Now that the books have closed on 2022, it’s time to do a year end review, specifically of the 2nd half of the year but, also, the year as a whole. As I stated in my first half review, the format of this is a work in progress so it may differ here than in the first half review. Eventually I will settle on a format I like that will properly and clearly show the progress of my trading.
A Tale of Two Halves
At a high level, I can really see a difference in the two halves of the year. I was pleased with my first half performance and disappointed with my performance in the second half. Of course, market conditions are different all the time but my long term goal is getting more consistent. It’s ok to lose on trades, everyone does and if I didn’t ever lose I would wonder if I was being too risk averse but, in this case, I had too many bad trades which caused me to miss my targets as many times as I made them with September being a particularly bad month. So without further adieu, here are the numbers
As you can see, I lost about $150 in the 2nd half, mostly due to September December. Thanks to a strong first half, I did end up making about 8% on the year, but that was far from my goal of 3% per month.
What Worked? What Didn’t Work?
Butterflies dominated my trades in the 2nd half with all but 4 of my 28 trades being some kind of butterfly. So they encompassed all of the losses, but a big chunk of the gains as well. Volatility was high most of the time so it wasn’t really a good time for calendars. Volatility was so high at one point that I did a put vertical on VIX which is not my usual trade. It, essentially broke even so VIX plays were not a big part of the 2nd half of the year like they were in the first half. SPX Calendars did ok, but there just were not enough good opportunities to do them.
Two trades really stand out as bad ones, the 2 SPX flies where I lost $2200 between them. Without those two trades I wouldn’t have made my 2H goal but it would have been at least closer to my performance in 1H. Overall, the SPX balanced butterflies was my go to trade during this time which makes sense given the volatility levels during the year. Calendars did well when I could put them on but those opportunities were limited.
I also experimented with some tweaks on my trades due to high volatility that overall worked well. I started doing wider butterflies (as wide as 80 up/down) and, in some cases, went shorter on the duration to limit exposure. To balance that out, I went smaller on those shorter duration trades to limit my risk as price risk on those are more than my usual, 22-30 DTE flies.
During this time, it wasn’t that trades didn’t work as much as it was my poor execution on losing trades. This needs to be a major focus going into 2023. My mantra of “Pets vs Cattle” is just as important now as it’s always been and I need to remember it.
Some Interesting Visualizations
So that is the raw data, but my modeling software offers some basic visualizations that I found to be interesting so I thought I’d include some here. Note: these are for all of 2022
First is a basic P/L graph which spells out pretty much what I said in the summary, things were on the right path until September and then I really struggled.
This is shows why I don’t care about W/L ratios. I had 59 trades and had a 78% win ratio and my results weren’t that great. The key is the average loss size vs the average win size. My losses were about 2.8x my wins. So my W/L ratio saved me but if I can get the size ratio down, I’ll be far more successful.
I traded 3 underlyings this year, mostly SPX, but from a dollar net dollar amount, I made a little more in VIX than SPX. This is mostly because I didn’t have any losses in VIX. Almost all of those VIX wins were from the first half of the year. I honestly did not expect this one, but I’m glad I did those VIX trades as they really did help my overall performance. The GLD calendars were a failed experiment, but that’s ok. Once I saw they weren’t working I moved on. The key was I figured out why they weren’t working. It’s possible I may go back to GLD at some point, but what I was doing here clearly didn’t work.
This one is quite interesting as it tracks P/L based on how long I stayed in the trade. This tells me that the vast majority of my profits came from quick wins (6 days or less). This was mostly due to quick drops on my balanced butterflies. But it also says that the longer I stayed in a trade, the worse I did. I did not lose any trade where I was in it for 6 days or less, but at 7 things change.
What this does tell me when I lose, I’m staying in too long. This matches up with my experience as my worst losses were because I was trying to fix bad trades. What this doesn’t tell me is that I should only be in trades for less than a week. My key takeaway here is to be willing to give up on a bad trade earlier but it’s ok if a trade takes a longer than a week to work. But that the longer I stay in, the worse my odds so once I cross the 1 week barrier, I should put that trade on a tighter leash and cut my losses sooner. It also shows my one day trade, which I find amusing because I really don’t day trade, but every once in a while it can make sense even for a boring trader like me. But it also shows that even though most of my trades start with 21-30 days to expiration, quick profits are very possible. You don’t necessarily have to do zero DTE to make money.
Final Thoughts on 2022
While I’m disappointed that I didn’t make my goal and especially disappointed in my 2nd half performance, I still made money in a very challenging year. If you use the S&P 500 as a benchmark I outperformed it (in this account anyway), by a mile as the S&P lost about 20% and I made 8%. So I’m not going to beat myself up over this year. But I do see it as a chance to learn and get better. And how many times can you get paid to learn?
So far, I think I like this format, but I may tweak it next year. Let me know what you think. Feel free to comment here or reach out directly at email@example.com. I always like talking options with people.
On to 2023…look for more blog posts here as well as follow my video series “This Week @Midway Trades” for weekly reviews of a real-world retail trader.
As anyone who follows me knows, I’m a fan of alt-tech platforms vs the big tech sites. And I’ve decided to add another one to the mix. While all of my videos are available here on the blog site (check the links at the top of the page based on the series), I started putting my videos up on BitChute. Later, I added Gab TV. And starting with my videos in November, I have added Odysee to the mix. I like Odysee because they are not censorious like big tech but also the interface is good and, unlike the other sites, they have an app so I hope that will help make the videos more accessible in the alt-tech space. Just look for the channel “MidwayTrades” or https://odysee.com/@MidwayTrades:a
As many of you know, I am also on the Fediverse. You can follow me there at @firstname.lastname@example.org. I am in the process of testing putting this blog site up on the Fediverse as well using the ActivityPub plugin for WordPress. If you’d like to follow the blog on the Fediverse, you can find it at @email@example.com. Keep in mind that this is still a work in progress so you may not see things there immediately as I’m still figuring out how the integration works.
I will try make some time for more trading blogs here. Feel free to reach out if you have something you’d like to cover. In the mean time, you can follow me in the usual places and I’ve added some more!
This may be a topic more suited for newer traders but it is something I’ve seen come up from time to time so I think it’s worth writing about here. When putting in orders, especially on multi-legged spreads, how should traders enter orders to get a fair price?
The Market is an Auction
The first thing to remember when thinking about prices is that the options market is not like a store where you look at a price and decide if you want to buy or sell a contract. It’s an auction where prices can literally change by the second. As a market participant you will get to see what buyers want (the “bid”) and what sellers want (the “ask”). The theory is that buyers and selles will meet somewhere near the middle (the “mid”). For a single option leg (where you buy or sell some amount of exactly one contract), the distance between the bid and ask (the “spread”) gives some indication on how much liquidity exists in that particular contract. The less the difference, the more interest there is in that contract, and the easier it is to get a fill. For very liquid contracts, it’s common for the spread to be a penny or two.
But multi-legged spreads make this a bit more complicated. Even if all of the contracts have small spreads, when we combine the spreads of 2, 3, or even 4 legs, the spread of the entire trade gets larger even if the spread of each contract isn’t very wide. So the question becomes how do we, as traders, find the right or fair price?
A quick side topic that I think is really important on the topic of orders: Always use limit orders. A limit order gives the most you will pay or the least you will accept for the order to be filled. This is critical to getting a decent price. The alternative is a market order which tells the broker to fill the order at literally any price. While it’s possible to get a good price with a market order, you are taking a big chance of getting a bad price, maybe a very bad price. Limit orders give you, the trader, a measure of control in whether a order is filled or not. This is especially true for opening orders, but it’s just as true for closing orders or adjustments. It’s ok to not get filled if the price is bad. And while it’s easy to get frustrated at an order not getting filled, do not get impatient and resort to a market order just to get it done. Just like in real life, you need to be able to walk away if the price is not right. This can be frustrating when trying to exit a trade when the market is moving against your position, but I still hold that limit orders are the right way to handle this.
Understanding What is the “Mid” Really?
So what is a “fair price”? Well, the simplest answer would be the mid (the midpoint between the bid and ask). But here’s the problem: offers from buyers and sellers are coming in all the time. This moves the bid and ask around which, in turn, moves the mid. So, in theory, there is a mid price but, in reality, there is really a mid range. You will see the mid range by watching the mid price change. In most market conditions it will bounce around. How much depends on the liquidity and volatility of the contracts but the vast majority of the time you will be able to see the range just by watching it move. This range becomes the basis of what I call “price fishing”.
Closing for a Profit
The simplest case is when I am trying to close a trade for my target profit. I simply have a GTC (Good ‘Til Cancelled) limit order at the price I want. By doing this if my exit price can be filled, it will whether I’m at my station or not. I don’t sit in front of my station all day. I have a life outside of trading that included a day job. So I always have a limit order in at the exit price I want to meet my profit target. The only exception to this is if the trade has more than 4 legs. Then I have to manually enter 2 separate trades to exit. In my trading, this only happens if I have a double butterfly (which has 6 legs). All of my other possible trade structures have 4 legs or less which allows me to always have a closing order at the broker. The market can move quickly so I don’t want to miss an opportunity to close and move on.
Opening, Adjusting, and Closing for a Loss
Closing at my profit target is the easiest case. For the rest, I am putting in orders myself and in these cases I deploy price fishing. The idea is that I don’t know the right price, but I can see a range of reasonable prices. So I start by placing a limit order a bit above the top or below the bottom of the mid range (depending on whether I am selling or buying). Then I move up or down until I either get filled or I walk away from the trade. Initially, I may put in new orders quickly, but as I get closer to the center of range, I tend to slow down and give it time to fill. I rarely get filled on my first order. In fact, if I do it’s a bit disappointing because that means I may have been able to do better with a bit more time. Or maybe I just got lucky with a really good price. But the key is to put out offers and see where the fish are biting.
A Real World Example
This wouldn’t be a MidwayTrades blog without at least one real world example. So on a recent trade I was opening, I captured the orders I put in to show how I fish for prices. Below is the order log of a trade I opened recently:
This trade opens a 3-lot unbalanced (65 up / 70 down) butterfly in SPX. I started at the bottom by putting in an order for a $3.80 debit. This was likely $.10 under the range I was observing at the time. Then 20 seconds later, I upped my order to $3.85 ($.05 is the smallest I can do spreads in SPX). About 15 seconds later I put in a new order for $3.90. Those were pretty fast, but this is normal as I started about $.10 under the range I was observing. The goal here is just to see if I can get a deal. If not, I move forward. Now I waited a bit at $3.90, eventually putting in a new order at $3.95 which filled nearly a minute and half later which means I sat at $3.90 for a minute or so, waited some more and then got filled about 30 seconds later.
The point of doing this is that I can’t know what the “right” price is…and even if I did that price could change by the time I put in my order. So like a fisherman, I cast out a few times at different places, depths, etc. to see where the fish are biting.
So that’s what I do. What do you think? How do you find a good price? As always, I love to hear from folks out there. Feel free to comment here or send me an email at mailto:firstname.lastname@example.org
Once again, I know it’s been a good while since I’ve done a real trading blog but this idea came to mind and I think it has potential. I create all of my trading content for a few reasons. Of course, I like to share ideas and talk about trading options but I also do it because I believe it makes me a better trader. Reviewing all of my trades publicly on a weekly basis forces me to look at what I’m doing in a critical manner and take lessons from it. I feel a certain amount of accountability by posting my results and my rationale every week. Trading can be a very solitary business and finding ways to hold myself accountable is important for me.
So in that spirit, I am thinking about starting a new series of reviews that takes a higher level look to get a better idea of how I’m trading. The weekly reviews are important, but to really see how things are going at a higher level I want to do semi-annual reviews. And instead of just doing another video, I’m switching it to be a blog post. I’m going to start with the first half of 2022 and if I find it useful I’ll continue to do it twice a year. I can say that just doing the research on how I did was interesting and useful. I hope some folks out there find it helpful as well.
So since this is the first post in this series, I think it’s a good idea to state what my goals are for this trading account. This account is a learning account for me. It is quite small compared to other investment accounts, retirement accounts, etc. but the purpose is to learn how to trade consistently. If I can get consistent returns, I’ll increase the size and go from there. The trading decisions I make in this account aren’t that different from a larger one outside of the dollar figures of the trades. So if I can consistently do well in this account, I believe I can handle something much larger and, possibly, make it a real income stream.
That being said, my goal is to make 3% of my account balance per month. Compounded monthly, by my calculations, that would be a 42.5% annualized return. Feel free to check my math on this as this isn’t my strong suit, but I put in my starting balance for the year of $16,705, and I ran it through a compound interest calculator at 3% per month and the expected balance at the end of the year was $23,817.34. So that’s a gain of $7,112 (I dropped the cents for simplicity). Taking 7112/16705*100 gets me to 42.5%. For most investments that would be fantastic but I think it’s possible to get at or near that with the options strategies I employ. The goal of this account is to see just how feasible that actually is for me.
So now that I’ve stated my goals, how did I actually do for the first 6 months of 2022? 2022 has been a year that, I think it’s fair to say, has been a challenging investment environment with all the major indices down for the year. I know I’ve seen my retirement accounts take a hit as I’m sure most of you have as well. Because my goal is monthly I took my monthly results based on closed trades. If a trade was still open at the end of month, it was not counted until it closed (usually by the next month). All that being said, this is my first draft of tracking my progress:
Note that the dates reflect the results of the previous month, so Feb 1 is the results for Jan, etc. The columns are as follows:
P/L: This my Profit/Loss for the month (again based on closed traded)
Goal: This is my goal for the month based on making 3% each month. The goal assumes that the goal was completed the previous month so it goes up regardless of how I actually do.
%Attained: This is the percentage of the goal that I attained.
Balance: This is my actual balance (not including open trades) on the first day of the month
Goal Balance: This is where my balance should be based on making my goal.
%Balance: This is where I am with respect to the goal balance on the first of the month.
I fully expect that I may change this format at some point and if I’ve messed up an idea here please reach out either via comment or email and let me know where I messed it up. Again, this is my first attempt at doing this level of tracking so it’s entirely possible I missed something or just messed it up.
As to the results themselves, you can see that I made money 4/6 month and made or exceeded goal 2/6 months. That’s not too bad given the market conditions of 2022. If my numbers are correct my balance at mid-year is 91% of where I should be based on making 3% per month.
The most common trade of this year was SPX butterflies and they worked most of the time quite well. I’ve been doing these when VIX is between 20 and 30. Because I primarily trade SPX, I use VIX as a guideline for SPX volatility. Butterflies are negative vega and 20-30 has been generally on the high side of the normal range really since the pandemic started around March 2020. I like butterflies here because they are negative Vega and so they will benefit from volatility falling. I have been doing them mostly balanced so that when I first put them on they have very little downside risk as the downside has been pretty strong this year. There have been 13 of these trades that have closed in 2 days or less for 6-8%.
VIX PUt Verticals
When VIX has charged up into the 30s (usually above 33) I don’t like trading SPX as it’s too volatile. So when that happens I’ve been putting on longer term (45-60 days to expiration) put verticals to take advantage of the eventual drop in volatility. So far VIX has not stayed above 30 for more than a few weeks and so these have worked out pretty well. Not much to do with them except watch them move around a lot, but it gives me some way to try and make some money while volatility is too high for SPX trades
What Didn’t Work?
Another trade I was playing with while VIX was high was short term (1-2 weeks) GLD calendars. I had some success with them at first but, ultimately, concluded that they were too expensive to put on at any decent size (I usually had to put on 15-25 lots which are 30-50 contracts) and that was too much for these trades to make up to make decent money vs the risk. The idea wasn’t bad (GLD isn’t necessarily tied to SPX volatility) and I did win a few of them. But, I stopped doing them until the price or volatility of GLD gets high enough that I don’t need to put on as many contracts and get my expenses down.
What is Missing?
Since March 2020, I’ve been putting on SPX calendars when VIX is under or near 20. I like these because calendars are positive Vega and benefit when volatility rises. While I still like this trade, I was only able to put on 1 during this 6 month time frame as VIX stayed on the higher side when I was ready to put on a new trade. That’s not to say I won’t do them (or use them to adjust a butterfly on the upside when vol is low), rather, there were not as many opportunities to use them as there was, for example, last year.
How Could I Have Done Better?
So I think I did pretty well all things considered this year, but I still didn’t quite make my mid-year goal. I was $1,768 short. This shortfall came down to two bad trades. One is forgivable as I was experimenting with short-term GLD calendars. I ended up taking a loss of $607 (48%). It was around this time that I started questioning doing these trades. I ended up doing 2 more and then stopped after losing around $180 more. I say it’s forgivable because I was working on finding trades I wanted to do when SPX wasn’t in a good place with respect to volatility. I had some success with the trade, but ultimately lost more than I made as seen here:
So that was ultimately a $390 lesson. Not too bad when it comes to trading, however not taking quite as much of a loss on that big one would have definitely helped.
I also let one SPX trade get out of hand. I over-adjusted a 21-day butterfly and took a bad loss of $1,153 (45%). This is not acceptable. To avoid doing that in the future, I am being more strict as to how many times I adjust my trades and I started going out further in time on my butterflies. After that trade I opened flies from 30-35 days instead of 21-25 days. Having time in a trade is helpful when you are trying to repair it. This trade led me back to my Mantra of “Pets vs Cattle“. Feel free to read the post for the details but, in short, it means that I can’t get too attached to a trade. Some losing trades are worth just letting go. This is something I have struggled with as I learn this craft, but I think many traders do as well.
So this is how I saw the first half of 2022. Overall, it was a good six months with some very good trades. I did some experiments with respect to trading when SPX isn’t a good underlying. The VIX verticals did well, the GLD calendars did not. I think it’s possible to make up ground in the second half, but I need to stay the course and better execute my trade plans.
As usual, let me know what you think. I always like hearing from readers and viewers.
I realize I haven’t blogged in a while. I get a lot of projects going and with a day job it can get a bit crazy. This is one of those side projects I’ve been working on for a while now. The idea is to combine two things I really like: trading and alt-tech. As you know, I tend to be more active on alt-tech platforms than the ones from traditional big tech. So I stream my videos on BitChute and GabTV rather than YouTube. I use Gab rather than Facebook. I do use Reddit a bit so there are exceptions but I’m pretty limited in the subreddits I join over there. Another alt-tech project I’ve had my eye on for a while is called Mastodon, which is an open-source decentralized version of Twitter. Literally anyone can set up an instance of Mastodon and have to talk to any other instance of Mastodon out there. So you can join an instance and follow and talk to people on other instances. This is known as “federation” and has lead to the term “Fediverse” describing the world of Mastodon instances. But because it’s decentralized, no one entity owns it. Because it’s open source, no one entity controls it. This appeals to me quite a bit.
Ok, enough of the tech talk. What does this have to do with trading? I have set up my own Mastodon instance at social.midwaytrades.com. So if you are already on any instance of Mastodon, you can follow me. If you aren’t but are interested, you can join my instance. Right now, all new accounts will be approved by me, but that’s mostly because I’m still learning this stuff too. But I welcome anyone who would like to try this to join my instance and see what this stuff is about.
Why Am I Doing This?
So that’s all well and good but what’s the point? My goal here is to create more ways to talk to people about trading. So I plan to put out content (called “Toots” instead of Tweets) when I open, adjust, or close a trade. I still will do my weekly review videos, but if folks are interested in something a bit more real-time, this is one way to get that. And it’s another way to get discussions going. For example, I did open a trade today. Here’s what I put out:
These read from the bottom similar to Twitter. But as you can see, I not only say what I opened, but I try to talk about the reasons as well my plan as well. My hope is that these can be used as an example for those learning to trade…and, of course, lead to more discussions.
So if you’re already on Mastodon, feel free to follow up at @email@example.com. Or if you’d like to try it out, stop by the server sign up and look around. I’d love to hear from you.
Now I need to get back to blogging about trading..I will do that I swear!
I had a very good conversation with a reader recently. He is getting started in trading options and was looking for ideas with the S&P 500 (SPX/SPY). As that’s what I do almost exclusively, I was glad to hear his ideas and give my opinions on them. But the conversation really turned into a discussion about risk. He, as well as many newer traders, want to find ways to “play it safe” and minimize risk while still making money. Of course, it’s not just newer traders who want this. I think everyone would be happy with a low-risk strategy that makes money. The reality is that this business is a risk management business. We, as options traders, are paid to take on risk. That doesn’t mean we should take bad risks chasing high rewards, but we can’t entirely avoid risk either. But, more importantly, I think it’s important to understand the risks of a position or strategy. There are lots of different options plays out there each with different risk profiles. In addition to the contracts that make up the strategy is the element of time. And it’s easy to get drawn into a strategy that looks safer than it is. That’s not to say it is a bad strategy. There are times when most strategies are good plays. But it’s important to know the real-world risks of a strategy before deploying a significant amount of capital on it.
The Risks of Options
So, before talking about the risks of the trades he proposed, I think it’s worth talking about the risks of an options trade. One cannot define the risks of a trade without knowing the actual risks.
Price risk is the one risk that most people understand as it’s similar to the stock world. The price of the underlying defines the intrinsic value of a contract. A contact that is in the money (ITM) has inherent value as opposed to an out the money (OTM) contract. Long calls and short puts benefit from a rising price in the underlying while Long puts and short calls benefit from a falling price in the underlying. These risks are estimated in the greeks delta and gamma.
Time risk simply refers to the amount of time left in the contract. Time value is a component of the extrinsic value of a contract. Time value decreases as expiration approaches and it’s not linear. Rather it is doesn’t really start to move until around 45 days to expiration (DTE) and really is really moving in the last few days of the contract. Time risk is estimated by the greek theta.
Volatility risk is, in my opinion, the least understood by new traders. But it is also a component of the extrinsic value of a contract and it quantifies the speed of price movement in the underlying. This one is tough because implied volatility (IV) is, well, implied which means it’s tough to measure until after a move has happened. But it’s important when thinking about the probability of a contract being profitable or not. And, to make matters more complicated, the value of that probability is derived from the live prices of the market. Because of that, it’s not entirely predictable. This could be a topic all to itself, but I’ll leave it here as a summary. Volatility risk is estimated by the greek vega.
Strategy: A Long Straddle
One idea that attracts new traders is the long straddle. In short, a long straddle is an equal number of long calls and long puts at the same strike price and the same expiration. An example of a 32-day long straddle is here:
As you see, the long straddle makes money if the underlying moves in either direction since you own a long call and a long put. This trade as shown above is what it will look like when the trade is first opened. The graph looks safe..from a price risk point of view. If SPX moves down, the put side makes money, if it moves up, the call side makes money. You have minimized price risk. But the risk of the trade is if SPX stays range-bound and just moves back and forth in a series of normal days. In a long straddle, you don’t just need the price to move, you need it to move a lot in one direction. You need the winning side to make more than the losing side. This is where volatility risk comes into play. You need a large move in one direction. So perhaps you put this on before an event like earnings or you pick an underlying that tends to move a lot anyway. Well, everyone else in the market knows these things too and that will be reflected in the contract prices. If an underlying is reasonably expected to move during the life of the contract, the volatility component of the price of those contracts will be higher. This means your total price of the trade will be higher which, in turn, means you will need an even bigger move to be profitable since you have to make up the money you put into the trade. So you not only need a big move in a particular direction, you need an unexpected big move in a particular direction. And once the event is over, a good amount of that volatility can come out resulting in a “vol crush”. This lowers the price of your options (even the winning side) and can act as a headwind to your profits.
But it doesn’t end there, there’s still time risk. Because both legs of this straddle are long, both are negatively affected by time decay. This reduces the price of both contracts over time and acts as headwind to making money. So, you not only need a large unexpected move in a particular direction, you need it to happen as soon as possible because with each passing day, the hole gets a bit deeper.
This past week we had a large one-day down move in SPX…106 points or 3 standard deviations. Just the kind of move you would want for a trade like this. Given that we put this trade on Nov 15 (11 days prior) here’s a graph of that same long straddle:
It’s making money to be sure, but it’s up 5.5%. That’s nothing to be mad about however, that’s after a one-day 3 SD move. These kind of moves don’t happen often…this is exactly what this trade needed, and the reward isn’t amazing for the rarity of the event. Part of this is the $200+ dollars of time decay in this trade every day. And what if that big move had not happened? Here’s that trade at the end of the previous trading day:
The trade was down 7% and it took a 3 SD move to get it to 5.5% up. I don’t think it’s a good strategy to count on a 3 SD move to make money on a regular basis. In this case, time and volatility risk can mask the lack of price risk to a new trader.
I’m not saying that a long straddle is a bad trade. If done at the right time, it can be quite profitable. But if your goal is a trade that will generate regular income, the odds of this trade stacked against you.
Strategy: Day Trading Calendars
So the next idea that was proposed was very short-term calendars. Now, anyone who follows my trades (which I post every week on this site) knows that calendars are one of my favorite trades. Very quickly, a calendar spread is selling contracts in a near term and buying an equal number of contracts at the same strike later in time. Because time will decay faster on the short contracts (since they have less time) the trade is positive theta so time works in favor of the trade (within a range). The idea was to day-trade calendars and try to skim off regular small profits and avoiding price risk by not holding the position overnight. Again, I see the appeal of this idea. In some ways, it is the opposite of the long straddle. Time is in your favor and not having a large move is also in your favor. You would lose in the case of a large move in one direction within a single day. So what don’t I like about this trade?
At first glance this trade doesn’t look too bad considering the goal is to be out by the end of the day. Yes, the range is narrow but that’s because the shorts expire in 2 days. Why so short-term? Couldn’t I just go further out in time and get more room? Yes. But then I won’t get much theta decay to actually make money on the trade. If my plan is to day-trade this, I need the trade to be very near expiration to capture enough time decay to make money. That, in turn, gives me a very narrow range. In this case I have about 30 points on each side. But that assumes I stay in for 2 days. The plan here is to be out by market close of the same day. Why does that matter? Let’s look at a very normal market day. This was not a crazy day, in fact, it’s a pretty slow day (+10.75 / 0.2% / 0.3 SD). It’s the kind of day you think would benefit this trade.
This is the trade at the close of the day. A definitely loser and that’s on a calm day. Why did the trade not do well? While the time and volatility risks are low since the contracts are near expiration and most of the extrinsic value is gone from the contracts, the price risk is a lot worse than you think because of gamma. Gamma estimates the change to delta and in the last week or so of a contract, it gets very significant. So when this trade was first entered, it had a delta of .47 which is very good. But the gamma was -.30. So with a one point move in SPX, delta would change about 64%. And it only gets worse and the up move continued as you see at the end of the day, delta is now -8.12 and that was on a small move. This is one of the reasons I don’t like expiration week and try to avoid it. The price risk near expiration is much higher than it may appear on a graph.
Could this trade work? Of course. But, again, I don’t think it will win with any regularity. Just like the long straddle needed an unusually large move to win, the day-traded calendar needs an unusually small move to win. These trades, in my opinion, are highly speculative and not low risk even though they may appear to be low-risk at first.
So What Can Work?
Every trade has risk and can lose and it’s easy to pick apart a trade idea and show how it won’t work. But I would be remiss if I didn’t give an example of what I consider to be a good balance between risk and reward. This is not to say that this trade is good for everyone. It can lose money and certain moves can hurt it. I also cannot say that this level of risk/reward is right for everyone or anyone in particular. I have no idea of the skill and experience level of anyone reading this blog. But with all that being said, I would like to present a trade that I like in certain market conditions that I think strikes a balance between risk and reward. It may also help calm down some nervousness involving overnight risk. Overnight (and weekend/holiday) risks are real. But if a trade is well constructed, that risk can be managed most of the time.
Strategy: A 23-day Narrow Calendar
This is real-world example of the last trade I did but I think it works as an example of understanding risk. This is a 23-day Narrow Calendar which is one of my regular trades that I put on most weeks, specifically when the volatility is near the center of the range. Note: Markets can change and as they do, my volatility ranges will change with them. This is based on a range that I’ve been using for the past year and a half, basically since COVID. Because I trade SPX, the VIX is a good estimate of the volatility. This may not be the case for different underlyings so you’ll need to understand the volatility of your particular contracts. But when I put this on VIX was 16.9 which is on the higher side of the middle. This is why I like a narrow calendar. I define a narrow calendar where the longs are less than a week away from the shorts. This is only possible in underlyings that have mid-week expirations, but SPX does. This is the trade when I opened it.
The first thing you should notice is the room on each side. Because the shorts are 23 days away, I have between 1.5 and 2 standard deviations of room. This is based on a single day, but that is relevant since the concern is overnight risk. The odds of open open that will go beyond my range is very low…possible but low. And this is how the open looked the next day.
SPX opened up 8 points. Not a problem at all, in fact, I’m up a bit in the trade. For brevity’s sake let’s look at the close of the week (2 days later).
So when the trade went on SPX was at 4693 and 2 full trading days later SPX is at 4698. So the trade is fine. But what about a bigger move? Not a crazy big move, but perhaps more typical market open. Let’s see what happened when I held this over the weekend.
SPX opened up 23 points (0.5%, 0.67 SD) and the trade is not only fine, but it’s doing very well. In fact, this trade came off around mid-day for about 8.5% (not bad for 5 calendar days). Would it have been doing well had SPX moved 100 points at the open? Probably not. But how often does that happen? Not very often. (Interestingly enough SPX did have a large down move later that week so it’s possible but it’s not common. Maybe a few days a year).
The point of showing this trade is not to promote it or say anyone else should do it but, rather, to help you better understand risk and how it can be managed. This starts with a good trade plan. Had SPX made bigger moves, I had a plan to handle it. In this case, I didn’t need to do anything as the market behaved quite normally. But with any trade, you must be prepared for abnormal things to happen.
My goal in this post is to help demystify risk in the options market. First by identifying the risks and then looking at strategies to face the risks with some examples that look less safe than they are and by showing how I use my understanding of risk to set up a trade. As always, I welcome further discussions on this or other topics relating to options trading. Please reach out here on the site, or to me directly at firstname.lastname@example.org. Who knows? Maybe you will inspire a new blog post.
I’ve wanted to write this post for a while now because I think it’s really important for traders, especially new traders. So many times on various forums I see new traders asking what to do about a trade they have already put on. The questions typically fall into one of two categories: 1) My trade is in trouble, what do I do? or 2) When should I take off this trade? My response to these types of questions is: “What does your trade plan say to do?” and the conversation generally ends. This may seem like an answer that isn’t helpful but I think it actually is helpful. When someone asks a question like that, it’s tough to give a useful answer if you don’t understand the purpose of the trade and, more importantly, the risk tolerance of the trader. This is where a solid trade plan is important. A trade plan should lay out very clearly the goals of the trade as well as the risk management of the trade. When the trade is closed, the standard of evaluating the trade should be the trade plan. There is no one standard or criteria for success or failure that applies to everyone. Trades, ultimately, reflect the trader. What is a good trade for me may not be a good trade for you and vice versa. Your risk tolerance may be quite different from mine. But all of these things can be included into a trade plan built for a specific trade by a specific trader.
The time to consider what you do in a trade is before the trade is put on, not after. The market can move quickly and taking time to figure out what to do in the moment can lead to bad decisions. And while it’s perfectly reasonable to make changes to a trade plan, those changes should happen in between trades, not while a trade is on. Changing course mid-trade, in my experience, leads to more negative outcomes than positive. Could you get lucky and do well? Yes. But decisions made in the heat of the moment are usually based on the emotion of the moment. Our goal as traders is to be as mechanical as possible and to do that we need a solid plan that covers all situations before we enter a trade.
The Anatomy of a Good Trade Plan
Now that I’ve established the importance of a good trade plan, it’s fair to ask, “What’s in a good trade plan?” I will first attempt to describe the parts of a good trade plan and then look to an example. Here are the elements I consider to be vital to a good trade plan:
Entering the Trade
ENtering the Trade
While this may seem really basic, you’d be surprised how many new traders don’t really think about this part. But setting up a trade is vital to the success of the trade. What is the structure of the trade? Where does each set of contracts start? At the money? In/Out of the money? Are the positional Greeks important? There is no one right answer here because there are so many different trades. But this shouldn’t be a pure guess. How you put on a trade should be intentional. If you can’t state this specifically, I strongly suggest taking a step back and think about why you think this is a good trade. I do not suggest blindly copying someone else’s trade (and I say this as one who shares all of my trades online). It’s not a bad thing to learn by what others are doing, but it’s really important that you understand what the other trader is doing and why. Putting on a trade without understanding the setup and goal is very dangerous. My standard for this (and for the entire trade plan) is that you need to be able to explain what you are doing and why to someone else clearly. If you can’t do that, you most likely don’t really understand it yourself. This is one of the reasons I put my trade reviews online. I force myself to explain what I’m doing.
Another very important concept in this part of the plan is trade size. Trading is, ultimately, a risk management business and the first element of risk management is the size of the trade. Many traders will tell you that the worst losses they took were either put on too large or were allowed to grow too large via adjustments. Knowing the initial size of the trade as well having a risk cap on the trade is a critical step to keeping losses under control. You can’t lose what you don’t risk.
The goal of every trade should include profit (or at least the possibility of profit in the case of a pure hedge). But what’s important here is to define specifically what the profit goal is. “This trade should make a profit” is not good enough. The plan should state a specific goal. That goal could be a raw amount or a % of the size of the trade. This helps answer part of the question “When should I take the trade off?”. If you are asking this question when a trade is profitable, you either did not set a profit target or are second guessing yourself. Neither is good in the long term. Again, the time to change your plan is between trades, not while they are on and the market is moving.
This is probably the toughest plan element in terms of execution. But you need to know when enough is enough. Even with the best plan, not all trades will succeed. Losses are a part of the business and taking them properly is critical to successful trading. It’s very easy in the heat of the moment to talk oneself into making more adjustments to try and save a trade and avoid taking a loss. And sometimes it can work. But many times, this is where bad losses happen. The one trade that took out 3 months of profits. I speak from first-hand experience. This is another critical part of a risk management strategy. This is why you need to know up-front how much you should risk on a given trade. As I stated above, size the first element of risk management but a close second is the max loss. If your trade hits or exceeds the max loss of the trade plan, especially at an adjustment point, it’s time to close the trade and move on. The ability to move on from a trade that didn’t work out is very important. It’s so important that I did a separate blog post on it called “Pets vs Cattle“. I use this analogy all the time to remind myself to take a loss before it becomes a bad loss. I don’t always succeed but I continue to work on this part of my trading as it does make me better. But what’s important here is that in order to execute properly on a max loss, it needs to be explicitly defined in the trade plan.
This is an element that I think gets overlooked by many traders. Unlike stock trading, options trading is very sensitive to time because, unlike shares, options contracts expire. Some specific trading strategies, like the wheel, can go all the way to expiration. But in many options trades, the risk/reward changes significantly as expiration gets closer and that should be reflected in a trade plan. The kinds of trades I do work better if I stay away from expiration week or “Gamma Week” as it is sometimes called. For more examples of why this can matter, feel free to read a blog post I did on this earlier called “Why I Avoid Expiration Week“.
Bottom line: It’s important to understand the risk of a given trade as expiration approaches and factor those risks into a trade plan. This may mean you have a point where you simply exit the position by a given point in time regardless of profit or loss because the risk/reward has changed enough that the trade no longer makes sense. One way to judge this is to ask yourself “Would I put this trade on as a new trade given the risk/reward?” If the answer is no, you should exit the trade.
This can be the most complicated part of the plan but it is vitally important. But I will start with this statement: Adjustments are not required in all trades. A valid trade plan can simply have exit points based on the initial entry to the trade. Doing so makes the trade plan and execution easier. The downside is that you may miss out on some potential winners. There is no perfect answer here. But if you are going to adjust, you need to have a set of conditions that would cause you to adjust, as well as know the adjustment up-front. When the market is moving against your position is not a time to figure out what you need to do. Ideally you have one specific adjustment per condition. You might have two but in that case, you should have specific criteria to help you decide which adjustment to deploy. And when first starting out with adjusting, keep it as simple as possible to help you execute properly. You will have time to make adjustments to your plan as you trade more (but only in between trades). The adjustments part of the plan should have specific conditions that trigger an adjustment. These conditions can be the price of the underlying, or a certain Greek value like delta. But timing is really important when it comes to adjusting. Knowing when to adjust is more critical than how to adjust, in my opinion. Adjusting too early can lead to reversals that kill your trade. Adjusting too late can lead to throwing more money at a bad situation and taking larger losses than you planned. The speed of the market can certainly affect how you may adjust. When the market is moving very fast, especially on the downside, an adjustment involving multiple legs may not be possible as prices are just moving too quickly. These situations are rare, but they happen and a trade plan needs to account for them. Sometimes all I can do is grab a put and hang on. But that’s really not specific enough. How many puts? Which puts? What expiration? How long do they stay on? All of this must be part of the trade plan.
Another important element here is to know when not to adjust. Did the market just open? Maybe it’s a good idea to wait a bit and see if it reverses. Is the trade profitable? Maybe it’s a good idea just to take it off and move on to the next one. How many times have you adjusted this trade? Maybe it’s a good idea to just take the loss and move on. How long has the trade been on? Does the trade still have time to work post-adjustment? As you can see, this part can get complicated, and some of these elements you will learn as you trade more and get more experience.
An Example of a Good Trading Plan
So now that I’ve talked about the elements that make up a good trade plan, I want to show an example. PLEASE NOTE: This is just an example of a trade plan. This is not a trade recommendation. I have no idea of your level of expertise, risk tolerance, account size, etc. The goal here is show how one might put the elements of a trade plan together. I hope I can show that here. This particular trade is one the trades I’ve done regularly over the past year or so with reasonable success.
TRADE: 23-day SPX Narrow Calendar
ENTRY: I enter this trade near the end of the trading day on Wednesday. This is a trade that starts at the money with the shorts 23 days out. Where I put the longs depends on the VIX at the time I open the trade.
VIX under 12: The longs go 14 days away from the shorts*
VIX between 12 and 15: The longs go 7 days away from the shorts*
VIX between 15 and 20: The longs go 5 days away from the shorts
VIX between 20 and 25: The longs go 3 days away from the shorts
VIX over 25: Do not put on the trade due to very high volatility.
* Not really narrow at this point, but a standard calendar. Rules still apply.
The reason for this is that the longer the distance between the shorts and the longs, the more the trade is exposed to volatility (position Vega). The higher the volatility, the less Vega exposure I want for it. I understand that in exchange for less Vega exposure, I get less Theta decay. That’s a trade-off I’m willing to make.
As for size, I want to risk around $3000 on the trade.
If VIX is up more 2 points or more on entry day, I will probably delay entry until Thursday. If volatility keeps going up, skip the week and wait.
PROFIT TARGET: The profit target for the trade is 10% of the original risk of the trade. Within the first week I’m willing to take 8% I bump the target up at 6-7 days in the trade.
MAXIMUM LOSS: My max loss for the trade is 15% of the the original risk of the trade. In the first two days, it’s 12%.
MAXIMUM TIME: I want to be out of this trade no later than Monday of expiration week.
Under normal conditions, I adjust if the trade crosses either expiration break-even or if the the market appears to close within 5-10 points of an expiration break-even. I’ll go on the lower end of the range mid-week, I adjust closer to 10 going into a weekend. The adjustment here is to add a new set of calendars equal to the number of calendars put on originally about 30 points past the break even point. Optionally, I can move half of the calendars to the new place to keep the risk the same instead of doubling up.
Once in a double, my new adjustment points are the centers of each calendar. If the underlying crosses either one, the adjustment is to take off the other structure, returning back to a single calendar. From there I could go back to a double if desired.
I usually don’t go to a double more than twice and at that point will consider just closing. Three times would be the absolute most and only then if I like the graph going into the 3rd double.
If the underlying moves down more than 1.6 standard deviations in a day and an adjustment is needed, I consider buying a put to flatten the deltas about 80%.
I usually buy the put in the later expiration of the calendar or later if needed. The expected life of the put is 20% of the time left on it at the time it was bought.
I keep the put until the underlying gets back to the center of the nearest calendar or if the expected life is exceeded. If the expected life is hit, I could roll it out for more time or just sell it.
The goal of the put is to just keep the trade from getting out of hand in a fast down market.
If the trade is up at all at an adjustment point, I will close the trade entirely.
If the trade needs adjustment before the first weekend, I will consider closing the trade. This decision is based on the graph at the time (experience counts here)
This is an example of a trade plan that covers lots of cases. If for some reason the plan can’t be executed due to something unexpected, in my experience, it’s best to close the trade and re-evaluate the plan. This happened to me once on an SLV trade where there were no options available to do my upside adjustment. They just weren’t on the market. I hadn’t accounted for that in my plan so I just closed the trade. This is part of the learning process.
To a new trader, I can easily see how this can be overwhelming. There are trades that can have simpler plans. Most of the complexity is in this trade is in the adjustments and, like I said, not all trades need adjustments. But the goal is to show what I think is a good trading plan. Every trade needs a plan. Then the trick is to properly execute the plan. As the famous boxer Mike Tyson once said, “Everyone has a plan until they get punched in the face”. But building a plan and executing that plan is how to become consistent. The important thing with a new trade is to start small. One-lots are perfectly fine. Keep the risk under control while developing and executing your plan.
As usual, I’d love to hear what you think about trade plans. Feel free to comment here or reach out to me directly at email@example.com
It’s certainly been a while since I’ve posted here but I like to post when I find topics that I think are relevant to what I’m seeing in the various trading communities with which I’m involved, including this one. I do put a good amount of time and effort into these posts and so I want them to be useful to other traders.
That being said, the point of the title is not to be click bait, I swear. I’m not here to say that Iron Condors are a bad trade or that there aren’t traders out there who make money with them. Those traders exist and more power to them. This is very much an opinion piece as to why I don’t like them and what I think new traders need to understand before putting them on. The inspiration for this blog is that several newer traders have reached out to me talking about wanting to do Iron Condors. I understand why. When you look at the risk graph, they look like one of the safest plays out there. Those wide break evens are a siren’s song to new traders. But none of this is to say that there are not strategies to handle the risks of this trade. Just about any trade can work with a solid plan and good execution. But I think it’s critical to understand this trade before jumping into one.
The width of the spreads is up to you, but the idea is that if the underlying stays roughly between the two shorts, by expiration, the trade wins. If not, the trade loses. So the biggest risk is a large move in the underlying. Typically the shorts are far out of the money and so this gives the underlying a lot of room to move while getting a net credit when the trade is put on. As these are credit spreads, the maximum gain is the credit received and the risk of the IC is the width of the spreads minus the credit received. If you aren’t familiar with credit spreads, I advise you learn about them before even looking at an Iron Condor.
The Appeal of an Iron Condor
Why do traders like Iron Condors? Primarily, it’s the room they can provide. You can put those spreads out as wide as you like. This can greatly increase your probability of success at expiration. It’s relatively simple to set up an Iron Condor that has a 90% probability of success at expiration. This “safety” is what I think lures new traders to this trade. Why not put on a trade that should almost always win? Those odds sound really good. And when they see the risk graph at the start of the trade it looks like a trade that you an pretty much set and forget. Easy money, right?
The Risks of an Iron Condor
As I stated earlier the primary risk of an Iron Condor is that the underlying moves beyond one of the short strikes. At expiration this would result in the maximum loss for the trade. Of course, you are not required to stay in the trade until expiration (in fact, I almost never do) and there are adjustment strategies that can help trades that are moving too far in either direction for comfort.
So, why does this trade look too good to be true? Why isn’t everyone doing Iron Condors? Who wouldn’t like a trade that can win 90%+ of the time? And this is on one of the reasons I don’t like Iron Condors or, more specifically, wide Iron Condors. As the two spreads get further apart, the trade gets more room to work and the probabilities get better, but the reward also drops while the risk really does not. This is because far out of the money options contracts have less premium to sell while the difference in the premiums based on the width of each spread doesn’t change much, certainly not in proportion to the drop in premium. And the net credit is the maximum reward of the trade. The best case for this trade is that all of the contracts expire worthless and you are left with the credit received. But the further out you sell the spreads to get more room, the less premium you collect. This can lead to pretty low returns which vs the risk of the trade.
Example: A High Probability Iron Condor
Let’s look at some real-world examples to try and make this clear. Here is an example of what I would consider to be a high probability IC:
In this trade, the shorts are opened at around a .10 delta on each side, and the spreads are 5 points wide. This yields a probability of success at expiration of nearly 90%. The net credit of this 3-lot is $198 which the most that it can make (note: this is after commissions of $12. If your platform does not charge commissions, you could get $210 but my point will still stand). But the total risk on this trade is $1302. So you are risking $1300 to make no more than $200 (using rounded figures). That’s over 6x the risk compared to the reward. And, remember to get that full credit, I have to go to expiration (which my readers will know, I don’t like to do, as the price risk can get crazy). In addition to far out of the money options having low premium, the theta is also low. So for this trade, my starting theta for this trade is less than $7/day. Theta is a big component of making money in this trade since I want both spreads to decay as quickly as possible. The range of this trade is very nice with about 200 points on the upside and 350 points on the downside. But it’s a 30-day trade. Given this past year, do you think those kind of moves could happen over the next 30 days? Iron Condors are negative Vega trades so traders prefer to open them when volatility is high because a vol drop helps the trade and with higher volatility comes higher premiums overall. But when volatility is high, the underlying tends to move more so there’s added risk.
Something else to consider with Iron Condors is how fast the trades can get into trouble. With those near vertical sides, as the underlying moves out towards the shorts, the delta and gamma tend to increase and the trade starts to become directional which is exactly the opposite of what you wanted when you put this trade on. If you want to pick direction, just put on a single credit spread and only take risk on one side. So while the Iron Condor gives you a lot of room on the expiration graph, let’s see what the curves look like 2 weeks later.
The slope is starting to get steeper as you move towards the edges, especially on the upside. This means that if SPX moves in that direction, you will become more directional as delta and gamma increase and each move up hurts the trade more. The downside certainly looks better but keep in mind as well that a sharp move to the downside will spike volatility and so the curve won’t be quite a generous ad the graph currently shows. So if you let the trade go to either side, you may have some white knuckles while you are holding on. Alternatively, you can adjust but most of these adjustments reduce the total credit of the trade which, in turn, lowers the amount of the win. If you over-adjust this, you may end up with no credit left and, at that point, the trade will just lose.
The most I can make on this trade is about 15% but I can’t get that until expiration. If I go to expiration and lose, I will lose $1300. I’m just not happy with the risk/reward ratio on this as well as the glacial speed of time decay.
Example: A Lower Probability Iron Condor
It is, of course possible to sell higher deltas. If I do this, I take in more premium, and get higher theta decay. What I lose is the room to move. Take a look at this example:
In this trade, I’m selling around a .20 delta on each side. In this case I sold a 4-lot to try and keep the risk close to the other trade. In this case, it’s a bit more at $1356. However, my credit is now $660 (or $644 after my expenses). This puts my risk/reward at about 2x. I certainly like this better. But the downside is my range is now 140 points on the upside and 176 points on the downside. That’s a significant difference and it brings my probability of profit down to about 66%. On the positive side, my theta is better at about $10.50/day at the beginning of the trade. If I had to trade an Iron Condor, I like this better than the first one. However, this puts your risk/reward closer in line with other trades that I like better.
A butterfly is the most extreme condor in terms of width. Both spreads are selling the same short. While I prefer butterflies that are all calls or all puts, I’ll use an Iron Butterfly here because it is more similar to the Iron Condor (both have two credit spreads) so it will compare better to the Iron Condors.
With this trade, my range is very narrow compared to the Iron Condors. And, with this trade, the width of the structure is determined by the width of the spreads themselves rather than the distance between the shorts since that distance is zero. So why do I like this trade better? It’s not the range as, in this case, I have around 70 points in each direction which gives me an expiration probability of about 26%. But, remember, I have no plans on staying to expiration week, yet alone expiration day, so the expiration probabilities don’t mean as much to me. I’m far more concerned with the next week or two. Ideally, I’m out of this trade in 2 weeks or less. My total risk is between the two Iron Condors at about $1330. but I took in $5671 in credit. That flips the risk/reward ratio over to the reward side. Now, with any butterfly, the goal should never be to get the maximum profit as the underlying would have to expire on the exact short strikes which is akin to winning the lottery. But, I’m usually trying to make about 10% on these trades in far less time and having that large total credit gives me plenty of room to reach it, even if I had to reduce the total credit with adjustments. And if I was actively managing an Iron Condor, especially the lower probability example, if the underlying moved 70 points in either direction, I’d probably have adjusted the Iron Condor as well which means the work to maintain each is similar given similar market conditions. I also like the starting Theta of about $12/day even though my total risk is a bit lower than the lower probability Iron Condor.
So while the butterfly doesn’t look very appealing compared to the Iron Condor in terms of room and expiration probabilities, there are other benefits that help me make money with it.
My goal is not to encourage or discourage you from any particular trade. If you are comfortable with a given trade, have a detailed trading plan, and can execute that plan consistently, any trade can be a good trade. Rather my goal here is to show my preferences and the reasons why I prefer one trade over another. Have questions? Have a trade you really like? Feel free to reach out in the comments here or to me directly.
When folks first get into options trading, one of the most popular options strategies out there for beginners is the covered call. The idea is that you own 100 shares of stock and you sell a call against the shares (1 for every 100 shares owned). The idea is that you get paid to wait for the stock to go up and you get some downside protection if the stock goes down a bit since the call will lose value allowing you to potentially keep more of the premium. The primary risk of this trade is exactly the same as owning the stock. There is some opportunity risk if the stock goes up past the strike of the call you won’t profit much beyond the strike price. But in this case you won’t lose money in absolute terms which makes it a low stress trade. The shares can be called away but the trader gets to set the price so as long as that price is a good one for the trader, it’s not a bad outcome. Ideally, there will be an opportunity to sell multiple calls against the shares over time thus lowering the cost basis of the shares, thus adding to the potential profit of the position. Some folks take this further and pair this strategy with cash secured puts to acquire shares as well. This is commonly called “the wheel” and is a topic of another day.
So, once a trader is comfortable with the covered call, the next question becomes, “Can I do this without owning the shares?”. And the answer is yes. This is done by creating a long diagonal spread. But not just any long diagonal spread, rather one that mimics the risk profile and reward of a covered call. This is known as a “Poor Man’s Covered Call” (PMCC). The “poor man” idea is that it can be done for less money than a full covered call. How much less will depend on how closely the trader wants it to behave like a regular covered call. This is done by substituting 100 shares of stock with a deep in the money long call. This call is usually far out in time. Then you can sell a call against each long call you purchased nearer term just like you would in a standard covered call. This creates a long diagonal call spread but if done in this manner, the risk profile can greatly resemble the risk profile of a covered call.
My Approach to the PMCC
Because this is a popular trade with new traders, I see questions about it on options forums all the time. I’ve answered the question so many times that I thought it was worth doing a longer form explanation here on the site. In the spirit of transparency, I will state that I don’t trade this all the time. It’s not one of my regular monthly trades. But it is a trade I will do occasionally. I’d estimate in 2020, I did this trade about 6 times. But I think my approach to it as a solid one. If you disagree or have other ideas, feel free to comment below. I’m always open to hear other ideas on trading. When I have traded it, it has worked out well so I think the approach is reasonable. Of course, there are no guarantees in this business so if you learning any new trade you should start small (or even on paper) to control your risk while learning it and scale up over time as you become more comfortable. These are just my guidelines with respect to this trade that constitute my trade plan.
Every trade plan starts with a setup. There are many different ways to start this trade each with advantages and disadvantages. To me, the important concept of the setup of a PMCC is to get a very similar risk profile while still putting up less overall risk. There is no perfect setup. Every setup has trade-offs. The primary trade-off of the setup of a PMCC is cost vs risk profile. The closer the risk profile is to a real covered call, the more the trade will cost. This makes sense because if it were possible to get a 100% match on the risk profile for significantly less risk, why would anyone do a real covered call?
That being said, my setup is pretty simple. I look to buy my calls about 6-9 months out at about an .80 delta. Is this perfect? Of course not. But I think it’s a good balance of trade risk vs risk profile compared to a covered call. The further out in time you go, the more opportunities you have to sell calls multiple times against you longs, but the higher the cost of the long calls. The deeper in the money you go, the more it will resemble the risk profile of a covered call, but the cost will be higher.
Once I have selected my longs, I will sell my shorts around 30 days out around a .30 delta. This is where you have some flexibility as well. If you are used to selling covered calls, you can sell the same calls you would sell against your stock. If you prefer to nearer term options, that’s fine. If you like to sell a different delta, that’s fine too. It’s always a good idea to look at the model in your broker’s platform and ensure that you are comfortable with the risk profile and the total risk of the trade. You most you can lose is the debit you pay for the trade (unless you adjust, then it will change by the amount of the adjustment).
In the ideal scenario, there would be no adjustments. You put this trade on and simply continually sell calls against your longs until the long is ready to expire, then you close the entire position and make a nice profit both from the longs and the multiple shorts over time. But the market does not always cooperate, so it is important to have a trading plan that includes what you will do in every situation. You don’t want to be in a position where you are looking for help while an active trade is moving against you and you don’t know what to do. All of my adjustments (short of taking off the entire trade) involve only the shorts. I do not like to adjust the longs. In my opinion, there is a fine line between adjusting an existing trade and closing a trade and opening a new one. To me, rolling the longs is creating a new trade. Others may certainly disagree, of course. But it’s very easy in trading to try to fool ourselves into not taking a loss by endlessly adjusting a position. Every trader does this at some point, myself included. I think it’s important to look at trades clearly and honestly. Do not be afraid of taking losses. Everyone takes losses at some point. They key is to manage them properly and endless adjusting is a very easy way to allow a bad trade to get out of control. Again, I speak from personal experience here.
My first adjustment is based on the value of the shorts. There is a temptation to want the shorts to expire worthless thereby keeping all of the premium. Most of the time I think this is a bad idea. I think it’s more important to look at the reward vs the risk of the position when deciding when to take off (and potentially re-deploy) the shorts. My rule of thumb is when the short has lost 75-80% of the premium paid for them, it’s time to close them and potentially roll them out in time for another run. Trying to squeeze out that last bit of extrinsic value isn’t worth the risk to me. Another condition that would cause me to close the shorts is expiration week. I have no desire to hold the shorts open later than 2 days to expiration. Most of the time, I will close them before this. I have no desire to go to expiration, the risk is too much for the last bit of extrinsic value left in the contracts. Finally, if the underlying stock has a dividend, I would close the short before the extrinsic value of the contracts meets the amount of the dividend. This is to avoid early exercise of my short calls. This is especially true close to the ex-div date, but I would follow this at any time. My goal is to avoid the exercise of my shorts and following these guidelines will do that the vast majority of the time.
My second adjustment condition is based on the share price. If the underlying stock price drops, the value of the short calls will drop with it. However, there will come a time when the short is no longer providing any more protection against the downside. At this point, I’m not interested in having this short on my trade and I’d prefer to roll it down (and possibly out in time) to get more downside protection and to bank a bit of profit on my shorts in the process. I will show an example of this later in this post. This isn’t free. In exchange for more downside protection and the banked profit, I will give up more potential upside profit because I am rolling down. If the stock rebounds past my short strike, the amount I can participate in the price gain will eventually stop because of the short.
Closing the Trade
What if the price goes up beyond the strikes of the shorts? This means the shorts are now in the money and are probably worth more than the premium received due to intrinsic value. This is where I see the most questions in options forums. Usually the question is about the shorts getting exercised. As I’ve already stated it is never my goal for my shorts to get exercised as that is not why I am in this particular trade. So what’s a trader to do? You can certainly wait and see if the stock comes back down. Maybe it was just a temporary spike and doing nothing is the right answer. But be cautious here. I would only do this if I had at least 50% of the time left on my shorts and the breach isn’t very far above my shorts. It’s OK to wait a bit and see if things move back in the preferred direction, but hope is not a strategy. At some point, you may need to act. My next guideline is to simply take the entire trade off for a net profit. If the shorts are in the money, you will lose by closing the shorts, but you should have gained more with the longs due to the delta difference between them (remember I am buying around a .80 delta vs selling around a .30 delta). So the entire trade should be profitable. Maybe it wasn’t the profit I wanted when I set it up, but it’s a profit and there’s nothing wrong with taking it. How often does a trade move against you and you still make money? There’s no law that I can’t take a trade off now, wait a bit for things to settle down, then put a new trade on later and try again if my thesis on the underlying is still reasonable.
And let’s never forget the best reason to close a trade: You reached your profit target. Every trade plan should have a specific profit target. This can be a dollar amount or a percentage of the risk, but it is a critical part of the plan. The biggest enemy here is greed. If your plan is to get 20% on a given trade, and you can close it for 20%, close the trade. Getting greedy is a great way to lose. Now, if you’re doing so well that you can bank your profit target by only taking off part of the trade and you want to play with the rest, that can be done. Just always keep in mind that whenever your trade is on, you have risk. The primary job of a trader is risk management. Do not add risk back to the trade when you do this. The whole point of doing this is to realize your profit and continue with significantly reduced risk, ideally so little that if you lost it, you would still make money overall on the trade. The bottom line here is that every trade plan should have a specific profit target and it should be respected. When the market gives you what you ask for, take it.
Finally, just like every trade plan needs a profit target, it also needs a maximum loss which should also be shown respect. In this particular trade, the biggest risk is the stock dropping and approaching (or even crossing) the strike of the longs. There will come a point when rolling the shorts for more credit makes the trade ultimately unprofitable. If either of these things happen, it’s time to close the trade for a loss and move on. This is probably the hardest part of trading, but it must be done. Even though this trade should work the majority of the time, it can lose and you must be prepared for that possibility.
A Real-World Example
So I’ve gone over the theory of this trade as well as my approach to it, but there’s nothing like seeing it in the real world. This is one example of a trade I did earlier this year in Delta Airlines (DAL). I did several PMMCs on this stock in 2020 with some reasonable success. But I think this particular trade demonstrates some of the concepts I discussed earlier.
So I opened this trade on May 4, 2020. DAL was trading at about $22.35 at the time I opened the position. I bought a Jan 15, 2021 Call (about 7 months out) at the $15 strike which had a delta of 81.85. I then sold a June 5, 2020 (about 32 days out) call at the $25 strike price which had a delta of about 38. My profit target was 20% and my max loss was 25%. The rationale behind this trade was that DAL pulled back about 7% that day (this was during the pandemic) so my forecast was that it would rebound a bit from that. I paid a net debit of $836.30 for the trade so the trade was a a reasonable discount to owning 100 shares of DAL. This is the risk profile at the start of the trade.
So 9 days later, on May 13, the stock had dropped to $20.13 and the trade is down $110 or about 13%.
Not what I wanted, of course. But the good news is that my short for which I collected $1.30 of premium was not trading for about $.30 or about a 75% discount. This meets both criteria for my guidelines for rolling my short. In this case, I choose to roll down to a $23 strike and out 2 weeks to June 19 for a net credit of $.74 (bought the short back for $.30, sold the new one for $1.04).
The result of this roll is that I have more downside room and I banked a bit more credit, but my upside is more capped since I rolled down. That green 20% target line is going to be tougher to reach. Because of this, I’m willing to take a bit less should the market give it to me. It’s possible I could end up rolling again which could put 20% back in play, but for now, I’d be happy with perhaps 15% depending on what happens.
Not much happens the rest of that week, but the following Monday, DAL makes a nice gain, nearly 14% so the trade is at least starting to make money again.
As you can see, my short has gained value (now trading at $1.66) which hurts the trade but the larger delta of my long has made the overall trade profitable.
A little over a week later, DAL popped again now trading at $25.35. My short has jumped to $3.60 but, again, my long has pushed the trade up even more.
At this point, I could try and wait it out and get the full 20%, but I go ahead and take a bit less. This is still a nice profit and I’m glad to take it. I don’t want to roll the short because getting a net credit at this price would be next to impossible (I’d have to go way too far in the future which breaks the trade structure) and I don’t want to roll for a net debit. So, I simply take the trade off for a nice albeit slightly lower profit than my target.
This is how I approach the PMCC. It is certainly not the only approach, but I think it’s a good place to start if you are new to the trade. You may make your own adjustments to my trade plan that that’s fine. What is far more important is that you have a detailed trade plan for this and every trade you open. This plan should have all of the elements I have described here: a setup, a profit target, a maximum loss, and adjustments for each direction. Once you have this, trading is more a matter of execution. That doesn’t mean every trade will work (I have lost on this trade with this plan) but you should be able to control the losses and be overall profitable with practice.
If you have questions, comments, suggestions, please feel free to reach out. I really like talking options trading so feel free to comment below or you can reach out privately via email at firstname.lastname@example.org
If you’ve followed my style of trading you know I like non-directional income style trades where I try to make money on time decay (positive theta). Most of the time, this works out well. I do lose on occasion as everyone does but I go into each trade with a plan to handle various market conditions. Most of my trades have enough time that I can adjust them if the market moves too far against my position. This, essentially, allows me to buy more time to allow the trade to work. If you’ve watched my This Week @MidwayTrades series, you’ve seen me execute this plan over and over again. Most of the time on these income trades my adjustment plan involves adding structures such as butterflies or calendars making a double or removing a structure from a double and returning to a single.
But there is one kind of move where this does not always work: A big market drop. I work hard to keep my trades in a good enough position to handle at least a 1 standard deviation move in either direction. Statistically, a stock should move less than that about 67% of the time so this keeps my trade in a relative safe position. On the bigger moves, I can make adjustments as described above. But what about a 2 SD move? Or even more? These moves tend to be on the downside so that’s where I’m going to focus this post. We do get occasional big crash moves and just adding or removing spreads isn’t going to work well because pricing is all over the place. Finding a steady price for 2 or 3 legs in a spread just is not practical, and legging out one at a time can be just as dangerous. You may be able to get out for some price, but that price could be really bad and make a big loss. As traders, we like to avoid big losses so what can we do to try and ride out the crazy storm?
Back To Basics
As one learns more about trading and gets more sophisticated with multi-legged trades, it’s easy to forget why options were created in the first place. In short, they act as insurance to protect a position. Traditionally that position was a long or short position in a stock, but it works just as well to protect a position made entirely of options. And for a big drop, that answer is simple: long puts. A properly purchased single long put can save your position and, in some cases, your account (if it got that bad, I would strongly suggest you are trading too large, but it still works). The simple act of adding a long put to a position at the right time can make the difference between a big loss and a small loss, or even a win. They come with a consequences, of course, so I do not like to use them all the time but, at the right time, a long put is a simple fix to a bad problem.
So this post will look at when I buy them, what I buy, and when I sell them. You may tweak these to suit your style, of course, but don’t think a trading plan is complete without having this as a possible response to a big down move.
When to Buy Puts
Buying puts is not a free pass. First, they cost money. You are sinking money into a trade that has gone badly. If done at the wrong time, you can easily dig a bigger hole for your position and take a bigger loss than needed. In addition to costing money, long puts reduce theta. All long options have negative theta so adding a long put to a position will hurt the theta of the position (maybe even taking it from positive to negative). As one who likes positive theta trades, this isn’t my goal. But when things get really bad, sometimes theta has to take a step back to the threats of delta and gamma (i.e. price movement risk). When delta and gamma get out of control quickly, a long put can stop the bleeding and give you time to catch your breath when things are going wild. This has an added benefit of allowing you to think clearer about your next move. If done properly, the stock can continue to tank and you’ll be just fine. Very few good things come from a state of panic so fixing the big problem in front of you helps with the next decision.
With all that being said, my guidelines for buying a put are the following conditions:
The stock has moved at least 1.6 standard deviations down. Less than that and my regular adjustments should work just fine. This is a guideline so don’t take it too literally but I think it’s a good rule of thumb. It’s beyond this point where prices tend to get weird and buying or selling a spread gets really difficult. But in a big down move, buying a put is easy as there are plenty of folks willing to sell them.
My position is at an adjustment point. There’s no sense buying long puts if the trade is still working even with the big move down. Sometimes, my trade can withstand a 2 SD move down. If that’s the case, there’s no need to add long puts.
What To Buy
So that’s when I buy puts, but now what puts do I buy? The critical idea here is to not buy too much or too little. As I stated before, options aren’t free in terms of cost or in terms of the Greeks so my goal is to buy just enough but not much more.
My guideline here is based on the delta of the position at the time I am buying the put. I want to buy enough to nearly flatten my position deltas such that further big movements won’t harm me. This means I’m looking to cut them around 80%. Yes, that’s a big delta cut but this is in response to a big move. That being said, this usually means I am buying far out of the money. This has the advantage of being less expensive while still getting the job done. If, for some reason, I need a lot of deltas, there’s nothing wrong with still buying far out of the money but buying multiples to get to the target. Which to do would be based on the price of the options you are considering. For example if I needed 40 deltas. I could but a .40 delta put or I could consider buying 2 .20 delta puts. Both will do the job so I would choose which ever is cheaper. Most of the time I don’t need anywhere near that many deltas so a single put will suffice.
But there is still the question of expiration. This depends on the spread I am trying to protect. If it is a vertical style spread where all the options are in the same expiration (this includes butterflies, condors, etc.), then I tend to buy in the same expiration as the spread. The only exception to that would be if there were very little time left in which case I would go further out in time. I’ll explain how far when I talk about when to sell, but as I tend to not be in trades during expiration week, this rarely comes into play. If the trade involves spreads in different expirations (e.g. calendars or diagonals), then I will use the later expiration.
When To Close the Put
The final piece of my hedge plan is when to close it. The temptation here is to look at the price paid for the put and base when to close it on the profit or loss of that put, essentially looking at it as a trade within a trade. I don’t do that. This long put hedge is part of my trade and so I try to look at it in terms of the what it’s doing for my trade. The goal isn’t to make money on the put (although that can happen), but to make money on the entire trade which now has this put as a part of it. So there are 4 times I look to close the long put hedge.
When I’m ready to simply close the entire trade. If I have hit my profit target or my max loss on the entire trade and it’s time to close the trade, then it’s time to close the put along with it. Again, the put is not separate from the trade.
When the market calms down and I can do a proper adjustment. So let’s say we had a big drop and I added a put, but the next day things are calm and a normal adjustment to the trade is now possible. The storm is over, I can buy that new spread or close the upper part of the double. Once I do that, my Greeks will be out of whack due to the long put. If I can do the regular adjustment, I will close the put after I get the adjustment done. Do not do it before because until that adjustment is on, the trade is still at risk.
The trade recovers. Sometimes a big drop if followed by a recovery. Maybe it’s the next day, maybe two, maybe even the same day in a really crazy market. If the market recovers such that my trade doesn’t need the help anymore, I will close the put for a loss. That leads to the question “what is a sufficient recovery?”. For me, a sufficient recovery is if the underlying comes back far enough to cross the center to the structure (or, in the case of a double, the center of the lower structure). There’s a big temptation here to take it off earlier to take a smaller loss on the put. The danger here is that if the stock drops back down again, you bought high, sold low, and potentially bought high again. That’s not a formula for profit. So the key here is to be patient and keep the insurance until the chances of needed it are lower.
Time. Long options have time decay. As they decay, the help they provide your trade diminishes. My rule of thumb is I will keep a long put on for up to 20% of the time remaining when I bought it. So if when I bought the put it had 20 days to expiration, I will keep it for up to 4 days. This would be the exception to the rule above on what expiration to buy. If there isn’t much time left in the spread, then buying the put in that expiration may not make sense based on the 20% guideline. In that case, I would consider buying something further out to avoid having to close it too quickly. If time runs out on the put and I still need the protection, I simply roll it out to a later time with the needed delta help.
Real World Examples
I’ve thrown a lot of information in this post so I think it’s valuable to show some examples of trades I’ve done where I’ve deployed this strategy. This year has certain had some volatility, so it wasn’t too difficult to find examples that demonstrate my methodology.
Back on January 29 I put on a simple butterfly:
This is a common setup for a butterfly for me. It’s an unbalanced butterfly 44 days out, 40 points up, 50 points down which makes a nice flat delta trade with .80 deltas on a 2-lot. However, 2 days later the trade looked like this:
SPX moved 51 points down in a day which constituted a 2 SD move. My trade is at an adjustment point so instead of trying to buy a lower fly, I add a put:
I bought a 2550 put (way out of the money). This is because to cut my deltas by about 80% I needed around 1.75 deltas. But now I’m not worried about the trade getting into trouble on the downside and I can wait it out and see what happens given that I’m really flat so that price movement doesn’t scare me. In return for that, my position is negative theta at the moment. While I don’t like that, I’ll take it for now to help stop the delta/gamma bleeding. When I bought the put it had 42 days left in it. That means I’m willing to keep it on for about 8 days before I need to sell it outright or roll it out. This happens to be a Friday so I kept this put on over the weekend and even into the early part of the week. It wasn’t until Tuesday Feb 4 that the trade looked like this:
Note that we had a big up day that put the stock above the middle of the fly structure. At this point it’s time to sell it off at a loss. I lost a bit over 50% of the value of the put but it was just insurance that wasn’t needed. On the plus side, I didn’t pay much for it and this trade eventually closed for a small win. In perfect hindsight, I could have done nothing and done better but there was no way to know that at the time and it was better from a risk management perspective to buy the put and protect the position so that it did not get out of control and become a big loss.
Another interesting example was on June 10 when I put on a narrow calendar.
This is a very typical trade that I put on for much of this year. In the crazy market we’ve had this year, I really like the initial room this trade has and the relatively low vega exposure for a calendar. However, the very next morning I woke up to this:
So in the first hour of trading SPX is down 2 SD and my trade is at an adjustment point. This was a rare exception where I was able to put on lower calendars as an adjustment. Had I not been able to get a good price on it, I would have gone right to the put, but since I was able to do so it looked like this:
So I got my double calendar on and I have a lot more room now, right? Not so fast, later that same day….
Just 2 hours later, SPX is now 133 points down or 3.3 SD down. At this point there is no way I’m going to try and take off the upper calendars (I was lucky enough to get the lower calendars on when I did), so I go ahead an buy a put:
By buying a 2400 put in the back side of the calendar I was able to cut my position deltas to 1.8 from 5.4 and stop any more bleeding. The next day, the market calmed down and I was able to properly take off the upper calendars. At that point I was able to sell off the put since, with my proper adjustment, it was no longer needed.
Now the trade is back to normal and, in this case, I was able to sell the put off at a profit. While that was never the goal, it was a nice bonus. This trade ended up doing very well (over 30% profit) and it was made possible by being able to weather the quick storm that came through the market.
In these examples I used long puts to save trades that got hit by a big market drop. Long puts are not a cure for every trade. I have used these and still lost money, although not as much as I would had I not bought the put. But long puts can be the right fix for a crazy down move.
Hopefully you found this helpful. I’d love to hear what you think or other ideas you may have to handle these kinds of big moves. Feel free to comment here or reach out me directly at email@example.com.