How do I trade a delta neutral portfolio and why it is important?
Trading a perfectly delta neutral portfolio at all times is nearly impossible because every second that the market is open deltas for positions are moving up or down. Delta is a fluid data point with respect to an option’s change in price as a result of a stock’s movement. Any traders who attempt to trade a delta neutral portfolio would have to add or remove positions very frequently throughout the day in order to maintain 100% neutral deltas. This doesn't mean that you can't have a neutral portfolio setup to generate income regardless of the market's direction - you can and we have shown how to set it up many times before in our portfolio management video training module. However, this does mean that the concept of a perfectly delta neutral trading system only would apply if you have significant capital to put at risk and can make hundreds of trades per day.
I’m timid about leaving my position unattended - do I need to monitor my positions all day?
No. In fact, our head trader Kirk is a stay-at-home dad and watches his 2 young children all day. If should never be necessary that you need to monitor your positions all day. Here’s a simple process to follow that might help get you out of this vicious monitoring cycle you may be in. First, login to your broker platform early in the morning and then again late in the afternoon to quickly check your positions for no more than 30 mins. If you spend too much time watching positions all day it will ultimately lead to analysis paralysis. The reason that you are timid is because you might have undefined risk, meaning, that you are trading naked positions and are afraid of a quick and sudden move. In this case, we suggest that you absolutely start trading or focusing more on defined risk strategies like credit spreads and iron condors. This will give you the ability to have defined risk heading into the position which means that you don't have to worry or be timid about living them unattended. In the long run, the high probability trades will always play out in your favor as long as you keep making small positions. There’s no need to babysit your positions unless you are entering too large of positions to begin with.
How many trades should I be putting on each week/month/year?
As many good trades as possible. In order for high probability trading to be profitable long term you need to make a lot of trades so that the probabilities work themselves out over time. It's similar to how a casino runs it’s business in that you need lots of people gambling and placing little bets over long periods of time to eventually become very successful as the odds play out. Think about it for a second - if you are placing trades with a 70% chance of success but you only place 10 trades all year it’s very likely that you could see 5 or 6 trades out of 10 lose right? But what if you placed 100 trades over the course of year - now you are much more likely to see something very close to 70 trades win because of the law of probabilities and large numbers. Though you may find success early in your career, we believe you should look to target making at least 500 trades or more per year if possible. And don’t force trades just for sake of trading, these should be smart, high implied volatility, option selling strategies. With 500+ trades you have a much higher chance of seeing a profitable P&L moving forward as the odds are more likely to work themselves out over a long period of time and with a high frequency of trades made.
Should I diversify my option trades amount different stocks and ETFs?
Absolutely. Having uncorrelated stocks and ETFs in your portfolio is a great strategy to diversify and prevent anyone sector or industry from taking down your portfolio. For example you would not want to have an entire portfolio full of just social media stocks. Instead, you want to have social media, technology, utilities, commodities, financials, etc. whenever possible to spread the risk among different areas.
How much money should I have in reserve/cash in my account?
We firmly believe that at no point should you allocate more than 50% of your account balance towards options trading. The reason is because options trading by design is a leveraged investment vehicle where by you should be generating a much higher returns on a per trade basis. Many new, and experienced traders, blindly assume if they can make a 40% gain on a single position that they just need to scale up and do as many contracts as possible. How ignorant this concept really becomes when you think about it logically. Plus, if you are trading undefined or naked positions you need to leave room for margin to expand if the market drops quickly as margin can expand by as much as 50% more than the initial requirement for a particular position. As your account grows in size this reserve fund should continue to stay large as you take on more positions with more risk naturally through the growth in your income stream. Besides, if you cannot learn to generate money with a small portion of your account allocating more money to more trades is not the solution and will guarantee that you blow up your account at some point in the future.
Sell a wider credit spread or more contracts - which is better?
Wider. I will always default to using a wider spread versus more contracts because you are able to get in and out of them quicker with less commission. However you do always need to make sure that there is enough liquidity in doing a wider spread and if the options at that wider spread strike prices are not liquid enough then I will narrow my contract and increase the number of contracts I'm trading. Again the default is wider vs more contracts.
How do I know how much risk my portfolio has relative to the general market?
The best tool to use as a way to measure overall portfolio risk relative to the general market is to beta weight your portfolio to the SPY or SPX. Beta weighting your positions to the S&P 500 will show you how bullish or bearish your positions are relative to the overall market and give you a good understanding of where you need to either increase or reduce risk to get back to neutral. On trading system focuses on remaining as neutral to the SPY as humanly possible each week meaning that we’ll always look at the overall portfolio and ask ourselves, “What types of positions do I need to get back to, or remain, neutral?” As an example, if we already have 10 bearish positions we’ll likely enter a couple bullish positions because it will give us more balance overall for the portfolio.
When you referred to trade duration do you also mean timeline?
Yes. Duration is the financial term for holding time and whenever I refer to a trade needing more or less duration I’m also referring to that trade needing more or less time to profit.
How can I make sure that my portfolio is neutral to future market movements?
There is no way to guarantee that your portfolio will always be 100% neutral to the future market movements. You can trade an initial position delta or market neutral but as soon as the position starts to move, the deltas are fluid and will start to change as the position evolves. That said, we also like to use portfolio beta weighting as a great tool to show us how bullish or bearish all of our underlying positions are relative to the overall market.
How can you synthetically go long/short stock with options vs shares?
Creating synthetic long or short stock positions is a great use of capital and the power of leverage in options. To go synthetically long a stock you would buy the ATM call option and sell the corresponding ATM put option at the same strike price. For example, if a stock is trading at $50 currently you would buy the $50 strike call option and sell the $50 put option. To go synthetically short a stock you would buy the ATM put option and sell the corresponding ATM call option at the same strike price. These will give you a replicated stock position for a fraction of the capital usage that would traditionally be required to hold the underlying shares long or short.
When should I add additional money to a trade or increase the number of contracts I’m trading on a position?
Because we suggest that you enter small positions to begin with, we rarely suggest that you add capital or increase your trade size at any time. There are rare instances when you can increase the number of contracts that you trade if you are scaling into a position that you've already predetermined, but other than that we highly suggest that you do not add to positions as that is not a good recipe for success. For example, if you initial position for a call credit spread was to sell 10 spreads and allocate 5% then you would not increase your position size in the future for that trade because you are already maxed out. On the other hand, if you pre-planned to invest 5% into 10 spreads but only sold 2 call credit spreads today then you could sell 8 more in the coming weeks to get up to your 5% allocation target. Full disclosure, we favor the later example of scaling or laddering into positions here at Option Alpha.