A Trading Method For Long-Term Returns

Revisions

2/1/12 — First Draft
2/19/13 — Updates: Hedging precautions, rolling strategies
3/24/13 — Updates: Added examples
6/23/17 — Refresh
10/25/19 — Updates: Variations
12/24/19 — Updates: Stats and Variations

What Is This?

This blog is normally reserved to discussing topics related to my line of work — as an enterprise software executive and venture capitalist. I love that work. But, we all have hobbies, and for the past decade, one of mine has been fine tuning a derivatives trading algorithm. Periodically, this analysis is updated with new results, learnings from activity in the market, and risk analysis discussion with experts.

Overview

In 2010, I became ill and recovered 9 months later. At times I was uncertain whether I would heal. I fought a two front war: neutralizing attacks to my nervous system and battling anxiety that a long term disability could eliminate work opportunities.

I began to obsess with finding ways to yield 10% regardless of a market’s direction. A consistent return would provide long term financial security.

The obsession took root. As normal life returned, long nights of research did not wane. The problem’s complexity was a fixation. It became an unanticipated hobby. It’s been enough fun over the years that I enjoy sharing any experiences for others to learn.

This is a good a time to insert legal jargon that this blog is for informational purposes only, you should not construe any information or other material as legal, tax, investment, financial, or other advice. Investing is risky. Loss of principal is possible. There are many nightmare scenarios that I or my lawyers can paint for you. Please do your own research and seek advice from a professional.

By year’s end, a solution began unwrapping itself. Could time and volatility provide consistent, risk-managed returns? Theory suggested amazing possibilities.

I tested the hypothesis with my life’s savings. The adrenaline and fear from risking ruin was essential to formulating creative recoveries to unforeseen circumstances.

Since 2011, the results are 18.1% CAGR. Annualized returns have been lumpy: 13%, 24%, 4%, -8%, 58%, 24%, -1%, 12%, and 34% 2019 YTD.

I like to compare my results against the SP500 Total Return, which takes capital appreciation of the SP500 combined with reinvestment from all issued dividends in a buy-and-hold strategy. Over the same period, SP500TR is 15.15% CAGR vs. my 18.1%. While the spread doesn’t make TTM seem more attractive, there are two elements skewing the long term results:

1. TTM performs weakest in bull markets, especially in strong updrafts. Flat and bearish years should generate higher average returns.
2. 2017’s returns of (-1%) were ~10% below what they should have been due to excessive experimentation with algorithm modifications (chasing a higher return) that yielded much lower returns than what would have materialized had I kept trading the original (and working!) algorithm.

There is also an argument that this strategy is neutral to the SP500TR as this style of trading generates immediate taxation events if not done within an IRA. My results are blended returns across an IRA and PM account, with the IRA trading to near maximum utilization before adjustments and then allowing other tax-based accounts to be used as overage spillovers. Given the annualized taxation events, I estimate that my CAGR would be 1.8% higher if this strategy did not require periodic withdrawals to pay for taxable events. Though even this argument is a bit flawed as while SP500TR tracks a total return, unless you were holding SPY in an IRA, the dividend distributions would be taxable events. So this comparable which justifies potentially higher returns might be pointless.

I’ve shared this strategy on specialty discussion forums to uncover vulnerabilities and aid others seeking similar outcomes. The most extensive discussions were on the Karen Super Trader Yahoo group and participants dubbed it the “Tyler Trading Method (TTM)”. TTM is an acronym, not a trademark, but might become one.

Sharing does not jeopardize my alpha. Helping others improves personal discipline and is a moral obligation from accepting the insights of others. Scheisters promise unproven returns with techniques unfurled only after your paid subscription has cleared their bank account. This philosophy is influenced by experiences with Open Source Software (OSS). OSS provides a new forum for democratic action against intellectual property with higher quality, greater reliability, and more flexibility. It’s foolish to believe that future improvements will come solely from self-study. A social contract exists for those that extract value from TTM to contribute back to its improvement.

About Options

Options are a derivative. A derivative is a trading instrument whose price is derived from the price of another. Options, such as those for the S&P 500 (SPY), are expiring contracts. Option prices are determined by multiple factors including the time to contract expiration, price of the underlying, the strike price, and implied volatility. Implied volatility is a way to measure the market’s anticipation of how much the underlying price may move. Calm markets have low implied volatility, while markets with uncertainty move significantly causing high implied volatility.

The markets are continually opening new option contracts for trading against an underlying. While SPY is a ticker that does not expire, option contracts are distinct to an expiration date. There are often dozens of different expirations available for trading at a single time. It stands to reason that two contracts with similar parameters but expire on different dates, have different prices. Usually longer-dated contracts are more expensive than nearer-dated contracts.

This date expiration structure causes contracts to decline in value over time, assuming that the other underlying factors have not changed. This is similar to how insurance works. Consumers buy protection in the form of a premium that lasts a period of time. The premium is priced based upon underlying factors such as the insurer’s risk profile and coverage length. The insurance premium degrades over time linearly. An insurer that cancels 10% of the way through a six month agreement will have 90% returned. Sometimes an insurer makes a claim against the contract. If the matching conditions that allow a claim are met, the insurance provider makes a payment and likely causes an ensuring loss for the provider. Subsequently, the insurer’s risk profile is increased and premium prices increase. When insurers make no claims, the insurance provider retains the premium as profit.

Insurance companies are professional actuarials managing the balance between risk, premiums, and profit. To protect the consumer, governments usually regulate the profit allowance of insurance providers placing a virtual ceiling on premium prices. Insurance profits are continual as the populous desires constant coverage. Providers navigate tricky waters avoiding black-swan disaster events that trigger volume and size of claims that overwhelm their capital savings available to service valid claimants.

With options, traders can enter in as a buyer (the insured) or a seller (the insurance). Sellers have time decay of contracts, mathematically measured by the Greek symbol theta. Time decay causes the value of the contracts to decrease to the benefit of the seller. Underlying price movement can cause the value of the contracts to increase or decrease depending upon the type of contract chosen. It’s helpful to think of price movement and distance from the expiration strike price as a percentage measurement that the contract will expire at a location where its value has increased to the benefit of the buyer and detriment of the seller.

It’s possible to structure options contracts so that the chance of a seller benefit is significant and while outcomes that benefit buyers to the harm of sellers are impossible to avoid, they losses from those scenarios can be managed through adjustments called “rolling”. In other words, a provider that suffers many claims from a new insurer whose premiums were less than the claims will recover their losses over time by dramatically increasing the insurers premiums to an equilibrium where outflows will be lower than inflows.

For decades, funds and individual investors sell options for profit. Most case studies are concerning where steady gains for long periods are obtained followed by wipe outs due to over leverage. Options are traded at a significant multiple to the underlying. SPY options trade at a 100 multiple to the underlying. A trader can purchase one share of SPY at $241.80, but selling 1 240 put option risks $24,000 if SPY’s price went to $0. Additionally, brokers that allow buying and selling options can only require capital reserves of the trader that are a fraction of the risk under taken. If too many options are traded and an unexpected price movement occurs, the trader could find that the money owed to the broker is more than the capital invested. A trader faces a capital call, and probably ruin if they cannot inject new capital to cover the liability.

Unexpected, extreme price movements are rare. They always happen and cannot be predicted. A system’s strength is its balance between returns and risk management against the extreme.

Because price movements cannot be predicted, traders start from a position of caution. The insurance that they buy with options reflects this concern. It’s been historically shown that roughly 93% of the time the implied volatility priced into options has been higher than actual 30 day volatility. In other words, fear drives up the prices of options most of the time, giving sellers an arbitrage edge between selling when implied volatility is greater than the historical volatility witnessed after the sale until contract termination.

Philosophy

Ask yourself, has the stock market ever crashed up? The 20 largest single day gains by percentage were between 6.84% and 15.34%. However, each were the day after a dramatic drop or during a bear market where downward pressure could be anticipated.

Markets do not spontaneously crash up. Spike price movements require one side to overwhelm another at a point in time. Downward crashes occur as panic behavior allows many to simultaneously sell. Buyers do not panic buy. Markets bleed up as inflows outpace the outflows steadily over extended periods.

The average trader biases against shorting markets. Inflation and global earnings growth implies long term asset appreciation. Therefore, shorting the market must be a fool’s errand. Opportunity to profit from upward movement markets exists by continually shorting them to a level where they are unlikely to reach. After all, markets bleed up, but not crash up. It’s possible to use extensive leverage with options to sell options, creating a short bias, and profit even though the market is moving upward.

Additionally, time is infinite. It is impossible to have every trade be a gain. It is guaranteed that some sold options will be losses. However, new contracts with longer-dated expirations are continually available for trading. Contracts facing near term losses can be “rolled” to a new expiration date and terms that generate more cash and make a recovery possible if the underlying’s price movement reverses.

This strategy uses safe leverage to strangle the market with options selling. It pairs the safe leverage with extended leverage to further short the market at a strike distance where in-the-moneyness from strong upward moves occurs infrequently. Time and volatility are used to recover losing trades.

Underlying Selection

I trade options against broad-based indexes such as SPX, RUT, or NDX. Starting in 2014, the strategy was further modified to trade exclusively SPX. Small accounts can substitute SPX with SPY, which requires 1/10th the capital for the same position.

Diversification — Coverage across the equities markets means lower volatility, but lower upside or downside sudden risks.

Tax Advantages — Options against indexes in the US are taxed as 1256 contracts where 60% of profits are treated as long term gains. The same option on an equivalent ETF, such as SPY, is treated as short term capital gain for all profits in this strategy. Options trading on ETFs or individual equities that are not treated as 1256 contracts need to have ~13% better gross returns to net the same funds as returns on vehicles that support 1256 contracts.

European Contracts — Index options are generally European style, which means that there is no risk of early assignment if you accidentally got caught ITM. One less thing to worry about in risk mitigation.

Option Liquidity — Generally, you want to see at least 50K options being traded on the underlying each week to have enough liquidity in order to get the best possible price and to have liquidity when options need to be adjusted in times of market momentum.

Strike Variety — The underlying should have a wide range of strikes available each week. As a rule of thumb, you want to see strikes at least 8% and 20% lower than the underlying. Underlyings with limited strike selection, such as RUT, can create problems in situations where certain rolls are occurring or may not offer enough margin of safety in momentum markets.

Reasonable Volatility — We are generally seeking a daily implied volatility of at least 1.1%, though SPX rarely trades at that level except in periods of high VIX. Lower volatility forces the seller to either give up weekly premium to maintain a reasonable margin of safety or to give up their safety.

Implied Volatility Mismatch — More often than naught, the 30-day actual volatility of a price is lower than its implied volatility. Fear of loss causes put option buyers to pay a higher price for protection. Option sellers profit by selling during these periods, and may lose money if they sell when historical volatility exceeds IV.

Better Commissions — Generally, indexes have large underlying values. A seller of contracts has to open fewer contracts to generate premium given a starting base of capital. Fewer contracts to open (and to adjust in tough times) equates to lower overall commissions, which is a contribution to the bottom line.

Expiration Weeks — Having many near term week expirations available gives the manager more adjustment options to pursue in a situation where an adjustment is necessary at all. In particular, SPX has weekly expirations that go for the near term 8 weeks. When an adjustment does need to occur, it is preferable to only go out a single week, but if the adjustment happens early, having the room to go further out in time is helpful. Recently, the RUT has also added in this capability, making it a possibly attractive target.

Trade Structure

Sell an out of the money call and put with expirations in a couple days. The intent is to let the options sit until expiration, and there may be some situations where you close out the options early. When this strategy was first devised, there were only weekly expirations. Starting in July 2017, there are SPX expirations every Monday, Wednesday, and Friday. There are also monthly and quarterly expirations which offer additional expirations from time to time. As a result, it’s possible to open positions on Monday that expire Wednesday.

A strangle (position with both a call and put on either side of the current market) leaves the seller naked on both sides of the sale. This structure does not work in IRAs due to cash-margin requirements. In IRAs, a $1350 put requires $135,000 in margin reserve. Naked calls are not permitted in IRA accounts due to the theory that their risk is infinite. IRA accounts are forced to “bound” their risk by converting the strangle into a combination of vertical spreads, with long options further OTM. However, the same put and call on a portfolio margin or TREG margin account will require a range from $100 to $135K depending upon numerous variables applied by your broker.

Margin is powerful, and in equal parts can increase returns or wipe you out with subtle market movements. Please use margin carefully and for your favorite deity’s sake, know what you are doing before deploying it.

For TREG & portfolio margin (PM) accounts, brokers are smart enough to recognize that a put and call that expire at the same time against the same underlying are perfectly hedged against you, so the margin reserves required to open both contracts is the higher of the individual margin reserve of each individual component.

In some situations, bull put spreads and bear call spreads are better than naked. These situations include:

1. IRA accounts where spreads are the only way to get leverage.
2. PM accounts where a spread with a distant long leg lowers the margin reserve significantly, giving the seller more leverage.
3. As a hedge against rising vega for black swan events.

Sale Timing

Opening trades are made with options on expirations that expire in 7–31 days. When this strategy was devised, SPX only expired on Fridays.

We are seeking a day where the market has a strong move in either direction (up / down), with an increase in implied volatility. Dates that are closer to Thursday are preferred over earlier in the week, though I have found myself opening positions on Monday or Tuesday most frequently.

Starting in 2015, this strategy was modified to become systematic to opening positions Monday morning holding them to Wednesday, and then opening new positions immediately after the previous positions expired. The patience required to time or select an ideal market opening is only suitable for those willing watch price action charts continuously while the market is open. Those employed with full time jobs need systematic openings to facilitate how automation can augment the algorithm and to also obtain maximum theta.

If any trade needs adjustment, the adjustment will be made to the following option expiration (moving from the current expiration to the next one) if the options can be moved to a strike that is further OTM and collect premium. If neither condition is achievable, then adjustments can be explored to expirations that are further out in time.

If the market moves strongly when your options are first opened, this is a candidate for opening up options in the direction that the market is moving. If the market is moving up strongly, I tend to open puts in a lagging fashion to avoid whip saws, and tend to be aggressive with call placement closer to at-the-money since upward moves have exhaustion. The further in time you are away from expiration, the further out-of-the-money your options must be placed. The reverse is true for markets that are downward moving.

Strike Selection

To determine the strike price of the calls and puts to open, we use a small amount of fundamental and technical analysis to find strike prices that are distant and with support / resistance. Additionally, for SPX at $1500 we seek $.8 — $1.5 of premium on the calls, and $1 — $3 premium on the puts. With a VIX at 23, this gives 2–3% protection on the upside and 3–6% downside protection, depending upon the strike selected. With a VIX at 13, you get about 1% protection on the upside and 2% on the downside. To reduce risk, and lower the overall returns, you can go further out of the money on either side. I generally target 3 calls for every 1 put (reasons below). On a $1M portfolio with VIX trading at 13 and SPX at 1500, would open up around 70 calls at $1520-$1525 for $.35 credit, and look for 25–30 puts at $1440 for $.60 credit. This would be done with 3–5 days remaining to expiration. At maximum opening, this would generate $2450 in premium from the calls and $1800 from the puts. A total of $4250, or just over .42%.

Adjusting Positions

Monitoring and adjustment of the positions is key. ~80% of the time, positions will not need adjustment — the market is operating in a normal band and the options will let time slowly degrade and the premium turns to profit. Essentially, you “sell” the initial options to receive the credit, but you still have a liability and must buy them back. As time degrades the value of the option, you can either buy them back for diminished amounts or even just let them expire worthless while you keep the collected credit.

Markets do move, however — whether up or down. Price action in the market is like a surfing wave, the price moves with velocity in a direction. Sometimes the water is choppy, sometimes it forms a steady wave, sometimes waves move in different directions. Your job as a trader is to adjust your positions so that the current price attempts to stay away from your strike prices, preventing them from going in-the-money. As the current price gets closer to your strike price, the cost to buy back the option increases and you will be showing (sometimes significant) paper losses. But time is infinite, and with the way that options are priced, you can roll the position from one expiration to a further expiration, often at a strike price that is further away from the current price action, all while collecting more premium.

If at any time SPX gets within .75% of the put or call strike, buy back the strike and roll out 1 week to a strike that is further out of the money. Experience shows that a call can be rolled up and out to a strike that is about 1.4% — 2.0% further out of the money while collecting another $.35 — $.7 of additional premium. For puts, you can tend to roll out and down for anywhere from 1.5% — 3.0%. It partly depends upon how close to expiration the adjustment is made. The equity value at the moment the adjustment is made shows negative, but the position lives on another week with additional premium buying time for the market to reverse course. For calls, given this indefinite adjustment technique of 1% / week, the adjustments will eventually move ahead of even the most bull markets. There will be a week that flat lines or reverses course, and the investor keeps the entire premium collected.

Additionally, over time, have found that it is a good idea to reduce risk when rolling out. Even though you are giving yourself price protection by moving further OOTM, I find that it’s healthy to take 10–20% of the contracts off the table. If I have to adjust because the market is surging up, I’d move from 100 call contracts to 80 call contracts one week out. To compensate, the further week out puts will be tighter. Instead of 4% OOTM, maybe only 2.5%. When markets move in a certain trend direction, they tend to continue in that path, and reversals that come all the way down are not that common. But even if this does occur, you are quite pleased because your large batch of call options are now safely OOTM, and you are working to adjust your puts down and out. With this model, an investor keeps riding the wave up and down until there is a week where all contracts expire profitable & safe. At which point, you start over the following week at the beginning.

With this sort of adjustment strategy, I view this type of trading strategy as surfing the waves. You are looking to create positions that have far enough expirations and are strike prices that are away from the current price action so that time is your friend — that all of that accumulated credit is burned down due to theta decay and eventually the positions expire worthless with that credit in your pocket.

Position Sizing

We are the most aggressive with the number of calls opened. We use the maximum number of possible calls to open each week based upon margin allowances & assuming the market has a 10% rise. This means that the account is highly leveraged and could show significant losses if there was a significant crash to the upside. There have been few instances in history where markets move more than 5% up in a single day, and most of those instances are after significant crashes. What we do avoids any issues from whiplash in the market, so we are in a position that even if the market moves up with momentum, we have enough time and space to keep adjusting outward. In a Portfolio Margin trading account, the number of calls to open is determined by figuring out the allocation array for the underlying and then forecast a 10% rise in the underlying. For RUT trading at $800, a 10% rise would be $880, and the maximum margin required for a call with RUT at $880 is $8800 (10% * 100). An $880K investment account would be able to open 100 RUT call contracts.

The put side is different. Markets can crater. Flash crashes can wipe 10% out in an instant. 30% Black Monday’s are no longer a concern as the market has circuit breakers to halt trading now. Our nightmare scenario is a flash crash that occurs at 12:45PM. The markets close before the crash rebounds. This triggers massive global sell offs overnight, and the US markets continue their downward movement the next day. Overnight brokerages would probably liquidate many options positions or change their margin requirements with little notice for adjustment. To account for this, we use less leverage on puts. We only open enough puts to survive a 40% drop in the underlying before we can enter the market to make an adjustment.

One way to calculate the number of puts is to just assume that for every 10 calls that you sell, you sell 2–3 puts. Another way is to take the current SPX, divide it in two, and then determine how many puts are required to saturate that amount. With the market at $2400, a 50% drop would be a loss of $1200. Each put contract for SPX represents $120,000. If you have a $1.2M account, then you could open 10 puts and remain solvent through a 50% market correction assuming no adjustments.

Hedging

Based upon some guidance given by colleagues and for my own peace of mind, I have found that it’s good to create hedges to protect against black swan events. An overnight terrorist attack with nuclear weapons would cause a dramatic price movement without an opportunity to adjust.

A gap down of 10% + another drop of 20% would quickly wipe out a portfolio even if your put contracts are a fraction of your call contracts. Also, if you have a significant crash, IV would be spiking and even though your calls are significantly out of the money, they would have also increased in value. Check it out with models — a 1000% climb in vega with a 30% drop in price would cause the calls to increase in value as fast as the puts.

So, for protection, have found myself doing two cheap things:

1. I buy $.05 puts against my short puts each week. It effectively makes it a put credit spread. On a week where I sell my puts at $1450, I can buy $1300 puts for $.05. For a $1M account, I would have opened 70 calls and 25 puts. My maximum loss is $15K / contract, which places my maximum loss at $375K in case of a black swan. And if the black swan occurs, I will not take that loss, but I will begin the process of rolling out and down, collecting even more premium to get ready for the eventual market correction.
2. I buy $.05 calls 4 weeks away from expiration. If I open my $1550 calls for this week, I’d be looking to open $1700 calls 4 weeks out. One long batch of calls will last for 4 weeks. If vega does spike, both the short calls and long calls will increase in value, and I can sell my long leg (for a nice profit) right as my short calls are expiring.

All told, these hedging strategies reduce my profit each week by around .03%, which is not a bad price to pay for peace of mind.

I do not regularly practice these hedging strategies. I do pick times where the market warrants having the extra hedges — especially if the price of the underlying has been neutral for an extended period of time, the market is becoming complacent and reducing risk and layering on hedges becomes important to address what will be an eventual return to volatility. While I have not summed up all of the losses and gains from the hedges, I am certain that even in situations where the hedges have made a profit, the losses from the hedges far outweigh any of their profits, so take them with a grain of salt.

Since I now trade a single algorithm across my IRA and taxable accounts, with maximum leverage within the IRA account, I get the put and call hedges somewhat for free as creating iron condors is a requirement in IRA accounts as you cannot have unbounded risk. So there is always a batch of floating long call and put options within those accounts.

Example

Let’s say you have a $1M account. Pretend it’s Friday March 22nd and you want to target a March 29th expiration. SPX is hovering around $1555.

Target
.4% return for the week. .4% * 1M = $4000 premium target.

Bias
Market is trending upwards and you suspect that its momentum is slowing. Let’s target 50% of premium from calls and 50% from puts because the market is generally going up. $2K from each.

# of Calls
Target strike is around $1585. Given an 8% leverage, this means that we can open 68 call contracts and avoid a margin call if a spike upward.

Call Premium
We seek $2,000 premium for a week from 68 calls. $2,000 / 6800 = $.2941 / contract required. If we look at options expiring in 7 days, a $1590 strike can be opened for $.30. This is >2% OTM, which is fairly safe, as markets move >2% in a single week less than 10% of the time.

# of Puts
A 50% drop in market value before adjustment gives you $800 movement in SPX. Each put contract represents $80,000, letting you open 12–13 put contracts for a $1M account.

Put Premium
We seek $2000 premium for a week from 12 puts. $2,000 / 1200 = $1.66 / contract required. We can find put contracts with that premium roughly 3% OTM, which is a reasonable margin of safety within a single week.

If you have market direction biases on any given week, either moving further up or down, you can optionally choose to get more aggressive with your put or call strike selection, boosting the returns further. Or, if you have concerns about the market moving aggressively in an unpredictable direction, you can place the calls and puts further out of the money taking a lower return but offering a wider margin of safety.

If at any time during the week SPX were to touch $1580, it would be time to think about rolling the calls one week out. I’d look to buy back the calls at whatever price and sell new calls one week later. I would probably reduce the calls by 8–10 contracts, so we’d go from 68 to 60 or so. Also, we would collect more premium, and would look to be gaining about $.50 for the effort. At the same time, the puts should be getting tightened to better strikes to help compensate for the pressure on the calls. I would not reduce the number of puts until the puts are under pressure themselves. If my calls came under pressure early in the week, I would move the puts aggressively from $1470 to $1520, and probably collect a good $1-$2 in additional premium. The rationale is that your calls are going to be showing some nice near term losses and if the market reverses, you will be gaining money even if your puts start to get in trouble. If your calls stay under pressure, you are dramatically reducing the near term losses and setting yourself up for an even bigger gain if the market steadies or reverses. If your puts suddenly come under pressure, then you apply the same adjustment techniques in the opposite direction. You keep repeating adjustments until all of your contracts have been reduced to zero, or the market expires in between your puts and calls.

Variations

Over the years of trading TTM, I have made adjustments to increase returns or mitigate perceived risks. The flavors include:

1. IRA Adjustments
2. Risk Adjustments
3. At-the-Money Exploitation — The Money Losing Kind
4. At-the-Money Exploitation — The Money Making Kind
5. Underlying Diversification
6. Small Account Adjustments

IRA Adjustments

I first started trading TTM at eTrade in a TREG margin account. I left my 401K and IRA accounts invested in index funds.

After I became comfortable with the principles of TTM, I wanted to get the same benefits for trading in an IRA account. IRA accounts are cash margin, requiring risk to be bounded. The presumption is that IRA accounts can never have a margin call.

TTM calls for using margin safely. The upside and downside scenarios have been mapped out and understood. Given this understanding, why would IRA brokers not allow for trading a similar philosophy in that account? If the trader has mapped out the various outcomes and willing to assume the risk, could they pursue the higher risk strategy?

IRA accounts can be converted to behave similarly to TREG or Portfolio Margin where the extra leverage is exploited. This is where I remind readers that the risk associated with leverage is immense, and please do not trade anything with leverage without a clear understanding of the risks you are taking. And my lawyer would be telling me that I must tell you that trading is inherently risky and that you are trading at your own risk.

Many brokers will let you trade options in IRA accounts as long as the risk is bounded. You can do this with long options at the same expiration in the same contract size as the short options.

Let’s assume you are targeting .3% return / week on a $500,000 IRA account. On July 7th, the market closed at $2425. If you are accepting a 50% drop before adjustments can be made, this would allow you to open 5 puts. 50% survival means the market can move $1210 before you can make a move, allowing you $121,000 / contract. $500K / $121K = 4.1. (I use a ceiling function in my calculations to round up as I do not mind accepting the additional risk). The ceiling of 4.1 is 5 puts. The target is $1500 for the week and $750 from the put side of the strangle. You will need $1.50 / contract @ 5 contracts to generate the put side. As of July 7th, you could open puts that expire on July 17th (9 days to expiration) for $1.50 at a $2365 strike price, which is just a little under 3% margin of safety.

For this to work in an IRA account, I would also open 5 long dated puts, purchasing them for $.05. I would seek the highest strike price where options are selling for $.05. This is around $1850. This would make the IRA have 5 vertical put spreads, each with a spread of close to $600. Your IRA broker would calculate this as $300,000 in risk, which is below the $500,000 maximum they would allow. The long dated options are effectively worthless and have given the account the behaviors of a portfolio margin account.

The call side is similar. Saving you the calculations, I would look to open 15 call contracts generating $.50 each. I would look to open $2465 calls that generate $.50 credit. This gives a little less than 2% margin of safety. The long dated calls would be around $2520, or about $6000 / contract, or $90,000 in total risk allocation by your broker. Some brokers will treat the put and calls as offsets against each other as long as they are on the same expiration. Other brokers do not so the combined risk of the call spread and hte put spread must be below the total account value.

Adjusting positions in an IRA account requires extra management.

First, it’s generally quite difficult to adjust both the call and put position at the same time. So you will need to adjust one position at a time. If margin is offset between the call and the put, then adjusting one side to a different expiration wipes out this offsetting calculation and your broker will require that the margin allocated to puts and calls are combined below the total account margin value. If I am adjusting options out a week, there is usually a non-threatened short side that is at $.05 or close to it. You can close this side first, leaving the long position in the IRA account and removing the short side. IRA brokers treat any margin required for that spread as released. You can then adjust the threatened side using the full margin available to you.

Second, you will need to decide how to roll threatened positions. You can either do it in two transactions or a single transaction. If you perform it in two transactions, you will close the short option on the threatened side, and then open a new spread at the new expiration further out. The challenge with two transactions is that if the market is moving, then you will experience slippage where the premium you collect after the adjustment could be higher or lower than if you had done it as a single clean transaction. Market makers are tricky and usually a double transaction leads to slippage that benefits the counter party more than myself. In a single adjustment, you need to do a three legged order. You are both buying back the short position that is threatened and opening a new spread at the further expiration. This guarantees that you will not get any slippage, but makes the transaction harder to complete for the market maker. You may have to give up $.05-$.10 in additional premium to get a good price so that the transaction can complete.

Third, if you have a fast moving downward market, the risk gets harder to manage. As the market moves downward, implied volatility spikes. In order to purchase $.05 options at a new expiration, you will have to move further away in strikes. While in our example, $60K was the spread for a single week, as IV moves up, it could easily be $200K to get the same $.05 spread. This will force you to reduce the number of contracts that you are trading to fit within the margin requirements or perhaps you will purchase more expensive put options at $.20 to keep the spread manageable. Chances are that if IV has increased dramatically, then you are also collecting a lot more premium. If you have gotten inverted where your short option is ITM, then you may be collecting great premiums, but have to look at pushing your short option out much further than one week to get out of trouble. And the further out in time you must push, the further down the stack your long options will be to find. So, please be careful trading within an IRA account, some of the adjustment philosophies available to PM accounts are less flexible in an IRA account.

Risk Adjustments

It’s possible to change the strategy to reduce or increase risk. My historical rate of return has been 18% CAGR, which is .3% CWGR. This includes times where I have made great aggressive rolls during a week and also times where I have made severe mistakes. I guess that my losses from mistakes cancel out the gains from being aggressive over time.

Mistakes and unnatural gains have a tendency to happen when I trade closer to the money. When I set an aggressive weekly target, the strikes are closer to at-the-money, and the likelihood of having to adjust early or more frequently is higher. Once you get into a cycle of rolling and adjusting, it’s a continual process. If you are aggressive like I am, you frequently have either calls or puts ITM, and so certain sides of the trade are showing losses or gains, sometimes dramatically so. So, this leads week over week oscillations that are higher as the market is bouncing around.

I can moderate my risk by closing all open positions and beginning again from a new starting position where the strangle is appropriately spaced away from where the market currently sits. I do this by always opening the same number of puts and calls, but lowering the weekly income expectation. By reducing the weekly income expectation, you lower the amount of premium that is targeted for a single week. And this lets you find strikes that are further OTM from where the stock is currently at.

For example, if I wanted to target a .2% weekly gain, which would lead to a 11% yearly gain, I would open the same number of contracts at different locations. With the market closing at $2425 on July 7th, 2017, I would open puts closing on July 17th at $2350, more than 3% margin of safety. A 3% move in a single week is around a 4% probability, so in a bull market this may be a once a year phenomenon. The call side would have a similar protection, opened at $2470, about 2% OTM. This would be threatened seriously 2–3 times / year. In either case, if the position was threatened, I could adjust early giving myself ample room to move out in time and further away from ATM. In a low IV scenario, this likely means that the market would lose momentum quickly and exhaustion would keep my options OTM or perhaps a reversal would increase the margin of safety.

Reducing the risk does not mean no risk, however. No matter how small your weekly expectation is, there is always risk. Reducing the weekly expectation just reduces the number of weeks where you are threatened and you have to use adjustments to dig out of the hole that is created. There are some traders that use the reduced risk to create a mental mindset that they must not be as skilled in adjusting threatened sides. When threatening happens infrequently, then the trader is less skilled (emotionally and tactically) in how to trade through the threatening periods. I always trade with a mindset where I will always be threatened. This keeps the risk in perspective and transforms it into a number, but prevents risk complacency from setting in.

At The Money Adjustments — The Money Losing Kind

There is more premium at the money than out of the money, so it harbors the consideration that if you can trade fewer contracts closer to the money, that your returns can be higher.

In the “lost year” that I wrote about at the beginning, where my total returns were -1%, but they should have been closer to 9%, this was due to trading for most of the year right ATM. Instead of trying to stay away from the price action, I embraced it and tried to open up as many contracts ATM as possible, allowing some to go ITM when the price moves while allowing the others to expire OTM. I would trade equal numbers of puts and calls. I then had a series of actions for how to trade ITM options:

1. Treat the options that were ITM as things that needed to be rolled to far dated, ATM positions — creating a bunch of theta for eventual capturing.
2. Continuing to open opposite ATM options for the opposite type of contract, with a nearer strike to capture more of the early premium.
3. Continue this back and forth.

In many cases this could work out, but I would have to trade such lower numbers of contracts, and when the markets would move aggressively, I might have to push the ITM contracts out nearly 3–6 months to get them back to ATM. This created a low theta situation. And when markets would reverse, the contracts that had been losing money were making money, but had been pushed so far out to be ATM, that the losses from the opposite side would be significant that they, too, would have to be pushed out 3–6 months ATM. And so the whole theta train would just be slowed unnecessarily.

At The Money Adjustments — The Money Making Kind

Starting in 2018, I used ATM adjustments in a different way, and it’s proven to be quite a profitable means by which to make money.

There are times when the market moves — fast. When it does that, it puts one side under pressure. Over the past couple years, it’s mostly been pressured on the calls with heavy leverage, but there have been the opposite situations as well with 5–10% SPX price drops.

In any situation where I need to roll a pressured side in a non-standard way (ie, usually beyond 1–2 weeks) in order to get enough extra spacing to keep the pressured side OTM, then chances are I am going to need to roll that position again as the buffer obtained wasn’t that much for the time gained. When you get a fast moving up market, and if I don’t roll early enough, I may have to roll out a whole pile of calls 2–4 weeks just to get .6%-1% of additional OTM spacing. This isn’t encouraging, as trending markets will have no problem continuing to move fast, continuing to threaten that position.

In these times of fast moving markets, I have found that great returns can be had by taking the un-threatened side and moving it to ATM or just slightly OTM. I continue to hold it there until the total premium from the unthreatened side is roughly 1/4–1/3 of the total premium remaining on the threatened side. This ratio is important to maintain — it is the best place to be as it allows the markets to reverse slightly (now your threatened position showing huge losses, will return some gains to you), plateau while there is consolidation before the next move higher, or even move a little bit higher — every situation giving you a profit. The loss situations here are massive reversals where the unthreatened positions turn into bigger losses than the recovered gains of the threatened side, or another aggressive move to the threatened side (but in this situation, you’d just keep rolling and pushing out further and further until the markets stabilize).

What happens is that fast moving markets eventually slow down or reverse. When they slow down, they have a tendency to hang out at a price range for a period of time. The theta gained from the time collection of the threatened side and the theta from the unthreatened side turns out to be quite significant. The amount of premium collected from the unthreatened slide often times is more significant than the losses from having to roll the threatened side. So while there may be a few days where the losses from adjustments were quite significant, a couple days later, those losses are returned and the overall position in the green again.

I can then continue to do this as long as I have unnecessarily threatened and expensive options on one side, or if the profits have returned back into the normal range, can look to move both the threatened and unthreatened options to further OTM strikes, essentially returning back to a starting position, happy to have collected great gains from the movement.

2019 is a particularly happy here where this technique was employed multiple times, and even in the most aggressive situations found ways to take months where the market moved up 4–5% with threatened calls, and turn them into 1.5–2% overall return months by using this strategy.

Underlying Diversification

The biggest issue with trading only a single underlying is the risk of massive movements from a single construct. When the markets move fast in either direction for that particular asset, I will be temporarily losing money until I can allow all of the adjustment techniques to play themselves out so that any money losing period turns into a money making period.

Generally, different price assets have significant moves at different times. So, much the way that people build diversified portfolios to have different returns at different times, trading this algorithm against asset classes that move prices in different ways should smooth out any losses.

In 2013, there was a period where I traded this exact algorithm across a blend of futures options on gold, silver, cattle, interest rates, and currencies. It generally did work, but it was a lot of effort. There were a number of issues:

1. The liquidity in different classes was not as high as in US equities, so trading in a way to embrace the limited liquidity was essential. This also meant that when there were big price moves, it was harder to make adjustments fast enough.
2. The original trading algorithm makes assumptions that the market will never crash up, and that it will eventually lead to all prices eventually going up with enough time. Commodities don’t adhere to that rule, so leverage has to be adjusted carefully. I also generally don’t understand what causes commodities to move one way or the other as cleanly as SPX where future earnings are forecast and analyzed to umpteenth degrees, so black swan wipe out moves an happen more frequently.
3. By dividing resources across different asset classes, when trading SPX and having a side get threatened, it left me without as much dry powder to make adjustments in a way to accelerate the returns of any losses. As you get into trading super sized accounts, you are opening so many contracts on either side, that when an adjustment does come, you have a lot of precision in what you can do in how you roll. For example, if you need to roll 150 call contracts, you are dealing with so many that the opposite put side is 40 contracts, making it possible to have all sorts of degrees of aggressiveness in how many puts are ATM vs. OTM, near term vs. long term … and then reducing risk by removing different call / put options over time. Compare this to starting with a smaller account where you have 5 call / 2 puts, your choices are much more limited.

Small Account Diversification

People frequently ask about how to trade with smaller accounts. There are many adjustments:

1. Trade XSP. It’s new in 2019. It has all of the same treatments as SPX with European options, but it’s 1/10th the size. Be careful in that these are not heavily traded yet, so there may be some liquidity challenges, but I would doubt it. Even in markets where there is limited options liquidity, market makers help make liquidity by offsetting options with futures, which has virtually unlimited liquidity. You can trade both SPX and XSP simultaneously as well — if your analysis calls for 5.4 SPX options, this would be 5 SPX and 4 XSP — creating a form of ultimate precision.
2. Trade /ES Options. These are futures for the S&P 500. These are 1/2 the size of SPX and also trade most of the night as well. You will not get as good of pricing. There have been many times where I see /ES futures making big moves overnight where I know that I will have to adjust my SPX positions in the morning. Instead of waiting and allowing the market to move even further, I have opened up /ES options immediately during the night as my pre-day adjustment, and then when the markets open up the next day, clean up anything that was left over. You can even go further with this and just buy / sell /ES directly. You are not getting any theta benefit, but this creates an immediate offsetting hedge to any threatened position if you are afraid that the market is just going to keep running away, say because there was massive news and the market is crashing overnight. This would be something for emergencies — a kind of “emergency break” that lets you just freeze the account by having a perfectly number of offsetting /ES futures to your threatened side of options.
3. Trade SPY Options. Also 1/10th the size of SPX, but these trade against an ETF and have American expirations and short term capital gains treatment.
4. Trade RUT & IWM Options. The RUT is about 1/2 the size of the SPX and tracks the small business 2000 index. IWM is 1/10th of the RUT as an ETF. Smaller prices on the indexes allow you to trade more options and work well for smaller accounts.
5. Blend Accounts For Calculations. If you have two accounts, say an IRA and a taxable trading account where each account is only $100K, but combined they are $200K, then create a virtual pool. If you have $200K, do your open position calculations, and then open up the maximum spreads that you can get in the IRA. If at a $200K combined virtual account you determine that you can have 1.5 SPX puts and 3.5 SPX calls, then attempt to open up 3SPX call spreads, 5 XSP call spreads in the IRA. Then open up as many of the put spreads as you can. If you are not able to get all of the spreads opened in the IRA, then open any leftovers within the taxable trading account. Make sure that you never go over the number of contracts as if you had a $200K total account. One account will be maximized and the other would have very little activity.