Monday, September 30, 2013

Conrick and Hanson, Vertical Option Spreads

What can two guys from North Dakota tell us about vertical option spreads that we don’t already know? Even if we disregard the tongue-in-cheek geographical slur (and I feel comfortable making it because for a few years I had family ties to North Dakota), the question is misdirected. Vertical Option Spreads: A Study of the 1.8 Standard Deviation Inflection Point by Charles Conrick IV and Scott Hanson (Wiley, 2013) is more about developing a probabilistic trading strategy than about the nuts and bolts of vertical spreads. Which makes it a more interesting book than its generic title would indicate. There are also bonanzas for those who buy the book: a 180-day free trial of Oracle’s pricey Crystal Ball (an Excel add-in for predictive modeling, forecasting, simulation, and optimization) and the authors’ “Amazing Spreadsheet.” In this book they explain in detail how to use both.

Using S&P weekly returns from 1928 to 1989 and its ETF tracker SPY, the authors discovered a window of opportunity. “The area between plus or minus 1.0 and 2.0 standard deviations from the mean return is, in effect, an exact negative of what the normal distribution would predict!” (p. 107) Between plus 1.0 and minus 1.0 standard deviations from the mean there are about 13.2% more data points, between plus or minus 1.0 and 2.0 standard deviations 13.2% fewer data points.

Armed with this statistical information and Crystal Ball’s tools, the authors devised a profitable trading strategy using weekly SPY credit spreads and iron condors. Even though the strategy handily beats the index, it is not wildly profitable, which lends credibility to it.

Despite having probability on their side, the authors are not pure system traders. For example, if there is an upcoming Fed meeting they may trade further out than normal or just stay out of the market until after the announcement. “There is no reason to get into a trade just because you feel compelled to do so. Use good judgment, and make sure all the edges are in place.” (p. 234)

Some of the authors’ trading practices are questionable, which means that this is not the best book for someone who is just starting out in options. There are better places to learn how and when to open and close trades, what brokers to use, and how to manage risk. But for someone who is trying to exploit “improbabilities,” it is a good case study. That you get to play with Crystal Ball for 180 days is icing on the cake.

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