Condor Options

The Powershares Nasdaq 100 Trust (QQQQ) is a highly liquid, very popular ETF with actively traded options. But for traders who want to implement an options strategy on the Nasdaq 100 with any precision, QQQQ may not be the optimal product.

Assume you are trading a strategy that includes the following rule:

When the 14-day Relative Strength Index (RSI) closes below 30, sell a put with a delta of -20 in the nearest cycle with at least 14 days until expiration.

We regularly conduct custom research for private clients involving the formulation and backtesting of options strategies, but this is not a rule we have tested, and I’m using it here solely for the purposes of illustration. Assume that QQQQ closes today at $43.75, and that the price behavior in recent weeks was such that today’s close would trigger the 14-day RSI entry signal. With only nine days until December expiration, we would look to the January cycle, which has 37 days remaining. If we pull up the option chain for QQQQ January 2010 puts, we’ll see something like this:

Delta values for the puts are displayed in the third column from the right. The problem should be clear enough: neither the 41 nor the 40 strike has exactly the level of delta exposure required. While a few deltas among friends might not be a major cause for concern, a position involving more than a few contracts will result in substantially more or less exposure than is called for by the strategy rule. A couple of possible solutions come to mind. We could sell the 41 puts and offset the extra negative deltas by buying shares of the underlying, or we could sell both the 40 and 41 puts in nearly equal amounts and arrive at the target delta exposure that way. These approaches are both rather inelegant, and the first isn’t even an exact solution, since the underlying shares will have to be adjusted frequently to match the desired exposure.

The reason that QQQQ lacks variety at the delta level is simple: strike prices listed at $1 increments encompass a fairly wide range of percentage movement for an asset with a low price and moderate implied volatility. At the moment, QQQQ at the money options in near term cycles have an implied volatility around 23% or so. If the market became extremely volatile and was expected to remain so in the future, the range of expected price movement between each individual dollar strike would, by definition, be smaller. Alternatively, if QQQQ were trading at $80 rather than $40 and had the same volatility, options struck at dollar increments would provide substantially more granularity. For proof, let’s examine a product with the same mandate (tracking the Nasdaq 100) and the same implied volatility, the Emini Nasdaq 100 futures options:

Where the QQQQ options skipped from -16 to -23 deltas, these NQ options have strikes with deltas of -16, -17, -19, -20, -22, and -24. That makes them much more suitable for the greeks-based trading we’re considering. And I haven’t even mention spreads yet: if it’s a problem to find a single option with a desired risk profile, additional legs make the task even more difficult.

One caveat is that NQ and NDX are considerably “larger” products than QQQQ. The table below shows the amount risked by purchasing one -20 delta January 2010 put in each product at the time of writing.

The size of the latter two instruments may put them out of reach of the smallest traders. For everyone else, QQQQ options seem inferior.