High Expectancy Trading

I laugh now as I read my last post.  At this point that seems like a year ago.

Sept was very ugly.  After such possibilities, I ended the month down 8%.  I had to defend and close nearly every Put position.  That’s ok.  It’s best to face the brutal facts.  This volatility is crazy.  I have no business selling options in this environment.  Probabilities mean nothing during times of insanity.

To take advantage of this volatility I’ve switched to buying straddles.  We see the market down 777 one day, up nearly 500 the next.  Now, on a daily basis I am opening straddles.  A straddle is a purchase of a call and a put at the same strike price. I trade these right at the money. I open a new position just before the close of the day, hoping for a gap open with follow-thru the next day.  This was profitable each day for the last week.  I close the straddle (usually for a profit) just before the close of the day.  I then open another straddle, again, right at the money.  That way, I make a profit if the market moves up or down the next day.  I just want it to move radically.  This is pretty much the opposite of the credit spread strategy.

When this period of massive volatility ends I’ll get back to trading credit spreads.

So far, all trades are behaving just as planned in September.  I have not defended any trades this month.  I am up 2.36% so far and it’s looking to be at least a 5% month if all goes well. 

Here’s a synopsis of my open credit spreads.  You could say I have Iron Condors where I have credit spreads on both the call and put side of the same instruments.  Again, Iron Condors are great because my broker (thinkorswim) only holds margin for the side most at risk.  I do not hold Iron Condors in most instruments because the I can not find positive expectancy trades on the opposite side of my current position.  When measuring expectancy I must consider the combined risk of both (put and call) positions.  If the expectancy is positive for a trade on one side but negative for a trade on both sides, I only open a trade on the one side.  Here’s the list of my currently open positions:

• Short AAPL Sept200 and Sept210 Calls, Long Sept220 Calls (trying to enter credit spread on Put side Monday)
• Short IWM Sept60 and Sept66 Puts, Long Sept57 and Sept63 Puts
• Short USO Sept120 and Sept125 Calls, Long Sept126 and Sept130 Calls
• Short USO Sept80 Puts, Long Sept76 Puts
• Short POT Sept270 Calls, Long Sept280 Calls
• Short POT Sept130 and Sept140 Puts, Long Sept125 and Sept130 Puts
• Short GM Sept7.5 Puts, Long Sept5 Puts
• Short SHLD Sept65 Puts, Long Sept60 Puts

OK, this takes my system gain to 10.35% since 1/29/08 (Mar expiration options), when I started trading this system consistently.  Considering the volatility this summer, I’ll take these results.  This is an 18.08% annualized gain.  Very few others will make that this year…just my hunch.

I have data going back 2+ years but I began strict system trading selling options with the March 08 expiration, so I will start tracking monthly results on this blog in March.

Expiration Month      Result
Mar 08                +3.55% (naked Puts in IWM only)
Apr 08                +2.93% (naked Puts in IWM only)
May 08                +3.05% (naked Puts in IWM only)
Jun 08                +4.08% (began credit spreads in IWM only)
Jul 08                -3.77% (began credit spreads and Iron Condors in IWM, USO, POT, AAPL and RIMM)

Total as of 8/3       +9.85% (19.12% annualized)

Aug 08 (as of 8/3)    +0.63% (month started late because of late closing positions in July)
Sept 08 (as of 8/3)   +0.73% (just opened positions in this month this past week)

July was a trendy month.  Stock ETFs all tumbled and oil rocketed. 

The IWM peak to trough move was 76.22 on 6/5 down to 64.52 on 7/15.   I tend to open positions for the next expiration month around the first of the prior month.  I get the best combination of ROC and exectancy here.   So, this move happened after I opened my July expiration trades.  This was a move of 11.20 or 15.35%.  The Puts I sell in IWM are between 12% and 15% out of the money.  I take first defensive action when the short option’s probability of being in the money reaches 15%.  I take the second defensive action at 25% probability.  (these probabilities are calculated using historical volatility averages…not implied volatility)  So, a move of 15% would result in me reaching both the first and second defensive points. 

See my previous post about defense to understand what I do at the first and second lines of defense.

The USO move during the tenure of my July positions was 98.62 to 119.17.  This is 20.55 or a 20.83% move!  But oil is much more volatile than IWM.  In July I sold Puts and Calls in USO between 13% and 15% out of the money.  Of course, a 20% move in a month would cause me to hit the second line of defense and close the positions.

This is a wild month.  You will notice from my past posts that at this point in the month I am usually closed out and moved on to the next month.  We had major moves in equities and oil in the past month so volatility is high, keeping option prices up.  This is not all bad because this system thrives on volatility.  The downside is I still have considerable capital tied up in trades for July that I need to free for August.  I will likely close the July trades Monday or Tuesday.  I do not like holding positions the last week before expiration. 

So far for the month I am down 4.65%.   After I close all open July positions I predict Iwill be down 3.5% for the month.

This is not too bad considering I had to defend 3 positions.  In all 3 I implemented a first line and second line of defense.  At the second line I closed each credit spread for a loss and opened other positions with the resulting capital.

So far this year I have gained between 3% and 4.5% each month until July.  Early in the year I was trading naked Puts without the extra gain potential I now get with credit spreads.  So, I expect future positive months to average at least 4%.  I can likely keep the impact in July to under a 4% loss.  Who knows how many negative months I’ll see in a year but let’s say this happens twice a year.   That means I can expect to gain 4% for 10 months and lose 4% for 2 months.  That a total yearly gain of 32%.  not too shabby.  I think I can improve this with some technical analysis tweaks.  I’ll post on this soon.

I’ll post again with an overview of my July positions once I close the month.

It is a rough month so far.  I had to defend 3 different trades.  This will likely occur 1-2 times a year.  The key is to stick to the plan I explained in the previous post.

At times in this system (of selling credit spreads and Iron Condors) trades will go against you.  You must have a plan for dealing with this situation before you find yourself in it.  Without a plan you will no doubt fall victim to hoping the trade does not go further against you.  …hoping it turns around.  This is very dangerous.  Losses can pile up and exceed many months worth of gains.  I have two positions going against me right now, an IWM Put credit spread and the call side of the USO Iron Condor.

With options we have tremendous flexibility when a trade goes against us.  Options allow us to defend a trade rather than just stop out of it.  In a typical trading system you use a hard stop to set the maximum loss point.  This is great for instilling discipline and cutting losses short.  It is not so great on the pocketbook when several trades go against you in succession.

When the market moves in the direction of the credit spread, or to one side of the Iron Condor, the most important thing to observe are the probabilities of the strikes.  Calculate (or use your broker’s software to get) the probability of the strikes in the position being in the money at expiration.  If you recall, I open the short side of the credit spread at around 6% probability of being in the money at expiration.  My trigger point for first action is when the short options reach 15% probability.  I say “first action” because there may be many steps to defend the position.  Never forget the goal, which is to exit the month with as much profit (or as little a loss) as possible.  It will take a considerable move to force us to lose money. 

At the first action point I usually close 1/2 of the credit spread or Iron Condor.  This frees 1/2 the margin held in the position.  I take the freed margin and double it, by dipping into my buffer margin, to open another position.  It is OK to dip into the buffer because this is precicely it’s purpose, to help in times of trouble.

When opening another position I generally look at 3 options:

1) Roll to strikes further out in the same month (I usually favor this one)
Open a credit spread or Iron Condor at the 6% probability level for the short strike(s).  This strategy will likely not capture the same amount of premium that was purchased to close 1/2 of the troubled position.  But, it keeps the margin in the current month for maximum time decay and lessens the impact in the current month.

2) Roll out to strikes in the next month
Same as #1 above but pick the next expiration month.  This strategy will like capture the same or more premium than was purchased to close 1/2 of the troubled position.  But, it essentially gives up on the current month in favor of a strong position in the next month.  Mentally, this is tough because a major objective is to maximize each month’s gains when trading this system.  This move will accept the loss for 1/2 of the position this month with no chance of recouperating it this month with the margin that was freed.

3) Roll to a position in a different instrument in the same month or next month
This is particularly attractive when the underlying instrument in the troubled position moves drastically due to an event like a supply report or earnings report.  This system thrives on volatility but it is sometimes wise to just move away from an ETF or stock when it gets crazy.  Usually you see it is time when options 1 and 2 above do not capture much premium.  This happens when the volatility spikes very high and it is necessary to trade way out of the money to be in the 6% probability range.

By acting at the first point of defense you lessen the risk in the original position without completely giving it up.  If the underlying instrument persists to move against the position there is a second and final line of defense.  I completely close the position at the 25% probability mark.  At this point I follow the same path as I did at the first line of defense.  I take the recaptured margin, double it, and open another position.  Again, I use one of the three strategies I lised above.

If you have to defend multiple positions in a given month it may result in a loss for that month.  This is OK.  You can’t win ‘em all. 

I believe that if I never have to defend a position all year then I am not being aggressive enough in my trading.  I am leaving $ on the table.  With a very diverse portfolio of spreads and Iron Condors it may be that some defense is required each month or so.  This may be just fine.

The key is to have a plan for defense and stick to it.  Do not just close the spread at a stop point and accept the loss.

     Short Jul91 Puts, Long Jul87 Puts, entered for .35 credit, now trading at .18 for a .17 gain
     Short Jul133 Calls, Long Jul137 Calls, entered for .23 credit, now trading at .08 for a .15 gain

IWM Put Credit Spread
     Short Jul68 Puts, Long Jul65 Puts, entered for .23 credit, now trading for .47 for a .24 loss

AAPL Iron Condor
     Short Jul145 Puts, Long Jul135 Puts, entered for .82 credit, now trading for .19 for a .63 gain
     Short Jul210 Calls, Long Jul220 Calls, entered for .41 credit, now trading for .24 for a .17 gain

POT Iron Condor
     Short Jul180 Puts, Long Jul170 Puts, entered for .33 credit, now trading for .50 for a .17 loss
     Short Jul280 Calls, Long Jul290 Calls, entered for .58 credit, now trading for .20 for a .38 gain

So far, I am -1.58% for the month (July expiration trades) because USO threatened the Call side of one of my Iron Condors and IWM threatened my IWM Put Credit Spread.  I had to take defensive action in both cases.  In a later post I will cover how I defend a trade when it goes against me.