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Deleveraging Put Verticals (Part 2)

Today I continue by discussing risk reduction of the put vertical strategy.

The primary factor that determines position sizing is probability of profit. Assuming I allocate full capital, this indicates how likely I am to survive until tomorrow. The lower my probability of profit, the smaller I will trade. I also want to understand average-loss-to-average-win ratio. If one loss wipes out many wins and I don’t have a sufficiently large probability of profit then I may not believe I could ever recover from a loss. This would be a strategy to avoid. I have talked about catastrophic loss and drawdown especially as it pertains to position sizing extensively in this blog.

The sample trade given has an annualized ROI of ~122%* but also hits max loss if the market falls >3.2% at expiration, which is not a rare occurrence. I do not need to profit at an annualized rate of 122%, though, to meet my profit goals.

One thing I could do is deleverage the trade by holding some multiple of the margin on the sidelines. The sample trade has a margin requirement of $64.05. If I allocate $64.05 * 4 = $256.20 instead then my annualized ROI falls to 122% / 4 = 30.5%. Not only is this sufficient for me, it allows for a positive size increase up to fourfold. If the market falls 3% then maybe I double the size and roll down. If the market continues to move against me then I could repeat. Backtesting can give an historical winning percentage for this trade, which can help me with initial position sizing.

Unfortunately, deleveraging does not result in a proportional increase in downside protection. I thought allocating 4x initial margin to the trade was effectively increasing my downside protection to 12.60% (3.15% * 4), which would be far less likely to occur in 10 days. As expiration approaches OTM options decay exponentially faster, which may impede my ability to roll down for enough credit to recoup losses even with a doubling/quadrupling of position size.

If the market moves against me then another possibility would be to roll the trade out in time. This would soften the blow from rapid option decay. I need to be careful, though, because in addition to lowering annualized ROI by deleveraging I would now be further lowering annualized ROI by lengthening trade duration. This decreases number of potential trades per year. Avoiding a loss is arguably the best thing I can do to save performance but I also want to monitor realistic probability the ROI will meet my income needs.

* Annualized indicates attainable by continuously having an open trade and winning every time, which is fictional at best.

Deleveraging Put Verticals (Part 1)

This post represents a meandering of thoughts about trading put verticals in reference to naked puts and position sizing.

As a starting point, consider selling a naked put on SPX on September 1, 2016. With the index at $2,166.20, I could sell one SepWk2 $2,125 put for $4.50. The Reg T margin on this would be $2,166.20 – $4.50 = $2,161.70. Were the option to expire worthless, the ROI would be ($4.50 / $2,161.70) * 100% = 0.21%. Since that option expires 10 days later, the annualized return would be ($4.50 / $2,161.70) * 100% * (365 / 10) = 7.60%. At expiration, the trade would be profitable down to $2,125 – $4.50 = $2,120.50, which represents [($2,166.20 – $2,120.50) / $2,166.20 * 100%] = 2.11% of downside protection. This means the trade loses money only if SPX has fallen more than 2.11% at expiration.

I believe it’s never a bad thing to make money when the underlying drops a little or remains unchanged.

On this particular trade, my maximum loss at expiration would be [($2,166.20 – $4.50) / $2,166.20 * 100%] = 99.79%. This is better than buying the underlying, which could conceivably lose 100%. I feel the real power in this trade is being able to repeat it 26 times (for example) per year in which case my maximum loss would be [($2,166.20 – ($4.50 * 26)) / $2,166.20 * 100%] = 94.6%. Over the course of 20 years I would look to work that cost basis down to zero, and, in effect, get my money back completely. But I digress…

One thing I could do to enhance the return would be to sell a put vertical spread rather than a naked put. This could be done with purchase of a long put at a strike price below the short put strike. Were I to buy a SepWk2 $2,100 put for $2.35, my net credit would be $4.50 – $2.35 = $2.15. My Reg T margin, however, would now be $2,166.20 – $2,100 – $2.15 = $64.05. My credit, therefore, would only be $2.15 / $4.50 * 100% = 47.8% of the original. My margin, though, would only be $64.05 / $2,161.70 * 100% = 2.96% of the original! My ROI would be $2.15 / $64.05 * 100% = 3.36%, which represents 3.36% * (365 / 10) = 122.52% annualized. That is bookoo bucks!

Before getting too excited, let’s get back to maximum loss considerations for the sobering reality. My maximum loss at expiration would be (100% – ROI) = 96.19%, which is better than the 99.79% were I to sell the naked put. My downside protection here would be [$2,166.20 – ($2,125 – $2.15)) / $2,166.20 * 100%] = 2.00%, which is a bit less than the naked put. If SPX were to drop to $2,100 or below at expiration then I would realize that maximum loss of 96.19%.

And therein lies the rub! With the naked put, SPX would have to drop 100% (to zero) to force me out at maximum loss. With the put vertical spread, SPX would only have to fall ($2,166.20 – $2,100) / $2,100 * 100% = 3.15% to force me out at maximum loss.

I will continue next time.

The SEMI Trading Collective

Greetings everyone!

In the time since our last contact, I have teamed up with a full-time retail option trader to organize this group. After lengthy discussion, we have decided to change our focus.

Welcome to the Southeastern Michigan (SEMI) Trading Collective. Our main goal is to promote financial literacy with a focus on trading and personal portfolio management.

We hope this group will be significantly different from other trading-related groups we have attended. Among other things, we welcome and encourage participation of men and women. We encourage and support presentation on different topics by different group members. We encourage networking and the formation of trading teams.

Here is a partial list of topics for discussion:

The cost to be a member of this group will be $10 per year. We will also charge $10 per Meetup for those who attend.

If you make this group a priority, attend meetings consistently, and keep an open mind then we hope you will come away with an understanding of finance unlike anything you have seen before.


SEMI Trading Collective provides information for educational purposes only. We are not a Broker-Dealer nor are we a registered financial adviser. We do not know your situation and have no way of knowing what level of risk may be appropriate for you. We make no specific trade recommendations. The risk of loss in trading options can be substantial so please be aware of all risks before placing any live trades. Hypothetical computer-simulated trades are believed to be accurately presented but actual profit and loss may vary due to market factors such as liquidity, slippage, and commissions. All information provided here is for your personal, non-commercial use only.

Don’t Believe the Hype! (Part 2)

Today I conclude with a few more posts from GB, one other post to GB, and my ultimate response after I had seen enough.

On April 13, 2015, GB wrote:

     > NLNK is my next possible trade this week. I
     > believe the $430 Call will provide over $33.00+ (my
     > goal is $1.00 profit per share per week) so this is
     > a triple grand slam with insurance. I can
     > only afford 2 contracts but will still make more
     > than my weekly profit goal. Thx. [italics mine]

In another post, GB wrote:

     > Hello… I’m not too familiar with the different
     > names like collars, spreads, etc. But my goal is to
     > create a near zero Delta, hence zero risk. I’m
     > thinking that it limits my upside but protects my
     > downside because the Put is already ATM or ITM,
     > again, a higher quality Delta… [italics mine]

Here was an insightful post by another member in response to one of GB’s posts:

     > …your suggestion to add long puts to a covered
     > call makes little sense. You are creating what is
     > known as conversion. Long stock + short call + long
     > puts. It is a flat position, which can only be used
     > to lock in profit/loss. If I understood your trade
     > you are adding puts after the stock has moved against
     > you. Hence you are locking in a loss. IV variations
     > might diminish your loss or even create a very small
     > profit but again conversion is a lock.

To that, GB responded:

     > Sound [sic] like profit to me all day long and all
     > the way to the bank!!

After some hearty laughs, I felt compelled to offer GB one response to all his posts:

     > If there’s potential reward then there is no such
     > thing as zero risk.
     > If you don’t know the different names then learn
     > them. Ignorance is no excuse for being oblivious
     > to risk. Don’t put on any trades unless you fully
     > understand what your exposure truly is.
     > Your posts have been entertaining with phrases like:
     > –consistent weekly profits
     > –‘gravy’ forever into the next generation
     > –the coast is clear to keep it and make premiums
     >    until it is ran up again
     > –those who stayed are rich and retiring out this
     >    year and next
     > –sound [sic] like profit to me all day long and
     >    all the way to the bank
     > –so this is a triple grand slam with insurance
     > Where’s the one about trading being an ATM machine?
     > Nothing about trading or investing is free, nothing
     > is guaranteed, and nothing here is ever worth the
     > kind of exuberance you seem to project with your
     > posts. There’s risk inherent with everything and
     > if you trade too large aiming to be too greedy then
     > you will one day learn the hard way by getting blown
     > out of the game for good.
     > Just my two cents: be careful and watch your back!

I feel that pretty much said it all.

Don’t Believe the Hype! (Part 1)

Almost two years ago, a new guy started posting in an e-mail list I read. Today I am going to paste some of his posts. The moral of the story here is don’t believe the hype: any trade has risk and can always lose!

On April 12, 2015, GB wrote:

     > Hello Mark… Did you use quality Delta Puts for
     > the coal stocks? I work with a guy who lost tens
     > of thousands…now he is in the dog house with the
     > wife who is… threatening divorce if he trades
     > again. I had him backtest a couple his major losers.
     > He came back really upset because he could have
     > used Puts to offset the loss. He had heard about
     > Puts but never used them. I’m all for taking the
     > middle ground using Puts for consistent weekly
     > profits. Matter of fact, the lower the stock drop
     > the more the Put increases. Then, you might be able
     > to buy higher Puts to get out of the dropped stock
     > to recoup even more cash. Hmmm! I’m going to run
     > numbers on that last idea.Thx. [italics mine]

On April 12, 2015, GB wrote:

     > …think of it like this: You keep getting premiums
     > and dividends you will recoup all of your money and
     > the rest will be “gravy” forever into the next
     > generation
. Also, look back to see if ITM Puts
     > by 1 or 2 strikes would have made you money on the
     > initial position. I do not care to own stock for the
     > long term. I use my employment retirement account
     > for funds. I will use index funds for my IRAs going
     > forward. I use stocks as a financial tool…like a
     > hammer or saw. I use to get stuck in a stock when
     > it dropped…but usually way back on top after 2
     > weekly trades. I believe the “hype” is out of a
     > stock when it drops…so the coast is clear to keep
     > it and make premiums until it is ran up, again…
     > like an upcoming dividend
.Thx [italics mine]

In another post, GB wrote:

     > Mike, I’m not an analyst but I’m sure your right…
     > coal will save the country. I agree not to be afraid
     > of a paper loss. Too many of my co-workers dumped
     > their retirement shares in 2008. They lost, big.
     > Those who stayed and kept putting into their
     > retirement accounts are rich and retiring out this
     > year and next!!
Do you mind if I check out those
     > stocks? [italics mine]

Yes he minds because he likes to control all the shares?!?

No, incidentally, Mike did not praise coal stocks nor did he say paper losses do not matter.

Until I conclude next time, recognize that any trade can always lose and that without risk there are no profits!

Against Target Date Funds (Part 4)

I want to wrap up this blog mini-series on target date funds (TDF) by going back to the initial question: why TDFs?

I found the following on a robo-advisor website in the comments section of a blog post:

     > So, back to the subject at hand. I love the article,
     > and the ideas are great, but the closet quant would
     > like to see some numbers…

The author’s response:

     > Thank you for your comment… the key here isn’t
     > focusing on returns, per se – both [your TDF] and
     > [our product] invest passively. We are both trying
     > to track the index, not create active alpha.

Indeed, each TDF component aims to track its index, which is what so many financial products strive to do. The industry conditions us to be happy with this by making a strong case that it is difficult to achieve.

Articles deprecating actively managed funds are easy to find. I did an internet search for “what percentage of money managers beat the market.” I found one article citing S&P Dow Jones as reporting 86% of active large-cap fund managers did not beat their benchmarks in the previous year. Another article, also citing S&P Dow Jones, says out of 715 mutual funds that performed in the top 25% over 12 months ending in 2010, only TWO remained in the top 25% for each of the four succeeding 12-month periods.

Passively managed funds also fail to match the benchmark because of the fees. Think about it. These funds aim to track the indices or overall market. They advertise low fees (“expense ratios”) compared to actively managed funds. If the best they do without fees is match the benchmark, though, then they always lose to the index after fees regardless of how small those fees are.

Given how difficult it seems to match the market (not to mention beat it), I think people who do feel they have stumbled upon some sort of “Holy Grail.”

I believe this is all a distraction. My goal is not to beat the market, which wins some years and loses [big] in others. My goal is to pay the bills. I want consistency and I think when we strip away the ego that surrounds issues of money for so many people, they would also admit to dreaming of a linear positive-sloping equity curve.

I would argue the best way to achieve this all-important goal of consistency is with options rather than stock: something the financial industry spends too little time discussing.

Against Target Date Funds (Part 3)

Going back to the beginning, why bother with target date funds (TDFs)?

TDFs do offer convenience but as discussed in the June 2016 AAII Journal, they are not without controversy. Few things reducing to simple, select categories can be well-tailored (think target date and speed to target allocation) for the masses. Even more in doubt is whether TDFs offer better annualized returns or a lower standard deviation of returns. If you have seen such a study in support of TDFs then please let me know.

What we have here sounds like a product being sold without any supporting evidence. If this occurs in the current era of evidence-based medicine then a physician may be sued for malpractice. As a pharmacist, when customers asked me about over-the-counter products not backed by research, I told them straight-up: it’s just marketing and advertising.

Marketing and advertising accounts for too much of the financial industry. Related talks/seminars often feature a financial professional who presents on market outlook (useless unless s/he has a functional crystal ball), about some product (e.g. fund or ETF), or about a relatively simple strategy like asset allocation. People mistake the speaker for a teacher when s/he is actually a paid spokesperson. Whereas other attendees often raise hands in an attempt to ask questions and procure knowledge, I raise my hand to challenge contradictory premises or conclusions lacking sufficient supporting data. I find their descriptions of things more akin to Swiss cheese.

This is consistent with my perception of financial advisers as accomplished salespeople. I believe advisers should be data scientists or traders: two occupations that would be much more likely to understand the mechanics of making/losing money. Salespeople just repeat what they are told and embellish with positive spin since they have not done the research or trading themselves.

Members of an audience are conditioned to believe the presenter is an objective expert in virtue of an introduction claiming professional work in the industry and some formal attire. It is probably an illusion, though, as both the presenter and sponsoring organizer/venue are likely benefiting from the event.

So why TDFs aside from the fact that this is what the financial industry has chosen to market and advertise? I have categorized this post as optionScam.com until I figure that out.

Against Target Date Funds (Part 2)

I previously discussed two articles in the June 2016 AAII Journal arguing against target date funds (TDFs). Charles Rotblut, CFA, (AAII vice president and editor) wrote a third article in the same issue that takes aim at TDFs.

In the article, Rotblut samples six different TDFs. He discusses the importance of speed to final allocation:

      > The Vanguard fund will reach its final allocation
      > by 2027, versus 2030 to 2039 for the Fidelity
      > fund. A shorter glide path and a larger
      > allocation to bonds… may be a plus for
      > someone with a shorter expected life span and/or
      > greater cash needs in retirement… The ideal
      > strategy provides a person the right amount of
      > money to fully fund retirement and no more
      > beyond what is desired to be bequeathed.

Rotblut says target date depends on expectations for other retirement income that may ease the burden on your nest egg:

      > For example, say you plan to retire in 2020… if
      > you do not expect to be reliant on your portfolio
      > for retirement income—thanks to a pension or
      > other sources of income—you could choose to go
      > with a 2025 or later-dated fund instead. A
      > later-dated fund will give you a greater
      > allocation to stocks at retirement and thereby
      > more long-term growth. On the flipside, if you
      > don’t think you will be able to withstand a bear
      > market near your retirement date, you should
      > consider a shorter-dated fund.

Rotblut concludes by suggesting creation and management of one’s own portfolios:

      > Setting aside questions about whether TDFs use
      > the most optimal allocation strategies… the
      > biggest downside to them is the lack of
      > customization. Shareholders in these funds
      > are locked into specific fund families. They
      > are also locked into allocation ranges based
      > on planned retirement ages.

I think his most damning critique of TDFs comes near the beginning of the article where Rotblut shows a lack of clear consensus on capital allocation. Six funds with a target date of 2020 have a current allocation of stocks and bonds ranging from 38-65% and 30-59%, respectively. Final fund allocations for stock and bonds range from 20-30% and 46-80%, respectively.

How much of a leap is it to suggest I might as well put on a blindfold and take aim at a dartboard?

Against Target Date Funds (Part 1)

At the second local Fintech Meetup a couple months ago, we had a presentation by a startup company (name omitted to protect the professionals) selling target date funds (TDF). The entire presentation begged the question: why bother?

Wikipedia describes a TDF as a collective (e.g. mutual fund or collective trust fund) investment scheme offering a simple solution by gradually shifting the portfolio to a more conservative asset allocation by the target date (usually retirement).

Intended as constructive criticism, I suggested the presenter do some backtesting to demonstrate that TDFs are better than conventional vehicles.

The very next day, I read my June 2016 American Association of Individual Investors (AAII) Journal and found three discouraging references to TDFs. The first reference was an interview with Jane Bryant Quinn: a nationally known personal finance writer/commentator. She concluded the interview with:

      > I think the research shows that if you reduce
      > the amount you hold in stock—you reduce the
      > stock amount and increase the bond amount
      > every year starting at 65—that is the least
      > optimal way to make your money last for 30
      > years. At least hold steady.

I viewed this as the weakest challenge to TDFs, which decrease equity allocation over time starting from a much younger age. Quinn cautions doing this from the age of 65 onward.

James Cloonan, however, suggests in a second article that Quinn’s comments are relevant to TDFs. Cloonan is the founder and chairman of AAII. He said:

      > I hope there’s been more emphasis on keeping
      > more in stock even at older ages or closer
      > to retirement. In a recent interview in
      > the AAII Journal… Quinn amazingly started
      > to show the importance of doing this, and
      > she’s a very conservative person. She
      > pointed out that you just have an awful lot
      > of your life ahead at retirement. You have
      > to be a long-term investor if you’re going to
      > make enough to keep up with inflation.

Indeed, Cloonan is largely against the idea of TDFs. He argues the conventional belief of increasing exposure to bonds as one gets older is completely flawed:

      > One rule of thumb has been that the amount
      > you should have in stock is 100 minus your
      > age. Well, people retire at 70 these days.
      > That means only 30% of their portfolios
      > should be in stock. And they’ve got 30
      > years to go. Bonds and cash may not even
      > keep up with inflation. I think that is
      > real risk.

I will continue with the next post.

Am I Worthy of Self-Promotion? (Part 3)

I feel grateful to have survived 9+ years trading full-time for a living. Do I have a successful story worth sharing? I dare suggest that I do.

In the last post I attributed some of my success to start-up capital available to help me through the learning years. That money did not just fall into my lap. I generated that capital by negotiating a respectable wage and studying to accrue investing knowledge. I put in the time to work and the time to learn. I put myself in a better position to start a business.

I also deserve credit for having the guts to leave a corporate job, which was stable income for me. It’s more complicated than “no risk, no reward” and for those who do take the risk and subsequently succeed, accolades should follow.

Plenty of people work in the trading industry but most are selling trading services or “education.” I am here to say you don’t need to pay for any service or education. Rely on yourself. Work hard to earn start-up capital and take it from there.

As a successful entrepreneur since 2008, I have been selling myself short over the last few years but none of this means it’s simply “game over.” I still need to maintain my efforts with strategy development and trading my system. Every day I need to be aware of the risk I take because it could all evaporate in a heartbeat. Although much of what I have is due to my own hard work and discipline, I will continue to be grateful for what I have each and every day because things outside my control have not blocked my achievements.