In our quest to understand trading options for income, we often rely on technical and fundamental information for a basket of stocks. What we fail to do is to keep it simple by focusing primarily on the basic guidelines.
What are the basic guidelines when trading options? There are four: minimizing trade risk; maximizing profits; money management; and market awareness.
Minimizing Trade Risk
When considering credit spreads, reducing the risk of the trade refers to the location of the short strike. The flip side of this coin is POP (probability of profit).
For example, if the risk level is a 1 SD (standard deviation) move from the current underlying price, then the probability of loss is 16%; or a POP of 84% (100% - 16%).
This means that we expect the short strike to expire OTM (out of the money) or worthless with a probability of 84%; thus, the probability of the short strike expiring ITM (in the money) and causing a loss is 16%.
Another factor to consider in reducing trade risk is diversification. Since our ability to determine the direction of an underlying (stock, future, commodity, etc.) is rather limited (the best we can expect is a 50% probability of correctly identifying direction; we or either right or wrong), the more underlyings we trade, the less affected we are by losing trades.
Therefore, the two ways to minimize trade risk is: POP and diversification.
There is one metric we rely on to maximize profits: ROC (return on capital).
For example, if I wager $100 on a bet and the reward is $10, the ROC is 10% ($10 / $100). Given this level of ROC, I would expect the POP would be 90% (assuming one of two outcomes: losing $100, or winning $10). However, when trading credit spreads, the POP more accurately reflects earning a profit greater than zero (not the maximum premium); on the flip side, the risk level reflects a loss greater than zero (and not the max loss).
A more accurate representation of profit would be the expected return (ER). This can be determined by adding the products of expected profit (POP x max premium) with expected loss (POML x Capital at Risk; where POML is the probability of max loss, and a negative number). Btw, POML is determined by the position of the Long strike that comprises the credit spread.
ROC is an accumulation metric; every time we use the same $100 over many bets, the return increases. For example, if we had five successful bets (winning $10 each) with no losing bets, then the ROC would be 50% ($50 / $100).
When choosing between two or more underlyings, select the one with the highest positive ER; if all choices have a negative ER, do not trade any of them.
Separate from trading strategy is the amount of capital put at risk.
The general guideline when trading many underlyings is: risk no more than 3% of your account size.
For example, if your account size is $10k, then the most you should risk on any one trade is $300 (3% of $10k).
The general guideline for managing your portfolio is: risk no more than 50% of your account size.
For example, if you have a lot of individual positions, the total capital at risk (by adding the capital at risk for each open trade) should not exceed $5k (50% of $10k).
This will give enough of a cushion in your account to avoid margin calls, and for any adjustments deemed necessary.
The portfolio guideline will also minimize your risk of ruin (ROR). ROR is a statistical measure that looks at POP, POML, account size, and total capital at risk. The lower the ROR, the more likely you will survive losing streaks.
Keeping track of what is happening in the markets involves the following: being aware of scheduled economic news, and how the markets react to them when the reports are released; and current market expectations (as quantified in the VIX, an implied volatility (IV) measure), and whether the VIX is rising or falling.
Market awareness will help determine what level of trade risk you should use (as the VIX starts to rise, you might consider moving your risk level higher (ex.: from 1 SD to 1.5 SD, etc.) to adjust for wider swings in the underlying).
And market awareness will also influence the total amount of risk capital. In other words, as the VIX increases, you may want to reduce the capital at risk in your portfolio from 50% to 40%.
In conclusion, by remaining focused on the basic guidelines (minimizing trade risk; maximizing profits; money management; and market awareness), the outcomes of your trades are likely to improve with far less effort.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.