adiggs
Well-Known Member
I've absorbed pretty much all the OptionsAlpha stuff. The videos available for free are pretty dense in content, well done. Kirk, the owner, calls himself a numbers guy and I can see why. However, as a numbers myself, the trading strategies seem to slim on profit. Maybe someone can explain where I've missed something.
Here's a typical trade they mention, using imaginary stock FOOBAR:
Sell $30 calls for $2.50 each that have a 70% chance of being out of the money at expiration
Buy $35 calls for $1 each
Net credit: $1.50 per share or $150 on 1 option.
Kirk then says that $1.50 is the minimum you're looking for. Why, because:
$500 max loss * 30% chance = $150 -- same as your premium.
So, this is a net zero trade from a math perspective. Now, it's not all that simple, it's really integral calculus to figure out expected losses, not a simple 70%/30%, but it's a reasonable approximation for small gaps in strike prices (which is what they recommend). Still, that net zero is what seems questionable about the strategy. You need to have a positive net on average to make money. And even if you get particularly favorable $1.60 credit, you're only netting $10 on average. And that's not including the commissions, which are going to eat about 20% of that $10 at 65 cents per option on TDAmeritrade. And the smaller the stock price, the more the commission eats at your profit.
Plus, he recommends closing positions at 50% of max profit. If you took in $150, close when it'd only cost you $75 to take it back. Which seems questionable as you're cutting max profit in half, but you're not cutting max losses in half.
Bankroll management, no more than 2-3% of your portfolio on any one trade and no more than 60% actually in trades. Sound advice, use the law of large numbers for safety. But, 60%/3% = 20, so 20 open positions. Each position has a lifespan of about 30 days. 20 positions over 30 days at maybe $10-15 profit per position is a whopping $200-300 a month on profits...
With careful searching and orders, I've played about 6 of these trades to test things out. Small positions, losses are capped, so it can't hurt me too much.
Maybe someone can tell me what I'm missing, because I don't see any way for this to scale to making more than pizza money, even with a bankroll of $100,000 or more.
I've mostly arrived at the same conclusion, but I do see a path to better results (better than pizza money ).
1) have a big enough bankroll, that you're trading 10 contracts at a time (or some other number > 1). You still have the bankroll management, so the number of open trades remains high. But if you have $1M you're doing this with, then your individual positions will be more like $10k - $30k worth of buy power, where each contract is going to be a small amount of buy power. You might be trading more like 100 contracts / position in order to get each position up to the 1-2% target.
Example (totally made up): If a 1 contract credit spread has a $200 buy power / margin requirement, then you'll need to trade 50 of these to get to a $10k position size. 50 contract position sizes at $10 profit / contract gets you to $500 / position, $10-15k / month. This is also a 1% position size, so you can have 50-60 positions on at a time; that might get you to $30-45k / month. (Which is pretty good, but it's also a full-ish job that needs a $1M bankroll).
2) What I took away from the videos in the third track where he gets deep into position management and adjustments. For losing trades, there's a number of things you can do to avoid max loss. If your typical loss is closer to 20% of max loss, then that moves the numbers over large # of trades in your favor pretty significantly.
3) One of the reasons for the 50% profit target is that there's a decently large number of trades that reach that threshold, that if held later will go flat or negative later. This further increases the win rate, as well as turning over buy power into new trades much faster than the 30 day full trade length. What I remember is that their typical trade is turned over in 1/2 the expiration time (so 15 days on 30 day trades).
4) And remember that the IV overstates HV, so the 70/30 that he designs his trading system around is really more like 75/25, or whatever that HV / IV difference / edge would yield.
Also worth noting - he mentions that though they do still use credit spreads such as you describe, they do a lot more open ended trades such as selling strangles now (given that they can find high IV stock / ETF to trade). Presumably the theoretical profit is much better - though likely losses are harder to calculate as max losses are in theory open ended, but in practice not.
The net I took away from it - you design the trades up front to be roughly $0 expected value, with the early closes and adjustments providing the rest of the edge you need to make small steady profits. To make it into an income you live on, you'll need a large bankroll, and to treat it like a job. It might be a part time job, but it's something you're doing 2-4 hours every day. One advantage it has is you can start learning the system with a small bankroll while working; if/when it works for you, you can transition away from work later as your bankroll expands and you gain experience / skill.
All of which sort of sounds like I'm arguing for that trading system. I am definitely not. It's definitely not for me. It's way too close to day trading for my taste, energy, or time availability.
This option trading strategy is called "Selling Volatility". Here's one of the primers that talk further about this:
Option School: What the Heck is “Selling Volatility”?
EDIT: Another article, more detailed.
http://www.riverparkfunds.com/Data/Sites/17/media/docs/news/Structural_Alpha_White_Paper_Final.pdf
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