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.
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.