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Trading options for income: Position size is critical

Position size is critical
Position size is critical
OptionsAnnex.com

In our quest to understand trading options for income, we often hear from other traders that they lost a good portion of their account on one or two bad trades. Why does this occur? Generally because the capital at risk on a trade is usually too large a percentage of account size.

If you're trading a portfolio of underlyings, then the percentage would be around 3 to 5 percent; if you're simply trading the SPX, then 25 percent is a good starting point.

Tasty Trade recently ran a test on the SPX over a 5 year period. The test criteria is as follows: enter an Iron Condor trade if the IV Rank is over 50 percent; use $5 wide credit spreads at 1 SD (standard deviation); and hold till expiration (no adjustments). On a $10,000 account, two trades were setup: one trade on 5 percent of the current account balance; the other trade at 50 percent of the current account balance.

The results: there were only 23 trades executed over a 5 year period on the SPX; this is due to the requirement that IV Rank needed to exceed 50 percent. The P&L for the 5 percent of account balance was a gain of $741 after 5 years (an annual return on the account of about 1.5 percent) with a max loss of -$587; for the 50 percent of account size, the P&L was a loss of -$4,390 (an annual return on the account of -8.78 percent) with a max loss of -$15,675.

In conclusion, when viewing the P&L graph it is apparent that the higher the capital at risk, the more volatile the results; the peak P&L for the 50 percent trade was over $20,000. In fact, there were 2 bad trades after the peak revenue period that caused the account to go negative.

While the test results do indicate that trading too large is dangerous, there are other factors to consider when simply trading the SPX with Iron Condors.

Options Annex conducted its own tests of the SPX over a 5 year period, using 25 percent of the account size with $25 wide spreads (on a $10,000 account). First, removing the criteria for IV Rank will result in 60 monthly trades over 5 years with a final P&L of $5,917 at 1 SD (an average annual return of 11.8 percent). Second, considering 1.5 SD (as opposed to 1 SD) reduced the number of losses to 2 (vs. 10 at 1 SD) resulting in a P&L of $5,635 (an average annual return of 11.3 percent); the P&L curve is clearly less volatile with just 2 losses over 5 years. And third, increasing the number of trades to 260 over 5 years (by trading the Weekly rather than the Monthly) resulted in vastly higher P&Ls: at 1 SD and 22 losses, the gain was $25,042 (or an average annual return of 50 percent); at 1.5 SD and 4 losses, the gain was $20,962 (an average annual return of 41.9 percent).

As can be seen, when testing is performed properly and key variables are adjusted separately, the results will be far more illuminating.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.