Portfolio Return Graph

This is just a quick follow-up to my last post about making a 50% annual return. Remember, that number was assuming 80% of our trades are successful. Since the largest factor determining portfolio return is that percentage of successful trades, I thought it would be more interesting to see a graph showing this relationship, based on the same formulae from my previous post:

You can see we only need about 60% of our trades to be successful in order to break even, assuming we follow a strict exit strategy on bad trades. If 100% of our trades are successful (which is definitely attainable), we can make almost 120% in a year! And these numbers are actually a little conservative, since the formula assumes most of the trades are held to expiration (the scenario "c" example in the previous post), which in reality should almost never occur.

I'm coming up on the 4 month mark of my option selling adventure. In a couple of weeks I hope to post my 4-month portfolio return, reflect on the trades I've made, and talk about my future plans.

Option Selling - Part 6 - 50% Return?

I claimed that I expect to make a 50% annual return on my portfolio with option selling. To see how I might arrive at such a number, let's look at:

1) the expected gain on a successful trade

2) the expected loss on an unsuccessful trade

3) the percentage of successful vs. unsuccessful trades

4) the expected overall portfolio return.

1) Expected Gain on Successful Trade

By following various rules of thumb and with my experience so far in picking what seems to be reasonable trades, it seems I can make about $600 premium on a 4-month trade that should require about $1500 in margin. (This can be linearly scaled within reason - e.g. $450 premium on a 3-month trade for about $1200 margin).

The way I calculate the return on this trade is simply $600 / $1500 = 40% over 4 months.

It should be noted that most people actually calculate this trade return as 66.7%. Because you receive the $600 premium immediately, you can put this money to work in another investment, and so your "effective margin" or "out-of-pocket margin" on the trade is really only $1500 - $600 = $900. $600 / $900 = 66.7%. I'm taking the conservative approach of not allowing the premium to be re-invested, because even though the premium is received upfront, you're not guaranteed to keep that cash until the trade is closed out.

40% return over 4 months is what we will receive if we hold the trade until expiration. However, we often will make a higher percentage return because we don't usually need to hold the trade until expiration.

Let's look at the 3 general scenarios that could occur in the first month of a successful trade:

a) the futures price moves favourably for us (away from our strike price).

b) the futures price stays roughly the same.

c) the futures price moves against us (towards our strike price).

In scenario (a), the option price will drop significantly. The option we sold for $600 may only be worth $200 after 1 month, in which case we'd make $400 if we bought it back, or maybe $350 after commission. This works out to a 23% return on investment in 1 month ($350/$1500).

In scenario (b), based on my observations on far out-of-the-money options, the option price will typically drop to half its value in one month. Again accounting for commissions, we would net at least $250, or 16% in one month.

In scenario (c), the option value may rise or stay roughly the same price (depending on the speed and extent of the futures price move), causing us to stay in the trade. Since we are still talking about successful trades here, even if we have to hold until expiration we will end up keeping the full premium. This is just the simple example first described, which I said nets us 40% in the 4 months, or about 10% per month.

Even if scenario (c) happens most of the time, scenario (b) happens sometimes, and scenario (a) almost never happens, and ignoring compounding on the shorter trades, our average trade (or successive trades) will return over 50% in a 4 month period.

(Example math: 23% monthly return 10% of the time, 16% monthly return 25% of the time, 10% monthly return 65% of the time = 23*0.1 + 16*0.25 + 10*.65 = 12.8% average monthly return * 4 months = 51%)

This isn't even accounting for strangles, where we saw we can significantly increase our rate of return, usually over 60% minimum (if held to expiration) in a 4 month period on both of the 2 trades that comprise the strangle. Again, since we can often exit early, we can expect to average over 65% in a 4 month period on strangles.

2) Expected Loss on Unsuccessful Trade

I haven't yet talked about risk management and how much you can expect to lose on a trade gone bad. Really, it is up to you. The book suggests exiting a trade when the option price doubles. I find this a little too restrictive due to the volatility of option prices, so I would say a good rule of thumb is to exit a trade when the option price triples.

If we sold the option for a value of $600 and it triples to $1800, our loss is the $1800 to buy it back minus the $600 premium we originally received, which equals $1200. Since our initial investment was the $1500 margin, our loss is $1200 / $1500 = 80% loss.

It gets more complicated analyzing strangles because there are 2 trades, one successful and one unsuccessful. A typical strangle would be where we sell a put for $500 and sell a call for $500, for a total $2000 margin requirement. If one option tripled and we bought it back, and we assume the other option expires worthless (a valid assumption), the overall loss would be ($500 + $500 - $1500)/$2000 = -25%. i.e. this is the same as losing 25% on two separate trades.

3. Percentage of successful trades

With no history of trading, I have to make an educated guess on this number. I'm going to estimate I can achieve 80% success rate on single trades and 64% on strangles (since a strangle is two separate trades, supposedly each with an 80% success rate, so there's an 80%*80% = 64% chance of success on the overall strangle).

I know this number is pulled out of the air, and it is the variable that will most affect our overall rate of return, but I think it is a reasonable guess. Only time will tell, of course.

4. Overall Portfolio Return

I'm going to try to make half of my trades part of a strangle (e.g. on 8 trades, 4 would be single trades, and there would be 2 strangles (each comprised of 2 trades of course)). Reviewing the numbers, over a 4 month holding period:

- we expect to make 50% on a successful single trade

- we expect to lose 80% on an unsuccessful single trade

- 80% of the trades will be successful

- we expect to make 65% on the trades that comprise a successful strangle

- we expect to lose 25% on the trades that comprise an unsuccessful strangle

- 64% of the strangles will be successful.

(50%*0.8 - 80%*0.2)*0.5 + (65%*0.64 - 25%*0.36)*0.5 = 12% + 16.3% = 28.3%.

Thus, our 50+% average trade return over 4 months drops to an average 28.3% return when accounting for losing trades.

One important guideline that I'm following is that I will only invest half of the cash in my account and leave the other half as cash. This is a very important rule as you need to make sure you have enough room for margin requirement increases that will occur when trades go against you. Since only half of the portfolio is invested, this turns the 28.3% trade return into an approximate 14% portfolio return over 4 months.

Extending this to a full year, and allowing for compounding, our expected yearly return is (1.14 * 1.14 * 1.14) = 1.48 = 48%.

And there you have it, the math behind how I expect to make about 50% per year (before taxes).

The biggest variable, and the one that will affect my portfolio performance the most, is the percentage of successful vs. unsuccessful trades. Also, it has taken me a while to find trades and get up to half of my account cash invested. If I can't keep half of my cash invested, my overall portfolio performance will suffer.

Option Selling - Part 4 - Futures Options vs. Equity Options

Here's an article by the book authors that summarizes the advantages of selling options in the futures markets versus the equities market:

http://www.traderslog.com/optionscomparison.htm

It really boils down to the 1st reason listed: margin requirements are way less in the futures markets, meaning your ROI is much higher.

I can typically sell a far out-of-the-money futures option with 3 months to expiry and receive a $500 premium, while only requiring about $1500 or less to be set aside (the margin). That's a 30% return in 3 months. A similar type of trade in the equities market supposedly might get you a $300 premium and require $3000 in margin -- only a 10% return.

It's really the difference between whether you want to make $50,000 over 10 years or make $500,000 over 10 years.

Margin requirements can be even further reduced in the futures market due to the SPAN margin system, which takes into account your whole portfolio when determining your overall risk exposure. My favorite trade type that takes advantage of this is a short option strangle, which allows you to significantly increase your return on investment. I'll talk about SPAN margin and Strangles in my next post.

As for the authors' 3rd reason for why to trade futures options, that being that the futures options markets are more liquid, I don't think the statement has much weight. I haven't done any equities option selling, but I can't imagine it being less liquid than what I see in the futures options markets. Some commodities hardly have any options traded in a day. Yes, I'm looking at you, Cocoa -- not a single trade of the May options at any strike price over 2 days. And the bid/ask spreads, if there actually are any bids or asks, are simply insane. So the futures options markets are anything but easy to trade in.

Option Selling - Part 3 - The Book and The Strategy

After researching books on option selling, I ended up buying the book "The Complete Guide to Option Selling (2nd edition)" by James Cordier & Michael Gross.

This is the book to buy if you're interested in option selling in the futures market. Actually, I think it is the only book out there devoted to the topic, but thankfully it is a great book written by experts who explain things very clearly, and whose views I could fully agree with every step of the way. However, do NOT buy this book to learn about the futures market or options trading, as it does assume you have some knowledge in these areas. I skimmed some good introductory books in Chapters/Indigo a long time ago, but I don't remember their titles.

In the book, they present a fairly specific approach to selling options, and they sold me (no pun intended) on their techniques, even completely changing my mind on a few key strategies (longer-term vs. shorter term options and naked selling vs. spreads).

James Cordier's company is Liberty Trading group, and their website is here: http://www.libertytradinggroup.com/

Oh, and I should've posted this perfect introduction to option selling from their site for my "Why Sell Options" post: http://www.libertytradinggroup.com/benefits.html

But the point of this post is to point out the core strategy that I'm following, which is explained here: http://www.libertytradinggroup.com/strategy.html

Since the above links explain the concepts so well, there's nothing really for me to add here. If you're too lazy to read the links, the core concepts are:

1) Knowing your fundamentals

2) Selling with 3-5 months to expiry

3) Selling deep out-of-the-money options (as in 50 - 100% out-of-the-money).

4) Proper risk management.

The only thing I've noticed in my trading adventures so far is that it's really hard to find an option that's 50 - 100% out-of-the-money with any decent premium. Although, I guess I've been looking closer to the 3-month expiry dates than the 5 month ones. I need to learn to not be so scared to go out longer term. However, I still think those percentages don't make sense in some commodities. For example, with gold, knowing the fundamentals (concept #1), you know trying to sell gold puts at $550 (50% of price) is ridiculous -- everyone else knows this too, which is why you can't get a gold put at that strike price for even $20. So I think there's some leeway in those percentages. But the key is to go farther out of the money than you think (I'm already close to getting burnt by not following this advice in one of my trades).

Option Selling - Part 2 - Why Sell Options?

So what are the main reasons for selling options?

1. Odds are on your side

Studies have shown that about 80% of options expire worthless. This holds true in bull and bear markets, for both put and call options. The large majority of those who buy and hold options will lose 100% of the premium they paid for it. For a detailed article on these stats, see this article: http://www.tribecacapital.com/pages/sellers_vs_buyers.pdf.

As the article mentions, more than 80% of the buyers are actually losing money, because even if an option expires in-the-money, the buyer had to pay a premium for the option, and so the option would have to expire a certain percentage higher than the strike price for them to break-even. There's certainly a large number of options that expire in the money but where the buyer still comes out at a net loss. The only unfortunate thing about the study is that there is no information on the percentage of people who still make a profit on options that end up expiring worthless by selling the option before expiration - e.g. selling during a temporary price spike.

I'm surprised at the 80% number, but I guess it just shows how the option contracts that are out there are not evenly distributed around the asset price. For 80% of the options to be expiring worthless, most people must be "gambling" on out-of-the-money strike prices that are rarely ever going to be reached.

If we only look at options that are far out-of-the-money, the odds of them expiring worthless are obviously higher. You're looking at maybe a 95% chance of keeping the buyer's premium if you sell these options. Of course, the farther out of the money you go, the lower the premium you'll receive, so there's a balance to find.

By being a seller of options, you already start with the odds on your side before you even make a trade.

2. No need to predict where the market will go

Let's say gold is at $1000 and you think it will go down. You could sell a gold futures contract. However, if you guess the direction of the gold price incorrectly, of course you will lose money as gold rises. But even worse is that when you're right about the longer-term direction, you can still lose money from short-term moves. For example, gold might spike to $1050 and you might be forced to exit your trade at a loss as part of your risk management (as you're already at a $5000 loss now). But gold could then reverse and drop to $950, meaning you were right about the direction in the end, but you still lost money on the trade due to the volatility.

Now let's say you instead had decided to sell a gold call option at a strike price of $1300, which expires in 3 months, and you get $500 for this sale. Gold can stay the same, drop, or even go up, and as long as it is under $1300 at expiry you keep the $500 premium from the buyer. Even if you were completely wrong and gold skyrocketed a whopping $250 to $1250 at expiry, you'd still keep the $500 premium. (And even if gold were to skyrocket to $1250 before expiry, you'd likely be able to get out at less than the $5000 loss you would have taken with the futures contract itself when its price reached a mere $1050. Note: this addresses point #5 later on.)

This is one of the best things about selling options. You can be completely wrong about the direction of the market (as we traders often are) and still make consistent profits, as long as you are selling far enough out of the money and not overpositioning yourself (i.e. being greedy).

3. Time is on your side.

For an option buyer, every day that goes by, the option loses some of the "time value" that makes up the premium of the option. If the underlying security doesn't move, time will gradually erode the value of the option. Option buyers know how depressing it is watching your option gradually lose its value while you wait for a move in the underlying asset.

As an option seller, time is always working for you. When selling far out-of-the-money options, ALL of the value of the option is time value and this time value can drop quite quickly. For most options you sell, you will be able to buy the option back a month before expiry to close out the trade early for almost nothing. This allows you to capture most of the potential profit early and get into some other trade, instead of waiting another month to just collect a measly extra $50 or so.

4. It's easy.

Do you stress out about timing your trade entries, figuring out when to exit when the trade goes against you, find it hard to monitor the markets daily - or hourly? With selling options, you simply enter your trade and wait. You don't have to time things perfectly (you might not collect as big of premium if your timing is off, but even movements against your position will likely not affect you if you are far enough out of the money). It's easy to take profits... because you don't have to! You just sit and wait and let the option expire worthless -- no action required on your part. It's much less stressful too, as even a move against your trade is of no concern unless it's a significant move.

5. Lower risk than owning the underlying asset (in my opinion)

I may try to provide a realistic example of this some other time, but knowing me, I won't get around to it. The gold example in point #2 above pretty much illustrates the point.

And those are the key benefits to selling options.

Option Selling - Part 1 - Introduction

I mentioned a while back that I've discovered my trading destiny and would post about it. Well here it is...

The investment approach I am going to be following in my futures trading account from this point forward is Option Selling, also known as Option Writing. More specifically, I will be selling far out-of-the-money naked options on futures with 2-4 months until expiry. I believe this is the ultimate strategy for making consistent small profitable trades that will result in an average portfolio return of about 50% per year.

What is Option Selling?

Most investors have heard about options. If not, there are many places you can read about options trading, such as here: http://www.investopedia.com/university/options/option.asp.

Usually only the buying of call or put options is discussed. But think about it -- when you buy an option, you are buying from someone who is selling, or writing, that option contract. The buyer pays the seller a premium for the contract, and the seller keeps this full premium as long as the underlying instrument does not reach the strike price.

As an option seller, you are no longer predicting or betting on where the price will go; you are picking a price level (usually an extreme one) and betting that the price will not go there. You can be completely wrong about the direction that the price ends up moving and still make money, as long as it doesn't reach your extreme price level.

A Comparison:

Selling options is often compared to selling insurance. Say I own a car insurance company. I might sell a 1-year contract to 1000 drivers at an average of $1000 per contract for a total of $1 million. i.e. the buyers each pay me a $1000 premium to protect them if they get in an accident. I know that 90% of these drivers will not end up using their insurance for the year. The other 10% (100) of those drivers that get into accidents and choose to use their insurance will cost me an average of about $4000 per accident. That's $400,000 I have to pay out. $1 million in premiums - $400,000 in payouts = a profit of $600,000. Not bad.

I ensure that the 10% figure will stay that low buy only selling insurance to low-risk drivers. If I were to sell to high-risk drivers, I might charge a $2500 premium.

Insurance companies are just playing the odds, and making sure those odds are always in their favour. And that is why insurance companies are always profitable.

Now this example isn't perfect, because in the options world we don't have to sit by and watch while "accidents" happen. In the car insurance world, you can't control the fact that there might be a $1 million claim that comes up. But imagine for a moment if I could monitor all the cars in real-time, and when I see an accident about to happen, I could slow down time itself to bullet-time. So I see Joe starting to slide on some ice and headed for another vehicle. There's a chance his car might get totaled, which would cost me, say, $20,000. So I phone Joe up while he's sliding and say, "hey, I'll make you an offer: I'll give you your $1000 back PLUS an extra $3000 to cancel our contract right now". Joe thinks he can avoid the vehicle, and if not, it will just be a fender-bender, and so he says "Deal. Sweet!" And we're both happy.

In the options world we can manage our risk during the lifetime of the trade like in the above example. When selling far out-of-the-money options, we always have plenty of time to get out at a reasonable loss even if there is a severe move in the market.

A quick note on risk:

Usually any mention of selling options is relegated to a paragraph on how it is extremely risky (unlimited risk!), extremely complicated, requires huge amounts of capital, and is a technique only employed by full-time professional traders, and everyone should stay away from it!

The truth is that selling an option -- even naked selling -- is no more risky than buying/selling the underlying stock/futures contract itself, and usually much less risky when done properly. One quick example is described here: http://daytrading.about.com/od/options/qt/ShortOptionsRisk.htm.

Option selling is not understood by even most professionals, and the exaggerations of risk and misinformation around selling options are just perpetuated by such professionals. This myth of incredible risk is so pervasive that is hard to convince people otherwise, and it means that most people stay far away from selling options.

Selling options on futures is more risky than selling equity options, but only because of the leverage that exists in the futures market, not anything to do with option selling itself. In other words, selling a futures option is typically no more risky than buying/selling a futures contract itself, and when done properly, is way less risky. I will try to talk more about risk some other time.

Summary

I should have just linked to this article, because it covers everything I've said and much more, and is way clearer than what I've written.

Next Steps:

Here are the topics I hope to cover over my next set of posts:

- Why Sell Options?

- The Strategy

- Futures Options vs. Equity Options

- 50% return? Yeah right.

- Risk: Naked Selling versus Spreads

- Risk: Selling Options is less risky than owning the underlying asset?

- My trades so far and potential trades - Sugar, Gold, Orange Juice

- Strangles