High Expectancy Trading

Well, the Fed helped me out.  They lowered rates again today by .25 a point down to 2%.  The market reacted negatively to this mid-day.  This signals that the Fed is not convinced the economy pull-back is over.  This may mean we have another quarter or two of volatile trading.  This is great!  Volatility keeps investors nervous about stocks.  Nervous investors buy insurance to protect themselves.  Most investors us Puts in ETFs as insurance.  Demand in Puts drives the prices for these Put up.  I’m selling these Puts!  I will open a new position late this week or early next week.  I expect some continuation of this drop over the next few days.  I want to let that play out before selling more.

OK, I did open a position yesterday, Monday.  I did this because I was behind a week.  I closed two weeks worth of trades in one week so I found myself needing to put my hard earned capital/margin to work for me.  Yesterday I sold 60-strike Puts in IWM with a 6/30/08 expiration.  I sold them for .32 with a 95.75% probability of collecting all the planned premium. (.32 - .04 = .28 profit = $28 per contract)  My expectancy is 45 cents per dollar of premium.  This is excellent.  A positive expectance means the odds vs. payoff is in our favor.  Anything greater than 0 is good.  …greater than .25 is great.

I love this system for the simple fact that I can actually calculate the expectancy per position.  Most trading systems must be traded for 200+ instances before you can estimate expectancy.  I can calculate it without a single trade.  This is because I have a model to estimate probability of success and a method for estimate how much I make if I win and how much I lose if I lose.

Friday I sold the IWM 59 Puts with a 6/30/08 expiration.  The symbol recognized by Fidelity.com is -IQXRG.  I sold these for .33 per contract.  IWM was trading at 71.10 when I sold these Friday.  IWM closed at 72.38 today.  These 59 Puts in June traded at .23 at the close of the market today.  That is a $10 gain per contract since Friday AM.  The margin required is $908 per contract.

The ROC at the time I sold these was 24.54% annualized.  The ROC today is 16.36%, a drop because I collected about 33% of this position’s gain already.  (in just one day!)

The expectancy at the time I sold these was $0.11 for every $1 of premium collected.  This seems low because the implied volatility of the options fell faster than the volatility of the IWM.  The volatility of IWM is used to estimate probability and probability is used when calculating expectancy.  This IWM volatility will come down soon considering it is starting to trade higher and will probably have fewer wild swings.  This situation is OK, it just means the premiums for these Put are coming down.  Fewer traders are buying insurance.   The next Puts I sell will likely be a strike or two closer to the money, which will increase ROC and the expectancy will probably still be around .10 to .20 per $1 of premium.  Please comment if you would like me to explain this further.

For a description of implied volatility, see the list of my favorite posts on the left.

I closed my short May 60 Puts yesterday by buying them back at .04.  That was many days earlier than I planned.  I closed out all May expiration positions for full gain.  It was a very good month.

I now have limit orders in to sell June 59-strike Puts in IWM. 

I will post more details when I have more time.

IWM closed at 70.55, up .05.  My short May 60 Puts traded at .05 at the closing bell today, down .02 since yesterday.  A decent move up tomorrow or Friday should allow me to close this position by buying these options back at .04.

I have not opened my new position yet.  I am looking for a dip tomorrow or Friday.

IWM dropped today to close at 70.50, down 1.18.  This was a decisive move against my short 60 Put position and against the breakout from Friday.  However, time decay is really taking it’s toll on these options and there is only about 3 weeks to expiration now.  So, this drop today did not have much affect on the price of my short 60 Puts.  They closed at .07.  This means they only increased by 2 cents.  These options are more then 10 strikes out of the money and with so little time remaining to expiration they simply are not going to trade much higher unless we see a huge move down.

There is only a 1.81% chance these options will be in the money at expiration.  I will probably close this position at .04 on the next decent move up.

I am looking for an opportunity to sell more Puts.  I am looking for a continuation of this drop today to open my next position.  

They are still trading around 5 cents.  I have a limit order in to close them at 4 cents.  That should happen today if we see a rally in IWM.  A rally today would be considered a continuation of the rally Friday and a good sign for the bulls.  A pull back today may mean we need a little more time before the impending rally and it would boost Put volatility and therefore boost Put premiums.  That’s what I need for my next sale.  I plan to sell more Puts this week.

I closed my IWM May 58-strike Put options.  I bought them back at 4 cents Friday to collect all of the planned premium.

I opened the position on 3/28/08 by selling the options for 44 cents.  I closed the position by buying those options back at 4 cents on 4/18/08.  This is a gain of $40 per contract. 

The average margin required over this time period for one contract is $875. 

Margin Warning: 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 3/28/08 just divide the amount you want to use as margin (again, I use 75% of my capital, and I call that 75% my Risk Capital) by $875.  Multiply the result by $40 (subtract commission) and you have your profit.  You would have made this profit in 21 calendar days! (the difference between 4/18/08 and 3/28/08).

The gain in those 21 days was 4.19% return on capital. (ROC - % return compared to the amount of margin required) The annualized ROC on this trade is a whopping 73%!  This means that if you made this bet with these same parameters every 21 days, for an entire year, you would gain 73% of your risk capital. 

This was an exceptional trade.  The value of IWM on 3/28/08 when I opened the position was 68.52.  The value of the IWM when I closed the position was 72.05.  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 this soon. 

Now I’m watching for an opportunity to sell more Puts!

This is an extraordinary day.  I closed the short May 58 Puts in IWM at .04 early this morning. Now, my short May 60 Puts are trading at .05!  I just sold these Tuesday for .29!  I have a limit order in to buy these back at .04.  That may even happen later today!

IWM was down .28 today.  My short May 58 Puts closed at .05 again today.  I have a limit order in to buy these Puts back to close the position at .04 for full profit.  I will probably close this position if IWM moves up tomorrow.  As soon as I close this position I will look to sell more Puts next week, likely with June expiration.

> IWM closed at 70.92, down .28 today.
> My short Puts in May at 60 (strike price) closed at 10 cents, up 1 cent. 
> This position is just under 11 strikes out of the money now.
> I now have a 97.56% probability of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 16.04%.  The calculation now assumes I close this position at 4 cents on 5/3/08.