High Expectancy Trading

Friday I sold Put options in IWM with May-expiration.

I chose the 58 stike based on several parameters:
> The probability of the 58 strike being in the money at expiration on 5/17 was 5.45% (according to the Black-Scholes model) when I entered the trade.  IWM was trading at 68.52 when I entered.
> The return on capital (ROC) was 35% annualized.  This is good.  This says the volatility is still present in the IWM and in the Put options.  FUD still exists to drive considerable demand for Puts as protection for long stock portfolios.
> Expectancy was $.41 per dollar of premium collected.   Of course, I expect to collect all planned premium since my probability of success is 94.65%.

The margin requirement for each short Put contract at 58 is $918.   Brokers will only allow you to cover this with actual capital in your account.  They will not lend you money to cover this amount.

This tells you a bit about my entry criteria in my system.  I only enter a trade if the probability of success is 94% or greater.  I only enter if the ROC is 25% annualized or greater.  I only enter if the Expectancy is 25% (or $.25 per dollar of premium collected) or greater.

I will not share the number of contracts I am trading but I am giving you enough information to apply this to your account size.  Please let me know if you have any questions.

Now, hopefully we have a boring month and we cash in for the full planned premium by buying these Puts back at $.04 sometime in April!

I closed my IWM April 57-strike options.  I bought them back at 4 cents today to collect all of the planned premium.

I opened the position on 3/14/08 when I sold the April 57 options at 41 cents.  I closed the position by buying those options back at 4 cents today, 3/27/08.  This is a gain of $37 per contract. 

The average margin required over this time period for one contract is $859.  I use 75% of my total capital for margin.  DO NOT use all of your capital for margin because your broker will raise the margin requirement on a daily basis if the position moves against you.  You need some buffer to allow the market to move against you without a margin call.  A margin call is costly, it will force you to close part of your position while the position is losing $$$.  

To determine how many contracts you could have sold on 3/14/08 just divide the amount you want to use as margin (again, I use 75% of my capital) by $859.  Multiply the result by $37 and you have your profit.  You would have made this profit in 13 calendar days! (the difference between 3/14/08 and 3/27/08).

Now hold on to your hats.  the gain in these 13 days was 3.9% return on capital. (ROC - % return compared to the amount of margin required) The annualized ROC on this trade is a whopping 110%!  That’s just out of hand.  This means that if you made this bet with these same parameters every 13 days for an entire year, you would gain 110% of your required margin. 

This was an exceptional trade.  The value of IWM on 3/14/08 when I opened the position was 66.43.  The value of the IWM today when I closed the position was 70.05.  So, IWM moved up about 3.5 points during this period.  This really helped the position.  If IWM would have dropped over this period then I would not have closed the positon today.  The 57 Put would be trading for much more than 4 cents today.  So, this is an exceptional result.  The market helped me out and I’ll take it! 

Now, I’m researching which Puts in May to sell.  Stay tuned!

> IWM closed at 69.58, down .64 today.
> My short Puts at 57 (strike price) closed at 7 cents, no change today despite the drop in the IWM.
> I am a little more than 12 strikes out of the money.
> I now have a 99.05% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 31.76%.  I adjusted this calculation to assume a closure date, short of the expiration.  The calculation now assumes I close this position at 4 cents on Monday 3/31/08.
> My expectancy is still 20 cents profit for every 1 dollar of premium collected. 

Today is a good example of how time works in favor of this system.  IWM moved against us and the position did not lose any value.  I will be trading out of this very soon and ready to open a new position in May options.

Well, another day went by, which brings me one day closer to expiration for my short IWM puts at 57.  Each day that goes by erodes the value of these way out-of-the-money options. 

> IWM closed at 70.22, up .11 today.
> My short Puts at 57 (strike price) closed at 7 cents, down 1 cent today. ($1 per contract)
> I am still a little more than 13 strikes out of the money.
> I now have a 98.67% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 9.06%. 
> My expectancy is now 20 cents profit for every 1 dollar of premium collected.  This means that if we made this same bet many times, we should expect a profit of 20% of the remaining premium. 

We are getting near the end, assuming the IWM does not make a big move down.  (if it does, that’s OK, as long as it does not drop 13 points!)  It is typical for the expectancy and ROC to drop right a the end because we collected most of the premium in the position already.  When the option trades down to 4 cents the ROC and expectancy are both near 0.  I close the position at that point, 4 cents, and use all the margin to start over with a new position next month.  Hopefully I will close this position at 4 cents this week.  If I don’t, then I will wait it out and there is a good probability I will close it next week. 

This is where I could deviate from my system and go ahead and close the positon now at 7 cents, thinking I could put all that margin to work on a May positon with better ROC, but my analysis says the optimum close point is 4 cents over the long run.  So, I wait it out.  I do not want to start deviating from the system.  That might become a trend and make me think I should make other changes that may hurt my expectancy. 

The early gains I mentioned held through the end of the day.

> IWM closed at 70.11, up a whopping 2.63 today.
> My short Puts at 57 (strike price) closed at 8 cents, down 12 cents today. ($12 per contract)
> I am now a little more than 13 strikes out of the money.
> I now have a 98.45% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 10.57%.  This dropped considerably because the position gained so much today.
> My expectancy is now 22 cents profit for every 1 dollar of premium collected.  This means that if we made this same bet many times, we should expect a profit of 22% of the remaining premium. 

Expectancy for this position dropped today for the same reason the ROC dropped.  We gained a huge chunk of premium today.  As the option price nears 0, the commissions (that you must factor in) take a more significant chunk of the profit.  When I close this trade for the full profit I’ll write a post and describe my exit strategy.  The bottom line is that I exit before expiration, at a value where the ROC and expectancy are near $0.   This frees margin to open another position in the next month.  I can’t afford to wait two weeks to expiration just to gain the last 3-4 points of the dying position.  I need to use that margin to start over with the next month.  ROC and expectancy indicate when it’s time to cash in and start over the next month.  We are nearing that point for the April options.

Wow, the IWM is up 2.35 as of 10:20 AM Central time today.  My short April 57 puts are trading at 7 cents right now!  They closed at 20 cents Thursday, so they are down 13 cents.  That is a $13 gain per contract.  We’ll see what the market does for the rest of the day…but again, I really don’t care, as long as it does not set a trajectory to drop 12 points (strikes) before 4/19/08.  …unlikely.

Hopefully I will get to write a post about exits this week!

Probabilities are fundamental to my system because they are a major element of the expectancy calculation.

Recall the expectancy calculation:  Expectancy = (The probability you will win * the amount you will win) - ( The probability you will lose * the amount you will lose)

My system allows for the sale of both calls and puts in the most volatile index Exchance Traded Funds (ETFs).  The stock market action since January 1, 2008 has created a huge demand for index ETF puts as “insurance” against long stock portfolios.  This demand has driven the price of these puts to historically high levels.  So, I am selling these puts.  Success for my system is to collect all the premium planned for the puts I sell.  To achieve this, the underlying instrument (the actual ETF) must not close below the stike price of the puts I sell on the option expiration day.

So, we need to estimate the probability that the underlying instrument will be below our strike price at the expiration.

For those of you wanting a quick and easy way, with mediocre accuracy, you can just use the option Delta.  Delta is one of the option greeks.  It is a value which is typically used as the expected rate of change in the price of the option relative to the price change of the underlying instrument.   (if you are new to options you can pick up a book on option basics or research the greeks on wikipedia.org) But, many consider the Delta calculation as an approximation of the probability of the underlying reaching the associated stike at expiration.  I do not use delta, because I find it is frequently 1-5% different than my calculation.  But, you can obtain delta easily, so that makes it attractive and it may be “good enough” for some traders.  All trading websites that support options and most free option informationsl websites offer the greek calculations for free.  I trade with Fidelity and they give me the greek values in real-time for free.

Right now, the delta of my (short) April IWM calls at 57 is .06.  You could translate this directly into a 6% probability that the IWM will reach 57 by 4/19/08.  My probability calculation (described below) shows a 3.15% probability that  IWM will reach 57 by 4/19/08.

For those wanting the most accurate estimate, you can find the formula I use for this calculation in Lawrence G. McMillan’s book “Options as a Strategic Investment”.  Be sure to use at least the 3rd edition.  McMillan explains the method and the model.  He also describes how the probability calculation is different than Delta.  He lays out the details for the calculation which you could plug into a program or spreadsheet if you have the time.  I found it tedious, and I have a minor in mathematics.  I worked out the math in my spreadsheet and I use that spreadsheet to this day for trade decisions.  This spreadsheet covers probabilities but also expectancy and return on capital calculations. 

I’ll say it this way, “I don’t bet on where the market will go, just where it won’t go”.  Read this, then read it again.  I admit, it is hard to believe.  I’m selling way out-of-the-money Puts.  I profit for the month if the market goes up, stays flat, or drops less than 15%.  Yes, the market can drop up to 15% and I will still collect all the premium for the options I sell!  It gets even better.  The market has to drop that 15% by 4/19/08, the expiration day.  Get this, the drop in the IWM from 1/1/08 to today, 3/20/08, is about 12%.  …and most people think we were/are in a recession!  Again, I’m betting based on probability, not prediction.  The probability that the market will drop 15% by 4/19/08 is only 3.15%.  Wow.

This was a great day, the IWM closed at 67.48, up 1.18.
> My 57 short Puts closed at 20 cents, down 16 cents today. (…a gain of 44% of the monthly premium, just today.)
> I am now a little more than 10 strikes out of the money.
> I now have a 96.85% chance of collecting all the premium. (according to the model)
> The annualized return on capital is now 29%.
> My expectancy is now 45 cents profit for every 1 dollar of premium collected.  (again, this means that if we made this same bet many times, we should expect a profit of 45% of the premium collected.  Anything above 0 is good, above 25 is great)

Have a happy holiday everyone.  I may not post until Monday…but I can’t take my mind off of these odds!

I certainly gave back some gains but the drop in the market today doesn’t worry me a bit.  I want volatility in the market.  This keeps fear, uncertainty and doubt (FUD) in trader’s minds.  This causes a high demand for the out-of-the-money Puts as insurance against long positions.  Again, my strategy is to sell these over-valued Puts to those willing to buy insurance.  The upshot here is that market volatility  keeps the expectancy of my positons positive (in this market, very positive) because it drives the prices of these Puts unsually high.  We want volatility to be high when we sell options next month, the May expirations.  We have to just accept days like today and stay positive.  Volatility is good.

Other than volatility, there is another reason to be happy today.  Just the fact that another day passed by is reason to celebrate.  That sounds crazy but remember, we sold Puts at 57 (strike price) with an April 19th expiration.  If IWM closes above 57 on April 19 (a little more than 9 strikes away!) then we get to keep all the premium we collected when we sold those contracts.  Today is one day closer to 4/19!  Options slowly lose value as every day passes.  This is called time decay.  On days like today I like to say “time is on my side”.  Time decay erodes option values at an increasing rate as expiration nears.  There will even be days, near expiration, when the market moves against my positons where the option values do not increase!  Time is on my side.

OK, IWM closed at 66.30, down 1.70 today.
> My 57 short Put closed at .36 cents, up 14 cents today.
> It is now ~9 strikes out of the money.
> I now have a 94.48% chance of collecting all the premium. (according to the model)
> The annualized return on capital is now 47%. (WOW, this volatility is putting $ in our pocket!)
> My expectancy is now 46 cents profit for every 1 dollar of premium collected.  (again, this means that if we made this same bet many times, we should expect a profit of 46% of the premium collected)

Well, I prefer to bet based on the probabilities rather than prediction.  So, what will the market do tomorrow?  Well, I really don’t care, as long as it does not cause the IWM to drop dramatically.  Even if it does drop, we are another day closer to 4/19!  What I can predict is that with the volatility in this market, tomorrow will be interesting.

This was fun.

My position (short April Put contracts in IWM at 57) gained 62% to close at 22 cents today on this big rally.  Woo Hoo!

> The IWM closed at 68.00, up 2.99 today.
> My 57 Put is now 11 strikes out of the money.
> I now have a 97.59% chance of collecting all the premium. (according to the model)
> The annualized return on capital dropped to 27% because of all the return I collected today.
> Yes, my expectancy in the position is still positive: I expect to profit by 62% of premium collected in the long term.