Strike Pickins
Vol #180: May 23rd, 2024
You don’t have to know anything about volatility to trade options.
Fire up your brokerage account
Net the stock price, the strike price, and the price of the option
Send order.
Your final PnL now depends entirely on the relationship between the underlying and the strike you are long or short. You paid or received some money for a risk transfer, and while the price might wiggle in between, the final value is simply stock minus strike. There’s no volatility on the trade feed, just dollars and cents.
To chart an options strategy, we draw lines on the axes of stock price and PnL. What is this call, covered call, or protective put’s terminal value with respect to the underlying - no gamma, volga, or charm. At settlement, everything’s black and white.
Options define outcomes because they put kinks in the profit and loss curve, and those kinks are the strikes. At those underlying prices, your path changes. Before implied volatility can matter, it’s the strikes you’re long and short.
I don’t really advocate ignoring volatility when trading options. The price of the option is an important dimension of that PnL, and expected variance is a key part of the value. How much are all those scenarios worth? An option, and trading options, is ultimately taking a position on the fair price for a range of outcomes.
But just as important to recognize, is that these volatility positions are expressed by securities with defined strikes. You can’t have exposure in the options markets without CUSIPs that have breakpoints and end dates. The strikes matter for your PnL, but also for the range of potential positions you can put on.
The covered call’s elegant simplicity speaks to the broadest swath of options traders. It aligns with our intuition about stock investing, and offers a basic trade off. Whether it’s the output of a multi factor portfolio optimization model or putting your finger in the wind, you might decide that if SPY goes up 5% in the next three months, you’re okay selling there. Time to write a call. After all, a little extra cash couldn’t hurt and this rally feels toppy.
Once the options strip populates, the first decision you have to make is what expiration is 3 months out. There’s August 16th at 84 days, and August 30th at 98 days. Even in the most liquid ETF, settlement dates don’t always line up with your theory.
One consideration might be that August 16th is the serial expiration, which tends to have better liquidity than the end of month options. It’s also technically closer to your ideal target.
Now it’s time to pick a 5% OTM call. There’s the 555 strike that’s 4.78% out of the money, or the 560 strike that’s 5.72% out of the money. Collect $3.12 or $2.11? 17 or 22 delta?
If you’re struggling with that decision, you’re not alone. Outside a proprietary pricing model that guesses about a slightly better or worse theoretical value, it’s really hard to find a “correct” answer. The answer is the high delta if it doesn’t move, and sacrificing $1 in premium to get $5 more in runway in the bull case.
Regardless of how fuzzy or precise your initial 90 day, 5% target was, you’ve had to make two implementation decisions that could lead to several hundred dollars per contract in outcome differences.
The answer is not infinite strike listings. There are over a million different options series you can trade on a given day. We don’t necessarily need any more just for the sake of it.
Strike listings are already a strictly regulated process. There’s a 26 page document called the Options Listing Procedure Plan, that sets the competitive boundaries for exchanges to create new listings. When do LEAPs get listed ? No sooner than the Monday after September expiration 28 months prior.
Did you know that exchanges get five special exemptions for adding strike prices which are more than 100% greater than the current underlying price? They only get to nominate those selections annually.
The reason for all these rules is that a new strike is not all upside for the industry. There’s the baseline market data processing costs. Pipes need more bandwidth, and computers need more cycles to manage every new addition. Additional strikes that don’t beget additional volume fragments liquidity.
If the addition of the 557 strike in SPY meant more volume today, liquidity providers, exchanges, and customers would all agree it should be listed. But if the customer will just nudge up or down and trade anyways, there are distinct benefits to having fewer strikes with greater individual liquidity.
Market makers are faced with adversarial counterparties. Their balance sheets don’t go up because new strikes are listed, so they have to split up their capital or improve safety mechanisms to quote additional strikes. More strikes means more updates, and if stock moves quickly too many strikes tax horsepower. Markets get wider and thinner.
New strikes also can provoke some scaries. Volume and open interest are an important gut check on an options series because it tells you how many other trades have priced this specific strike. More is always better.
If zero open interest is concerning, a newly invented strike and expiration date make you run for the hills. For big traders who can’t make hay from the existing strikes, there’s a mechanism to create your own. A “FLEX” option follows the same clearing conventions as a regular option, but lets the counter parties decide on the terms.
The clearing part of this is fairly important. While the trades are non-standard, the plumbing basically follows the same rules as regular listings.
The fact that a FLEX trade doesn’t take any extra margin or siloed capital helps practically, but it hardly makes the trade any less daunting from a market maker’s point of view. With predictable expiration cycles and strike listings, there’s already a bottomless pit of asymmetry from the buy side.
If someone wants to push the settlement forward a couple days - do they know something? Why would you come after the $23 strike when we have $20 and $25 listed already?
FLEX options aren’t available to traders in a regular account. You need a broker contact that can go out to the world and convince a counterparty that you’re just as uninformed as regular old orderflow. A dealer is going to look at a special exception very carefully, because a demand for precision often indicates information.
The tide is inevitably going towards more strike listings. Every day processing power grows, and OCC volumes have remained strong to justify them. This is a virtuous cycle as greater listings provide the potential for more nuanced strategies, increasing volumes, and bringing about more reasons to list strikes.
More complicated strategies demand granularity at strike and tenor. Adjusting a covered call up or down a few basis points is one thing, but with multiple legs in condors or broken wing butterflies, the customization potential drops off more quickly than you might expect. Low priced stocks only compound this.
While it’s good for future implementation, to the extent that you’re using backtests, those become less representative as the markets get more listings. The number of choices today compared to just three years ago is significant. How do you adjust historical PnL to account for future precision? Is the extra cash from the fortunately wide put spread that you happened to put on before COVID appropriately representative?
In even the most basic strategy, a good idea can be thwarted by the reality of the strike listings. I regularly see MLPs and REITS show up in scans for wheel opportunities, but the strikes are too far apart and there’s not much action in many of them. And an options chain isn’t always the most accessible way to play around with strategy parameters.
To help with this, I’ve introduced a new tool at TheTape.Report. It’s totally free, and designed for the two most popular options strategies I work with; covered calls and hedged equity (GULL).
Choose your ticker and walk through the target expirations and strike listings, to compare prices and returns for these core setups. The Covered Call feature uses both delta and %OTM targets, and the GULL lets you choose put spread parameters to compare against a dollar neutral call.
Happy Trading.