At Option Alpha we believe (and the research confirms) that the options trading possibilities for retail investors are nearly endless. Higher returns and better performance for your portfolio are possible, but only if you cross this one trading bridge first. So many newbie traders learn about options and the stock market and experience a rush of energy and motivation to jump in with both feet and start trading. Naturally, this jolt comes from the expectation of huge returns. But without the proper framework and understanding of how portfolios evolve, all that excitement can quickly turn into burnout and failure.
Key Points from Today's Show:
- One issue that a lot of traders have is that they focus too much on ROI off the bat.
- However, you have to have some mental toughness and the right mindset first.
- It is all about knowing what to expect, which is why back-testing trades is so important.
- You do not always have to choose the strategy with the highest ROI, because that may not be the strategy that your mental toughness can withstand.
- It is important to understand what the sequence of returns and what your portfolio could look like moving forward in the future.
IWM Case Study
Weekly trade setup in IWM, doing a short strangle where you sell a call option and you sell a put option. This strategy is mainly for margin accounts, though you can create an iron condor to do it in a risk-defined IRA or retirement account. There was 30% overall allocation in these trades, taking profits at 50%, and no stop-loss. The only time the trade was exited was either at expiration or when taking profits at 50%. There was also no IV rank, so when IV was high, the trade was made; if IV was mid-range, the trade was made — regardless of IV, a trade was made. In the short strangles, the short Deltas were at 20 (selling the 20 Delta calls and 20 Delta puts) targeting about 40 days to expiration.
- The short strangle had an annual CAGR of 9.45%, absolutely out-performing the S&P.
- The payoff diagram had an amazing return, the Sharpe ratio was 0.64, and the trade won 88% of the time.
- This is where we can start to prove that even though you are making a trade at a short strike of 20 on each side, which theoretically looks like you should be winning about 60% of the time, you are in fact winning 88% of the time.
- This proves the point that when you take trades off early and you factor in IV's over expectation you win more often than the initial probabilities suggest.
- There were 390 trades over a 10-year period and the max draw-down at any one point, peak to trough, was 42%.
- This is where many traders get stuck because they do not have the mental toughness or mindset to work through the drawdown.
How the PNL Diagram Evolved:
- If you started trading $250,000 in 2007, in July of 2008 you went from a high in your portfolio of $384,000.
- As the market starts to get into the depth of the correction, there was a drawn-down from $384,000 to $265,000.
- At this point, 95% of traders quit and don't continue on with trading.
- After the big draw-down, the market starts to recover and you regain the highs in your portfolio by January of 2011.
- From that point, your portfolio continues on a steady curve up with no major market corrections.
- The key is to get over the major hurdle of the draw-down and stick with the long-game strategy.
- You cannot just focus on ROI; you have to have the stability, mental toughness and consistency factor that is required to get to these higher returns.