Framework for Backtesting Super Trader Karen's strategy

During the holiday season, our super trader study group made some progresses. We started using TOS software to back test Karen's strategy. It will take quite some time for us to complete it. Here're some of my initial thoughts that I can share.

The ThinkOrSwim software provides two features that can be used for back testing: ThinkOnDemand and ThinkBack. The TOD supposedly offer a market DVR that records all market data at intraday as stated by the vendor's announcements. In reality, we found it not suitable for any option strategies that use high probabilities. These type of strategies require usages of far out of money strikes which are missing in TOD. TOD offers most option Greeks up to 10 strikes. Delta for far OTM options can be retrieved in TOD, but other important Greaks and ITM probability numbers are not available. The implied volatility of far OTM options are also available, but not consistent with actual IV in trading window as pointed out in a previous post. Additionally, the important market crash data happened in 2008 are not available in TOD.

The ThinkBack (TB) feature supports end-of-day data for a lot more option strikes, including the Greeks and ITM probabilities. So we have to use the ThinkBack feature in our back tests in order to find the option's ITM probability, etc. NOTE: The Greeks presented in ThinkBack were reported to have some discrepancies in my post before.

Going through TB manually for any serious back tests are not practical, as it requires users to click on each date. The ThinkScript (TS) becomes handy to help the back tests when used together with the TB. The TS can be developed to show all entry, exit, adjustment points on a chart, along with other important trading portfolio information. However, there are also limitations by TS: the ITM probability is not accessible and option Greeks can not be cross- referenced in a portfolio that includes multiple options.

Back-testing under the above mentioned constraints is challenging. But I believe it will still provide some insights about the strategy. I have created a step-by-step guide for how to use ThinkBack and ThinkScript to perform back tests on the super trader's strategy in a document. Using an initial version of our script, it gives a couple of charts that illustrate a simple strangle trade and a short call trade.

Sold FXI Feb$36.5 Put and its return on capital

After closing a profitable naked put on FXI last Fridday, I started waiting for a possible rebound of FXI near the low up-trending line. Today the stock price did jump with a bullish MACD divergence. So I sold the Feb$36.5p for $0.65 with a Delta of 0.32 and a covered return around 11%. I plan to get assigned to the stock if it falls below the strike. I'll also set a GTC order to nail down profits earlier than expiration as discussed before.

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FXI Annualized Return on Secured Capital

To examine the ROC for the cash secured naked put, I created a ThinkScript to chart the curves relevant to Return on Capital. There are two ROC curves shown in the image below: One for Annualized ROC and another for approximated annualized ROC for a trading period of 30 calendar days (about 20 trading days assumed).

In the chart, the life long annualized ROC of this specific put option changes along with FXI price and time. At the price around 37.9, the following table showed annualized ROC values have not changed that much before.

• Date:   ROC
• 12-24: 11%
• 11-15: 11%
• 11-01: 12%
• 09:30: 11%

The lowest sub-graph showed annualized ROC if the trade lasted 30 calendar days. Note this number is usually higher than the life-long aROC if the stock price stays above the short strike. For example, if we buy back the option sold on 11-13 (20 trading days ago and ITM put selling) with a credit of $1.83, the return would be 41%.

The ThinkScript is given before as a reference.

#---------------------------------------------------------------------
#This script calculates Annual Return On Secured Cash for selling puts
#AROSC = [Profit/(Strike - Credit)] * (365/Days)
#---------------------------------------------------------------------

# 1. AROSC at entry for option life span
#def SoldCredit = OptionPrice();
# OptionPrice does not give current option price
def SoldCredit = Close();
def Days = GetDaysToExpiration();

def AROSC_Life0 = (SoldCredit / (GetStrike() - SoldCredit)) * (365/Days) * 100;

# Limit AROSC to 100% so that it displays curve better
plot AROSC_Life = if(AROSC_Life0 > 100, 100, AROSC_Life0);

Time decay chart and analysis of individual put options

As planned analysis of my closed naked put selling of FXI & TBT, I updated my ThinkScript to chart the delta-adjusted time value decay of Out-of-The-Money (OTM) put options. The updated script uses an average moving line to show the actual time decay of the option under analysis. Additionally, it shows the Bollinger bands of the time value in order to illustrate the overall time decay effect. BB showed a big contraction in the last 2 weeks in both cases. Some people may say the Bollinger band of the time decay is a wavy cone as a result.

To me, it suggests the option can be bought back 2 weeks prior to expiration. The charts provides supportive evidence to the conceptual drawing of OTM time decay after the inflection point in my previous post.

For the FXI put option trade, it demonstrated a more volatile time decay curve as the price of FXI fluctuated around the sold option strike. It can be found that time value was relatively high when the option is ATM.

For the TBT put trade, the price of TBT stayed OTM all the time. So the the time value at the last 4 weeks was quite small. When did time value start quick decline? It was difficult to tell from the chart. In June to July time frame, the option time value had big decline as a result of the rapid price ascend, even though we are using Delta-adjusted time value on the chart. In August to October time frame, the stock price dropped but the option price also fell as a result of time decay.

In the next posts, I'll examine the option time decay from a return of capital perspective.

Closed FXI Naked Put on Expiration Date

I finally closed the short Dec$37.50 puts on FXI today by buying them back at a cost of $0.13. I decided to take a good amount of profit on the expiration date, rather than getting assigned to FXI as the stock price was a few cents below strike.The intention is to sell another put when FXI rebounds.

As a winner management strategy, I could have set an good till cancel order to buy back the short put at a price of $0.10 to reduce risk of getting assigned when FXI fell. This option price was reached recently intraday, but not at the AM time period when I was trading.

I'll post the complete time decay chart of this option later with further analysis of the put selling strategy in the next few days.

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The time decay chart of a put option adjusted by Delta

Time decay is a fascinating part of option premium selling strategy. In my quest searching for suitable time decay, I'd like to get clear picture in areas such as what are good entry and exit points that capture rapid option time decay in a option's life span. I had posted a conceptual OTM option time decay chart  and an actual OTM time decay chart before. This time, I further studied the time decay of my naked FXI put option sold 3 weeks ago with the help of ThinkScript.

Since option price changes with underlying stock due to the impact of Delta, I decided to observe the option premium decay after taking out the Delta-induced option price changes. The option time value in my study was restricted to changes due to volatility (Vega) and Theta mainly in this way:
Option time value = extrinsic value  =
previous price + Delta-induced change + sum of Vega and Theta induced changes.

Using a simple approximation of Delta-induced option price changes, I was able to chart the Delta-adjusted time decay curve of the naked put which took out the Delta-induced change in the above equation. The directional price change from Delta is calculated as shown below using ThinkScript:
plot TmValExclDelta = extrVal - ((absValue(Delta()) + gamma() * opChange)/2) * (opChange);

The entire script is downloadable for anyone who is interested. It can be used as a base for other option premium analysis. The resulted chart is downloadable in a PDF file if anyone needs to see a clearer picture.

As shown in the above chart, I found a few key points below. I think a picture is worthless a thousand words. There are other points that can be observed from it as well. Note the left vertical axis is FXI ETF price and right vertical axis is FXI Dec$37.5 put option price.

• The FXI option price was high while its time value was low as FXI dropped below the strike price.
• The FXI option time decay acceleration started at about 2.5 months before expiration.
• The naked put sold at Delta around 0.3 and its time decay stayed close to the bottom downtrending line as FXI price consolidated for 3 weeks.

One of the interesting point to me is that this option started rapid decay around 2.5 months. If one sells the option on 2.5 months before expiration and exit it at around 1 month before expiration, he would capture a good amount of premium values with relatively smooth time decay as well. 

OTM Option Time Decay and its Exit Time

TastyTrade posted a video on Theta Based Exits for Sold Options on Youtube. It was quite educational. I’d like to share with everyone some of my review and thoughts on this topic.

On the time decay part, we sell options of delta of 0.30 to 0.35, which implies the ITM probability around 30% to 35% by expiration date. A credit is received after the option selling, which is similar to selling insurance premium. The OTM option time decay manner is somewhat different from that of ATM options which is show-cased in a lot of option text books. Based on the video introduction, the OTM option with Delta around 0.33 has a time decay chart as shown below. [Note I believe the hosts made a minor error in describing the units of the axes. The horizontal axis represent the passing time of the option in weeks (not days as they said) for an option that expires in 10 weeks. The vertical axis is the   option price x 100 in Dollars (not option price as they mentioned).]

For OTM options, the option’s price is the same as its extrinsic value. Time decay functions similar to insurance premium. This chart suggests OTM option (Delta = 0.33) price decay is relatively faster at around the first 7 weeks (49 days), which is the inflection point. After that, the time decay slows down as the price of the option has already dropped significantly and there is not much value left. The big assumption is that the OTM option stays OTM, although it was not elaborated how much price movement of the underlying could have to maintain such as time decay pattern. The discussion seemed to suggest that this 0.30 ~ 0.35 Delta OTM time decay chart is the merge of a 0.4 ~ 0.6 Delta ATM option at the 1^st few weeks and a 0.1 ~ 0.2 Delta OTM option at the last few weeks.

In reality, it may be difficult to come up with the above curve for any specific options, as prices always fluctuate. Demonstrating the daily rate of return on capital (ROC) in a chart is also interesting and it can give very good clues on when to exit this type of trades. Thus, this is one area that I intend to investigate in the future with the help of ThinkScript.

On the management of winners using Theta decay for exits, I believe it’s a great rule and Tom has been telling many of his students for a long time. Once most of the premium is decayed through time, the remaining value is quite small and the rate of decay becomes very slow. From risk to reward perspective, it will not look good if we try to gain a small reward that remains in the last couple of weeks before expiration. Therefore, it makes sense to buy back the sold option in the last couple of weeks immediately after the inflection point, as the return of capital gets smaller.

TOS offers free trades for option buy-backs within a nickel. However, many options at the inflection points are likely to be worth above $0.05. Only very low priced options can meet the free commission trade criteria. It would be much helpful for retail traders if TOS could offer free buy back trades at the inflection points such as Delta <= 0.10 or price <=  $0.10 J

Where should be a good point of entry to sell the options? This is not discussed in this video. But from the chart, it appears to tell us that 8 to 7 weeks before expiration is a good entry point where the option starts to accelerate its time decay. This entry point coincides with the option selling days used by Supertrade Karen.

In summary, the video discussed option premium selling by exploring the relationship of statistical probability (success rate and occurrence rate), return on capital, and management of winners. It did not use the option Greeks that much. Even though Theta had been mentioned in the whole discussion, the value of Theta or the trend of Theta was not shown at all.

The so called “Theta based exit” should be more accurately named as “Time decay based exit” in my opinion as Theta is only one component of the time decay. The other components for time decay include implied volatility/Vega and Delta which also change with time. There is no guarantee that Theta provides the most time decay when compared to Vega and Delta.

Added more TBT call contracts

TBT retraced about 5 days after my recent purchase of its 2014 Jun$73 call, then it started to resume up trend from yesterday. I liked its orderly pullback and the current upward candle today. So I doubled my long contracts by adding June$74c on TBT at a mid price of $7.70.

I'm considering raising my stop loss point to somewhere below the upper line of the recent downtrending channel if case the trade works against me.

I also prefer to wait a couple of more weeks before I consider selling calls to convert this trade to diagonal spread, unless the price and volume action change significantly from current trend.

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Skeptical about super trader Karen's strategy and performance?

Since I posted about Super trader Karen's option selling strategy, I have received a couple of anonymous comments questioning about her strategy and trading performance. Other on-line trading forums have a lot more critics of the trading performance of Karen, the super trader. So I'd like to share my 2 cents as well. Please note I'm not affiliated with Tom or Karen. They don't know me at all, at this time of my writing.

I was educated by Investools (same stock/option education company that Karen attended) and by TOS (founded by Tom) in option trading. I happened to attend a few seminars presented by Tom, the interviewer of the Karen. Thus, I believe Tom is a successful and honest businessman. So it's hard for me to believe he would lie about his client (Karen) in TOS. In my humble opinion, there is no dispute among option traders that selling option premium is the most consistent way to profit on stock option trades. Karen's option selling strategy appears to be sound and logical for me. [Update: I'd like to stress that the system and the rules disclosed in the interviews should be far more important than the phenomenal profits for traders who are process-focused.]

A lot of people know solid option trading strategies as they are taught by many education experts but only very few limited numbers of them actually make money for living using these strategies. I think Karen is one of the successful option traders who made millions of dollars. Her trading performance in the time frame discussed in the interview video was exceptional, as Tom stated in the interview repeatedly. It's so exceptional that Tom and other option education experts could not achieve. It also means all other traders are not likely to achieve unless they become really exceptional too. Exceptional also suggests the excellent performance may not last forever. Since Karen's strategy involves probability, I believe it's possible to calculate the expected rate of return in estimation. Anyone who can keep the rate of return should be considered as a successful trader of this strategy. This should be the target many of us trying to reach.

To make a good judgement about this option strategy and its potential performance, traders must understand its principles first. Many of the critics online do not provide enough substances in their comments. But I still like any critics about the strategy itself and its published rules. Otherwise, I suggest to put accusations in other on-line forums.

Sold Dec$37.5p on FXI

FXI gapped up and broke up the 2 month down trending channel today with high volume. Since I'm bullish on China over long term, I looked for a way to play this ETF. My rules require me to see a 6 week retrace from overbought zone for the MS line in order to enter an uptrend trade. But FXI MS is dropping for about 4 weeks only. Thus I used the naked put strategy as it requires FXI to move sideways or up. FXI also has a high cor-relationship with SPX. So I felt it's saver with the naked put as US market has been running up without a rest for quite some time. I plan to keep FXI if the put has to be exercised later. My cost will be 37.5-0.68 = $36.82. TOS indicated a 18% annual return rate.

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TBT: Profit from higher interest rates

Interest rate sensitive ETF's reacted on Government job numbers strongly today. TBT jumped above the recent 2 month long down trending channel with strong volume. My naked put Dec$70p sold about 10 days ago reached most of its profit with current Delta 0.09 in a surprising period of short time. So I bought them back for $0.25 each to nail down the profits and initiated some June$73c contracts for a longer term trade at the cost of $8.5 each. My stop loss will be around the recent low of $71. If TBT pulls back without heavy volume, I'll look for an opportunity to double my contracts. I'm impressed by the large pullback yesterday and the huge breakout today. The trade is consistent with my long term view of the interest rate rise. I'll change it to diagonal call spread later when I see TBT become far extended in price.

Another major beneficiary of the rising interest rate is the regional banks ETF KRE which also made an impressive breakout with huge volume today. I'll continue to investigate the possibility of playing with this ETF in the future. The real estate ETF's IYR got hammered again as a result.

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Sold TBT Dec$70p after its pullback for 2 months

TBT had risen for 4 months then started falling. Its price is around the support of an uptrending 200 DMA at $70. Since I expect an rising interest rate environment over the longer term, I sold Dec$70 put for $1.23 to get a cost of $68.77 in case I get assigned.

The average implied volatility shown in the chart appears to follow the price performance of TBT, due to its inverse relationship with market. This is different from other regular stocks. TOS option chain window indicated the covered return rate of 11.5% for this trade.

Similar to USO, TBT has a relative loose correlation with stock market. This gives me an opportunity to play the overheated market in the short team.

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Are there any ETF's remaining to be heated as SPY breaking into new highs

With the red hot market today, are there anything left with good potential for long term investment but not too overbought? I found two ETF's that looked interesting: USO (Crude oil) & DXJ (Japanese stock market). Both of them have smaller correlations with the US stock market performance.

With energy stocks performing well and US dollar falling, I don't think USO will keep dropping, particularly if Chinese economy remains healthy. My guess of the weak USO is due to the improved prospects of peace in middle east (Iran). I read one article stating oil price could drop 20% or more if Iran's oil is available. That may lead USO to $29 level from current $36.45, a $7.00 drop. At current option price, it will take about 1 year of selling call options for around $0.40 premiums to break-even, if one enters USO from selling puts with a break-even price of around $35.00. With the outline shown in the study, it's probably worth try to sell some puts on USO soon if USO price rises next day.

DXJ chart looks similar to that of EWJ which follows the Japanese stock market index I believe. I choose DXJ because it's of higher price with more option strikes. My understanding is that they have an export driven economy which benefit from falling yen FXY: It's beneficial for the Japanese market if US dollar UUP behaves stronger than FXY. The low interest rate environment in Japan should be reflected in the rising of Japanese bond GJBL. As shown in the 2nd page of the study, Japanese bound ETF JGBL is currently outperforming US Bond. So it looks to me that Japanese market may continue to perform well since it shot up about one year ago when the current Japanese prime minister adopted a new economic policy to pump even more money into its already heavy debt economy.

A study on Chinese ETF's

Since I bought HAO about 4 weeks ago, it was doing well as US market had some turbulence because American politicians played their threatening games for government closure and national debt ceiling. But I need to clarify my long term exit criteria for HAO. As part of my study for Chinese stock market conditions, I found the following interesting ETF's that are helpful to determine the health of China's economic status as reflected by Wall street.

Besides the Chinese big caps in FXI, we have the small cap HAO and Chinese technology CQQQ representing broad Chinese market. The Chinese bull market is led by the technology ETF CQQQ as it has rose over 50% year today. The Chinese real estate ETF TAO is lagging SPX but outperformed US real estate IYR (TAO provides no dividend) at this time. The thinly-traded China Energy ETF CHIE also showed an uptrend in the last 3 month.

The Chinese bond ETF DSUM has outperformed US bond ETF BOND manged by the bond king Bill Gross in the last 6 month. The Chinese Yuan ETF CYB outperform US dollar UUP and bond BOND in the same period. I think the Yuan price indicates longer term economic trends in China than the stock market prices.

If the Chinese economy is to collapse, I would expect the Chinese stock market ETF FXI, and bond market DSUM and the Yuan CYB to fall at the same time. If they don't drop at the same time, it's telling me that the Chinese economic may be healthy overall in the long run.

Additionally, Chinese economy has strong impact on commodities DBC and their producing countries like Australia EWA and its currency FXA. These ETF's are likely to lag the Chinese counterparts in time and to perform well later if Chinese ETF's gets real hot.

Long term investment entry for China small cap ETF: HAO

The market had turned into bullish on last Monday 9-9, after Nasdaq broke into new yearly highs. After that, the market behaved in healthy way last week.

Looking at the long term trends, I felt we are already in a bullish long term uptrend as we are facing the initial interest rate hikes environment. We did not have a market correction since this summer.  So a correction would be nice to provide attractive entry for SDY, the dividend equivalent ETF for SPY.

Among all uptrending ETF's, HAO is the one that I like right now, since it's not too extended yet. This China small cap ETF is showing an uptrending 200 day moving average with the current price slightly above the 200 & 50 DMA. Other positive entry signs are listed in the doc, along with the stock chart. My stop point will be the point where 50 DMA crossing down 200 DMA and the price falls down to $21.15.

Due to the changing economic environment, I think the interest rate is going up in the long run. Thus my portfolio of long term investment will change. For example, the real estate ETF IYR may not perform well in a rising interest rate. I'll invest more on the technology sector for this market.

Stopped out of SPY Call Yesterday

The market had shown a few distribution days in the last few weeks. IBD declared market in correction on last Thursday on 8-14. In the afternoon of last Friday, SPY fell below my stop level around $166 as posted before. So I decided to exit the bullish position trade of SPY on Monday morning as it did not rise at higher volume. Due to an technical issue of the ProphetCharts, my trade did not get posted yesterday.

I noticed the market was in an oversold condition as SPY were sitting around the 50DMA and the lower band of the bollinger bands and the VIX reached the top level of its bolling bands, ... This is kind of typical for my stop levels, which I'd like to honor as part of trading rule. If the market turns uptrend again, I'll consider a new bullish position trade. Otherwise, I'll look for opportunity to initiate a bearish position trade.

Since I'll be on vacation sometime at the current option cycle, I'll not trade the high probability option income trade for this cycle. But I'll spend some time to analyzer previous trades and post my reviews here.

May to July Trading Review

My last monthly trade review was in May. Since then, I had two trading cycles, a smooth one lasted less than 1 month and the other tough one lasted over a month. I was not able to review my trade on a per trading cycle basis.  Overall, the June cycle went well as market offered a good opportunity while the July cycle was rough for me. Here's my current multi-month trade review using my regular review template.

Trading Rules

• Adherence consistency

I think I followed entry trading rules and the exit rules. There is an improvement for the exit rule since I've fune-tuned my exit rules to make them clearer.

• Skillful application/execution

I had a cancellation trade error as described in a previous post when I was making multiple adjustments in a short period of time. My trade validation step does cover review of adjustment strategy, potential cancellation of strikes in existing position, order size and order fills, when new order is about to be placed. But I may still forgot checking one of these components occasionally or in a trade adjustment spree.

• Monthly rule review/study

I did not have time for trading rule review & study in July as I was very busy at work and other life. Need to improve my Delta adjustment values in various scenarios as explained in a prior post.

Psychology

• Action during uncertainty

Used the Greeks and P&L chart to determine trades and adjustments, but need improvements at proper amount of Delta adjustments.

• Risk Comfort ability/Adverse damage impact

There were bigger losses than I had expected in July. I seemed to be able to withhold it. The adverse damage impact remains to be seen.

• Trade anxiety

As usual, there was no impulsive trading for the period.

• Winning Altitude Development

I did not work on this one in this period.

Trading Time

• Trading days

It was possible to meet the target of 15 to 20 minutes per day on average. But on a busy inventory closing day, it may take 45 minutes to over 1 hour to get all trades closed. It did not include the optional trade study and blog time.

• Resting days

I spent time for mostly non-trading related activities.

Trades and Market Replay

• Market Forecast

The following analysis in May also occurred in July:
Was expecting a market correction of some sort, but the correction signal got invalidated quickly. An overbought market can become even more overbought in strong trending markets.

• Trades and Adjustments

Need to study the proper amount of Delta adjustment as soon as possible. I think this is big issue for me at the moment.

To Do List

I should use this to-do-list to help me stay focused for my near term trading work.

• Further review of Integration of successful mind set to trading rules
• Identification of components of trading process
• Create ThinkScripts to track the portfolio for my trading and for trades similar to super trader Karen
• Quarterly Performance Analysis
• Continue investigation of the effect of price, time and volatility on option Greeks
• Study major losses since the starting of the blog and devise proper guidelines for the amount of Delta adjustment

Retrospect of August Option Exits

As noted in my previous post, I'd like to record my exits of the August option portfolio a few days ago. On August 1, the market rose and my option income portfolio had a P&L chart below. Since the P&L (white curve) of the remaining positions was close to the max potential (red curve), I decided to close all remaining positions except the bull put vertical spreads for SPX & RUT. The bull verticals were far out of the money and looked safe to expire worthless.

Looking back for my option trades in July, it was a tough month that ended with a loss. I believe I underestimated the bull market starting at the 1st adjustment of this cycle. In retrospect, the 2nd adjustment on 7-11 did not offer enough Delta neutralization. It was a 2nd confirmation day to follow through the market up-turn. At that day, I should have reduced the portfolio Delta to less than 10 in absolute value (-30 in reality), by closing out some positions like calendars if necessary, in anticipation of a continued uptrend. It's usually not a good idea to expect market pull-backs for a sustained period of time at the starting phase of a market turning point.

Bought SPY Call after it broke out of the small handle

The SPY formed a double bottom with a handle in the last couple of months. Today it broke above the handle. So I bought some SPY calls for a position trade. The stop price is around $166. I'll watch for market condition and Delta rises to exit if market continue to go up.

I also exited most of my option income portfolio for August and will post it in the next couple of days.

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Started to exit August positions due to strong market

My option income trading rules require me to exit 4 to 3 weeks before expiration in order to reduce Gamma risk. Yesterday, I decided to take a first step to exit, considering the market resisting to fall much and my portfolio Delta was over -20 and Gamma around 1.4. I forgot to capture the TOS screen before exiting the SPX DC. So I had to reconstruct with addition of a double calendar. The following image showed the approximate Greeks at the time of this exit and the P/L day value was higher than actual value due to the addition of the DC into the analyzer.

So I closed the double calendars for SPX & RUT and the UPRO which has a Delta of 12. In the end, I got a mostly Delta neutral portfolio as shown below. The resulted Gamma and Theta were acceptable for me.

What amount of Delta adjustment should be used to hedge portfolio

It's always an interesting question for me regarding how many Delta adjustments been used to hedge my option income portfolio.

Should it be bull market or bear market condition dependent or should we always try to adjust to neutral Delta? I had a question posted in Feb 16, 2013: Does it make sense to adjust to a more Delta  for each adjustment if the adjustment is following the current market trend? Obviously, I have not been prepared to answer this question as of now.

The main reason that preventing me from a total neutral Delta adjustment is that there is always a possibility of market to reverse back, reducing original profit potential to some degree that is dependent on the Delta value adjusted.

If the Delta adjustment is not enough, continued Delta adjustments are required as market follows its force of inertia. This creates frustration in trader's mind and demands extra time for portfolio management. It happened in my trading in July this year.

If the Delta adjustment is large enough to make the hedged portfolio Delta neutral, there is a possibility of market reversal and associated Delta re-adjustment in order to maintain proper portfolio Greek values. The previous color-coded chart seems to be useful to identify this scenario or adjustments vs market reverses. In the week of last Oct. 15, there was an IC roll up adjustment. The adjustment changed Delta by 5 points only. After the adjustment, the market reversed.

It seems to me more neutralized Delta may be better if market sentiment line is not in overbought/oversold zones (80 < MS < 20). Otherwise, smaller Delta adjustments may be better due to the likelihood of market reversal.

Due to limited time today, I will update more thoughts on this one in the future.

Trade adjustments for the last couple of weeks

The market has been performed bullishly in the last 5 weeks. In the last couple of weeks, I had to make additional Delta adjustments for my non-directional portfolio. On 7-18, my portfolio SPX Beta weighted Delta reached more than -40. So I bought 90 shares of UPRO which is a 3x SPX ETF with equivalent Delta of 12 as shown in the chart below. As explained in my previous post, I used the ETF because I did not want to increase Gamma mainly.

This adjustment brought my Delta to the top limit of my acceptable Delta range, with 30 days to expiration. 2 trading days later (on 7-22), market continued its ascend. My portfolio Delta reached -50 so I had to make additional adjustments. The chart below showed a Delta of-65 due to a TOS SW issue. This was a Monday after a weekend TOS SW upgrade. The new version updated at last weekend did not show the 12 Delta of the UPRO. I was concerned about it and a few days later found the Delta field of UPRO came back.

On that Monday, I decided to close two most damaging positions of SPX (Iron conder) & RUT (double calendar) to make significant Delta reductions, because I had done many other adjustments already. In the end, I reduced my Delta to -27 as shown in the chart below. After that, the market had taken a 4 day rest giving me sometime to catch with Theta decay.

TOS software does not account for closed positions. So the realized loss for this cycle that is not accounted in the above diagram is about $2050. With about $950 profit shown in the above chart, the real loss at that date on paper is $1100.

As of today, it's apparent that my initial Delta adjustments were not big enough. I have to post my analysis of this month's adjustment later.

Another Delta cut for August non-directional option portfolio

Today is the 8th day of RUT consecutive rises. It looks like the RUT is running outside the top Bollinger band for 6 days now. I had refrained from adjusting the Delta of my RUT positions in the last few days. However, my current portfolio Delta is approaching -45 from last Friday's value around -36. It's a little bit over may desired range. Hence, I cut the portfolio Delta by 5 using TNA (the 3 X RUT ETF equivalent) as I planned before. I could not find a satisfactory option strategy for the adjustment at the moment. I think this happens after a few calendar adjustments which increase the Gamma and Vega of the portfolio significantly. The black horizontal line in the chart below represents the real zero profit level.

Since the market is due for a pullback (just my opinion which market does not care), I did not use more shares and UPRO to further Delta reduction, as I think market is unlikely to jump continuously in the next few days.

A review of Detla Adjustments using leveraged ETF's for SPY & IWM

I had written about using less expensive adjustment vehicles for Delta neutral portfolio before, which explained the usage of SSO. Now, I found out TOS is able to show Delta's of more leveraged ETF's. Here, I'd like to review the corresponding ETF's for SPY & IWM so that I can establish some guide lines to use these leveraged ETF's in case I need to make Delta adjustments without additional Greek changes to my high probability portfolio.

As shown in the above table, every 100 shares of UPRO (which is equivalent to 3 x SPY) can produce a Delta of 13. Every 100 shares of TNA (which is roughly 3 x IWM) can produce a Delta of 10. Note the Delta discussed here are SPX-weighted Delta. I believe TNA produces less Delta than UPRO as IWM is lower priced than SPY even though IWM is more volatile than SPY.

Similarly, we can find out the SPX-weigthed Delta for triple short leveraged ETF's: SPXU (-3 x SPY) and TZA (-3 x IWM). I think the proShare's triple ETF's URTY & SRTY are less frequently traded. So I don't plan to use them for my current trades.

Compared with using SPY/IWM directly, using the triple leveraged ETF's requires less capital. Although the leveraged ETF's do not perform exactly at the targeted rate of changes, I think it's OK for my type of trading since the overall concept of using SPX weighted Delta is not mathematically accurate anyway.

For my Delta adjustments, the stock or ETF trades are used in scenarios where I need to keep other Greeks (such as keeping Gama < 1, Vega < 400) from additional changes, or other option adjustment strategies will destroy the smooth profit and loss zone. The holding of these ETF's is expected to be less than 1 or 2 weeks so it will be adopted near the end of expected trading cycle usually.

Delta Adjustments in response to continued market rally

As noted in yesterday's post, Market cheered for FED's meeting notes with a solid rally on strong volume. It changed IBD's outlook to uptrend at the market close and caused my portfolio Delta to reach -40 intraday. I had to take some actions to reduce the Delta further.

After playing with various strategies for 40 minutes, such as debit verticals at several different strikes below, across or above the SPX market price, I finally settled on a combination of calendar spreads and long ETF as shown in the chart below.

I could use additional double calendars to maintain a good looking P&L curve. But it would increase my Gamma to more than 1 and Vega to over 500. Thus, I decided to use the ETF SSO instead, as I had analyzed the usage of SSO as an adjustment vehicle before. Overall, my adjustments for this cycle had been slow, each time adjusting portfolio around 5 points or so. The initial reason was the market was in correction mode and the 2nd reason was SPX & RUT prices are at the top line of the Bollinger bands.

Due to the multiple adjustments in a short period of time, I forgot to verify the strikes of RUT used in the calendar against the exiting strikes and made a minor mistake such that my new calendar had a short strike that cancelled an existing strike as circled in the above chart in red color. The major impact of this strike cancellation is that the TOS software now considers I had taken a $1100 profit out and the TOS software shows adjusted P&L figures of -$2254 for the remaining open positions after that. The new break even points shown in the chart are not the real break-even points for this cycle anymore. To overcome this impact, I need to move the $0 profit line downwards by $1100 to get the actual P&L and B.E points for the monthly cycle. I had this type of errors before and created a validation rule in my trading process. It looks like it's still not firmed embedded in my trading execution though.

Stopped out of SPY Puts

Market continued to rise with strong volume. Nasdaq rose over 1.29% at this time. It will constitute a 2nd confirmation day of the market uptrend if it still holds at the close time.

SPY also broke above my stop around $166. So I need to follow the plan to exit the trade. It's currently at a resistance level around $167. It has consolidated for around 7 weeks. If it pulls back, I may enter a bullish position trade on SPY after MFI reaches over 50.

I also adjusted my August option income portfolio, and should be able to post the adjustments tomorrow when I get the time.

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Created with ProphetCharts®

Continued to neutralize Delta of August option income portfolio

Yesterday, SPX rose to 1650 level, up $75 points in last 2 weeks. The SPX-weighted Delta of my non-directional portfolio reached -34 and the SPX price continue to move to the edge of the P&L zone as shown below. So I decided to make additional Delta adjustment, on top of my calendar spread adjustments on Monday.

I used a couple of verticals for both SPX & RUT to neutralize Delta by about 10 points. The short put options had Delta around -23 at the time of my order. I could have reduce the portfolio Delta even more, but I decided to wait since my technical outlook was still bearish near term as we had not seen a 2nd confirmation day yet.

If the market continues to rise, I might have to use a vertical debit spread to significantly reduce Delta in the next few days. For my position trade on SPY put, I may have to exit if SPY rose above $166 firmly as planned before.

Calendar Spread Adjustments to August Income Option Portfolio

As market continues to rebound in the last week, the SPX & RUT prices reached the edge of my August high probability income portfolio P&L curve as shown in the image below. The portfolio Delta was around 30, a little bit shy from my adjustment level around 36 as posted before.

So I used single call calendar adjustments for both SPX & RUT positions. The outcome is that the profitable zone is right shifted a little bit and the right edge is raised, while the portfolio Delta is reduced by 2 only. The larger Delta change shown in the P&L chart below was caused by the market price fluctuating in the downward direction at the time of my adjustments.

I decided to hold off more Delta adjustment today as the overall portfolio Delta is still in the acceptable range. I could use a few vertical put spreads to neutralize the Delta. But I wanted to spread my adjustments over multiple days as the market condition allows. If the market offers me higher Delta in the next couple of days, I would take action on the Delta.

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).

Completed August option income inventory with another DC for RUT

Today, market is slightly up at the moment. RUT is pulling back after touching the 50DMA. I bought a RUT August/Sept double calendar to complete my August high probability option selling portfolio as shown below. This trade brought in additional Theta of $10. Since the RUT did not change much at the time of my order, it took more than one hour for the order to get filled.

Currently the portfolio is perfectly delta neutral. The curve shows more potential profits if market goes down which reflects my market outlook at present.

Added a double calendar to August option income trade

I had built half of my August option inventory since last Tuesday. Today, I added the 3rd position to my August non-directional trading portfolio. Since my outlook is bearish right now, I used a double calendar on SPX with its profit zone towards the left side. Due to the relative high volatility in the market, I was able to select a $50 width without a major sag in the middle of the DC P&L chart as shown below. Normally, the span of DC is around 30 to 40 points.

The Theta of the original SPX IC reduced to around 2 as a result of recent market selling off, even though the half portfolio of August were still profitable at the moment. The added DC bumped up the Theta by 16 and changed Vega from negative to positive 68 which is helpful in bearish market.

There is one remaining position on RUT to be added to complete the August incoming portfolio. I plan to add another DC tomorrow with slightly different option strikes if possible, in order to spread the risk further. If that happens, the targeted profit income for the month will be around $800.

Bought SPY Put again

Yesterday SPY broke down the support level around $160 and closed at this lower low with extremely high volume. The market used the FED new about ending QE's as an excuse. Considering the intermaket analysis definitely showed the bearishness of the market, I need to start my bearish trade as indicated in my previous post.

So this morning at my usual trading hour around 8:00AM PDT, I purchased a few SPY DEC Puts with Delta raning from 0.55 to 0.67, depnding on my risk tolerances for my accounts. Since this is not ideal point to start the bearish directional trades, I reserved soem buying power to add more positions in case the market rebounce. The ideal point for me is the resistance level of $160 right now.

My stop conditions are similar to the prior bearish trade on SPY with the stop price adjusted to the lower high of $166.

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Created with ProphetCharts®

Started August non-directional trade with an iron condor

Yesterday was the 58th day to August SPX option expiration. So I started my 1st option premium selling trade for August and will continue to add August income trades to my portfolio in the next few days, pretty much one trade for each other day. This is a typical trade with short options of Delta around +/-0.23 for a credit of $6.65. I could have sold credit over $7.00 with other strikes of Delta 0.25. But I chose smaller credit for higher probability after looking at the resistance and support level.

If the market does not show any significant bearish signs, I'll use all iron condors for the August portfolio. Otherwise, I may use verticals and double calandars for it. On the 4th trade, I'll assess my portfolio Delta and consider adjusting the Delta with multiple trades that receive smaller credits. If that is the case, I'll also split the trade into two days in order to reduce the risks.

Currently, the SPX option chain still projects a higher possibility of downward movement in the future, since the average monthly volatility values are higher for longer time expiration series. We'll see if this term structure will be changed in the next few days.

Closed SPY Puts after market switching back to confirmed uptrend

On last Thursday, SPX surged over 1.2% with volume higher than the prior day (Wed). This constituted a 2nd confirmation day since it was the 6th trading day after the market made a  prior low on 6-6. As a result, IBD changed intermediate market trend outlook to confirmed rally.

According to my exit rule as noted in the last post, I had to exit the SPY put if market returns to the confirmed uptrend. Therefore, I was watching market on Friday and saw market falling with lower volume. It was not a bearish sign of institutional distribution due to the lower volume. So I exited all of my the SPY puts.

This trade intended for intermediate term only lasted for a few days with minimal losses. There was no frustration for me since it's part of trading life.  I still consider a high probability of a significant market pull back (over 10%) when market starts to signal bearish signs again, because all of the previous pullbacks were shallow with less than 10% changes.

The next time when market gives us bearish signs for us to declare market in correction, I will continue to look for opportunity with intermediate term directional and bearish trade. I will stop any bearish directional trades if the intermediate term correction is not considered as high probability anymore. It means I may not do this type of trade for many months.

Bought December SPY Puts

Market finally gave a bearish distribution day yesterday and it made IBD to declare market in correction. As described in my previous post on inter-market relationship, this gave me a signal to initiate a directional trade on SPY with straight puts. This is the first time that I started a bearish position trade since I started the blog.

My stop point is $168 for SPY. The targeted profit is at a price when the Delta of SPY DEC$171p reaches 0.85. If market shows a 2nd confirmation day before the stop is hit, I will exit the trade as well.

I have used a spreadsheet to calculate the potential losses if the stop is hit, and made sure my trade losses will not be more than 3% to 0.75% of my trading accounts. If market continues to drop and break the 50DMA, I can buy additional contracts within my risk tolerance.

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Created with ProphetCharts®

Closed July option inventories on new profit target for non-directional trades

After about 3 weeks since initiating the July option premium sales and 2 weeks since completing the July option selling portfolio, the market returned to my portfolio center with a neutral Delta today. In the last few weeks, I have firmed up my profit exiting rules and included them in my plan. So I took the action to follow it through by closing all of my smooth portfolio option positions for a limited profit. I'll describe my profit exit rules in a separate post.

The above image showed the portfolio status at the point I decided to exit all positions. The actual profit is usually smaller than the value shown in this type of charts due to slippage of option trades.

One of the effects of my current profit target appears to be the early exit. I'll continue to work on my ThinkScript to track the performance of these July options so that I can come up with good exit criteria if necessary.

A study on intermarket relationships for market outlook

On last Thursday, the stock market was falling off at mid-day when I was watching it. The market had logged a few distribution days before that. There were other signs of weakening market as well. I was really inclined to declare market turning into bearish at the intermediate term (> 6 to 8 weeks). But I did not take any bearish trades in the end, because the intraday volume did not appear to be definitely higher than the prior day.

Since then, the SPX had re-bounced from its 50 day moving average. So what is my current market postures supposed to be? Today, I'd like to study the market at the inter-market relationship perspective for valid clues. I found this type of analysis had helped me before to determine the long term trend of the market.

Of the intermarket indices that I watch, SPX is of the most importance. In the last 6 to 7 months of the current uptrend, there were 2 times (marked on the chart above) of serious distribution days occurred. IBD declared market in correction at these two times. Note this time, there are quite a lot more bearish signals showing in the charts.

Currently, I'm waiting for the 3rd time to declare market in correction. In my past experiences with the IBD method, it's quite possible market does not turn in the first couple of times IBD declares market condition changes. But it's very rare that the 3rd time declaration is wrong. I have not planned to do any directional trades against the long term trend. But I consider the 3rd or 4th time of market weakening as higher probability trades. So if the market continues to demonstrate weakening signals, I will initiate some intermediate term bearish trades.

Other intermarket signals that I'm looking at are shown in my 4 page PDF file here. Most of them are now exhibiting market weakness. One thing to note is the behavior of US dollar. I think it restored it's long term (historical) relationship with the stock market in that the UUP rose along with SPX. It was not like this in the last couple of years though.

Another aspect that is noteworthy is the fall of bond, GLD & IYR. I consider them to be inflation protection plays in some degrees. They got hammered recently. It seems to suggest the next market upturn (after a correction) will be significant and I need to rebalance my long term portfolio at that time to align with the market force changes.

Lastly, the new high/low index is still in a nice uptrend. I consider it to be a long term indicator, signaling the long term uptrend is still intact.

Completed July Non-directional option income portfolio

In the last few trading days, I added a couple of July iron condors for SPX & RUT since the opening of the July portfolio as described 1 week ago. Market was falling in general until today on which it shot up in the morning with strong volume. So, I entered my last trades of the opening positions for this option cycle with two bull put spreads as shown below. The short puts had a delta around -23. With these two vertical credit spreads, my potential profit is similar to my regular portfolio made of all IC's, but the two vertical spreads required twice amount of margin as equivalent iron condors. They also provide a little less theta compared to the IC. However, they generate the positive Delta for the portfolio to remain close to neutral.

Although my adjustment rules seem to be clear to myself at the moment, I've been thinking about refining my exit rules as described in my recent trade review and should be able to describe the update in a new post soon.

A review on trading option Greeks

A few years ago, I attended a couple of Dan Passarelli's live Webinars and remembered him as one of the most knowledgeable and passionate option trading educators. Recently, I bought his book "Trading Options Greeks: How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial)". I did spend sometime reading interesting sections of the book. So I created an initial post on the summary table of the effects of prices, time and volatility on option Greeks and another study on the implied volatility and its time decay. Since this book is pretty useful for me, I'd like to share some thoughts on it with my readers.

Compared with a couple of other option trading books I have that cover similar topics, this book describes a mathematically simple way to manually calculate approximate option price changes using the option Greeks. It is a unique part of this book that it uses many examples to illustrate how to estimate option price changes using the option Greeks with approximation equations that involve a few addition, subtraction, multiplication and division only.

I consider this book an intermediate level one for option traders that require a solid understanding of the Greeks, as this book goes a little further beyond the introduction phase. It explains what the Greeks are, and more importantly, how the Greeks change under various scenarios which is missing in most other option trading books. This book also gives introductions about various option spread strategies and volatility spreads in particular.

I don't consider it as advanced level, as it rarely describes Greeks and their changes at option portfolio level or for complex option positions. It's not an option trading system book as well, since it does not offer any specific criteria for trade entry, exit or adjustment. To get more detailed descriptions about the 5-star user rated book (as of today) and other reader comments, you can click on the book image below.

Feb to April Trading Review

My last monthly trade review was in Feb. It seems I kept skipping my monthly trade reviews for various reasons. I think this is one area that I need improvement: don't get side-tracked by other seemingly interesting trading stuff, but use my limited time to stay more focused on my trading process. I definitely need to remind myself about it from time to time. Anyway, here's my current month trade review using my regular review template.

Trading Rules

• Adherence consistency

I think I followed entry trading rules and hesitated on the exit rules. This is partially because I'm still trying to fune-tune my exit rules since I switched to open trade for 2 month ahead.

• Skillful application/execution

I had a big trading execution error as describe here and I refined my trading desktop environment.

• Monthly rule review/study

I'm still contemplating for an optimal exit criteria that works better in low volatility markets. I also realized some issues in ThinkOrSwim Software and thus started investigation on using ThinkScript for portfolio tracking and option Greeks study.

My validation step should cover review of adjustment strategy, potential cancellation of strikes in existing position when new order is about to be placed, order size and order fills.

Psychology

• Action during uncertainty

Used the Greeks and P&L chart to determine trades and adjustments, but need improvements at exits.

• Risk Comfort ability/Adverse damage impact

There was no major risk at this period. So this was not really tested this time.

• Trade anxiety

Not much.

• Winning Altitude Development

Complete the 2nd part (integration of successful mind set) on the psychology of consistent winning altitude. Furthermore, created a 3rd part on applying successful mind set for trade exits.

Trading Time

• Trading days

It was possible to meet the target of 15 to 20 minutes per day on average. But on a busy inventory closing day, it may take 45 minutes to over 1 hour to get all trades closed. It did not include the optional trade study and blog time.

• Resting days

Studying trading option Greeks and ThinkScripts. Spent time on family and busy work as well.

Trades and Market Replay

• Market Forecast

Was expecting a market correction of some sort, but the correction signal got invalidated quickly. An overbought market can become even more overbought in strong trending markets.

• Trades and Adjustments

Did not find major adjustment errors in the last couple of months so far. Whether enough Delta were adjusted in the strong market is still a subject for further analysis.

To Do List

I should use this to-do-list to help me stay focused for my near term trading work.

• Further review of Integration of successful mind set to trading rules
• Identification of components of trading process
• Create ThinkScripts to track the portfolio for my trading and for trades similar to super trader Karen
• Quarterly Performance Analysis
• Continue investigation of the effect of price, time and volatility on option Greeks