A budget is telling your money where to go,
instead of wondering where it went.

– Dave Ramsey

Prologue

There is no way to measure my performance without knowing where I started. ‘Here’s some cash and make it happen’ was good enough for a flailing start to this journey, but as I shift gears going into 2020, I need to define starting points to measure my progress, then ultimately my results.

This effort’s original mission is to determine if I can make a relevant income from Options Trading. Coming up to the end of 2019, I’m now at the point where I need to define what “relevant” means. It’s time to look at how to set a starting budget.

This week’s post reviews the minimum account balance necessary and the level of Options trading activity required to produce the expected monthly paycheck. The budget outlined below will be paycheck-centric. If I change the desired paycheck amount, then the account balance and the activity requirement will need to be adjusted to accommodate the paycheck change.

Budget Goal for 2020

I still consider myself a newbie, and I still want to make sure my dollar risk is relatively small. In support of keeping with a low-risk profile, I need to identify what my monthly paycheck should be and from there back-engineer an initial account balance and a trading activity that will get me there. So right now, I’ll arbitrarily declare that my first monthly paycheck will be $250.

The hopeful results would be on Dec 31, 2020, my trading account’s closing-balance will have the same dollars as the previous January’s starting-balance (or more) – all the while paying myself $3,000 over the year.

$250 is by no means what I would call a career income goal. But if the mechanics of this plan go as plan, then the following years is just a matter of scaling.

Budget Assumptions

I would have NO IDEA where to begin in defining these assumptions without going through the machinations and bouncing off the trading walls this year. 2019 was presumed to be the year of mistakes and building the learning curve. (And I certainly made my share of mistakes, and my learning curve still has a long way to climb.)

From what I’ve learned so far, these are my 2020’s beginning assumptions:

  1. Anticipated win-ratio = 80-85% (Spreads with > 80% probability of profit)
  2. Maximum risk per trade < $500 (what I consider low risk)
  3. Minimum Return on Risk (ROR) per trade= 7.5%.
  4. Anticipated trade profit = $37.50 (+/-) based on $500 trade risk and 7.5% ROR
  5. Average broker’s fee for each position traded = $1.00

The anticipated win-ratio and average trade-risk are not based on 2019’s performance but from what I’ve learned during 2019. I’ve certainly lost more than I should by bumbling through my initial learning curve.

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The win-ratio comes from the Manage Rate of Max Loss post, where I discussed the Law of Large Numbers. I intend to focus primarily on those spreads whose short strike has an 80% – 85% (delta .2 – .15) probability of expiring with a profit. This includes both calls/puts and debit/credit spreads.

The anticipated trade profit is based on this year’s activity, where the low-risk position I have been trading comes with an average gain of about $37 minus fees. A typical Spread profit will range anywhere between $25 and $40.

The maximum risk per trade of $500 is what I have found I need to risk to yield an average credit of $37 (about a 13:1 risk-to-reward ratio). But the actual risk should be less as I will actively try to manage losing trades. A per-trade risk level far below $500 will yield premiums too low to be considered “fun.” 

Avoid the Total-Kill

The “Total-Kill” scenario is when every one of my position within a month suffers the Max Loss. A Total-Kill can happen with a flash market correction where the market loses 10% real fast and stays down for a couple of months. If all my Options positions are Vertical Bull Put Credit Spreads, a flash market correction will likely result in a Total-Kill. This scenario occurred in Oct 2018 and lasted until the end of that year.

I can avoid the Total-Kill scenario by dividing my active Options positions between Vertical Bull Put Credit Spreads and Bear Call Credit Spreads within any thirty-day time frame. If the market has a massive swing either up or down, then part of my positions will be in the cross-hair of the Total-Kill possibility.

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Beginning Account Balance

What should my budget be, and what schedule should I have to achieve my monthly paycheck?

I set up my spreadsheet to look something like this:

Monthly Pay$250 =$250
Anticipated Win Ratio80% =80%
Maximum Risk per Trade$500 =$500
Anticipated Return on Risk7.5%7.5%
Average Trading Fee1.00 =$1.00
   
Profit Per Closed PositionMaximum Risk per Trade * Anticipated Return on Risk – Average Trading Fee =$36.5
Required Trades per MonthROUNDUP(Monthly Pay / Profit Per Closed Position * (1 + (1- Anticipated Win Ratio)), 0) =9
Max Monthly Dollar RiskMaximum Risk per Trade * Required Trades per Month =$4,500
Budget Multiplier2 =2
   
Beginning Account AmountMax Monthly Dollar Risk * Budget Multiplier =$9,000

The “Budget Multiplier” is not so much of an arbitrary number as it seems. I know that some months will be winners, and some will be losers. The number of two is to make sure I have enough funding in my account to manage a lousy start without limiting the number of trades to recover and without having to sacrifice my $ 250-month pay. It is also to make sure I carry enough cash to avoid a Reg-T Margin Call.

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Trading Activity (Budget)

 WeekMonthYear
Pay Check ($36.5 * # trades * Anticipated Win Ratio) =$58.4$262.80$3,153.60
Max Dollar Risk (Maximum Risk per trade * # trades) =$1,000$4,500
Required # trades (split between Calls and Puts) =29108

Achieving a $250 profit for the month is not a function of the number of trades, but the dollars I have at risk that will return greater than 7.5% ROR (Return on Risk). So within a week, I should have close to but no more than $1,000 of trade risk. The anticipated ROR for each trade to be greater than 7.5%. If I can do that with two trades, then OK. Otherwise, I may need to submit three or four trades to get the risk to the right level.

Actual Trade Risk in Major Market Corrections

Operationally speaking, if I submit one Call Bear Credit Spread and one Put Bull Credit Spread that expires in the same week, regardless of any wild overall market swings. I am only at risk of losing only one or the other – not necessarily both (functions similar to water-down Iron Condor). So if one Call Credit Spread has a trade risk of $500, and one Put Credit Spread has a trade risk of $500, technically (and according to the Broker’s system), there is a $1,000 risk in my account. But operationally, the maximum I can lose with a total-kill is one Spread or $500.

The caveat to the above statement is that I’m trying to engineer some protection from a total-kill scenario caused by a significant market movement, aka a “Correction,” aka what happened Oct ’18 and May ’19. I am not, however, protected against substantial moves within the individual ETFs. But since I am currently trading mainly in market indexes that tend to move in concert, I’m hoping this strategy will have a saving effect.

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Beware of Reg-T Margin Call

Additionally, to not have a Reg-T Margin Call, I need to keep enough cash in my trading account to cover the technical risk for all working positions. So regarding the above budget and schedule, I must maintain at least $4,500 cash in my trading account if I have $4,500 of technical risk – even though there is no way I can lose more than $2,250.

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P&L and Performance Status

YTD (2019)

Realized Net Profit from Spreads: -$1,061.45
Spreads started: 67
Realized ROC (target = 72% for the year): -24%

A little caveat to the dismal P&L shown above. Throughout this year, I made a lot of rookie mistakes, and I’m still paying the price. It’s going to take a couple of months to recoup. But I do feel I have improved my trading understanding to fair better.

Last Month (Sept)

Realized Profit: $-10.75
Spreads Started: 7 (6 Spreads closed)
Realized ROC (target = 6.0%): -.7%

Spread Trades Won: 3
Spread Trades Lost: 3
Win Ratio: 50%

Month to Date (Oct)

Realized Profit: $38.5
Spreads Started: 6 (1 Spreads closed)
Current at risk $$$ for Spreads (original Max: $3,960): 2,757.05 (70% of max risk)
Realized ROC (original target = 6.0%): 8.3%

Spread Trades Won: 1
Spread Trades Lost: 0
Win/Loss Ratio: 100%

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Schedule for this Week

Monday:

  • Review and tweak the Trend-Channels for the general Market direction.
  • Determine if the IV is high or low so I can better choose Debit or Credit spreads.
  • 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 Nov 15 (39 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 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 premiums closer to ATM prices and resubmit. We want only 1 spread accepted so keep watch.
  • Recheck/tweak trend-channels. 

Thursday:

  • Reset target expiration date to Nov 22 (43 days out to the following Friday). 
  • By 10 AM, stage possible trades for all watch list stocks. 
  • Submit a couple of 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.
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Trades Ended This Week

SPY: 265p/260p – 1 Contract – Open 10/3 – Expires 11/8 – Credit = $42.00
(Vertical Bull Put Credit Spread)
Opened: Prob. OTM = 86.3%, ROC = 9.2%, Max Risk = $456.00, Max Gain = $42.00
Closed: Now Probability OTM = 98.3%, Debit = .03, Realized Profit = $38.50

This position has reached 93% of its max profit while still 22 days until expiration. Following policy, I closed this position early at a debit of $.03/share * 100 shares + ($.50 trading fees * 2 legs in the spread) = $4.00. Now I can take this $456.00 risk off the table.

Trades Still Cooking

DIA: 252.5p/247.5p – 1 Contract – Open 9/25 – Expires 11/01 – Credit = $44.05
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 83.6%, ROC = 9.6%, Max Risk = $444.05, Max Gain = $50.00
Now Probability OTM = 93.9%

SPY: 308c/313c – 1 Contract – Open 10/11 – Expires 11/01 – Credit = $27.00
(Vertical Bull Call Credit Spread)
Open: Prob. OTM = 93.0%, ROC = 5.7%, Max Risk = $471.00, Max Gain = $28
Now Probability OTM = 95.8%

QQQ: 201c/206c – 1 Contract – Open 10/11 – Expires 11/01 – Credit = $22.00
(Vertical Bull Call Credit Spread)
Open: Prob. OTM = 93.7%, ROC = 4.6%, Max Risk = $476.00, Max Gain = $23
Now Probability OTM = 96.1%

DIA: 277c/283 – 1 Contract – Open 10/9 – Expires 11/15 – Credit = $42.00
(Vertical Bull Call Credit Spread)
Open: Prob. OTM = 80.7%, ROC = 9.2%, Max Risk = $456.00, Max Gain = $42.00
Now Probability OTM = 87.4%

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New Trades for This Week

Spreads started this week: 3 (2 Bull Put Credit, 1 Bull Call Credit)
Potential week’s profit: $84.00
Total dollars at risk (max= $1,000): $910.00 (ROR: 9.2%)
Actual dollars at risk: $552.00 (ROR: 15.2%)

DIA: 259p/255p – 1 Contract – Open 10/15 – Expires 11/8 – Credit = $32.00
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 83.7%, ROC = 8.7%, Max Risk = $366.00, Max Gain = $33.00
Now Probability OTM = 81.2%

Think or Swim

Several good news items seem to be pushing the DOW up. There is talk about a Brexit deal agreement, and there is a sigh of relief on a US/China deal. The Implied Volatility (IV) has taken a significant drop in the past two days signaling that DIA may start back on its long-term trajectory of moving up.

The current DIA price of $270.53 is a decent jump above the SMAs, even though the 9-day SMA is still below the 50-day. The short strike price of $259 is near 4.5% below the current rate and more than one standard deviation from the current price. The Dow would have to fall 1,100 points within the next 24 days for this position to fall ITM.

SPY: 287p/283p – 1 Contract – Open 10/15 – Expires 11/8 – Credit = $33.00
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 83.8%, ROC = 9.0%, Max Risk = $365.00, Max Gain = $34.00
Now Probability OTM = 84.0%

Think or Swim

The same market optimism is also pushing up the S&P in much of the same way. The short strike price of $287 is also 4% below the current ETF price and over a standard deviation away.

IWM: 160c/162c – 1 Contract – Open 10/17 – Expires 11/15 – Credit = $19.00
(Vertical Bull Call Credit Spread)
Open: Prob. OTM = 87.4%, ROC = 10.6%, Max Risk = $179.00, Max Gain = $20.00
Now Probability OTM = 89.1%

Think or Swim

I made this trade in keeping with the activity level I suggested above, even though the $19.00 premium collected is not typical. I wanted to raise the week’s “at-risk” dollars to near $1,000 to see how that will work…

IWM has been trading slightly down for the past six months and staying mostly in the trend channel. The Short Strike of 160 is just shy of the one standard deviation above the current IWM price and over 2% above the trend channel. The 9-day SMA is below the 50-day, and that is also below the 200. So the future trend suggests IWM will continue to trade slightly down or flat.

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Epilogue

President Trump held a news conference this past weekend and share a phase-one deal on the US/China trade war. Since then the market has been positive to neutral. Any impeachment discussion is being taken with a collective yawn.

Cheers…

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