.

When looking to use an adjustment technique instead of

an outright exit, the trade has to be adjusted well before

the traditional price based exit of a quadrupling of the

entry of one of the vertical spreads.


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One adjustment technique is to wait until one vertical

spread increases to 2.5 times the entry. At this time the

entire iron condor is purchased back. Then, a new iron

condor is established using options which expire further

out, and are sold for a slightly higher credit than the debit

to close the original iron condor. The vertical call and

put spreads are reset at nearly equal prices with the hope

of the market stabilizing. This will very often work, but

if the market continues to move directionally, or snap

back, there will likely be slightly larger loss taken.

Running through adjustment scenarios is a great exercise.

Just use great care in putting them to work as they nearly

always complicate the strategy.


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Calculating Expectancy.

Average winning month = 170 170 / 2000 = 8.5%

Average losing month = 190 190 / 2000 = 9.5%

Win Rate = .75

Loss Rate = .25

Expectancy = (.75 x 170 = 127.50) – (.25 x 190 = 47.50)

= $80 per combined call and put spread (iron condor).

$80 / 2000 = 4% per month average.

4% per month compounded is well over 50% per year.

4% a month is an average, but the equity curve will not

be smooth as it will experience winning and losing

months, multiple losing months are very possible. A


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strategy such as this needs a minimum of 12 months for

statistical tendencies to materialize.

These numbers presented are raw and do not include

transaction costs. Short term expectancy is probably

higher; some positions will be shut down early at a

smaller loss or even a small gain. There will be larger

losses due to gaps and trading errors, long term

expectancy could be lower as a whole as the likelihood of

a rare event becomes higher.

By pulling in the short strikes slightly closer to at the

money (current market price) the average trade profit and

loss will increase. For smaller returns and lower risk,

push the short strikes out further.


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The major criticism about the deep out of the money

(strike prices far away from the current market) iron

condor is the large loss which can be incurred with a rare,

but enormous, move in the market. If the short strike

goes at the money, the spread will, on average, be worth

about 10 points. Even if two points were collected for

the position, that is a risk reward of 5:1. The

mathematical max risk for the trade is 10:1.

The trader simply cannot allow these trades to get away

from themselves, especially with the short vega trade

structure. If the exit price is hit, exit early and move on.

At the end of this report a modified iron condor method

is described transforming this trade from short vega to


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long vega, offers a better absolute risk:reward, and still

maintains a short theta posture.


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When Not to Sell

With the entry and exit rules in place, we may want to

explore when not to sell options. Evaluating market

environments is notoriously difficult to do. 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.

What we have found is, over the long term, and by

averaging the number of excursion violations as

measured by our criteria, implied volatilities are largely

accurate.


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For example, when selling an options one 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 naked strangles were to

be written, with call and put strikes one standard

deviation out, over the long term, one of the sides would

be violated, before expiration, 32% of the time.

Coincidentally, there will not be an excursion violation

68% of the time, which represents a 1 standard deviation

figure.

However, there are a select few 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.


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A vertical spread on its own can have positive

expectancy, but it is usually on the put side due to skew.

Short calls are fairly well priced but they can often be

exited early for a gain when given the opportunity.

A way to mathematically define when not to sell

premium is difficult to develop. From using historically

low VIX levels to attempt predicting sell-offs, to using a

price regurgitating trend indicator when trying to stay on

the right side of the market, systematically predicting

when to avoid selling options to steer clear of dangerous

waters is challenging to accomplish. Many say to simply

buy cheap volatility and sell expensive volatility.

However, volatility trends can clearly continue much

further than anticipated.


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The Slope Indicator

Through continued collaborative efforts, we have

developed a proprietary indicator which measures the

steepness, or slope, of a market relative to implied

volatility. We simply refer to it as the slope indicator.

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 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.


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The formula is proprietary, but 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.

Using the Slope indicator 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

we 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


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front month, and our exit price has not been hit, which is

5 times the entry price of one leg, we are unwinding the

position. No need to be on the wrong side of accelerated

theta.

The Slope Indicator is not flawless, 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


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most well known, premium sellers experience severe

drawdowns 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. Revenge trading has been the downfall of

many a short options trader.


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Summary

The iron condor options system presented is a viable

means for a trader to have a system with clearly defined

entries and exits. Although different strategies may be

better suited in different market environments by an

experienced trader, this system can get the trader well on

their way. www.GoTradeSignals.com trades the GTS

Method of the iron condor for autotrade subscribers.

Some discussion on that method follows.


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GTS Method

The GTS Method is a way to establish a position with an

expiration graph very similar to an iron condor and yet be

long vega on the put side, have the potential for windfall

profits in a crash scenario, and still maintain the positive

theta posture. The risk graph at initiation looks similar to

this.


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Although the trade structure continues to utilize 20 points

spreads on the SPXPM, the trade structure is slightly

modified. The trade is long vega on the put side which is

a tremendous advantage over the long term. Below is the

represented risk graph with an 11% increase in volatility.


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Here is another look with the graph expanded. As can be

seen, a market crash could actually be fortuitous.


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The emphasis of being long vega is placed on the put side

as an implied volatility explosion will most assuredly

take place with a large move down. With a spike in the

VIX of more than 20 points or more, the vega response is

even more pronounced.

The GTS Method is a way to sell option premium while

still having protective positions at the wings. The put


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vertical spread is converted to long vega with the

potential for a benefit from a crash. The call vertical

spread uses the reverse skew of calls against itself. Short

call spreads are notorious for their drawback of

accelerating gamma with a smaller spike up in the

markets. The GTS Method takes much of the bite out of

those relentless moves up in the market, especially at

trade initiation.

The other major piece of the GTS method is

diversification of the model itself. Instead of trading the

model on a single stock, the model is traded on an index.

This eliminates company specific risk and allows the

underlying to be more statistically viable. One top of

using an index as the underlying, the model is split into 2

to 3 positions on the index where the trades entreies and


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exits are staggered. This enables a shift in the market

environment to be accommodated. This theory can also

be applied to all iron condor traders as well.


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Conclusion

There are no secret option positions out there, just

different ways of constructing risk graphs with known

tools. The iron condor position laid out in this report is a

great way for a trader to begin trading with a high win%

strategy. The pace of the trade is also low with decreased

gamma levels, allowing a trader more time to evaluate

necessary adjustments. If iron condors are utilized, make

sure the entry credit is adequate, and honor those stops.

High probability iron condors very often take care of

themselves.

The GTS Method is a unique way of maintaining a

positive theta stance for the iron condor and defend


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against the potential pitfalls of both put and call vertical

spreads. The GTS Method can be autotraded hands free

with our affiliated brokers. For more information please

visit www.GoTradeSignals.com. Good trading.

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