When the bears come out

Man, are the market news sites really capitalizing on this holiday crash or what?! Not that I blame them at all, it’s their business. Fear attracts more eyeballs than anything else, and that’s how they make money. Their revenue is certainly not from trading. The articles that get the most clicks are the ones where they drag out some guy who “predicted the 2008 collapse” or “made billions in the crash of ’87” and have them warn us that the worst is yet to come.

Of course I have no clue what will happen in the next few weeks, or months for that matter. Sure the S&P 500 could keep dropping. Yes, it’s possible we are entering the worst bear market in modern times.

Yet, I have observed this phenomenon many times and find it both fascinating and exasperating that we get suckered by the same trick every single time. What trick? The guise of hiding the fact that the market is JUST AS LIKELY to go on a heart stopping tear upward to the stratosphere after a crash like this. It’s like we all collectively forget. We are inundated with news and social media, and suddenly it becomes a fully accepted forgone conclusion that stocks are doomed for the foreseeable future.

No disrespect to folks successfully trading this momentum, or trend, or change in fundamentals . . . . well, not so much the fundamentals. I don’t think there is anyone who actually believes the economy growth has slowed enough to justify further crashing. Not that it matters.

In any event, my point is that one of the most dangerous things in trading is bandwagons. Because the sharks love bandwagons.

And when the bandwagon gets full, the sharks eat them for breakfast.

I think it’s better to stay focused on following and analyzing one’s personal trading plan.

Stay safe out there.

How an options seller deals with a crash

When the market is crashing, it’s tempting for an options seller to panic and throw a huge short position on, perhaps even buying puts. Some folks end up making money and I’m not going to knock them at all.

But I’ve been there, done that, many times, and I’m not going to do it again. I always got killed by a bounce—every time. The odds of the market continuing to crash day after day, without a relief rally, are slimmer than one would think.

So what is an options seller to do when the S&P falls 10 percent?

First, use the event as one of the most valuable learning opportunities you can find. Seriously, it’s a golden opportunity. How did your trading plan react to this move? Are there things that would have reduced risk without greatly dragging down your profits?

I will put forth that my plan is handling the situation well, though I didn’t always have a solid plan in the past. Many of the parameters that saved me from a lot of pain these past weeks are things that I am usually teased about.

First of all, I do stay way the heck out of the money. After this massive drop, only one of my 23 positions actually went “in the money.” That’s pretty impressive when I think about it.

As many of you know, I am only able to stay so far out of the money and collect a decent credit by selling options 150 days from expiration. Most people would never consider selling that far out; years ago I wouldn’t have either. But hard earned battle scars can change you.

Also, I do employ tight stop losses (2x credit received or option strike breached) so that no position remains sitting in a dangerous spot where a big drop can really demolish it without warning. While backtests tend to frown on such stop losses, I defend positions aggressively with the sole purpose of avoiding my stop loss—which is something backtesting does not simulate.

So, learning this wisdom is all good, but what can be done now?

In times like this, other traders often jest: “You wanted volatility for premium selling, well here it is.”

Yes, premium is now high which is great for selling. But those positions we had put on before; we still have to deal with them. They can still hurt. So it takes time, at least a month, for the richer premium to really penetrate the portfolio and start paying off.

In the meantime, patience is key. The existing positions are to be defended mechanically until they either come back to profitability or hit their stop loss. Either way, it’s all part of the plan.

We also stay focused on the big picture and continue to put probabilities on our side.

Trade well!

J. Arthur

The J. Arthur Squiers Trading plan: Cheat Sheet

I have been asked to create a cheat sheet for my trading plan, something that can be referenced when trading without sifting through all of the explanations in my other blog posts. I thought that was a great idea, so here it is.

Trade Strategy

• Strangles in liquid ETFs
• 100-150 days until expiration
• 10 delta options, or less

Trade Entry

• Start with the highest IVR ETFs
• Verify the options are liquid, preferring less than $5 bid/ask spread.
• Aim to take in $100-150 credit on the entire strangle, per $50K in account size.
• Use an expiration cycle that is closest to 150 days till expiration without going further out than that, but never less than 100 days till expiration.

Defending Trades

• If the delta of an option becomes 2 times what it was on initial trade entry, roll the untested side in to 3/4 the delta amount of the tested side.
• If the delta of an option becomes 4 times its original delta, again roll the untested side to 3/4 the delta amount of the tested side.
• If the delta of an option becomes 5 times its original delta, perform the same defense as above.

When to close the trade

• If the overall trade (including rolls) reaches a profit of 50% of the original credit received.
• If the overall trade (including rolls) reaches a loss of 2x the original credit received.
• If one of the strikes in the strangle goes in the money.
• If the trade was defended once and the overall trade (including rolls) reaches a profit of 25% of the original credit received. *NEW*
• If the trade was defended more than once and the overall trade (including rolls) reaches a profit that is more than the commissions that have been paid for the overall trade. *NEW*
• If the options on the trade have less than 21 days left until expiration.
• If the trade has less than 50 days left until expiration and the overall trade (including rolls) reaches a profit that is more than the commissions that have been paid for the overall trade.

Overall Portfolio

• Do not use more than half of the buying power in the account at a time.
• Try to diversify the underlyings used, such as gold, bonds, silver, oil, etc.

…. and that’s my cheat sheet. For explanations, please see my other blog posts that outline my plan. Happy trading!

How I’m tightening up my risk management.

Managing risk is crucial to a successful trading plan.

Because of this, I am always testing for better ways to manage risk with my strangle strategy. Selling longer termed strangles has proven to be a solid, winning strategy for me, yet one can always improve their ability to reduce the volatility in their portfolio and keep their profits on a smooth upward trend.

Of course, position size is always number one.

The most recent example of this is the OptionSellers.com tragedy, where a hedge fund was blown to smithereens by a natural gas spike. Most mainstream financial writers are using this event to proclaim that naked option selling is too dangerous. However, experienced option sellers know that the fund manager was trading over 20 times the amount of contracts that he should have been. And natural gas futures is a HUGE product (see my post When is a trade too big for my account?).

The importance of position size is why the core of my portfolio is built on ETFs with a market price of $50-250, and I collect a small credit compared to my account size.

/NG is not chump change

Another major factor in risk management is knowing ahead of time when to get out of a trade.

If you have read my previous trading plan posts, you know I was doing a lot of testing based on letting losing positions get to a loss of 3x the credit received before pulling the plug. I was also looking at going inverted and continuing to roll if the strike price of my naked options were actually breached. After much study, I have reached a conclusion.

First of all, I am going back to closing positions that reach a 2x loss.

Yes, a good portion of the trades that go past that limit do eventually become profitable. And yes, many backtests that focus on a single underlying, with one trade on at a time, do show that the 3x loss management is statistically better.

However, from an overall portfolio viewpoint and psychological perspective, I just don’t want those stinker trades hanging around. While they may have a good chance of becoming profitable, they are also more dangerous than my other trades. They are sitting in a spot where the delta of one leg could cause a significantly bigger loss.

One can also look at it this way: If I opened up my portfolio and had no trades on, would I put this losing trade on exactly the way it is? No, I would not; so why am I expecting that position is what will get my loss back? Granted, one could take this philosophy too far and take off any trade that starts to go against them. Well, no, the trades need time to work and they are going to move, often showing a small loss at some point. But the major stinkers, well they’ve had their chance and now they’ve become a bigger risk than I want lying around.

Would I open a trade like this?

Now, I know market cyclicality is a thing, and that it should work in favor of a trade coming back to profitability. I just haven’t found it to be dependable. Mainly, that’s a timing thing; often the cycle takes months or much longer, and I don’t want to keep a higher risk position around just hoping it will someday come back.

In addition to decreasing the max loss of my positions, I am also planning to take off any trade where an option strike is breached. I had already been tinkering with this idea when a recent Tastytrade study intrigued me enough that I decided to implement it into my plan.

So there you have it. A max loss of 2x the credit received and closing any trades where an option strike is breached—that is my plan going forward. While this will likely decrease my win rate a little (currently 93%), it should also decrease the volatility in my portfolio and, if my assessment is correct, increase my long term returns.

Happy trading!

JS

When is a trade too big for my account?

Some trading products are highly leveraged or just plain huge; futures contracts can be a good example of this. So how do I know if a trade is too big?

My primary rule of thumb is that I look at the credit I will receive for my strangle and know that I will close the trade if it hits a loss of 3 times that initial credit. I should be fine with taking that amount of loss on a trade.

But sometimes a product itself can be huge and an outlier move can change the value of the options much faster than expected. This can especially be confusing with futures, as they are not standardized like equity options. Notional value may also be misleading because it does not take into account the viable range for the underlying.

So what do I do? I look at the at-the-money put of the closest expiration to 150 DTE (but still under 150 DTE).

If the value of that option is more than 4% of my account value, I become hesitant to sell a strangle on the underlying. In the British Pound example above, the option is worth $2,431 and would give me pause for an account size less than $50K.

Now if I look at corn, the story is different:

With corn, I’m seeing an ATM put for $375 in the expiration I would trade. I would certainly sell a strangle unless my account size were under $10K.

In comparison, oil futures are huge.

That’s $4,980 for the ATM put. It’s good to have a feel for the size of the product.

And natural gas futures are massive! $9,840 for the ATM put!

So that is how I put context around the size of the futures products, because not all of them are behemoths. But some are, and this is how I gauge it.

Again, no part of this blog is a recommendation to enter a trade. I am sharing my own trading experiences for learning and entertainment.

Happy trading!

-J. Arthur

Why I Created an Open Source Trading Engine

I created an open source trading engine because I believe what we retail option traders really need in order to compete is brilliant technology to efficiently execute our personal trading plans.

We need things like Wingman, and whatever Option Alpha is promising to roll out.

And we can’t depend on brokers for this technology because they have enough to focus on by just running a brokerage. Plus, I don’t think we want to be handcuffed to one specific broker.

The fact is, most of us retail options traders have full time jobs. We can’t (or at least shouldn’t) be checking deltas and adding up rolled position credits all day. The full time traders and retired folks can do that. So, how do we keep up with them?

Technology.

Not only would a trading engine do all the processing to keep us informed, but even more importantly it keeps us disciplined in following our plan. If we are cowboy slinging with our accounts, and trying to make hero trades when things are going against us, I believe we will lose money in the long run.

With that in mind, my goal in creating this open source trading engine is not to compete with professional companies.

On the contrary, I am trying to open up the market space by getting traders interested in what technology can accomplish for them. Not to mention, I hope to provide other entrepreneurs with ideas and code that can help them in their endeavors.

I believe that would benefit us all.

Apple Watch face with position data.

If you want to check out my project, you can visit this page: Fire by Arthur Trading Engine

Also, if you are a developer who is interested in contributing to this project, be sure to contact me through this blog so I can give you access.

Happy trading!

-J. Arthur

Surviving a Market Correction

A market correction is a great opportunity to analyze your trading plan.

How did your portfolio react? How did you react? Can you stay the course?

I am pleased with the resilience my portfolio has shown. Yes, I am showing paper losses in my portfolio—nothing to lose sleep over. Most of this is due to the implied volatility spike (remember, I keep a high vega portfolio). The good news in this trading plan is that implied volatility is mean reverting; it will go back down. What is less predictable is whether the market will go back up.

The most important thing was that none of my positions came close to hitting my stop loss. My number one goals is to prevent my positions from having to tap out. Because I sell premium and have a rolling strategy, if I can keep a position from ever getting to a loss of 300% of the original credit received (where I close them for risk management), it will eventually win. Some positions do fail, but very few.

I did have to adjust a few positions by rolling down calls. That fact that I wasn’t defending like crazy shows that my deltas were not getting too big. The red numbers were all vega, and vega is a beast I trust.

Speaking of calls, I’d like to address the reason I sell both calls and puts, as opposed to just naked puts, since this has been a hot topic in the option selling community.

Yes, selling calls does offer a little bit of downside protection, and yes, it does give me flexibility to roll down for defense. But that’s not the real reason I like selling calls . . . .

I sell calls because it lets me stay even farther out of the money.

Now, most of the studies that look at just selling naked puts, versus strangles, will assume that you would sell a strangle at the same deltas that you would use when just selling a naked put—you simply collect more premium. But that’s not how I look at it:

SMH naked put in the Tastyworks platform

Let’s say you want to open a position to collect $100 of credit, and you’d have to sell a put at 16 deltas to do so. If you then looked at a strangle, you could sell both options at 9 deltas and still collect $100 of credit. This is why I have a target credit amount; I’m not trying to get paid more, I’m trying to stay as far away from the battle as possible and still get paid.

SMH strangle in the Tastyworks platform

Yes, I know people say you get paid more for your risk when you are closer to the money. That’s where all the premium is. But when that correction train comes barreling at you, all the statistical risk premium mumbo jumbo gets smashed and goes flying through the air in tiny pieces.

However, when you are way the hell out of the money, like under 10 delta at 150 days till expiration, the train feels more like a slow moving barge in the distance. You respect it, but you’re not afraid of it.

Happy trading!

J. Arthur

Why a 95% Win Ratio is a Nice Way to Live

We had a little turbulence in the stock market the past few days.

It really wasn’t a huge deal. But if you follow the options trading groups, you would think we just had another 1987 crash. The same people who had been bragging that they were making big money a week ago were now lamenting that it was “all gone.”

That’s just not a way I want to live.

My account finished slightly ahead on Friday, even though I sell naked strangles. It was nice not to be part of the panic.

Granted, I did have to adjust one position (/ZN) and a few others were shaken a little. Yet, none of the positions became worrisome.

So, even though my plan isn’t always the most exciting (and requires patience), I have no doubt it is the way I like to trade. It is empowering to simply trust the mechanics and focus on making your process for executing those mechanics more efficient—rather than fighting for your life whenever the wind blows. And if my plan continues to deliver an average of 24% profit on a portfolio per year, I have no complaints!

Here are some ways to spend time making your process better:

• Work on a Google Sheet (or other technology) that analyzes your past trades and shows you what works best. Remember, while studies and backtests are nice, they don’t take into account all of your nuances, adjustment techniques, and personal temperament. Your own personal trading history is a valuable asset!
• Research new information that ties closely to your existing trading plan. If you have a process that is working for you, it is good to continue making tweaks that improve your trading. Be careful not to overturn the whole apple cart if you have a good thing going.  We’re talking about tinkering and gradually improving here.
• Have discussions with other like minded traders. This is another way to learn more and it’s fun to know your not alone in this endeavor.  Again, just be careful not to fall into someone else’s hype and subvert your own successful trading method.

 

Happy trading!

 

September Trading: Lessons Learned

September was a decent month for the J. Arthur portfolio, earning 2.21% on the account balance. I’m trending slightly above the yearly target of 24%. It’s safe to say the trading plan continues to operate as designed.

Yet it is important to look back at what happened and see if any improvements can be made.

First off, I have become an even bigger believer in true diversification.

I say true diversification because, at its core, I view the entire stock market as one correlated entity. Sure, it’s good to have ETFs that include lots of different underlyings. That, at least, reduces the chances of a crazy move. Yet, if the S&P 500 starts blazing in one direction, usually the entire equity market reacts the same way.

That’s why I’ve tried to balance out my positions with farm crops, currencies, and energy.

After this slight portfolio shift in September, my currency and farm trades were my best performers. A few of them hit 50% max profit within 10 days.

The products that really worked well were /6A (Australian dollar), /6C (Canadian dollar), /6B (British pound), /ZW (Wheat), /ZS (Soy), /ZC (Corn).

Needless to say, I am very happy that Tastyworks finally released futures options for trading. It had been impossible for me to get the kind of diversification I wanted without them.

Another plus for the month was that I didn’t have to close any losers. My last losing position was closed a month and a half ago. My win rate sits at 94.87%.

Also, I didn’t have to make a lot of adjustments; I just kept looking for a good trade each day with a goal of balancing out my diversification.

I do have a GDX position that I had to adjust until it became a straddle, and now I’m just waiting until it hopefully decays into a small winner. That position has been on for 80 days, which is rare but it happens.

One final nugget of wisdom I will reiterate is that it’s CRUCIAL to be able to just let the positions play out. A great trick is to use a spreadsheet to track lots of metrics about your trades, or work on building your trading system (maybe learn a scripting language). This way, you can still feel like you are improving your trading without getting frustrated with your positions and messing with them.

Happy trading!

J. Arthur

 

 

The J. Arthur Trading Plan: Part 3

Manage Your Portfolio!

In part 1 and 2, I talked about the strategy behind my trades. However, an equally important aspect is managing the overall portfolio.

I put a lot of emphasis on this because the trades need to work as a whole to provide a consistent and stable profit.

First of all, my plan strives to have an even diversification of underlyings. If, for example, the entire US equity market crashes, I do not want all of my positions to get killed. This is especially important for my plan because I base my strategy on pure probabilities and volatility edge. If your plan depends on choosing a market direction, or being “right” about a stock, I think too much diversification is bad. That is not the case for this plan.

Futures Options in Tastyworks are a great tool for adding diversification.

They way I handle this is by classifying the underlyings I trade into different categories. These groupings are based on my own experience, and some may disagree with them.

For example, many consider XOP to be an oil underlying, yet it is still based on actual companies, rather than the pure spot price of oil. So if the S&P crashes, I would view XOP as more dangerous, yet they are not going to give us half off on the price oil itself.

Below, I will show examples of the underlying groups in which I try to evenly spread my risk. I’m not going to list all my underlyings, but just give you an idea because this is a matter of opinion and everyone should form their own plan for diversifying.

Equities: (SPY, IWM, DIA, XOP . . . . )

Metals: (GLD, /GC, SLV . . . . )

Currencies: (FXE, FXB, /6A, /6C . . . . )

Oil and Gas: (UNG, USO . . . .)

Bonds: (TLT, /ZB, . . . .)

Farm Crops: (/ZS, /ZW, /ZC . . . . .)

Emerging Countries:  (EWZ, EWW . . . .)

Overall Portfolio Target Metrics

In addition to diversification, here are some targets I shoot for on an overall portfolio. All of these numbers are going to be based on a hypothetical portfolio size of $50K. They can be scaled proportionally based on a different portfolio size.

Target Credit Received per trade: $100-150. I view credit received as a great indicator of the risk being taken for a trade (so does the market, given that is the amount it is paying you).  Some folks use the buying power required for the trade, though that doesn’t bode well for futures options since very little capital is required. Other people use notional risk, yet that doesn’t take the probabilities for that particular underlying into account (if they start giving away gold for $1, you will find me in a bunker somewhere). While $100 may seem like a small credit for one trade, I like to spread the risk over many positions. As Tastytrade says, trade small trade often (at least I agree with the trade small part).

As stated earlier, I start at the 10 delta spot when selling the options. So how would I stick to the $100-150 range for a strangle? I have some tweaks I can make. If the credit received would be too high, I move down in deltas until the credit received is within my range. If the credit received is too small, I increase the contracts and then, if needed, I move the delta down until it fits within that range. My rule, however, is that I always open a position no closer to the money than the 10 delta strike.

Theta: $50 per day for the portfolio. This is hard to reach in the first month or two of starting the portfolio without getting over allocated, yet as some of the positions get much closer to expiration, the theta number will increase.

Total Portfolio Allocation: This one area, other than diversification, where I believe trading is more of an art than a science. I don’t like to get in the habit of opening trades just because I need more trades on. That tends to burn me every time.

When there are good trades available, I put more on. When there aren’t many, I will be less allocated. Another good metric is the total open liq of the positions. This tends to be around $3K for a $50K account, and gets up closer to $3.75K if there is a lot of volatility to sell.

And finally, I try to never let my buying power become less than half of the account size. It may dip below that if the trading environment is really good, but I am stay very aware of it.

Whew . . . . I hope you have found this 3 part series on the J. Arthur Trading plan to be very informative. In the future, I will continue posting about my trading and sharing my technology solutions for managing a profitable portfolio.

Happy trading!

-J. Arthur