Saturday, June 29, 2013

Balancing risks, profit targets, account margins and volatility

As noted in one of my previous post, I had been improving my exit plan for the high probability option income trade portfolio. The goal was to balance the risks and realistic profits under various market conditions.

Under low volatility environments or up-trending markets, the sold option premiums are smaller and the smooth profit zones are narrower. In high volatility environments or down-trending markets, the sold option premiums are bigger and the profit zones are larger. The differences in premiums and profit zones should be taken into account in my target profit for the monthly income trades.

In market conditions that are not extremely up-trending, if profit reaches 8% ~ 10% of portfolio margin or 30% of potential max profit, we should close positions to lock in profit of the month. This reduces the risks of staying in the market. In these types of conditions, the portfolio usually includes 2 to 3 IC’s plus 2 to 1 DC’s. In strong up-trending markets, the portfolio may include 4 IC’s or 3 IC’s plus 3 bull put spreads. In these cases, the targeted profit is smaller due to smaller credits in low IV environment.

Thus, the targeted profit for the following types of positions is listed below, assuming each IC receives a minimal credit of $6.5.
2 IC + 2 DC:        Margin $4000,   Target Profit $800
3 IC + 1 DC:        Margin $6000,   Target Profit $600
4 IC:                    Margin $8000,   Target Profit $450

3 IC + 2 Vertical: Margin $10000, Target Profit $360
This table is derived from my calculation based on the principle mentioned here and the trading experiences in the last couple of years.

To maintain high probability of success, my non-directional option trading portfolio uses different combinations of option strategies in different markets, creating different margins or buying power and portfolio risks. Since my option income trades involves premium selling mainly, I decided to use margin as the basis for my accounting purpose. The other possibility may be using the absolute portfolio risk. For my current portfolio of August options, I have two IC's and two DC's. The margin requirement is $4,000 (same as buying power) while the absolute risk is around $6,500 (IC Wing spread width - credite + debit of DC).

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