High Expectancy Trading

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.

USO Iron Condors
     Short Jul85 Puts, Long Jul81 Puts, entered for .35 credit, now trading at .10 for a .25 gain
     Short Jul118 Calls, Long Jul122 Calls, entered for .25 credit, now trading at .65 for a .40 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. 

I am distributing my risk capital to several instruments.  Today I opened an Iron Condor in POT:

Short Jul180 Put, Long Jul170 Put
Short Jul280 Call, Long Jul290 Call

I opened the positon with a net credit of .90.  The margin required is the difference between the strikes multiplied by the contract size (10 X 100 shares = $1000) multiplied by the number of contracts you want to trade.  I expect to close the short options when they reach .05 so that nets out a profit of.80, or $80 for every $1000 in margin.  I expect to close this trade in the first or second week of july.  That’s an 8% gain in just 2-3 weeks! 

The probability of my short Jul280 Calls being in the money at expiration is only 4.71% at the market close today.  This increased as the stock gained value today.  The probability of the short Jul180 Puts being in the money at expiration is only .39%.

This is a great trade if the stock behaves itself.  POT is very volatile and capable of moving fast.   That is why the option premiums are so high.  I do not recommend trading this stock with a large percentage of your account.

My trading is very active.  Refer to my post on 6/13 for a description of the Iron Condor trade.   Here is a summary of my current positions:

USO Iron Condors
     Short (sold) 85-strike Puts, Long (bought) 81-strike Puts, entered on 5/30/08
     Short 118 Calls, Long 122 Calls, entered on 6/5/08

     Short 91 Puts, Long 87 Puts, entered on 6/12/08
     Short 133 Calls, Long 137 Calls, entered on 6/16/08

IWM Put Credit Spread
     Short 68 Puts, Long 65 Puts, entered on 6/6/08

AAPL Iron Condor
     Short 145 Puts, Long 135 Puts, entered on 6/16/08
     Short 210 Calls, Long 220 Calls, entered on 6/16/08

Yes, I am trading in Apple (AAPL).  I decided to take advantage of the tremendous volatility in the options for a couple individual stocks.  I am only using 10% of my risk capital for any individual stock trade.

I am also looking at RIMM.  The returns on AAPL and RIMM Iron Condors is pushing 170% annualized ROC.  This is amazing, but of course, these stocks are very volatile.  I try not to carry a trade in these stocks when they release earnings.  AAPL earnings are in late July.  RIMM releases their numbers this coming week.  I may look to open an Iron Condor in those RIMM options after they release.

My AAPL Iron Condor (and one of my USO Iron Condors) is held in my Think or Swim account.    I highly recommend these guys.  They are all traders themselves so they are very knowledgeable and they are actually helpful.  They only hold margin for one side of the Iron Condor.  This dramatically improves the profitability (ROC) for these positions.  I stand to gain ~10% on each of these trades…yep, that’s 120% annualized.
 

Sorry for not posting for the past week…travel and family stuff.

OK, I currently have credit spreads in IWM Puts.

I also have credit spreads in USO Puts and Calls.  This combination position is called an Iron Condor.  Iron Condors are particularly attractive if option implied volatility is high in both Puts and Calls for the same ETF.  The key is ROC.  Only one credit spread will be at risk at expiration.  It is impossible for both the short Puts and Calls to be in the money at expiration.  So, most option brokers only hold margin for one side of the trade.  This is an excellent advantage for this trade.  You essentially get to trade two credit spreads for the margin of one.

I’ll post later on the specifics of my current positions.

This past Friday, 5/30, I opened a credit spread in USO (US Oil ETF).  It has moved against me ever since.  It may be time to talk about how I defend trades since this one is not going well so far.  But, we are not ready to defend yet.

Update on positions:

IWM 66/63 Credit Spread in June –> Opened for .17 credit, now at .05, so I have a .12 gain.  I will close at .04.
USO 85/81 Credit Spread in July –> Opened for .35 credit, now at .50, so I have a .15 loss.

My short 85 Puts in USO have an 8.45% probability of being in the money at expiration now.  I opened the trade when the 85 Puts had a 5.23% probability of being in the money at expiration.  I take action to defend trades when the probability of being in the money is 15% or greater.  This will happen if USO drops 4-5 points within the next week or so.  If not, I’ll just hold on to collect my full profit in the spread of .31.  (closing the spread at .04)

I opened the USO Put spread because the volatility in oil right now has created some outrageous prices in Put options.  At the time I opened the trade USO was trading at 103.1 so my short 85-strike Puts were way out of the money.  At that time it would take an 18% drop (Before 7/19) to lose money in the trade.  Even this far out I was able to place this spread at a .35 credit. (by selling the 85-strike Puts and buying the 81-strike Puts)  This equates to a 95% ROC and a 75% expectancy.  This is excellent.  But, oil is volatile and this trade has done nothing but go against me now for three days in a row.  I am preparing to defend.  I will post about my defensive techniques soon.