Trading System Design

The Option Selling Model

And Other Trading

System Analysis

J. Murakami

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
1
 Headings

1. Introduction

2. The Debate

3. Objective

4. Markets

5. Trade Structure

6. Technology

7. Entry

8. Exit

9. Calculating Expectancy

10. When not to sell

11. The Slope Indicator

12. Conclusion

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
2
RISK STATEMENT: The trading of stocks, futures, commodities, index
futures or any other securities has potential rewards, and it also has
potential risks involved. Trading may not be suitable for all users of this
Website and book. Anyone wishing to invest should seek his or her own
independent financial or professional advice.
The Information, Forms and other resources available on or through this
Website and Book and received from or through this Website and Book
such as e-mails and/or newsletters are provided for education and
informational purposes only, without any express or implied warranty of
any kind, including warranties of accuracy, completeness, or fitness for any
particular purpose. The Information contained in or provided from or
through this Website and Book is not intended to be and does not constitute
financial advice, investment advice, trading advice or any other advice. The
Information on this Website and Book and provided from or through this
Website and Book in the form of e-mails and/or newsletters is general in
nature and is not specific to the User or anyone else. USER SHOULD NOT
MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR
OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED
ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES,
INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT
DUE DILIGENCE AND CONSULTATION WITH A COMPETENT
FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that
any and all use of the Information and Website and Book which User
chooses to utilize, is completely at User's own risk and without any recourse
whatsoever to GoTradeSignals, its associates, subsidiaries, partners or
content Providers. User understands that User is using any and all
Information, Forms and other resources available on or through this
Website and Book and received from or through this Website and Book
such as e-mails and/or newsletters AT USER'S OWN RISK.

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
3
 Introduction

Welcome to the Option Selling model. With

this model you, the trader, will be able to do

what many successful traders are already

doing. It may not be 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 writing is probably best for the novice

options trader. While the greeks are not

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
4
referred to a great deal, there is 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 easy read for you too. And,

this is a very easy read. If you need a

primer, drop us a line,

[email protected].

This trading technique, as presented, takes

as little as $700 to implement. Yes, there

are ways to trade with even less. It might be

suggested one use at least 5 contracts to

mitigate the impact of commissions when

using this system on the SPY. In our

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
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examples, we will trade 5 contracts at a time.

This increases margin requirements to

approximately $3500 to get started with this

model.

The target profit potential per month is

approximately 5.5% on margin before

transaction costs. Margin rates vary, as well

as commissions…but you already knew that.

5.5% compounded for a year is nearly 100%.

But, winning every month is difficult to do, so

be prepared to take some losses.

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 The Debate

Option selling vs. buying can often be a

volatile debate. For the author, the debate is

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. If one is an objective individual, both

sides of the discussion can be seen. But in

the end, the trader has to make a choice.

The parallels between the options business

and the insurance business are numerous.

Option sellers are essentially selling

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insurance. Insurance companies, as a whole,

can do very well. If the 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.

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The question, then, can possibly be reduced

to 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.

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 Objective

The objective of this book is to introduce a

systematic options selling model, which can

be used by a common trader, with a common

understanding of options, on a U.S. equity

index, or a derivative thereof.

A brief note on system traders, I would like

to say affectionately, we’re an interesting

bunch. On average, we’re very methodical

and analytical, often isolated due to our

trading style, and hard working. Many of us

are hardwired to feel more comfortable

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trading with quantified rules, but we’ll keep

trying to loosen up…☺. Discretionary traders

are probably less enthused by systematic

rules, and they might be better suited

viewing the system as a guideline.

As with the last book, this one will be short,

even shorter actually. ‘Probably a good

thing, considering my writing abilities. The

information here is far from exhaustive.

There are some great books out there, with

much more advanced concepts and

definitions, and are truly enjoyable to read.

The Option Selling Model - J. Murakami

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 The Option Selling Model - J. Murakami
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12
 Markets

The underlying instrument used in this book

is the ticker SPY. However, other

instruments can be used, such as the ES,

SPX and others, but the trade structure will

be slightly different. Commissions incurred

using the SPY will likely be higher but the

bid/ask spreads are typically narrower than

the SPX.

I’m somewhat averse to pit traded markets

in general, because it can often take a long

while to get a fill, and many of those fills

The Option Selling Model - J. Murakami

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have been unfairly poor in my experience.

There are times, however, when pit traded

contracts are more than viable and are the

best vehicle to use. For years I used the

CME SP pit, and the SPX is also pit traded.

Many think the electronic markets are

actually improving spreads and liquidity in all

markets.

A benefit of using the ES is the availability of

End of Month options. This potentially offers

24 expiration opportunities a year, instead of

the normal 12. ES EOM options do have

wider bid/ask spreads with less liquidity but

they are viable. ES options are also

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electronically traded and available nearly

24/7. ES weekly options for week 1 and

week 2 are also available, albeit with low

volumes and open interest, but obtaining

data for them can be challenging as some of

the vendors are still working to avail the

data.

The SPY and SPX both have End of Month

options available during the serial months

(quarterlies) so this enables 16 expiration

periods. The SPX also has weekly expirations

and the volume and open interest is growing

quickly. Options with less than a week of life

left have theta amounts of nearly violent

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proportions. If weekly options are viable, it

would offer 52 expirations per year. The

trade off in selling weekly options would most

likely be the reduced cushion from a six

sigma market event.

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 Trade Structure

With regard to this system, in terms of

making an attractive absolute return in

equity markets, vertical spreads need to be

used. This option selling model uses vertical

spreads because the margin requirements for

uncovered option selling in equity markets is

substantial. Many traders simply call using

spreads a bribing of the margin deities.

However, uncovered, or naked, option selling

can be utilized using the lower margin

requirements of futures markets, as in the ES

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and SP. Selling uncovered premium is the

most efficient way to produce a credit, and

the most risky, in terms of theoretical max

loss, and vega exposure.

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A vertical spread is established by buying and

selling different strike prices in the same

month and underlying. It is often used as a

risk management tool. Uncovered option

selling is usually considered more risky than

selling premium via vertical spreads, and

most spreads in general, although covered

calls, a strategy accepted fairly well, has a

very similar risk profile to a written

uncovered put option. Again, this system

uses vertical spreads. Either way, if leverage

is used, positions need to be taken seriously.

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 Technology

There are some great trading platforms

available to the independent trader, many for

free. There are also a number of charting

websites which stream at no charge. For

quick 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 I want to thank them for their

content.

Drop me an email, I’d be happy steer you in

a direction for website tools, or trading

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platforms etc, if I can. If you have a great

tool, I would like to hear about it as well.

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 Entry

The put entry does not use probability

analysis, or a multiplier of the standard

deviation, to choose the short strike price.

This 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

put vertical spread with 30-45 days left

before expiration.

Every once in a while, a put can be written

with less than 30 days left before expiration.

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

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significantly faster than they rise, it is not

advisable. When trading in this fashion, the

trader does not want the underlying

anywhere near their strike price. Gamma

(rate at which an option will increase) will

simply grow too rapidly with a severe market

drop. One associate on a popular forum

referred to this as gamma gearing.

Pull up an option chain on the SPY and find

the put with a value of at least .50, usually

about two standard deviations away. An

option chain can be found at

www.Bigcharts.com, but they are not

streaming option chains. If possible, find a

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streaming option chain. The short put is

usually sold for about .50 and the long put is

usually bought for about .25. The minimum

points the spread should be sold for is .25

and not for more than .30. There are usually

7 to 8 strikes between the puts in the vertical

spread.

The call entry uses a similar concept. Eligible

calls have 21-35 days until expiration.

Typically, the trader is looking for a 3 to 5

point call spread with a credit of no less than

.25 and no more than .30.

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For the beginners, 1 options contract controls

100 SPY shares. So if we sell one option

share for .25, we multiply it by 100 for the

contract value, which is $25. When trading 5

contracts at a time, we multiply $25 by 5 for

a product of $125.

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Here is how the numbers line up trading 5

contracts:

Vertical Put Spread credit = .25

Vertical Call Spread credit = .25

.25 x 5 contracts (puts) = $125

.25 x 5 contracts (calls) = $125

Total premium = $250

$250 / $3500 (premium / margin) = 7%

The Option Selling Model - J. Murakami

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 Exit

The exit for the vertical spread is also price

based. If the vertical hits either 3 times the

entry, in this case .75, or drops in value to

.05 or less, then buy it back. If a 5 contract

vertical spread is sold to open for .25, and

bought to close for .05, the winning trade has

a $100 profit (500 x .20). Conversely, if the

same trade is bought back for .75, the losing

trade has a $250 loss (500 x .50). Since

there is a call and put vertical spread on, and

only one side can lose at a time, the average

winning month is $200.

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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 the market. But, it will sometimes

be tempting.

Some deviation from this exit is allowed, but

if the spread is allowed to more than triple

when taking a loss, expectancy is greatly

hindered. Also, unless a trade goes

significantly against the trader immediately,

the trade could very well need to quadruple,

or quintuple, to reach a price of three times

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the entry. This idea greatly increases the

odds of winning, but a good entry is key.

Our probability analysis suggests the odds of

an option quintupling is fairly low. And if it

does quintuple, the trade will probably keep

going against the trader, 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, and if the

trader must reenter, it would probably be

better to take the spread flat, and roll it out

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to keep gamma (the rate of the change in

delta) in check.

One of the few times to deviate from the exit

technique is if there is significant long term

support or resistance backing up the position.

Markets have an uncanny knack of gunning

for those nice round numbers, and then

reversing.

Once in a great while, we will allow options to

expire, but it is rare. Typically, I divide the

number of days left before expiration into the

value of the spread, and if it drops below the

desired theta (time decay expressed in

The Option Selling Model - J. Murakami

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dollars) per day, the position is no longer

worth holding. This ensures the most

efficient use of capital and usually requires

positions to be closed before expiration. If

the position is not ready to close, the market

is closing in on the position, and gamma is

most likely higher than I would like.

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 Calculating Expectancy

Average winning month = 200

200 / 3500 = 5.7%

Average losing month = 250

250 / 3500 = 7.1%

Win Rate = .80

Loss Rate = .20

Expectancy = .80 x 200 - .20 x 250 = $110

per combined call and put spread (condor)

$110 / 3500 = 3% per month average.

3% per month compounded is 42% per year.

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…Minus transaction costs, of course. Short

term expectancy is probably higher; some

positions will be shut down at a smaller loss

or even a gain. There will be larger losses

due to gaps and trading errors, long term

expectancy could be lower.

By pulling the short strikes closer to at the

money (options at current market price) the

average trade and risk will increase. For

smaller returns and lower risk, push the short

strikes out further.

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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 and quantifying market

environments is notoriously difficult to do.

By collaborating with some very talented

traders, 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.

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What we found was, over the long term, and

by averaging the number of excursion

violations as measured by our criteria,

implied volatilities, which are, in short, what

the market is predicting the future range will

be, are pretty accurate.

For example, when selling an option 1

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 a naked strangle were

to be written, with call and put strikes 1

standard deviation out, over the long term,

one of the sides would be violated, before

The Option Selling Model - J. Murakami

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expiration, 32% of the time. Coincidentally,

there will not be an excursion violation 68%

of the time, which represents our 1 standard

deviation figure. The numbers line up.

However, there are some 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. A vertical spread, on its

own, has positive expectancy, but it is more

pronounced on the put side, due to skew,

which in this case is the relatively high prices

The Option Selling Model - J. Murakami

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of puts. Stand along vertical call spreads do

very well sideways and bear markets.

A way to mathematically define when not to

sell premium is difficult to develop. From

using historically low VIX levels to try and

predict sell-offs, to using a price regurgitating

trend indicator to stay on the right side of the

market, systematically predicting when to

avoid selling options, and steer clear of

dangerous waters, is challenging to

accomplish.

The Option Selling Model - J. Murakami

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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. We’re so creative, we decided to call

it the Slope Indicator, only because

steepness is harder to say, with more than

one syllable and all.

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

The Option Selling Model - J. Murakami

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38
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.

As the formula is proprietary, I put it in my

temporary memory bank so I cannot be

tortured for it. At this time, however, 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.

The Option Selling Model - J. Murakami

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Using it 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 I 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 front month, and my

exit price has not been hit, which is 5 times

the entry price of one leg, I’m unwinding the

position. No need to be on the wrong side of

theta.

The Option Selling Model - J. Murakami

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In terms of the SPY, we are using short

vertical spreads, albeit large ones. But, there

is still some reduction in vega exposure (risk

of loss due to implied volatility increasing).

The VIX and VXO are implied volatility

indices. With a back month long strangle on,

The Option Selling Model - J. Murakami

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vega exposure is reduced even more.

Sometimes having long exposure comes in

very handy.

The Slope Indicator is not perfect, 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 most well

known, premium sellers experience severe

drawdowns. Some 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.

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 Conclusion

Presented was an options system with clearly

defined entries and exits. Clearly, different

strategies can be employed in different

market environments by an experienced

trader, but this system can get the trader

started. If you have any questions, feel free

to drop us a line. Good trading to you.

RISK STATEMENT: The trading of stocks, futures, commodities, index

futures or any other securities has potential rewards, and it also has
potential risks involved. Trading may not be suitable for all users of this
Website and book. Anyone wishing to invest should seek his or her own
independent financial or professional advice.
The Information, Forms and other resources available on or through this
Website and Book and received from or through this Website and Book
such as e-mails and/or newsletters are provided for education and
informational purposes only, without any express or implied warranty of
any kind, including warranties of accuracy, completeness, or fitness for any
particular purpose. The Information contained in or provided from or
through this Website and Book is not intended to be and does not constitute

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
43
financial advice, investment advice, trading advice or any other advice. The
Information on this Website and Book and provided from or through this
Website and Book in the form of e-mails and/or newsletters is general in
nature and is not specific to the User or anyone else. USER SHOULD NOT
MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR
OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED
ON, OR DELIVERED BY ANY OF THE PRODUCTS, SERVICES,
INTERNET WEB SITES WITHOUT UNDERTAKING INDEPENDENT
DUE DILIGENCE AND CONSULTATION WITH A COMPETENT
FINANCIAL ADVISOR OR PROFESSIONAL BROKER. User agrees that
any and all use of the Information and Website and Book which User
chooses to utilize, is completely at User's own risk and without any recourse
whatsoever to GoTradeSignals, its associates, subsidiaries, partners or
content Providers. User understands that User is using any and all
Information, Forms and other resources available on or through this
Website and Book and received from or through this Website and Book
such as e-mails and/or newsletters AT USER'S OWN RISK.

The Option Selling Model - J. Murakami

www.GoTradeSignals.com ©2010 All Rights Reserved
44