We can never see past the choices we don’t understand.”

– the Oracle (The Matrix)

Prologue

It was an iconic early Fall day in Central Texas – blue skies, fresh breeze, comfortable temperature. Feeling invigorated, I decide to spend a leisurely morning washing my car. After a couple of hours of scrubbing and buffing, I stood back to marvel at my work.

At that very moment, a flock of birds decided to fly over and completely decimated my car. Stunned, mortified, deflated, all I could do was to stand by slack-jawed.

As an extension to last week’s post “Managing Rate of Max Loss,” this post is to review the effects of my selling credit spreads with multiple contracts. Multiple contracts on credit spreads are a mechanism to functionally double the premium collected, but it also has the effect of doubling the rate of max loss. The wild market ride we had this week drove home the notion that this was a bad idea for us beginners.

What Just Happened!

QQQ: $185p/$183p – 2 contract – Open 7/16 – Expires 8/9 – Net Premium = $31.05

I open this trade on July 16, and set it to expire this coming Friday, Aug 9. When I open this position, the probability of this expiring worthless was 83%. Ten days later, the probability improved to 86.2% – sweet! But just like that…

In the three trading days between Aug 1-5, a flock of Feds flew over my scrubbed and buffed trades-in-play and similarly decimated them all. The above QQQ trade dropped below the $183 long strike to $180.46. The probability of expiring worthless for this trade just sunk to 23% with four days to go. Once again, I stand here, slack-jawed!

Evaluating the Current Status

Monday morning, 8/5, the price of QQQ was $182.46, which is $2.54 below my short strike of $185 and below my long strike of $183. So I am looking at the total kill for this spread trade if QQQ continues to fall or runs flat.

If this trade were to expire right now I would suffer the max loss of $185 – $183 = $2.00 * 100 shares = $200 * 2 contracts = $400 + $40 assignment/exercise fees = $440 loss. But I already received $31.05 credit from this trade, so my total loss on this trade would actually be $408.95. The $400 value (before fees) is the total “Intrinsic Value” of this trade.

As a parallel observation, Monday’s premium for this QQQ spread (expiring in 5 days) is now $1.00. If I were to buy-to-close this trade now I would have to pay $1.00 * 100 shares = $100 * 2 contracts = $200 + $6.95 trading fee = $206.95. Again, since I already received the $31.05 credit premium my actual loss would be $206.95 – $31.05 = $175.90.

What To Do

If QQQ starts a recovery now, the price of QQQ will need to raise to $184 or higher by Friday to match the loss I would occur if I would close right now (short leg strike of $185 – ($202.00 Time Value / 2 contracts = $101.00 / 100 shares = $1.01) = $183.99)

1) QQQ: $184p/$182p – 2 contract – Open 7/11 – Expires 8/9 – Net Premium = $39.05 (yellow horizontal line)
2) QQQ: $185p/$183p – 2 contract – Open 7/16 – Expires 8/9 – Net Premium = $31.05 (yellow horizontal line)

The chart above compares the market plunge the last time the US/China trade talks went south, mid-April through May. It took about 6-weeks to start a recovery. In this chart, I duplicated the downward tend-channel from last May and overlaid it as current (starting about a week ago). With the ferocity of the market plunge between Aug 1 through Aug 7, I’m betting that this severe drop is more of a tantrum (not an economic prediction) and will be relatively short-lived with a bounce-back within the next week or two. But I’m thinking not in time to save these two spreads.

From the start of this week, the safe decision is to close both my QQQ spreads early and minimize the max loss.

Lessons Learned

As a matter of observation, I know that I can construct a Vertical Bull Put Spread with varying ROCs and premiums depending on the strike width. Selecting a strike width with the maximum ROC requires looking at each long-leg strike combined with the desired short leg. Once I have the best strike width, increasing the number of contracts only marginally improves the ROC while multiplying the Rate of Max Loss.

My losses this week were compounded by my rookie mistake. The two QQQ Vertical Bull Put Spreads that I submitted on July 11 and July 16 (both to expire Aug 9) had two contracts each. If I would have learned this lesson sooner, then my rate of real dollar loss this week would have been half.

Sadly, I have a similar multi-contract credit spread expiring next week and the week after – so the carnage may not be over…

At my current early stage in my “Options Trading for Income” learning curve, I need to learn how to work through these kinds of market downturns without taking a real hit on dollars. Increasing the premium credit by using multiple contracts barely moves the ROC needle. I need to set my primary performance focus on maximizing ROC for this spread strategy and not on dollars.

In the long run… all of this is relative!

P&L and Performance Status

Note, starting with this post and forward, I am defining “Realized Net Profit” as “actual” profits AFTER trades have closed. Credits or Debits from currently open trades are “potential” profits and are no longer included in the posted profit calculations.

YTD (2019)

Realized Net Profit = $1,534,61
Started 93 trades: 47 Vertical Bull Put Spreads, 46 Cover Calls 

Realized Profit for Spreads $-722.20
Realized ROC for Spreads (target = 72% for the year): -18.2%

Realized Profit for Cover Calls $2,169.86

Last Month (July)

Realized Profit: $6.60
Started 13 trades: 8 Vertical Bull Put Spread, 5 Cover Call – (4 trades still open)

Risk $$$ for Spreads (Max: $3,960): $3,276 (82.7% of max risk)
Realized Profit from Spreads: $-169.65
Realized ROC from Spreads (target = 6.0%):-5.2%

Realized Profit from Cover Calls: $176.25

MTD (August)

Realized Net Profit: $0.00 (no completed trades)
Started 5 trade: 2 Vertical Bull Put Spread, 1 Vertical Bull Call Spread, 2 Cover Calls

Current at risk $$$ for Spreads (Max: $3,960): 840.95 (21.2% of max risk)
Realized Profit from Spreads: $0.00 (no completed trades)
Realized ROC from Spreads (Target = 6.0%): 0% (no completed trades)

Realized Profit from Cover Calls: $0.00 (no completed trades)

Going forward, the ROC for open spreads will be calculated as the “potential Max Gain” / “potential Max Loss”. Once open spreads are closed, then the ROCs will auto-adjusted to actual.

Schedule for this Week

I’m viewing this market pullback as a tantrum over the US/China trade talks and the notion that no one was pleased with the Fed’s rate-cut decision last week. It can also be a mini-correction, after all, we still enjoy a double-digit percentage up YTD.

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). 

I intend to sell a spread today or tomorrow, even though I’m watching the market in full meltdown. But instead of engineering the most $$$ above a 7.5% ROC, I’m going to find the highest OTM probability that will still get me +7.5% return.

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 Sept 6 (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.)

I intend to sell a spread today/tomorrow as well – despite the turmoil.

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 8/2/19

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
Expired Worthless…

CRON $17.5cc – 3 contracts – Open 7/9 – Expires 8/2 – Net Premium = $38.55
When Opened: Probability of OTM = 85.6%. Head Room = 13.0%
Expired Worthless…

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
Expired Worthless…

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%
Closed 10 days early (7/31) because it surpassed the 85% of Profit rule, plus the Option price to close fell to $.01 (total cost to close was $2.00).

Trades Still Cooking

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%

This trade was closed 8/5 after a significant market turndown.
When Closed: Probability OTM = 29.5%
Buy-to-Close premium: $.90
Net Loss = $134

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%

This trade was closed 8/5 after a significant market turndown.
When Closed: Probability OTM = 23.5%
Buy-to-Close premium: $1.00
Net Loss = $162

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 = 84.2%

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 = 90.5%, Head Room = 15.8%

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 = 71.4%

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 = 50.7%

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 = 56.9%

New Trades for This Week

This week’s Schedule and goals:

• Make 1-2 Vertical Bull 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 # of Contracts = 1
  • 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.

QQQ: $183c/185c – Open 8/6 – Expires 8/30 – Net Debit = -$115.95
Open: Prob. ITM = 40.1%, ROC = 72.5%, Max Risk = $115.95, Max Gain=$84.05
Now: Probability ITM = 54.8%

This is a Vertical Bull Call Spread – a different spread strategy. Providing a degree of rookie-speculation, I’m assuming that after the huge downturn the past 4 days QQQ will at least climb back to above $185 by 8/30.

I recognize that I need to expand my understanding and utilization of other spread strategies. Focusing only on the Bull Put Credit strategy is probably tying one hand behind my back. Starting in the next week or two, I will start an examination on Bull Call Debit spreads and compare it with what I’ve learned so far.

MA $295cc – 2 contracts – Open 8/07 – Expires 8/23 – Net Premium = $26.05
When Opened: Probability of OTM = 98.2%. HeadRoom = 12.4%
Now: Probability of OTM = 92.5%, Head Room = 6.6%

LMT $400cc – 1 contracts – Open 8/07 – Expires 8/30 – Net Premium = $24.05
When Opened: Probability of OTM = 96.1%. HeadRoom = 10.4%
Now: Probability of OTM = 94.5%, Head Room = 8.6%

This week, all my holdings have taken a terrible beating. Most all my keeper-stocks have fallen well below the trend channel. Master Card (MA) and Lockheed Martin (LMT) are two of the very few that still provided a small profit for a strike price above the original channel. Both these trades are still faithful to my cover-call requirements. And if it can get an extra $50… Hey…..

SPY: $277p/$272p – Open 8/9 – Expires 9/06 – Net Debit = 40.05
Open: Prob. OTM = 82.2%, ROC = 8.8%, Max Risk = $454
Now: Probability OTM = 81.2%

This Vertical Bull Put Spread shows the SPY 9-Day SMA moving above the 50-Day SMA. Even though this is following a harrowing week of wild market oscillation, it appears to be restarting the upward trend.

Epilogue

I’m railing at myself for submitting Credit Put Spread trades with multi-contracts. I’m still all over the map learning how to manage this strategy and I need to learn with minimum dollar pain. The point I need to drive home to my self is that for Vertical Put Bull Spread strategy, I need to manage the Return on Capital (ROC) – not maximizing dollars. I will start using multiple contracts as a multiplier to raise my paycheck after I grow up.

Cheers…