Capital

• The trading plan should not hinge on capital that might be withdrawn early for personal use

Instruments

Time-frame

Expectancy

Position Sizing (Risk Management)

• Capital of $25,000 => Maximum $1,500 invested per position

• Capital of $25,000 => Maximum $500 loss per position

Loss Management:

Trade Selection (Entry) Strategy

• Stock selection
• Unusually active option volumes
• Liquidity
• Daily average volume for equity > 500k shares
• Daily average volume for option (nearest expiration/strike price) > 25 contracts
• Open interest for specific option > 500 contracts
• Contract selection
• Option expiration 1-3 months
• Expected return > 33%

Stop-loss (Exit) Strategy

• As mentioned above, max. loss per position = $500 (33% of capital allocated to position i.e. $1,500)
• The no. of option contracts required to build a position of $1,500 will vary with the stock and the strike prices.

Note: For some option strategies (such as call/put purchases), it's important to also have a time-stop i.e. close the position if the trade is not profitable by a certain time. This will avoid losses from accelerating time decay near expiration, and also allow capital to be deployed in other (potentially more profitable) positions.

Profit-taking (Exit) Strategy

• For a position that involves only one contract:
• Close the position as soon as it meets the profit target of 50%
• For a position that involves 2 or more put contracts:
• Close one contract as soon as it meets the profit target of 33%, and simulaneously move the stop-loss target for the remaining contracts up to the 33% profit level
• Buy back second contract if profit = 50%
• Close all positions if profit hits 100%

Risk Normalization

• For ease of calculations, I'll use $100,000 as available capital
• Margin: 0%
• Capital available for: 1 year
• The trading plan should not hinge on capital that might be withdrawn early for personal use

Instruments

• Equity Options
• ETF Options

Time-frame

• 2-3 months for each option trade
• Compounding: A 2-3 month option period implies that the same capital can be turned over 4-5 times a year, thus allowing compunding of returns
• Exceptions: Scenarios where a stop-loss is activated, or the profit-taking strategy requires early closure of the position

Execution

• Interactive Brokers ($1 commission per option contract)
• Limit orders
• Avoid unnecessary expenses on software, data feed subscriptions, etc
• Use limit stops to implement stop-loss strategy

Expectancy

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

The table above shows how expectancy would vary with my win/loss ratio, and the average % profit/loss on each trade.


• I have highlighted my targets (win/loss ratio of 50/50, with average profit of 8% and average loss of 4%) - thus giving an expectancy of 2%.


• With an average trade lasting 3 months, my annualized expectancy = 2% * 12/3 months = 8%.


• For an average position of $5,000 this translates to an average profit of $400 or average loss of $200.

Hedging

• Categorize portfolio by sectors, and option expiration
• Purchase index (ETF) put options that match sectors and expiration
• I have written about portfolio hedging in earlier posts
• Consider purchasing short-term puts on specific stocks to hedge against sharp downside moves after quarterly earnings reports

Position Sizing (Risk Management)

• Maximum 20 positions, Maximum 5% of capital per position
• Capital of $100,000 => Maximum $5,000 invested per position
• Maximum loss per trade = 0.2% of capital
• Capital of $100,000 => Maximum $200 loss per position
• If I deploy the entire capital of $100,000 into 20 positions simultaneously, and end up with 100% losing trades, my worst-case loss would be $200 * 20 = $4,000 - this method of capital allocation is not suitable to effective loss management.

The table below shows my loss limits over different time-periods:




Loss Management:


• Deploy capital in chunks of $10,000 each month


• Maintain a year-to-date (YTD) loss calculation, updated weekly




• During the first 3 months, if YTD loss exceeds quarterly limit of $1,200 - do not trade or invest additional capital until the 4^th month


• During the first 6 months, if YTD loss exceeds semi-annual limit of $2,400 - do not trade or invest additional capital until the 7^th month


• Months 7 and beyond, if YTD loss exceeds annual limit of $4,000 - do not trade or invest additional capital for the rest of the year

Trade Selection (Entry) Strategy

• Stock selection
• Market capitalization > $5B, < $25B
• PEG ratio < 2.0, P/E ratio > 0.0
• Liquidity
• Daily average volume for equity > 500k shares
• Daily average volume for option (nearest expiration/strike price) > 25 contracts
• Open interest for specific option > 500 contracts
• Contract selection
• Sell naked put contract
• Option expiration ~ 3 months
• Expected return (if not assigned) > 8%

Stop-loss (Exit) Strategy

• As mentioned above, max. loss per position = $200 (4% of capital allocated to position i.e. $5,000)
• The no. of option contracts required to build a position of $5,000 will vary with the stock and the strike prices.

The table below shows some examples of option positions, and corresponding stop-loss targets.




Note: Given the time decay and volatility of options, my stop-loss targets might make me close a position at a loss, only to see the trade turn profitable at a later time, due to a rise in the underlying stock price. I'll work on a solution to this problem and update the stop-loss strategy accordingly.

Profit-taking (Exit) Strategy

The table below shows examples of the contract premium that would be necessary to meet the 8% profit target.
• For a position that involves only one put contract:
• Close the position as soon as it meets the profit target
• For a position that involves 2 or more put contracts:
• Close one contract as soon as it meets the profit target, and simulaneously move the stop-loss target for the remaining contracts up to the 8% profit level
• Buy back another contract when profit > 12%
• Hold 3rd contract (if any) to expiration

To be added ...

Diversification

Risk Normalization