Super Trader Karen Study Group

The successful story of super trader Karen has captured attention and imagination of many option traders. Some readers are looking for ways to communicate with each other about the strategy. They left great comments or contacted me via email in the last year or so since my original post. Encouraged by the enthusiasm, I finally created a Yahoo Group to help option traders who are interested in studying this strategy. I certainly expect to learn a lot of insights from fellow option traders as well, as I have seen some members stating great success in the last few years selling options or managing million dollar account.

This is a restricted user group focusing on the study of selling naked options, the Karen way. Main topics that I can think of right now include the following:

• Discussions on super-trader Karen's strategy
• Back-testing the option premium selling strategy
• Trading (paper or real) the strategy
• Other related topics

The strategy requires intermediate and advanced understanding of option trades, such as implied volatility, probability, option Greeks. So it's only good for people with the proper level of knowledge and experience. I'd like to make the posted messages available to the public even though only the members can post. But for some reason, the Yahoo group web site grey'ed out the option of Non Members can view messages section. If I figure out how to enable this option in the future, then the public could read the group messages.

In the past 3 weeks since the inception of the group, we have over 30 members joined which is beyond my expectation. Members seem to be from different countries, include USA, Canada, Italy, India, Singapore, etc. If you think you have the right skill and like to contribute, welcome to join this dynamic community.

Some thoughts on back testing Super trader Karen's portfolio entries

In the last couple of weeks, our study group started some back-tests on Super-trader Karen's strategy. I worked on the entry rules as a beginning. Although major rules are described in my original post, there are some details or flexibility that need further explorations regarding the opening of the monthly portfolio.

Since all positions are not opened on day 56 to expiration, we need to have a range of opening days first. Then we should have some rules on when (conditions) to open options within the opening day ranges. Next we will need to figure out how many more puts to sell if necessary.

Personally, I prefer to test the opening of positions around 56 DTE +/- 7 days, because some of my recent studies showed far OTM option decay with a good rate starting around 2 to 2.5 month to expiration.

So, what are possible conditions for entering new trades in these 2 weeks? I tested the following rule briefly today, using an up-trending period from late October to November last year.

o   Before half positions are entered around 56 days to expiration (56 DTE + 7 days)

§  Sell put if market drops for 1 day and sell call if market rises for 1 day

o   After half positions are entered around 56 days to expiration (56 DTE - 7 days)

§  Sell put if market drops for 1 day and sell call if market rises for 3 days

DTE	Date	Option	Strike	Price	SumPremium
58	10/23/2013	S Put	151	0.265
57	10/24/2013	S Call	184	0.4	0.665
52	10/29/2013	S Call	186	0.35	1.015
51	10/30/2013	S Put	154	0.245	1.26

The December expiration monthly portfolio P&L chart is shown below. In the rising market, the short call strike at $184 got approached but not violated near the end of the option expiration. The 50% profit target worked well for this month as shown by the green bubble. The yellow bubbles named C1Back, P1Back and C2Back were located approximately 1 month after their corresponding entries.

In this example, holding positions longer than 30 days caused maximum profits for the portfolio. It was a surprise that this cycle would end in profits as the original thoughts were trying to find a tough period for the back test in the up-trending days (I'll provide an update if my script is found to have a bug). Due to the multiple entry dates and the fact that SPY never ended above the lowest upper short strike, the P&L of this cycle was not challenged at all.

Portfolio entry tests are a beginning of the back tests. We need to test various entry rules on different types of market conditions. After that, the adjustment rules will need to be back-tested. This may be the most complicated part of the strategy. Later on, exit rules will need some tests as well. Finally, we will put the rules together for comprehensive back-tests and finalize all the rules of the strategy.

The back-tests use end of day data only, as explained in the prior post. We will have to perform and analyze some paper trading which will give us real time trading experiences for this strategy before going on live accounts in the future.

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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Created with ProphetCharts®

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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Created with ProphetCharts®

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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Created with ProphetCharts®

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.