Build an Options Portfolio w/ Just $3,000

This podcast is a long-time coming, but one that needs to be done. We get a lot of questions from newbie traders about how to build an options portfolio with a small amount of starting capital. And while we openly suggest that you really start trading with at least $5,000 or more, as you'll hear me say a bunch in this show, we realize that a good majority of new traders want to start with less. That's why in today's show, we'll play "pretend" and assume you absolutely want to start trading with just $3,000.

Inside, I'll walk through my thought process on building out a portfolio that gives you the highest possible chance of success. We'll cover everything from position sizing, ticker selection, strategies to use, what ranges or targets for setting them up, profit-taking and stop losses, and much more. The concepts we'll cover apply to any portfolio size, so don't think for one second that this show is just for small account traders. If you trade a larger account size, you can also pick up a lot of great nuggets of information.

Getting Started:

It is not impossible to trade with a small amount of money, but you won't be successful overnight.
Learning to manage a small account will help you in the future when managing a larger account.
If you can't learn to manage a small account, having more money is not going to be a solution to your problem.

Core Strategy Components:

Small positions - no more than 5% of your account allocated to one ticker symbol
Diverse and uncorrelated tickers - take advantage of diversification
Low overall allocation - 50% of account or less
Premium selling - take advantage of the overstatement of implied volatility
High trade count - place enough trades to let your edge playout

Steps for Starting with $3,000

1. Divvy Up the Pot

What portion of the account will be traded, and what portion will remain in cash?
Our strategy: at least 50% should be in cash at all times, on average.
Cash helps cushion against black swan events and allows you more flexibility.
For example, if as a result of a volatility spike, your broker requires more margin from you to hold a position--even though the stock really hasn’t gone anywhere--a strong cash balance keeps you from having to close a position at an inopportune time.
With a small account, this 50% target is going to be harder to hit, but we should always shoot for it.

2. Decide What to Trade

Allocate no more than 5% to each individual ticker that you are trading with a minimum number of 6 tickers.
Trade at least 6 uncorrelated tickers at a time for portfolio diversity.
For example, you could trade FXI (Chinese ETF), GLD (gold), TLT (bonds), SPY (broad US markets), XLP (oil & gas), and XRT (retail). These tickers are liquid and have a relatively tight credit spread.
The combination of these 6 tickers creates the lowest overall correlation coefficient amongst them.
If trading these 6 positions at $150 of risk per ticker symbol, you would be allocating $900 of capital for one set of laddered contracts.

3. Choose Your Strategy

Find a strategy with the smallest possible amount of risk that also helps check the other boxes you need to cover.
Our preference: begin by trading everything neutral and then rebalance along the way.
Two basic risk-defined, neutral strategies: iron butterflies and iron condors.
Looking even closer, an iron butterfly might be just too much risk to start out with initially.
Therefore, we would recommend gravitating towards doing more iron condors.
Iron condors are a great starting strategy for smaller accounts.
Iron condors are risk-defined, neutral strategies that allow you to control the width of the spread (your risk), and sell options out-of-the-money.

4. Review the Research

Go through the research to find an iron condor strategy that will perform the best but also fits with your trading objective from a risk per trade perspective.
From our Profit Matrix research, the best iron condor strategy across market environments was a weekly iron condor, 40 days to expiration, 20 Delta, $5-wide spread iron condor on a weekly basis produced the highest annual CAGR (no profit target, no stop-loss, no IV filter) - won on average 75% of the time, with a drawdown of 64%.
Use this research as a guidepost, a starting point, a framework for your trading strategy.

5. Run a SPY Backtest

Hone in on one particular individual backtest to double-check the strategy.
When we did our research for the Profit Matrix and looked at the results across a range of tickers, iron condors with 40 days to expiration, 20 Delta, and $5-wide spreads performed on par with the market.
In backtesting SPY, when we chose 60 days to expiration, 15 Delta, and $5-wide spreads, that combination outperformed the market - total return of 83%, and an annual CAGR of 7%.
There is no unicorn strategy that works all the time. Small tweaks can make a difference in performance, but we can get general guidelines by running tests like these.
Using these results as a framework, what we can learn is we should be trading iron condors between 40-60 days until expiration, 15-20 Delta, and $5-wide strikes.

6. Minimum Allocation Threshold

This is where you run into a roadblock with a small account: it forces you to trade at a higher allocation per ticker than desired.
At $400 or risk, that is 13% of your account when you start with $3,000.
If you had a $5,000 trading $400 of risk per ticker symbol, it would only be about 8% with 48% allocated.
However, with a $3,000 account and 6 positions with $400 risked per position, that will leave you with 80% allocated.
Now that you have a strategy, the goal is to be consistent and make the same types of trades over and over as positions roll-off.

7. Take Profits on an Opportunistic Basis

When a trade starts going your way, with 30 days until expiration and your premium has gone from $90 to $10, take the position off.
Be smart and rational about how you look at your positions.
If you make 90% of your premium in the first 10 days and you will only make maybe $10 in the next 20 days. Be rational and take the position off early instead of enduring those extra 20 days of potential risk.
With a smaller account, you have to be more opportunistic about how you take money off the table.

8. Stay Consistent with Avoid Using Stop-Losses

All of our research shows that using stop-losses creates more losing trades.
This might be harder for a new trader since there will be losing trades and trades that go against you.
Stop-losses can quickly diminish your account value and take you right out of the game.

9. Adjust to Reduce Risk and Curb Losses

As you get closer to expiration, deliberately try to be a mitigator of risk.
Ex: If you have the ability to roll one side of the iron condor closer to reduce risk and turn a $100 losing trade into a $20 losing trade, you should definitely do it.
When it comes to making adjustments, you generally want to be more patient than not.
Usually, the best time to make adjustments is around two weeks until expiration.
Once you get into the month of expiration, start looking for ways to reduce risk.
Remember to look at your portfolio as a whole, and make adjustments accordingly.
Listen to OAP #87: The 3 Option Adjustment Principles You Must Know Now for more information on adjusting trades.

10. Be Smart About Your Trades

In the research, it suggests we go $5-wide for the iron condor in all environments for XOP (see screenshots).

However, when you look at the options pricing table, in some instances, you don't need to go $5-wide to execute a good strategy on one end.
Take advantage of the prices in the market, opportunities to reduce risk, and high probabilities of success.
Don't go out $5 just because the backtesting says to; make sure to evaluate the market and the trade at hand.

Conclusion:

When starting with a $3,000 account, use six uncorrelated tickers, do iron condors with 40 to 60 days until expiration, and choose 15 to 20 Deltas. Try to take opportunistic profits, don't remove positions with stop-losses, and cut risk and reduce losses as you get closer to expiration.