In this video, I want to talk about and walk through the exact steps on how you can calculate your expected portfolio return or target your portfolio return to some figure that you want to make annually.
And then from that figure, we’re going to back in to figuring out what type of trade you need to make to hit that target. It’s going to be an intense video tutorial.
I know that this is going to be a lot of math and numbers and things like that, but I’m going to challenge you guys on doing this because this is how you create a long-term sustainable business, is by knowing not only where you want to go.
What your target is, but also how to get there, what types of trades you need to make to get there. Of course, we know options trading involves the use of very highly leveraged products, and therefore, it’s important that we first talk about portfolio return by making sure you first have absolute reserves or what I call absolute reserves.
We suggest here at Option Alpha having somewhere between 30% and 50% of your account in cash at all times, and that’s just our suggestion.
Sometimes if you're trading with less money and you have a smaller account size, you obviously don't have the luxury of having 50% of your account size in cash, but as you start to accumulate more money, it should be somewhere between 30% and 50% of your account in cash at all times.
And that's just what we like to do because the rest of your account will be then targeted to trading highly leveraged option strategies and positions. The whole idea here is that we’re going to set a big chunk of our money in cash, not touch it.
The other part of our money, we’re going to aggressively invest into options trading. The goal becomes making a frankly incredible return on a smaller portion of your account. I can’t stress it enough because I’ll keep saying it.
Even though what you'll see here in this video tutorial is an incredible return, I do not suggest that you allocate all of your accounts towards this and try to go for the big homerun because you will end up going broke. It’s just a matter of time, and the numbers don't lie on that aspect.
Let’s work backward on figuring this out. We first want to assume that you want to make just say 15% this year for a total portfolio return and we’re talking about everything. All the money that you have on your whole portfolio, you want to make about 15%.
Of course, that would be the [Inaudible] long-term average, and that’s a pretty good target for us to work with. But remember that we are keeping some of that money in cash for safekeeping, so we need to generate more than 15% on a smaller amount of our portfolio, and that makes sense.
We’re not going to invest the whole thing, so we got to be even better than 15% in a smaller amount of our portfolio. For the sake of this video, let’s just say that we want to use 30% of our account and trade only credit spreads on the SPX.
We’re just going to use the SPX because it's the biggest index, the most liquid index and it’s got really good option pricing, so we’re going to use that for this video and say you trade it all year only credit spreads on the SPX.
To get to that 15% annual return overall with just 30% of our portfolio, we would need to make more than 45% return on investment on the money that we have invested. That's the actual figure that we’re targeting. It’s somewhere around 45% return on that figure.
This probably sounds crazy, but here's exactly how you would do it. Step one: We first have to find high probability credit spreads. Let’s go to my Thinkorswim platform, and we’re going to do that live right now.
I’m just going to click here, and you can see we have the charts up here of the S&P and you can see this is SPX as of today, this recording of this video, and the S&P right now is trading at around 2717.
What we’re going to do is we’re going to go into the option chains here on our platform, and we’re just going to go to February because those are about 45 days out, so we’ll just use 45 days as our target, it just makes the math a little bit simpler, but they’re exactly 43 days out.
We’ve already highlighted that what we want to do is we want to go to an option strategy or credit spread down around the 15% probability of being in the money or less. In this case, the 1825s which are well below the market have a probability of being in the money of about 13.34.
What that means is that we're trading with better than 85% chance of success. This is a very high probability spread, and we’re going to limit our upside gain so that we can increase our potential chance of success here.
If we go ahead and just change this to spreads, to a vertical spread, you can see that the 1825/1820 here is trading for about $40 and we just used this credit for this video, so it went down to $35 right now, but it's trading for about $40, and it’s in that range today.
If we hit confirm and send here, and we do this particular strategy, we can see that we have the potential to make a $40 return with using $460 of capital or risk. That’s how much margin we’re going to put up.
This ends up being an 8.7% return on our usage of capital. If we go to the calculator that we have right here, (and I’ll just bring it up and show you guys) we would take the $40 that we make in credit, divide it by the 460 that we have to put up and that gives us 0.0869, so an 8.7% return on our investment.
Again, that $40 credit that we’re taking in, divided by how much capital we have to put up. We’re going to go through all the numbers here, and you can see that.
Let’s go back to the slides. The 1825/1820 put credit spread, about 45 days out has a return on capital of 8.7% which we just calculated with you. Now what we’re going to do is take this 8.7% and divide it by 45 days roughly to get our return per day which is going to be .0193.
Here’s the calculator. We’re going to take that number that we have here, divide that by 45 days and that gets us 0.001932%, again, 0.193% per day. That’s how much money.
If we make this trade, about 45 days out every single time, we’re going to make about .193% return on our investment every single day as we go out. We know that we’re going to make that, so we take that .193 per day and multiply that by 252 trading days per year.
This isn’t the whole year. We’re multiplying it by to 252 trading days. It’s a little bit more conservative than some people who do it for an entire year or 365 because we’re not making money on weekends because the markets aren’t even open.
But this equates to about a 48.72% return on our money, and that’s pretty crazy because this is just a small portion of our account and we’re making an incredible return on that small portion.
Again, let’s calculate it out. We’re going to take that .193%, and we’re going to times that by 252 and when I hit equals, you can see that it gives us .4869 which is .4872% rounded per year.
This of course is assuming that you make the same high probability trade month after month which is easy to do now that we've shown you how to find them and we just went through how to do it right here in this video.
The last thing we want to do is if you recall, we’re only trading 30% of our account, so we have to take that 48.72% figure and multiply that by 30% because that's how much money we’re going to invest out of our entire account.
The actual numbers are you take that .4872, times it by .3 which is 30% and that gets you an annual return of 14.61. And again, we’ll do the final calculation right here with you guys. We take that .4869 that we have, times that by .3 which is 30% and that gets us the 14.608 and we just rounded it to 14.61.
Although this is slightly under our 15% target, you now can see the exact steps we went through to earn 14.61 and we can just either maybe invest 1% more money.
But we don't know how much we’re going to make every single trade; we’re just using that trade and saying we’re going to make the same trade with the same return on capital every single month.
It might be different, and that’s how we could get to 15%, but you can see the steps that we took to get there investing just 30% of our money and leaving everything else in cash.
And you understand now the power of using options. It’s way more profitable, and you’re using less of your capital to do it to earn a better return.
Hopefully, this video has been helpful just trying to build some context around how to calculate and figure out how much you need to make per trade and how many trades you need to make throughout the year to get to some target that you have.
You can go through these steps with a lot of the trades. It works best with risk defined trades, but you can also do them with undefined risk trades. But hopefully, this video has been incredibly helpful in calculating an expected portfolio return.
As always, if you guys have questions or comments, please add them right below in the comment section to this video.