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Options on Futures
So, here’s an interesting question. What happens when you take a derivative of a derivative? It sounds like either something out of The Big Short or Inception. But, that’s exactly what options on futures contracts look like.
The Dorian Way is a trading philosophy that was adopted from the Volatility Hedge Fund called The Dorian Fund. The philosophy is centered around trading to make monthly income that can act as a supplement or primary source of income and/or to enhance retirement investing.
The Dorian Way’s principal investment strategy that was adopted from The Dorian Fund a Volatility Hedge Fund is to utilize a top-down macroeconomic approach to determine how to deploy capital across stock indices, commodities, currencies, and future markets. The future markets could consist of commodities, currencies and/or indices. Once opportunities are ascertained the Dorian Way’s trading method to take advantage of the possibilities are predominantly executed through advanced option strategies.
The advanced option strategies are based on probabilities comparable to how insurance companies write car insurance policies. When writing car insurance policies, insurance companies consider probabilities of policy contracts expiring worthless based on things such as age, driving record, previous coverage, and geography. Insurance companies make money if a policy can expire without a claim being made that is more than the original premium received. Likewise, when writing option contracts, the Dorian Way considers probabilities of expiring worthless based on things such as, option-delta, implied volatility, standard deviations, and duration of the option. Money is made if contracts can expire without a claim or bought back for less than the premium received. The Dorian Way is about executing trading ideas through option selling because options are believed to provide the best opportunity to make money irrespective of market direction. To minimize risk the Dorian Way consist of always hedging on an instrument and/or portfolio level. The breakdown of The Dorian Way process is as follows:
- We use proprietary quantitative and qualitative trade evaluators to determine which global markets to invest in. We primarily invest in global U.S. dollar denominated products that consist of equity indices, commodities, currencies, bonds, and volatility instruments. All products qualify as 1256 contracts.
- Once a product is decided on through our research we mostly determine how best to take a long and/or short position using advanced option selling strategies. Most positions are placed based on being around two standard deviations from the current underlying trading price, which is determined by its present implied volatility. See the image below based on standard deviations.
- An option position is initiated with 30 to 60-days to expiration (primarily).
- Depending on the trading situation we close out positions when we can buy back the option at 25%, 50%, and 75% less than the premium we received for selling the option. We also hold some of our positions(less than 1%) to expiration for full premium.
- We use futures contracts and we buy options to hedge positions and/or the portfolio. In addition, we spread our capital across instruments placing lots of small trades and we always keep a percentage of the portfolio in cash at all times.
The bell curve below shows how we primarily trade around two deviations from the current trading price. For example, if the index is trading at zero on the bell curve then we would normally sell put-spreads to go long the market at -2 on the bell curve and/or sell call-spreads to short the market at +2 on the bell curve.