Wow, I got quite a response to Part 1 of the trading plan. I will try to answer all of the questions I received, but first I’ll provide some explanation about one aspect of the plan that raises a lot of eyebrows.
Why sell options with 150 days to expiration? The short answer is that in my years of trading, it has been the most effective method of making money. Way more effective. I mean, a night and day difference.
How did I come up with that particular number? I learned the 150 DTE part of my plan from a couple of commodity traders. These were serious dudes, trading SERIOUS capital. I’m glad I listened to them, because it was my turning point.
Now, I have been asked about the “scary” vega risk at 150 DTE, since it is much higher than an option with 45 DTE. This means changes in the implied volatility of the underlying (stock) will affect the price of a 150 DTE option a lot more than it will affect an option that expires sooner.
My answer is that I would rather fight vega than gamma. Gamma means as the stock price gets closer and closer to your short option’s strike price, you are going to start losing money at a much faster rate with every tick. But if you sell options with 150 DTE, you can be way farther out of the money while still collecting a decent credit . . . . and gamma is much smaller.
The biggest thing for me, in this regard, is that implied volatility has been shown to be mean reverting, so it usually goes back to its normal level. Whereas, stock price is unpredictable, a random walk if you will. So if the stock makes a big move against your short option, it is statistically just as likely to keep moving against you as it is to go the other way.
With that said, I simply prefer to tangle with the beast that is more predictable.
Not to mention, I believe the edge is in implied volatility—because it usually overstates the actual move of the stock. So I want to sell the options that leverage that edge the most and I consider vega to be the amplifier of that edge. Don’t get me wrong, theta is great, and I consider it the relief pitcher of the trade. But there is no edge in theta.
But what about the wait time? Nobody wants to wait for a 150 DTE trade to come in.
My average time in a trade is 39 days. This surprises a lot of people. Part of that is because I have sold options with 150 DTE that hit the 50% profit target in 5 days due to a collapse in implied volatility.
Yes, some trades hang on forever, 70 . . . maybe 80+ days. There are even the 1% that I roll forward.
When thinking about that concern, the first thing to keep in mind is that trades get layered in over time. So, yes, the first month of trading 150 DTE options can seem a little slow. But after putting on more and more trades, you start to have a wide range of expiration dates in your portfolio, and there are always a few trades that are getting close to their profit target.
The other thing is patience. Like Warren Buffet said, “The stock market is a device for transferring money from the impatient to the patient.” I also consider patience to be a type of edge, because few people have it. While I can often find a decent trade to put on, there are times where it is best to leave the portfolio alone. Granted, this plan is still an active trading method and it does have its own type of excitement.
One last thing I’ll touch on before getting to the Q and A section is my final criteria for taking a trade off.
If a trade gets down to 50 days till expiration, I look at whether it’s a winner or a loser. If it is a winner, even by $1, I will take it off. A trade that didn’t reach the profit target before 50 DTE probably had to be heavily defended, and I am just glad to get out of it without getting hurt. Now if it’s a loser (but hasn’t reached my 3x original credit received max loss point), I leave it on longer.
If a trade ever gets down 21 DTE and it still hasn’t turned into a small winner (or hit my max loss), I will roll it out to 150 DTE again, using the same strikes. This tends to ruffle a few feathers as well, because some folks would rather take the loss and use the capital for new good trades.
Again, this is a matter of perspective. I’d rather keep the capital tied up in the one bad trade, rather than have to wait for the 3-4 new trades it would take to make up for the loser. Plus I am rolling it out to 150 DTE to try to really neutralize it and wait for implied volatility to decrease (more predictable), rather than hope for price reversal. If that doesn’t work, theta (my relief pitcher), has a decent chance a wearing down that premium as well.
With all of that explanation out of the way, let’s get to some specific questions I received in response to Part 1 of the plan.
Q: Do you ever take IVR into consideration?
A: Yes, when I am looking for a trade I sort my watchlist by IVR and choose from those highest on the list. When there are none with an IVR over 50, I will only put on a trade if I feel like my portfolio needs more diversification or that I just need to sell more premium. For commodities, I have a list of ETFs that have an IVR, but then I sell the equivalent futures options if I see high volatility in the corresponding ETF.
Q: What percentage of capital do you have allocated to trades at a given time.
I try to stay close to having 50% of my capital allocated, as a rule of thumb, but that is one area where I go by feel. I’m am more focused on having a diversified portfolio of trades at one time. Not just equities, but commodities, currencies, etc. I should also point out that one needs to be careful when selling futures options because the buying power required is extremely low compared to the notional risk.
Q: Do you replace a trade as soon as you take it off as a winner?
No, I don’t look at it that way. Each day I try to find a good trade to put on and it’s not tied to whether I just took one off.
Q: If you have defended a trade by rolling in and collected more credit, do you then target 50% of the total credit taken in, or still target 50% of the original credit.
Still 50% of the original credit. I want to get out of the trade as soon as I can, so I’m not going to increase my expected profit for it. In fact, if I have had to defend a trade more than once, I’m just expecting to get out of it as a small winner or a scratch. My goal is to eliminate losers, not get greedy.
Q: Are your 2nd, 3rd and consequent rolls all to 3/4 of the tested delta?
A: I try to stick to that, yes, or close to it based on what the strikes allow. I never go inverted, however. If I’ve turned my trade into a straddle, I wait until it reaches one of my exit criteria.
Q: When you are rolling the untested side in, is it always within the same expiration cycle?
Q: If there are no expiration dates at 150 DTE, do you choose one that is longer or shorter?
A: I’ll choose the one that is shorter. I never go longer than 150 DTE. Anything between 100-150 DTE is acceptable to me.
Q: Do you ever leg into your strangles?
A: No, they always go on as a strangle and come off as a strangle.
Finally, as promised, here are my watchlists.
ETFs: DXJ, EEM, EFA, EWW, EWZ, FEZ, FXB, FXE, FXI, GDX, GDXJ, GLD, IEF, IWM, IYR, KRE, OIH, QQQ, RSX, SLV, SMH, SPY, TLT, UNG, USO, XBI, XHB, XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XME, XOP, XRT.
Equity tickers that correspond to a futures option (so IVR can be gleaned):
CORN (/ZC), DIA (/YM), FXA (/6A), FXB (/6B), FXC (/6C), FXE (/6E), FXY (/6J), GLD (/GC), QQQ (/NQ), RUT (/RTY), SLV (/SI), SOYB (/ZS), SPY (/ES), TLT (/ZB), WEAT (/ZW).
. . . . and that’s it for Part 2. Be sure to check out Part 3 of The J. Arthur Trading Plan, where I will talk more about how I find new trades and manage my overall portfolio.