In 2012 Jim Bittman, Director of Program Development and a Senior Instructor for The Options Institute at CBOE, gave a presentation that outlined a 2-step strategy for trading the S&P 500 Index (SPX) using weekly options. The strategy is particularly attractive because Mr Bittman supplied very specific entry and exit points, back testing data, probabilities and a detailed comparison vs trading once a month using standard monthly SPX options. This weekly strategy was one of the primary strategies that inspired the creation of altarithm.
In this article, we will discuss the results and challenges faced while manually trading the strategy Mr Bittman outlined, how altarithm has solved those challenges while increasing returns by 1.5% per week and how to set up and use the Bittman algorithm for yourself.
For those experienced with options trading, below is a high level overview of how the strategy works. It is non-directional and involves selling either a Bull Put or Bear Call credit spread each week after the SPX moves a calculated amount in either direction.
- Calculate a 1/4 and 1/2 standard deviation (SD) move for the SPX using Wednesday’s closing VIX.
- Use SPX open price on Thursday and the values from step 1 to calculate 1/4 and 1/2 SD moves up and down.
- When SPX touches either 1/4 SD, sell “opposite” credit spread with a strike price 1/2 SD on the other side. This can happen Thur or Fri of the same week or Mon, Tue or Wed of the following week. The closer to it is to expiration the smaller the credit collected but with a higher probability of being profitable.
- If the market retraces to the opposite 1/4 SD price then immediately exit the position regardless of profit or loss.
- Otherwise, let the options expire worthless on the following friday and keep the full credit received when selling the spread as profit.
|66% +1.20||+1.20 x 2||= +2.40|
|34% -1.40 (avg)||-1.40 x 1||= -1.40|
|Profit per share after 3 trades:||= +1.00|
Strategy Results (Before Automation)
I had great success using the strategy at the end of 2012 and over most of 2013 with an average return of 3.2% per week including winners and losers.
Here are some of the things I liked about this strategy:
- 3.2% per week average return
- 79.3% winners over 39 weeks
- Taxed favorably (60% long-term / 40% short-term)
- PM settled options (unlike RUT)
- European-style SPX options (no risk of early exercise breaking spreads)
Here are some of the challenges I encountered using this strategy:
- The bid/ask spread on SPX options can be very large ($.50 to $1.50) and trying to get a favorable price in between is challenging – especially with spread orders because they can’t be modified. Enter an order around the mark price, wait a few seconds to see if it fills, cancel the order, wait for it to cancel, and then create a new order to try again – sometimes 3 or 4 times while the price moves against you. This is probably the most frustrating part about trading SPX spreads and where most investors, myself included, leave the most money on the the table.
- You have to monitor your positions every day. The market can move against you quickly and you have to be ready to close the position to prevent extended losses.
- Sometimes it’s hard to take the loss. I am usually pretty disciplined but I failed to close a couple positions when I was supposed to resulting in larger losses.
- SPX has a complex variety of options available on different option chains. Standard AM settled options are mixed in with Weeklys, Quarterlys, and if the expiration falls on the 3rd friday of the month, there is a special SPXPM chain.
Improvement with Automation
In early 2013, I started researching ways to solve those challenges using automation. I found that the algorithmic trading platforms available to individual investors all have the same focus: programmable quantitative analysis for equity trading. Very few have support for options trading and none provided the level of support needed to automate the trading strategies I was using without extensive custom development.
At alta5, our focus from the beginning has been to create an algorithmic trading platform designed specifically to automate trading strategies like the one presented by Mr Bittman, for use by everyday investors. For algorithm developers, it features a standards based, object-oriented API and a visual, color-coded drag and drop Algorithm Builder. The platform also transparently solves many of the challenges faced by active traders – like the bid/ask spread.
The #1 challenge of any options strategy (and #1 in the list above) is the bid/ask spread. Smart Pricing addresses this by making customizable, high-speed, incremental price changes to orders until they fill. For complex orders that can’t be modified (like spreads) it automatically handles the workflow to cancel and resubmit new orders.
Reasons to use Smart Pricing:
- Fully automates shaving the bid/ask spread – saving capital.
- High-speed, split-second changes to order prices that can’t be duplicated manually.
- Ensures all orders follow the complex CBOE order pricing rules.
- By using timed “limit” orders with incremental price changes, it naturally defends against high frequency traders who use small orders and speed to “sniff” out how much investors are willing to pay.
- Easy 1 step setup for everyday investors.
- Extremely customizable for algorithm developers, including creation of completely custom pricing rules.
alta5 is in active development and the current version may be slightly different than pictured below.
Setting up a new Trader using the Bittman’s strategy is very straightforward and requires no technical knowledge.
1. Click “New Instance” in the Strategy Marketplace. An “Instance” is a running copy of an algorithm customized by the settings supplied in step 2.
2. Select an account to use, Paper Trading or your brokerage account. For settings that match the values Mr Bittman used in his presentation, select the “Default” settings profile and click “Create Instance”.
For advanced users, custom parameter settings are available (large screenshot).
3. Your instance will start “unfunded”. Enter the amount of available funds you wish to allocate to the instance and a memo (optional).
That’s it, the algorithm is ready to trade for you.
It will wait for the entry signals defined in Mr Bittman’s presentation and automatically enter and exit positions for you each week. It will notify you as it enters and exits positions or if it encounters any problems.
Although the algorithm is fully automated, in altarithm you always have the option of exiting any position immediately or pausing the algorithm to take over and manage a position manually.
Results with Automation
My instance has been trading live for about 14 weeks and my average return has been 4.7% per week (an improvement of +1.5%). Smart Pricing increased my average premium collected by $.12 per share. My win-rate (75.8%) is slightly lower, but my average loss $ amount was much lower – probably due to strict, real-time adherence to the exit rules.
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