I can’t afford to die;
I’d lose too much money.

—George Burns

Prologue

Every week I learn something new. Whether it’s a caveat to an existing rule or a revelation that sets me back on my heels, this week’s lesson was a real eye-opener for me.

The schedule I have set up for myself is to stagger at least 2 Vertical Bull Put Spreads each week, with the parameters of a maximum dollar risk of $495 for each trade and no more than $990 risk for the week. On top of that, every new position must have a credit premium of 7.5% of risk or better. But if a trade did not quite add up to 7.5%, I would simply sell multiple contracts to up the ROC to meet these thresholds. What I failed to realize is the Rate of Max Loss.

There are two quick points that I want to discuss before I share my new epiphany.

The Law of Large Numbers (LLN)

The probability theory of the law of large numbers roughly says that if I perform the same probability test a large number of times, the results will be reasonably close to the probability chosen.

For example, in flipping a coin, I have a 50% probability of landing as Heads. If I only flipped the coin one time and it lands as Tails, and I stop flipping forever, then I can say, “if I flip a coin, it will land 100% of the time as Tails.” That is what I saw.

However, if I flip the coin a large number of times, even though the first flip maybe Tails and the second flip could just as easily be Tails if I flip 100 times, the end results will be fairly close to 50/50. If I continue flipping the coin 1,000 times, the results will be even closer to 50/50 than by flipping just 100 times.

Making this relevant, one of my guidelines for picking a Vertical Bull Put Spread is to select the short leg of the spread that will have an 80% probability of expiring worthless. Executing one spread, the trade has a high probability of success. Even executing two or three times, I can feel confident I will win each. But after opening 100 Vertical Bull Put Spreads with an 80% chance of success, the law of large numbers tells me I will end up reasonably close to winning 80% and losing 20%.

At first shrug, this seems fair. But keep reading below – because there is a gotcha.

Observed Market Behavior

The Stock Market is made up of a bunch of people’s money. All of which is intended to make even more money. With the advent of IRAs, 401Ks, and online trading, a significant percentage of the market’s money is made from the ‘buy and hold’ strategy. Thus if the market has a nature, then the force of that nature would be to slog its way higher.

But… in the past 5-years, the DOW has had sudden drops of multiple-hundreds points (mini-corrections) many, many times. When these market’s pull-backs occur, stock prices fall fast and then take its sweet time to slog its way back up. From my historical log, they rarely recover in time to save my Options Spreads. Without time to intervene, I tended to hit Max Loss most of these times.

So I need to construct my spread configurations to slow down the rate of max loss.

Critical Revelation

Consider the following:

• According to the law of large numbers, my perceived safe 80% probability of OTM for a Vertical Bull Put Spread will lose 20% of the time.
• The majority of my trades are constructed with two or more contracts, typically one strike wide. The multiple contracts are to get the net premium high enough to make it worth it.
• According to my trading guidance, all active spread trade will not exceed a max risk of $3,960 at any given time.
• According to my trading guidance, each vertical-spread trade should have a minimum of 7.5% ROC.

Here’s the Bad News

Therefore, 80% of the time, I will earn 7.5% on $3,960 ($300), and conversely 20% of the time I will lose 92.5% of $3,960 ($3,700). So over ten months (just making the math simple), I would have received $3,000 in premiums but lost $6,800 in capital. In my view, this is a strategy that is foredoomed to lose from the get-go. NOT GOOD!

Manage the Rate of Max Loss

Consider these 2 Vertical Bull Put Spreads for the DIA ETF:

ETF:DIA’s current price = $271.57

Both trade configurations yield close to the same premium, risk, and ROC. But the big difference is if DIA drops to $260.99 at expiration (-3.9%), it will cost me my max loss of $356 with Options Trade 1. But with Options Trade 2, my loss will be slightly over $100. For Trade Option 2, DIA will have to drop $13.51 (-5%) before extracting max loss.

Lessons Learned

While on my beginner’s trek with Options trading, avoid trading Options with more than 1 contract. Maximize the premiums and ROC by changing the strike-width. Focus on ROC, not premiums.

P&L and Performance Status

YTD (2019)

Net Profit = $1,954.31
Started 89 trades: 45 Vertical Bull Put Spreads, 44 Cover Calls 

Profit for Spreads $-216.10
ROC for Spreads (target = 72% for the year): -5.5%

Profit for Cover Calls $2,190.41

Last Month (July)

Net Profit: $510.2
Started 13 trades: 8 Vertical Bull Put Spread, 5 Cover Call – (9 trades still open)

Current at risk $$$ for Spreads (Max: $3,960): $3,887 (98% of max risk)
Profit from Spreads: $313.40
ROC from Spreads (target = 6.0%):8.1%

Profit from Cover Calls: $194.8

MTD (August)

Net Profit: $23.05
Started 1 trade: 1 Vertical Bull Put Spread, 0 Cover Calls

Current at risk $$$ for Spreads (Max: $3,960): 3,218 (81% of max risk)
Profit from Spreads: $23.05
ROC from Spreads (Target = 6.0%): 8.5%

Profit from Cover Calls: $0

Note: P&L for MTD only covers the first 2 days of Aug.

Schedule for this Week

Monday:

• Review and tweak Trend-Channels for all stocks in the watch list.
• Confirm that the target expiration date for all options trades is set to Aug 23 (25 days).
• 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.  

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). 

Note: This week, don’t make ANY trades until after Wednesday (7/31) when Jerome Powell, Fed Chairman, gives his Interest Rate speech.

Wednesday:

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

Thursday:

• Reset target expiration date to Aug 30 (29 days out to 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. (Do not submit a trade with for the same ETF as Tuesday.)

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 7/26/19

QQQ: $183p/$173p – 1 contract – Open 7/3 – Expires 7/26 – Net Premium = $54.05
When Opened: Probability of OTM = 82.0%, ROC = 5.8%, Max Risk = $940.00  
The threshold rule of ROC being >= 7.5% per contract was not defined when I made this trade. With a ROC of 5.5% this trade started out as a loser (going against my 6.0% ROC for the month). Even though it ended up a winner, this trade lowered my target ROC average and thus should not have been made.

This was the only Spread trade that expired this past week. I did have A SPY spread with the same 7/26 expiration, but I got the close-flag early last week and cheaply bought back the short-leg. I also received a close-flag on the QQQ spread above, but not until 3 days before expiration – a which time I just decided to ride it out.

Trades Still Cooking

Current dollars at risk for Spreads (max $3,960): $3,218 (81% of max risk)

DIA: $257p/$247.5p – 1 contracts – Open 7/5 – Expires 8/2 – Net Premium = $56.05
When Opened: Probability of OTM = 81.9%, ROC = 6.3%, Max Risk = $888
Now: Probability OTM = 98%

The ROC of 6.3% is less than the 7.5% target minimum per trade (even though my target monthly average for completed trades is 6.0%). I should not have made this trade either.

CRON $17.5cc – 3 contracts – Open 7/9 – Expires 8/2 – Net Premium = $38.55
When Opened: Probability of OTM = 85.6%. HeadRoom = 13.0%
Now: Probability of OTM = 98.7%, Head Room = 18.3%

I got the close-flag mid last week and tried to close early by buying back the short for $3. But my offer was always a half-cent short of the Market-Maker’s asking price. Now with less than 5 days until expiration, I may just ride it out.

CRON’s stock price started a pullback about 2 weeks ago when they agreed to purchase Ginkgo Bioworks and Redwood. Plus the pot sector as a whole got nail by a couple of notable scandals – CannTrust and Curaleaf Holdings. But Cronos is having their quarterly Earnings Conference Call on Aug 8th and I suspect that good news will revive the price.

IWM: $150p/$148p – 2 contract – Open 7/10 – Expires 8/2 – Net Premium = $41.05
When Opened: Probability of OTM = 78.4%, ROC = 11.7%, Max Risk = $352
Now: Probability OTM = 91.7%

QQQ: $184p/$182p – 2 contract – Open 7/11 – Expires 8/9 – Net Premium = $39.05
When Opened: Probability of OTM = 80.6%, ROC = 11.0%, Max Risk = $354
Now: Probability OTM = 70.7%

QQQ: $185p/$183p – 2 contract – Open 7/16 – Expires 8/9 – Net Premium = $31.05
When Opened: Probability of OTM = 83.0%, ROC = 8.6%, Max Risk = $362
Now: Probability OTM = 65.5%

IWM: $147p/$145p – 2 contract – Open 7/19 – Expires 8/16 – Net Premium = $33.05
When Opened: Probability of OTM = 81.8%, ROC = 9.2%, Max Risk = $360
Now: Probability OTM = 78.0%

AMD $41cc – 2 contracts – Open 7/19 – Expires 8/9 – Net Premium = $30.05
When Opened: Probability of OTM = 93.6%. Head Room = 24.7%
Now: Probability of OTM = 94.2%, Head Room = 21.0%
Note: AMD is having their conference call 7/30. Conference calls always creates an unexpected twist on the price of the stock. Additionally, the Feds are announcing 7/31 on whether to cut interest rates. So this week may be a wild expiration-week for AMD.

ACB $7.5cc – 3 contracts – Open 7/22 – Expires 8/16 – Net Premium = $20.55
When Opened: Probability of OTM = 81.4%. Head Room = 11.9%
Now: Probability of OTM = 91.6%, Head Room = 26.4%

ACB’s prices started to really tumble last week when Aurora was downgraded with a note that they are burning through cash.

QQQ: $184p/$181p – 1 contract – Open 7/23 – Expires 8/16 – Net Premium = $23.05
When Opened: Probability of OTM = 82.5%, ROC = 8.5%, Max Risk = $271
Now: Probability OTM = 65.9%

DIA: $263p/$261p – 2 contract – Open 7/25 – Expires 8/16 – Net Premium = $33.05
When Opened: Probability of OTM = 82.0%, ROC = 9.2%, Max Risk = $360
Now: Probability OTM = 57.7%

New Trades for This Week

This week’s Schedule and goals:

• Make 1-2 Vertical Bull Put Spreads by Friday.
  • All trades must be >= 7.5% ROC
  • All short-legs must exceed 80% OTM probability
  • 9-day SMA must be higher than the 50-Day SMA (using 90-Day Time Frame)
  • Find spreads with the strike-width between 3 and 10
  • Max trade risk:
    • Per Trade = $495,
    • Per week = $990,
    • At any point = $3,960
• 1 1-month cover call by Friday
  • All trades must exceed 90% OTM probability (unless I’m looking to unload the stock).
  • Strike price must be above the trend-channel at the expiration date.
  • Headroom must exceed 10% (this rule needs to be refined)
  • Premium received must be more than the assignment fee.

IWM: $151p/$148p – Open 8/1 – Expires 8/23 – Net Premium = $23.05
When Opened: Probability of OTM = 80.4%, ROC = 8.5%, Max Risk = $271
Now: Probability OTM = 57.9%

Because of the Fed’s induced dynamics this week, the only fund on my watch list that was within the right parameters for a spread trade was IWM (upward trend-channel, 9-days SMA above 50-days SMA, probability of OTM > 80% and ROC > 7.5%. The premium received is not eye-popping, but the dollar risk isn’t either.

Because of the relatively sideways movement of the Dow, NASDAQ and S&P 500 for nearly a month, plus the wild ride of the markets after the Fed’s interest rate decisions, the trend directions for these indexes became fairly flat. I will continue to hold off on these other ETFs until a trend and be re-established.

Epilogue

For about a month, the market was set on pins and needles waiting for the Feds to announce their rate cut decision. From the chart below, I see that the DOW moved mostly sideways over the past few weeks.

On midday Wednesday (7/31), the Feds announced a quarter-point interest rate cut, which surprise most of the talking-heads, who were expecting more like a half-point cut. Additionally, Chairman Powell gave somewhat of a confusing speech afterward.

To top that, late Thursday (8/1), Trump dropped another China Trade Tweet-Bomb.

What now seems to be an end-of-week punctuation to this week’s post topic – from midday Wednesday to late Thursday, the DOW tossed out more than 650 points (a 2.3% drop) in slightly over 24 hours. Most of my eight spread trades that I have cooking have gone from yawn-safe to sphincter-tight. I now have “close-flags” on all my spread trades except for 1.

As a final observation, on the above chart’s far-right, the DIA price has abruptly broken through the bottom of the trend-chart along with its simple averages. This is somewhat reminiscent of what happened in mid-April with another China/US Trump Tweet Bomb. If this is a signal that we are about to embark on another 6-week mini-correction, then the epiphany I had in writing this post may have come a month too late (since 5 of my existing eight spreads currently have two contracts)…

Cheers…