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BookingAlpha Option Trading Advisory

Thursday, December 29, 2016

A Trading Estimations exercise for the Credit Spreads trader

Toying with some thoughts in this post where the idea is to quickly estimate potential annual returns depending on the strategies and capital allocation we use, while also adding some theoretical losses along the way.

Let's say I'm trading a 100K account and that I want to deploy at least two income positions every month (max 18K per position, so 36K of capital working on each expiration cycle). Because there will be positions in two cycles at the same time, that leads to a total exposure of around 72K, which leaves room for a hypothetical 5th trade and also adjustments.

The two positions to trade every cycle are:

- Unbalanced Iron Condor. 10 point wide wings. Number of Contracts 20/20/10/10

- Unbalanced Lazy Elephant. 10 point wide wings.
This Elephant will be traded in such a way that if the Call side is threatened and removed (at a loss) the Put side alone can still make this trade a winner. So, the Elephant only loses when the Put side is the one that gets adjusted. The way to achieve this is by being less aggressive on the Call side. All explained in this article yesterday. By playing fewer Call spreads you also receive less overall credit in the position in total dollar terms. We can play, for example 20/20/8/9 contracts. Or complete the additional Long Call via Long 10 contracts of the equivalent strike price of the ETF (IWM or SPY for RUT and SPX respectively). The Elephants will also have long SPY or IWM Puts at 16 deltas to flatten out the T+0 line to the downside.

Now, we will have to make some assumptions here to make our projections:

. We will play the Credit Put spreads at 10 deltas, for which we will, on average, obtain 0.60 credit (even though we can obtain 0.65 and even 0.70 at times we'll go with the lower number) 

. We will play the Credit Call spreads at 10 deltas, for which we will, on average, obtain 1.00 credit.

 With these numbers we will be able to collect $2,200 per Unbalanced Iron Condor and $1,500 per Lazy Unbalanced Elephant.

On the way up
The losses on the Call side will be taken at 30 deltas. At that point Call spreads are worth around 3.60 debit on average, for a 2.60 loss. Typically this will be a $2,600 loss in Unbalanced Iron Condor given the 10 Call spreads we are playing. This loss goes down to $1,400 thanks to the $1,200 win from the Put side of the Unbalanced Iron Condor.

On the Elephant, the Call side loss will be smaller and the position will, on average, still be a winner but only by about $500.

On the way down
The Credit Put spreads will be closed at 30 deltas. On average, that is usually 2.20 debit. This represents a $3,200 loss  (0.60 credit - 2.20 debit) X 20 spreads. In the Unbalanced Iron Condor this loss is mitigated to $2200 given the $1,000 credit received from the Calls. On the Elephant the overall loss is also mitigated to around $2200 given the presence of long SPY/IWM Puts.

In both cases we are assuming that the losses to the downside will be further mitigated by $1,200 (so down to $1000) thanks to downside adjustments (20 spreads at 0.60 credit at the new 10 delta level). Of course once in a blue moon (about once in 20 months we will need to adjust the same position twice to the downside, but for simplicity, let's just assume one adjustment is generally a winner on the Put side). Plus we don't even want to obtain more credit, which is usually possible when volatility increases. We also won't increase the number of contracts to obtain more money either in this theoretical exercise. So, plenty of factors against us, plus others I will add later.

As for the upside: we will never adjust. We will just take the loss from the Credit Call spread. (In 2017 I will not adjust Call spreads of Elephants. However, I will defend Call side of Unbalanced Iron Condors, but for simplicity let's not do it in this exercise and see what we get).

To sum up:

Unbalanced Iron Condor
$2,200 credit
When the Up side  loses: -$1400 overall loss
When the Down side loses: -$1000 overall loss (with successful Put side adjustment)
When nothing needs adjustment: +$2200 gain

Unbalanced Lazy Elephant
$1,500 credit
When the Up side  loses: +$500 overall gain
When the Down side loses: -$1000 overall loss
When nothing needs adjustment: +$1500 gain

Now the fun part. Let's estimate how many times we win and lose.

Because we adjust when the 10 delta option reaches 30 deltas, all we need to estimate is the probability of a 10 delta option reaching 30 deltas at any point during the life of an option. Well, that probability folks is roughly 20%. This means that around 20% of our Credit Put spreads and 20% of our Credit Call spreads will need adjustments (will lose). So, overall roughly 60% of our trades will be the type of winners that don't need any adjustment at all.

In 12 months, we play 12 Unbalanced Iron Condors. 20% lose on the Call side and 20% lose on the Put side. That means 2.4 times the Call side loses and 2.4 times the Put side loses. In practice we need integer numbers for this, of course. Because probabilities are generally underestimated to the upside, let's say that we round that 2.4 number up to 3 for the Call side. And because probabilities are generally over estimated to the down side, then we will round those 2.4 losses to just 2 losses a year on the Put side. The rest of the trades (7) never need an adjustment.

Unbalanced Iron Condor throughout the typical year:
7 winners+$15,400
2 losers (Put side)-$2,000
3 losers (Call side)-$4,200

Unbalanced Lazy Elephant throughout the typical year:
7 winners+$10,500
2 losers (Put side)-$2,000
3 losers (Call side)+$1500

With the Unbalanced Lazy Elephant, in reality we don't close the Call side at 30 deltas. We can in fact wait until 32 - 40 deltas, which decreases the probabilities of locking losses on the Calls. But for the purpose of this exercise and to add one more aspect against us, I will just assume we lose on the Call side just as frequently as we do in Unbalanced Iron Condors, which again, is not the case, but just to be on the conservative side.

With the above estimations we have a total gain of $19,200 in the year. Or a +19.2% account growth. We never defend the Call side, not even once. We also never sell individual Credit Call spreads during overbought price extremes.

Let's now look at other scenarios. Let's say we have an additional loss on the Put side, which of course decreases our number of winners:

Unbalanced Iron Condor:
6 winners+$13,200
3 losers (Put side)-$3,000
3 losers (Call side)-$4,200

Unbalanced Lazy Elephant:
6 winners+$9,000
3 losers (Put side)-$3,000
3 losers (Call side)+$1,500

In this case, our total gain is $13,500 or +13.5%

Let's now add the additional loser to the Call side instead of the Put side:

Unbalanced Iron Condor:
6 winners+$13,200
2 losers (Put side)-$2,000
4 losers (Call side)-$5,600

Unbalanced Lazy Elephant:
6 winners+$9,000
2 losers (Put side)-$2,000
4 losers (Call side)+$2,000

 Total gain in the year of $14,600, or a +14.6% account growth.
Of course we can also have fewer losses than those purely estimated by the probabilities, but those are the more optimistic scenarios.

The table below is a summary of expected account returns depending on the number of wins and losses in both Unbalanced Iron Condors and Lazy Elephants. 12 positions each throughout the year (24 total).

Expected   Pessimistic   Pessimistic   Optimistic   Optimistic  
Winners 76688
Losers (Put side) 23212
Losers (Call side)33432
Acct Growth +19.2%  +13.5%  +14.6%  24.9%  23.8% 

You can play with as many combinations of losers and winners as you like, but I think these are the most representative and also reasonable. We also have a rather low percentages of winning trades, which I like for this exercise. Trying to not be overly optimistic here.

There is one type of trade we haven't included here: Individual Credit Put spreads during oversold extremes. This is historically my most profitable area, and most likely for most credit spread sellers out there too. Usually, my definition of oversold is materialized 6 - 9 times per year. Playing at 10 deltas (90% probability of success), if opened during oversold conditions (inflated fear) the winning rate is much higher than that (above 95%, or in other words 1 loser every 20 trades). Still, we will assume that we lose more than that. So, let's say we get 8 opportunities a year, out of which we lose in one of them. So, only a 87.5% winning rate. This is below what probabilities suggest, and below my actual/real history. Well, 7 credit put spread win (+$8,400), one loser ($1,200 - $4,400 = -$3,200) and that gives us a +$5,200 net gain throughout the year that we can add to the table:

 Expected   Pessimistic   Pessimistic   Optimistic   Optimistic 
Losers (Put side) 23212
Losers (Call side)33432
Acct Growth+19.2%  +13.5%  +14.6%  24.9%  23.8% 
7 winners in 8 CPS+5.2%+5.2%+5.2%+5.2%+5.2%
Acct Growth+21.4%  +18.7%  +19.8%  30.1%  29.0% 

Now you would say "well, you make it look almost too easy. Why didn't you make nearly those numbers in 2016?" Well, there are several reasons:

1- Due to changes of strategies I missed two months worth of Income Positions (February & March).

2- I traded Elephants at half the size reflected in the above tables. So, half the credit in total dollars.

3- I didn't even trade Elephants the entire year. I started trading Elephants as an experiment late in the year and I only got to trade four of them instead of the twelve elephants assumed in the above tables. Overall, I was under-invested throughout the year. Something that will be changing in 2017.

4- The above simulations have kept commissions out of the equation for simplicity. But you can subtract 2 - 4 percentage points (easily) to account for trading costs.

Other than that, the above account growth rates are in the realm of the "realistic" for Index Credit Spread traders. High 10's, low to mid 20's. And you are seeing that this is trading with the boat pretty loaded. Meaning, using most of the capital, most of the time. So, how to make the 40% - 50% annual returns as an Options seller?

- You can certainly trade closer to the money to obtain more credits. But then you will have more losing trades too. With some lucky years here and there (because probabilities won't always play out against you), your returns can slightly improve.

- You can delay the adjustments until price is about to penetrate or has actually penetrated your strike prices. This will give you a great winning rate but the few losses will have devastating consequences. This was the modus-operandi of most Option Selling newsletters in 2010-2012, making 40-60% annual returns and then totally blowing up in 2013 and 2014.

- You can trade naked/undefined risk positions to collect more credit and improve your probabilities of success, but you need to be able to run a "tight" defensive game in this case.

- The other answer would be "leverage". With portfolio margin you have access to more capital than the size of your account (also get less capital frozen when selling options) and that would allow you to basically double or triple the above returns. Although this is at the expense of potentially larger draw-downs too. No free lunch in this joke of an industry.

As usual, someone will say, "but I see this site of this guy that trades one single position every month and posts 8%, 10%, 15% return per month consistently". Shhhhhhhttttt. Shut up. Those are posting ROI. Return on that particular investment, but not on the overall account.

I enjoy these estimation exercises from time to time, even though fiction never perfectly aligns with reality. But, if anything, at least they allow one to write fun, thought provoking articles from time to time.


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