High Expectancy Trading

I could not post yesterday…was traveling.

I did open a new position yesterday by selling May 60 strike IWM Puts.

It proved to be well timed.  The market shook off the downside pressure of late and rallied today.

I sold those 60 strike Puts on Tuesday for .29 and they closed today for .09!  That’s $20 gain per contract in one day!

For those playing along at home, just divide your risk capital by the amount of margin your broker will hold aside for one contract and that is how many contracts you could have sold yesterday.  Multiply that number of contracts by 20 and that is the amount of $$$ you would have made today!  This was a good day.

The amout of margin required for 1 contract is $909.00.

> IWM closed at 71.20, up 2.46 since Monday’s close.
> My short Puts in May at 58 (strike price) closed at .05, down .1 since Monday.  I will close these at .04 very soon, maybe even tomorrow!
> My short Puts in May at 60 closed at .09, down .2 since Monday.
> I now have a 99.12% probability of collecting all the premium for this month from the 58 strike Puts and a 97.63% probability for the .60 strike Puts.

If I close my 58 strike puts this week at .04 then I need to consider selling more Puts (probably in June expiration at this point) with the margin $ freed up.

Tomorrow I will sell more Puts in IWM.  I am leaning toward the 60 strike Puts in May.  They are still demanding quite the premium.  They closed at .28 today, with a 40.23% annualized return on capital (ROC) with the assumption that I can close them at .04 at full profit by 5/7.  The expiration is 5/17.  The probability of full profit is 93.3%.  The expectancy is positive at .23 per dollar of premium collected. 

My 58 strike puts are still open and gained 1 cent ($1 per contract) today to close at 14 cents.

IWM sure dropped Friday, as did most index ETFs.  Even with this big drop I am still a 96.94% favorite to capture all of the planned premium in May options. This could be an indicator of the over-due pullback this week.  We’ll see.  I really do not care what IWM does, as long as it does not set a trajectory to close below 58 by 5/17.  

Stay tuned…I will likely open a new position early this week.  As I mentioned in a previous post, I break my risk capital into segments to average IWM prices to reduce risk overall.  I would like IWM to come down more before openning this new position but I will likely open by the close of Tuesday regardless.  I need to keep my risk capital in play considering the high volatility and over-priced puts right now. 

> IWM closed at 68.74, down 1.85 Friday.
> My short Puts in May at 58 (strike price) closed at 15 cents, up 6 cents. 
> The current margin required for this position is $885 per contract.  Divide your risk amount (I use 75% of my account) by 885 and that is how many contracts you can sell.
> I am just under 11 strikes out of the money now.
> I now have a 96.94% probability of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 26.69%.  The calculation now assumes I close this position at 4 cents on 5/1/08.  
> My expectancy is 30 cents profit for every 1 dollar of premium collected. 

Time is ticking away.  With IWM trading sideways I am collecting premium at a nice rate.  At this rate I will close this May trade before 5/1/08.  Analysts say we have a short-term top forming but it is developing slowly.  That’s fine…I’m collecting $$$ every day because of the rapid time decay now.

> IWM closed at 70.59, up .82 today.
> My short Puts in May at 58 (strike price) closed at 9 cents. 
> The current margin required for this position is $879 per contract.  Divide your risk amount (I use 75% of my account) by 879 and that is how many contracts you can sell.
> I am just over 12 strikes out of the money now.
> I now have a 98.09% probability of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 14.83%.  The calculation now assumes I close this position at 4 cents on 4/25/08.   I changed this date today because the time value for these options is depleting quicker than I anticipated.  For this position this is a good thing.  There simply isn’t much value left in the position.  I will close this at .04 very soon.
> My expectancy is 43 cents profit for every 1 dollar of premium collected. 

IWM pulled back today…as did just about everything else.  Apparently the was the break many traders were waiting for.  Volume is back up.  Volume break-outs like this are usually followed by a continuation day or two so we should see downward pressure through the end of the week.  I’ll be ready to sell my next round of Puts in IWM on this pull back.

My short May IWM Puts at 58 traded at .12 on Monday.  IWM dropped 1.39 since Monday and today the Puts closed at .13.  This is an excellent example of how time factors into option prices.  Time is running out for these options that are now just under 12 strikes out of the money.  A decent move against the position only caused a 1 cent change!  I’ll be closing these for full profit soon, even if IWM drops more.  Again, I make $$$ in this system if IWM moves up, moves sideways or moves down.  I only lose $$$ if IWM drops $12 or more by expiration.   That is a 17% move by 5/17.  That is very improbable, as a matter of fact, I can use the Black/Scholes model to calculate that the probability of IWM reaching my strike price of 58 by 5/17 is only 2.73%.  I like my odds.

> IWM closed at 69.77, down 1.19 today.
> My short Puts in May at 58 (strike price) closed at 13 cents. 
> The current margin required for this position is $883 per contract.  Divide your risk amount (I use 75% of my account) by 883 and that is how many contracts you can sell.
> I am just under 12 strikes out of the money now.
> I now have a 97.27% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 17.72%.  The calculation now assumes I close this position at 4 cents on 5/1/08.   There simply isn’t much value left in the position.  I will close this at .04 very soon.
> My expectancy is still 48 cents profit for every 1 dollar of premium collected. 

Take a look at the daily volume in your favorite index ETF.  (IWM, QQQQ, SPY for example) 

Volume was not this low since Christmas Eve!   Everyone is sitting on the side waiting for something to happen.  There are reasonable arguments now for both bulls and bears.  It feels to me like the market will pull back some.  This recent rally sure has stalled.  I don’t really care which direction the market goes, as long as it brings the volume back.  Volume will kick the volatility up.  Volatility increases Put values.  While that will hurt my current positions in the short term, it will allow me to collect more premium in my next round of sales.  I am not too worried about any short term drop.  My 58 strike Puts in May are 13 strikes out of the money.

> IWM closed at 70.96, down .20 today.
> My short Puts in May at 58 (strike price) closed at 12 cents. 
> The current margin required for this position is $883 per contract.  Divide your risk amount (I use 75% of my account) by 883 and that is how many contracts you can sell.
> I am about 13 strikes out of the money now.
> I now have a 97.95% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 14.39%.  The calculation now assumes I close this position at 4 cents on 5/1/08.  ROC is dropping because we collected most of the premium in the position already due to IWM moving up and implied volatility dropping.  There simply isn’t much value left in the position. 
> My expectancy is still 48 cents profit for every 1 dollar of premium collected. 

I try to break my risk capital down in segments that allow me to sell options every week or so.  In simple terms, I take my risk capital (75% of total capital), divide it by 4 and sell options each week that consume 1/4 of my risk capital.  This works well because the life-span of my positions is about 1 month.  It never works out exactly this way because, for example, IWM was stubborn in January and did not allow options to get to my close point in 1 month’s time so I do have weeks where I do not trade.  This gives you a basic idea of what I am doing.  This approach does require four round-trip commissions per month instead of one.  But, it averages the underlying instrument (IWM) moves so I never have all my capital tied up in a single trade that went horribly against me right away.  I am willing to pay more in commission for this IWM price averaging.

For this blog I chose to track only one trade per month.  I will probably keep it that way for a while, unless I get comments strongly in favor of seeing absolutely all trades.  

I believe it is important to keep all risk capital in play but not to let all of my risk capital ride on one trade.  Looking at actual results, the price movement in the IWM plays a considerable part in profitability when compared to volatility movement and time decay.  So, by trading 1/4 of my risk capital each week, and with position life-spans being about 1 month, I can average the IWM price movements in segments of about 5 trading days. (trading once per week)

So, to recap, I have two rules about trading capital:

1) Keep a capital buffer asside for periods where the IWM moves against me.  When IWM drops, the value of Puts grow exponentially.  Margin requirements increase as this value grows and as the IWM gets closer to my strike price.  I need a buffer for increased margin requirements.  Without this buffer I would surely get a margin call in most months.  This is bad because it would force me to close part of a position while it was down.  I could only re-enter when the position recovered.  My buffer is 25%.  So, Risk Capital is 25% of Total Capital.

2) Average the underlying instrument’s (IWM right now) price movements into my trading by breaking my risk capital down into sements that can be traded in even periods within the average life-span of one posiiton.  This allows all risk capital to be in play at any given time but also reduces the risk that the market moves against me immediately after putting on a position that might use all of my risk capital.

> IWM closed at 71.16, down .21 Friday.
> My short Puts in May at 58 (strike price) closed at 13 cents.  I gained $3 per contract.
> For those playing along at home, the current margin required for this position is $883 per contract.  Divide your risk amount (I use 75% of my account) by 883 and that is how many contracts you can sell.
> I am more than 12 strikes out of the money now.
> I now have a 98.29% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 13.29%.  The calculation now assumes I close this position at 4 cents on 5/1/08.  At this rate we will close much sooner than that.  ROC is dropping because we collected most of the premium in the position already due to IWM moving up and implied volatility dropping.  There simply isn’t much value left in the position. 
> My expectancy is still 48 cents profit for every 1 dollar of premium collected. 

I am not sure this rally is for real.  We will find out soon.  If IWM can convincingly move above 73 then we can probably say we are on the front end of a bull market.  If we see a retreat then we are due for more volatility and sideways trading.  For this system I would actually prefer the latter.  I need volatility to keep option premiums high for selling next month.

I collected more premium with the small up move today.

> IWM closed at 71.37, up  .41 today.
> My short Puts in May at 58 (strike price) closed at 16 cents.  I gained $3 per contract. 
> For those playing along at home, the current margin required for this position is $886 per contract.  Divide your risk amount (I use 75% of my account) by 886 and that is how many contracts you can sell.
> I am more than 12 strikes out of the money now.
> I now have a 97.65% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 17.66%.  The calculation now assumes I close this position at 4 cents on 5/1/08.  At this rate we will close much sooner than that.
> My expectancy is still 46 cents profit for every 1 dollar of premium collected. 

Time decay is working on these options.  IWM was up only 17 cents, yet the options I am short lost 10% of their value.  Time is on my side.

The other reason I gained 2 cents today on such a small move in IWM is because implied volatility (IV) is dropping.  IV is the measure of the volatility implied in the price of the options.  In other words, IV measures how over-valued the options are.  IV is dropping now because there is slightly less demand for these options now that the market moved up.  High volatility is great at the point of selling the options and collapsing volatility while in the position is even better.  If it keeps dropping I will reach my close point of 4 cents in just a couple of weeks.

Here is a good description of implied volatility:  http://en.wikipedia.org/wiki/Implied_volatility

Now, I don’t predict where the market is going in the future and I really don’t care as long as it doesn’t drop 10 strikes.  But, I’ve done my share of technical analysis and it seems this market is a bit over bought.  If it pushes higher, IWM convincingly over 73, then we can probably say we are at the beginning of a bull run.  More likely is a pull back right about now.  Either way, I’ll close this position in 2-4 weeks for the full planned premium.

> IWM closed at 70.96, up  .17 today.
> My short Puts in May at 58 (strike price) closed at 19 cents.
> I am more than 12 strikes out of the money now.
> I now have a 97.3% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 22%.  The calculation now assumes I close this position at 4 cents on 5/1/08.
> My expectancy is still 41 cents profit for every 1 dollar of premium collected. 

Today I gained about 1/2 of the premium remaining in the position I just opened on Friday! 

The current environment is perfect for this system.  The volatility and FUD factor is high because of the market drop since Jan 1.  The volatility causes traders (long in the market) to buy more insurance (Puts) to protect their positions.  I am selling that insurance.  Now, because of the Fed actions in lowering interest rates, the market is actually starting to recover to the upside.  Big moves like this really tear into the premiums of these over-priced Puts.

> IWM closed at 70.79, up 2.34 today.
> My short Puts in May at 58 (strike price) closed at 21 cents today. That is a decline of 24 cents just today.  Wow.
> I am more than 12 strikes out of the money now.
> I now have a 97.01% chance of collecting all the premium for this month. (according to the model)
> The annualized return on capital (ROC) for this positon is now 24.01%.  I adjusted this calculation to assume a closure date, short of the expiration, based on my actual trades in the past.  The calculation now assumes I close this position at 4 cents on 5/1/08.
> My expectancy is still 47 cents profit for every 1 dollar of premium collected.