I have always thought of options trading as an interesting way to leverage a trend following strategy. Dneagoy from Theta Trend has the exact opposite thoughts.
In his recent post, He discusses how he was having a difficult time trading an Iron Condors strategy on the SPY back in 2009. He quickly realized that the strategy was not going to perform well in such a strongly trending market.
This was the catalyst for the Theta Breakout System idea that he would develop. His basic goal was to use market trends as a filter to time which option strategies to use.
Here is how he explains it:
Many options traders attempt to trade the same strategy every month, but certain strategies work better in different months than others.
The reason that certain strategies work better in some months than others is due to some combination of market and volatility conditions.
The Theta Breakout system is a way to objectively step back and be aware of what the market is doing rather than hoping some particular strategy works well.
What dneagoy was attempting to do, was define the best time to trade an options strategy with respect to a market’s trend and then only trade the strategy during those periods.
Here are his system’s entry rules:
Initiate new options positions when a new 50 day Donchian channel breakout is triggered.
The options trades are always positive theta and in the direction of the trend.
If a new 50 day high is hit, the system will sell naked puts or put verticals while new 50 day lows will trigger the system to sell naked calls or call verticals.
The exit rules are based on expected profit and loss targets:
Always exit positions if the maximum risk is hit.
Because this system has a higher than 50% probability of success, the maximum risk is also equal to the maximum credit received.
For example, if a 50 day high is made and the system sells a Put for .50 with a profit target of .45, the maximum risk should not exceed .40-.45.
In other words, I’m not willing to take a loss that will take me more than one trade to recover.
The system also utilizes a trailing stop based on an ATR multiple.
While the author has yet to provide any backtesting support for this strategy, his combination of two different strategies is an interesting concept. He does a nice job of summing up his logic:
What we’re really doing with the Theta Breakout system is taking the good parts of the Theta Trend system including well defined entry and exit points, consistency across multiple asset classes, and rules for risk management.
We’re building on the system by adding Donchian Breakouts as a trend filter for options selling.
The original Theta Trend system just used an Average True Range trailing stop and was fairly agnostic about timing while this system times the market in an effort to reduce false signals.
Obviously, this is not a complete or tradeable system. At this point it is just an idea. However, it is certainly an interesting idea. With further development and fine-tuning it could evolve into a more complete strategy.