These aren’t the droids you’re looking for.

Obi-Wan: (Movie: Star Wars – A New Hope)

Prologue

I initially dipped my delicate tootsies in the tidal wave of Options trading by dutifully going through every online course that Ameritrade has to offer. After A LOT of hours of Puts and Calls, Greeks and Spreads, and videos, I came to this conclusion – “Damn, there’s a lot to learn!” It was like drinking out of a fire hose.

I did nothing but read, studied, and practice Options Trades with play-money from March ’18 through June ’18. (And it was a good thing it was all play-money; otherwise, I would have lost my 401K twice over). During that time, I pleaded sanity and decided to only focus on 2 Options strategies – Cover-Calls and Vertical Bull Put Spreads.

For me, Vertical Put Spreads was one of the most straightforward Option Spread strategies to understand. I originally started to construct Put Spreads the same way the online courses did, but it took some painful losses to force me to look closer to my Spread’s construction and decision points.

In this post, I do not plan to drone through the mechanics of Vertical Spreads. The online courses on Ameritrade do an excellent job. But here, I will go through some of these decision points I will watch for to submit a trade request.

Some Boundaries

To reiterate from my first post, I am still in the infancy stage of my Options Trading education – maybe approaching early adolescence, which is always dangerous. I have no desire to blow up my account (which can quickly be done). So I opened a separate brokerage account at Ameritrade for the sole purpose of using it for Options Spread trading. I have deposited my seed-dollar amount, and I work on a budget. As my performance improves, I’ll increase the seed money.

Account Seed Money: $12,000 (Began at $10,000. Will adjust as I gain confidence.)

Max Account Risk: 33% (For $12,000 I will not have more than $3,960 on the line at any one time.)

Vertical Spreads’ Decision Points 

Max Trade Risk: $500 (usually ends up around $300-$400)

I want to have 2 – 3 Vertical Spreads submitted each week. At a max risk of $500, it almost gets me there. To increase the number of trades per month, I need to close the short-leg of trades early as they approach expiration. If the short-leg premium price is $.05 or less, then Ameritrade will not charge a trade-fee. Early closing a short-leg will 1) cement the profit from the trade and 2) release the $500 max-loss allocation to be used in another position. If I cannot close any positions early, I will not trade anything new until something expires.

Also, when just closing the short-leg of a spread early, I will be keeping the long-leg to expiration (which does not cost anything more). Keeping the long-leg Option has a long-shot benefit. Should the market have a catastrophic drop, then that Option might become ITM.

Trade duration: 4 weeks (plus or minus a couple of days)

I want to manage my trading performance by months. So I need to choose my expirations dates for all my spread trades to last from 21 to 25 days.

Min ROC per Trade Risk: 7.5%

My monthly trading goal is to have an average greater than a 6% ROC on all spread trades. To measure this, I also have to limit my trade durations to 1 month – thus engineering my max risk amount of $3,960 to only has a life span of 1 month. I am therefore using the same $3,960 each month. So if the calculated Max Risk for a trade is $500, my expected profit (including fees) needs to be no less than $37.50 ($500 * .075 = $37.50). (Note, understanding that I may have to exit a losing trades from time to time early, I’m setting my per trade risk to 7.5% so to average down to 6%.)

If I make 6% profit each month ($3,960 * .06 = $237.60) that profit is accumulative. Therefore, after 12 months, I could conceivably make a $2,851.20 profit off the repeated use of the same $3,960. That is an annualized ROC of 72%.

Strike-Spread: variable width.
The Strike-Spread of a Vertical Spread vastly affects the trade’s ROC.

For example: ETF:DIA Vertical Put Spread (including fees):
261p / 260p (strike spread = 1), Max Gain: $8.05, Max Loss: $86.00, ROC: 9.36%
261p / 259p (strike spread = 2), Max Gain: $20.05, Max Loss: $174.00, ROC: 11.52%
261p / 258p (strike spread = 3), Max Gain: $30.55, Max Loss: $263.50, ROC: 11.59%
261p / 257p (strike spread = 4), Max Gain: $39.05, Max Loss: $355.00, ROC 11.0%

The Vertical Bull Put Spread of 261p/258p with a strike spread of 3 provides the highest ROC from this real-time example. So that would be the spread configuration that I would most likely use.

Probability of OTM: > 80%

The online course almost always used a 70% OTM goal for relatively safe spread trading. They used this because the premiums collected for a 70% OTM short-leg strike are much more than what is collected from an 80% OTM strike. So the examples look more attractive.

My primary focus is to have a predictable ROC – not maximizing dollars. If I have a predictable ROC, then by adjusting the Max Risk Amount, I could scale up or down the profit and maintain the same risk to reward.

Probability of Touch: < 35%
This is nothing more than a Sphincter-Factor setting. Suppose I have a probability of Touch at 50%. That does not mean that I am doomed. It just makes me pucker more…

Short Strike Price: Set well below the trend-channel at expiration.
My Trading the Trend post talks about how to determine the direction trend of the stock. I want to set my short-leg strike price well below what I believe how the trend is moving.

P&L and Performance Status

YTD

Net Profit = $1,809.36
Started 82 trades: 40 Vertical Bull Put Spreads, 42 Cover Calls

Profit for Spreads $-359.35
ROC for Spreads (target = 72%): -9.1%%
(Note: at this point, my expected YTD ROC should be around 35%-ish. I contribute my lack of progress to my still learning the ropes. A lot of the rules, goals and decision points were not well defined earlier this year.)

Profit for Cover Calls $1,271.73

Last Month (June)

Net Profit: $792.82
Started 15 trades: 6 Vertical Bull Put Spreads (1 still cooking), 9 Cover Calls (1 still cooking)

Max $$$ Available for Spreads (Max Risk): $3,960
Profit from Spreads: $330.27
ROC from Spreads (target – 6.0%): 6.9%

Profit from Cover Calls: $462.55

MTD (July)

Net Profit: $344.35
Started 7 trades: 4 Vertical Bull Put Spread, 3 Cover Call

Current at risk $$$ for Spreads (Max: $3,675): $3,452
Profit from Spreads: $200.15
ROC from Spreads (target = 6.0%): 7.9%

Profit from Cover Calls: $144.20

Schedule for this Week

I’m adding to my weekly schedule a requirement to keep up my education. During this week I will watch at least 1 webcast or take at least 1 mini-online course.

Additionally, the 2 spreads submitted this week should have staggered expiration dates.

Monday:

• Review and tweak Trend-Channels for all stocks in the watch list.
• Confirm that the target expiration date is 25 days out (exactly 4 weeks).
• Prior to 10 AM submit any 1-week necessary cover calls (may not be any).
• By 10 AM, stage possible trades for all watch list stocks (but don’t trade anything).
• Watch 1 Webcast or take one online mini-course to be completed by Friday. (New)

Tuesday:

• Review how yesterday’s staged trades moved. Adjust premiums to take advantage of movement (these are “long-shots”).
• Submit a couple of Vertical Bull Put Spreads, but keep a close watch. If one takes, cancel the others (we just want one new active trade).

Wednesday:

• If no “long-shot” spreads were accepted yesterday, then readjust premium to current prices and resubmit. We want only 1 vertical spread accepted so keep watch.
• Recheck/tweak trend-channels.

Thursday:

• Reset target expiration date to 27 days out (the following Friday).
• By 10 AM, stage possible trades for all watch list stocks.
• Submit a couple of Vertical Bull Put Spreads, but keep a close watch. If one takes, cancel all others.

Friday:

• Same as Wednesday.
• Update trading journal (this blog) and update it to the Internet by end of the day.
• Make sure you watched a webcast.

Trades Ended 7/5/19

5 trades ended last week

In the news: Tuesday morning (7/2), Fox News reported that Vice President Mike Pence’s flight to an event in New Hampshire was abruptly canceled and returned to Washington DC due to an undisclosed emergency. After about an hour of no follow-up and no other explanation, I did not want to take the chance of a national emergency tanking my trades. So to be prudent, I closed those trades that were close to expiration and still profitable.

ETF:DIA $251p/$246.5p – Open 6/18 – Closed 7/2 – Net Premium Collected = $29.07

ETF:QQQ $176p/$171p – Open 6/18 – Closed 7/2 – Net Premium Collected = $49.07

ETF:QQQ $176p/$166p – Open 6/25 – Closed 7/2 – Net Premium Collected = $43.06

CRM 155cc – 1 contract – Open 7/1 – Closed 7/3 – Net Premium Collected = $15.10 

This had nothing to do with Pence’s recall, but the current price got above the $155 strike and below the Break-Even price. Since this is not an urgent sale, I thought I get a little profit from last week and resell this week – which I did (see below)

Note: the 4 trades that I closed early last week were all profitable. Even though there is still no explanation for the Vice President being recalled. I still see all this as a win.

Trades Still Cooking

5 trades still in the oven:
Current dollars at risk for Spreads (max $3,675): $2,787

ETF:SPY $280p/$270p – 1 contract – Open 6/28 – Expires 7/26 – Net Premium = $76.05
The probability of OTM when traded was 80.5%. Probability OTM now: 93.5%
Probability of OTM when opened: 82.0%. Probability OTM now: 83.0%

• 1 vertical bull spread by Tuesday.
• 1 vertical bull spread by Thursday (Thursday = 4th July so this will be Friday).
• 1 1-month cover call by Friday
• 1 1-week cover call (CRM) by Monday (see “Trades Ended 6/28/19”)

The Stock Markets has may defining characteristics. Amount them: it is a neurotic, bi-polar, schizophrenic bitch! It moves in herds, it is amoral, and it is unforgiving. But it is also made up of lots of people’s money – so it has an innate pressure to move upward. This is overtly obvious when I look at the history of the market since the Great Depression.

Therefore, my focus will be on Option Spreads that bet that the market will go up (Vertical Bull Put Spreads). If the market gets into a depression or even a correction, I should back off Spread trading altogether until its tantrum is complete and back on track.

As I get more proficient, more consistent, more disciplined, and more adept at reading Market movement, I will be willing to put a greater amount of seed money into my account. With a larger account balance, I will have a larger trade risk. And if I can show that I can support a monthly 6% average ROC, then my expected profits should go up accordingly.

These are the droids I’m looking for…

Cheers…