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 5 - Strangles, SPAN Margin

The Canadian dollar is currently around 94 cents to the US dollar. With the weak U.S. dollar, Canada's stronger economy, news such as Russia diversifying into Canadian dollars, I think the fundamentals are strong for the CAD, and I'm very certain it will stay over 82 cents over the next couple of months.

I can (and did) sell 2 March puts (about 100 days to expiry) at a strike price of 82 cents. I received $640 for this sale, and it required $1200 margin. This means I will make about 50% in 100 days on this trade if the CAD/USD exchange rate stays over 82 cents.

Now, I also think the CAD price will be kept in check and will not skyrocket to $1.10 in a short period of time. With the US dollar so beaten down, there may even be a short-term US dollar rally here. I am able to sell 2 March calls at a strike price of $1.06 for a $560 premium. By itself, this trade would normally require around $1100 margin. So we can guess our total return and margin requirements are as follows:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $1100

Total:                                  $1100      $2300      
$1100/$2300 = 48% ROI.

However, this is not what really happens. In futures trading, margin requirements are calculated using a special algorithm called SPAN margin. The algorithm is a secret (you have to pay $1000 or something to even buy a program that will calculate it for you, although your broker has the program and will calculate it for you). All you need to know is that it calculates a 1-day risk value on your entire portfolio covering 16 different scenarios.

If you look at our trade above and really think about it, we didn't add much risk by adding the 2nd trade. If the CAD moves significantly in one direction, the losses in the one option will be partially, if not mostly, covered by the gains in the other option. E.g. if the CAD goes to 98 cents, the 1.06 calls may double in value (+$560), but the puts will then also drop to maybe $200 (-$440), so we've effectively hedged our position pretty well. The SPAN calculation recognizes this since it analyzes our whole portfolio, and thus only requires an extra $500 margin for adding the 2nd trade instead of a full $1100 if the trade were by itself.

With SPAN margin, our trade actually looks like this:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $500

Total:                                  $1100      $1700      
$1100/$1700 = 65% ROI.

A trade like this where you both sell a put and sell a call in the same expiration month is known as a Short Option Strangle, which I'll just call a Strangle from here on (because we're always "short" by being sellers of options).

I love strangles because you simultaneously increase your ROI while lowering your risk, which is totally counterintuitive -- normally to increase your ROI you have to take on more risk.

You could argue that you are taking on some more risk with a strangle, because a major market move in either direction is now bad for you, whereas with a single position, the market has to move in a specific direction to affect you negatively. However, I believe this type of risk is more than offset by the hedging nature of the trade.

In fact, if you follow a strict rule of exiting both trades and repositioning the strangle if one of the option's value doubles, you almost can't lose money. As I described earlier, if the CAD moved up to 0.98 and the call option doubled, you could probably exit the trade for less than a $200 loss. You could then place a new strangle at a higher price range, say 86 cents and $1.10, again for a total $1100 premium. Even if you had to reposition your trades like this 5 times until you were finally successful, you'd still break even in the end!

I try to do strangles whenever it makes sense. However, when the sentiment on a commodity is really bullish or bearish, it can be too difficult to do a low risk strangle. Right now, many commodities have a lot of bullish sentiment, and so the puts are practically worthless until you get to the strikes that are quite close to the current price -- too close for our comfort as far out-of-the-money option sellers.