OAP 159: How To Build An Options Portfolio With Just $3,000

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This podcast is a long-time coming but one that needed to be done because 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 are applicable to any portfolio size so don't think or 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.

Key Points from Today's Show:

  • It is not impossible to trade with a small amount of money, but you won't be successful overnight. 
  • You can learn to manage a small account, which will then help you in the future to manage 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.

Common Strategies: 

  • Small positions
  • Diverse and uncorrelated tickers
  • Low overall allocation
  • Premium selling
  • High trade count

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.
  • 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 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. 
  • Ex: FXI (Chinese ETF), GLD (gold), TLT (bonds), SPY (broad US markets), XLP (oil & gas), XRT (retail)
  • The combination of these 6 tickers creates the lowest un-correlation coefficient amongst them. 
  • If trading these 6 positions at $150 per ticker symbol, allocate $900 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: trade everything neutral to start, and rebalance along the way.
  • Two basic risk-defined 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 create starting strategy for smaller accounts.
  • These risk-defined, neutral strategies allow you to control the spread 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.
  • Best iron condor strategy for all environments: 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 framework for your trading strategy.

5. Run a SPY Backtest

  • Hone in on one particular individual backtest to double check the strategy.

Results for SPY: 

1. 40 days to expiration, 20 Delta, $5-wide spread performed on par with the market.

2. 60 days to expiration, 15 Delta, $5-wide spread outperformed the market - total return of 83%, and an annual CAGR of 7%.

*Should be trading between 40-60 days until expiration and 15-20 Delta with a $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 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 that will leave you with 80% allocated.

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, rather take the position off than 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 Not Using Stop-Losses

  • All of the research shows that using stop-losses created more losing trades. 
  • This might be harder for a new trader since there will be losing trades and trades that go against you.
  • But keep in mind, 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, 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.

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 back-testing says to; make sure to evaluate the market and the trade at hand.

Conclusion:

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

Option Trader Q&A w/ Matt

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Matt.

If your entire portfolio is made up of iron condor trades at the 70% success rate, given the recent drop in the market and the volatility that the indices have experienced, is it safe to say that your positions would be greatly hurt by the increase in volatility once you've established the position?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.