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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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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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.