where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
When it comes to extracting profits from the financial markets, over and over again I’ve witnessed success in my personal trading is a result of my consistent application of a prudent investment methodology. Meaning, the profitability I enjoy is far less about the stock choice and so much more about the steady application of my strategy.
As mentioned in previous issues of Profit Talk, the majority of funds in my active trading account is typically allocated to short option style strategies, called credit strategies. Doing so allows me to capitalize on the numerous benefits these option strategies offer which includes access to a steady flow of income from my investing activity.
The ability to utilize these powerful financial products together with modern tools for managing their benefits provide the average investor with a means to successfully draw income from the financial markets. This is done through the application of sound, duplicatable and sustainable investment practices. Combining the available knowledge and platform tools to manage your portfolio using key indicators is a huge component for success and is the focus of this edition of Profit Talk.
Let’s first review some of the reasons these strategies provide such a high probability for success and then we’ll cover the use of key portfolio indicators that are used to manage our portfolio by the numbers and how you can truly turn guesswork and chance investing into powerful and informed decision making.
As I often say, credit style option strategies provide a higher probability for success than the other common forms of investing. As you know, profit from credit style strategies come for selling, or “shorting” options. You’ve learned the higher probability for profit come from 3- main factors:
First, short Options create a “distance cushion” for price, allowing for a way to profit without being 100% right on price, even on directional trades. Selling OTM option automatically raises your chance for success because price has a distance to move prior to even threatening your profit. This creates an undeniable statistically higher probability for profit. Plus, they allow for non-directional investments based on price staying within a specified range.
These characteristics are possible because of the “time value” associated with Options called Theta and the ability to short sell this “time value” creating profits from the passage of time.
Second, Option sellers are providing a product in the marketplace and the market has to pay for this product to exist. The option seller is providing insurance on stocks and is limiting their upside potential in the transaction. The market “bakes in” a profit for providing this service. In a way, it’s a trade off for capping their profit.
The fact is, in high volume, liquid markets, the prices that Options demand from the market historically overstate the actual price moves that occur. Meaning, the historical evidence proves that the premium received creates a larger closing price range than actually occurs. This is because options have a built in premium to incentify sellers. They have to, otherwise nobody would sell them.
Third, option prices are directly affected by the human emotions of fear and greed. This is true of all asset prices, but no asset is as pure a measure of human emotion than Option prices. The index which tracks the average option prices of companies in the S&P 500 index, ticker symbol VIX. It is nicknamed the “fear” index.
The fact that Option prices come from human emotion is a good thing for investors who are paying attention. This is because emotions, unlike assets such as stocks, have a true mean-reverting quality. No matter how fearful or greedy the emotions become they always normalize. On the other hand, stock prices revert to a dynamic mean, a moving average. Stock prices can continue to go up forever, or at least for our lifetimes, as is the case for many well known companies today. Or stocks can go to zero. Emotions can do neither of those things.
This fact offers the option trader the ability to capitalize on the reversion quality that is inherent in emotional states and therefore in option prices. Aligning the style of Option strategy with the current implied volatility relative to its historical range, a value we call Implied Volatility Percentile, provides opportunity to take advantage of the mean reverting quality of Option prices. It’s why the knowledgeable trader looks to sell Options when the IVP is high and buy Options when the IVP is low. To sum up this third factor that gives premium sellers the highest probability for success, it’s the mean reverting nature of emotion, aka. Option prices, and the ability to capitalize on this truth.
These first 3-factors lay out the entire argument for those of us who love selling premium and profit doing so. These factors are the driving force behind a large part of my personal trading philosophy which is the Profit Effect trading style. Personally, I’d say 75% to 80% of my active trading account, that is outside of long term or retirement accounts, consists of a mixture of short Options strategies. This type of trading makes it possible to create steady income in a variety of market conditions while being just marginally correct, if that, on the direction of the markets. This philosophy says “strategy over stock picking” or “duration over direction”.
Proactively Manage Targets
Creating a portfolio with a variety of these well managed, non-correlated, short option strategies, can provide a steady stream of cash flow from your investing activity. The option pricing models are proven to be accurate. They provide us with the means to regulate our portfolio in a systematic way to create both our desired monthly cash flow targets and the amount of directional bias the portfolio holds.
The account can be proactively managed to maintain a specific time value or “Theta” exposure. This Theta exposure or “Theta number” is the theoretical daily return, in dollars, currently projected for the account or individual position. This number is dynamic and will rise or fall in your favor based on implied volatility in the option itself and the directional movement of the underlying. You can use the Theta number to help you keep on track to reach your financial goals for the account and to regulate the risk.
As mentioned, the amount of Theta the portfolio maintains is, in theory, the daily profit that will be derived from holding the positions. The holdings can be adjusted to regulate the amount of Theta exposure. This allows you to preserve the proper balance between the desired monthly income being produced from the account and the amount of risk exposure. The target numbers for both expected profit and risk exposure should be aligned with your personal risk tolerances.
Tracking the portfolio return by measuring Theta exposure is just one way to measure risk exposure. The advantage of this method is it’s easy to track and simultaneously doing so keeps you focused on your profit goal as well. The amount of risk tolerance each of us have varies substantially. As a general rule of thumb, a lower risk portfolio may target a monthly cash flow return of 1% - 2% of the total account. A more aggressive portfolio target lies between 3% and 5%.
The higher return portfolio creates a high risk of triggering a margin call when a fairly severe market move occurs. This is when the brokerage calls and asks you to deposit more money. Anytime a margin request can not be fulfilled, the broker will close trades on your behalf and perhaps without your input. This situation can lead to forced action that is not in your best interest.
For this reason, it is wise to have cash reserves available when targets are set at the higher end of the range. Past performance does not guarantee future results, but personally, I have had accounts that were positioned on the conservative end of that scale that have survived big market meltdowns, including the 2008 crash, without much trouble. But, when I have been at the higher end of that scale, maintaining exposure to create income in the 3% - 5% range, I’ve had cases where severe market moves have produced a margin call.
In order to use the monthly income target to guide portfolio Theta and risk exposure, decide where on the scale of 1% to 5% you wish to position the portfolio. For example, let’s use a $100,000 account positioned somewhat conservatively with a monthly income target of 2% or $2,000. The monthly income is used to determine the amount of Theta exposure to keep in the account. You can use the Theta number as guide to help regulate the entry, exit, and rolling of trades.
As mentioned, Theta is shown as a daily dollar value. In our example, the monthly target is $2,000. Divide this number by 30 days to get the approximate daily value. This comes to about $67 per day. In theory, this is the Theta number needed to create about $2,000 per month in income. $2,000 per month is 2% of $100,000, which to review, is our target.
In reality, the Theta number is dynamic and moves around a lot, especially when the portfolio is made up of fewer positions. Also, some positions registering positive Theta currently may have stages with diminished Theta decay, like if they become “in the money”. And, finally, winning positions are constantly being removed… that’s the idea anyway. All this being true, the Theta number has a downward drag on it. I’ve found, in real life trading, in order to maintain a real daily average profit using the Theta number I shoot for about double the theoretical number. I use double the theoretical number as the real number.
So, in practice it is best to set your theoretical target for twice the real daily income goal. In the example, this means doubling $67. This comes to $134 per day. I would use that as my high Theta target while maintaining the $67 Theta number as the low end number.
In practice, this means building the Theta number up to the maximum number, $134 in the example. Then, as the Theta “bleeds off”, making it’s way down to the $67 number, look to add positions or roll as necessary to boost the Theta number up again.
Maintaining the Theta number involves closing winning trades when Theta in them diminishes. Rolling existing trades to months and strikes that offer the best Theta advantage. And, continually entering new trades. The best results come when the portfolio of positions is made up of varied strategy types placed in accordance with the rules associated with the particular strategy. This means placing a mixture of credit style option strategies in markets that are experiencing elevated states of implied volatility. The varied style of option trade should also be varied in directional bias’ and correlations. Trades with a long, short and no directional bias should be placed.
The continual practice of putting on these high probability positions and actively managing the winners and losers is the cornerstone of the Profit Effect philosophy and as mentioned, accounts for 75%-80% of the type of positions that I maintain in my personal trading account. These trades “pay the overhead” as they say. This is what’s being referred to when professional traders make statements like “selling Puts on the S&P 500 is my mortgage trade”.
The remaining 20%-25% of positions may be allocated to pure directional debit trades.
The type of strategies that can be used for Theta based positions include short:
I’ve found that creating a portfolio that is made of a variety these income producing positions and at the same time maintains proper Delta Match and beta weighting performs best for me over time. This type of portfolio has a better chance to prosper across varied market conditions. The subject of “beta weighting” and “Delta Match” were covered in the December 12th edition of Profit Talk called “Balanced Portfolio Techniques”
Let’s quickly review the terms delta and Delta Match, which is a Profit Effect term. Also, beta, beta weighting.
Delta, measures the rate of change of the option value with respect to changes in the underlying asset's price. Deltas can be positive or negative. The number of deltas a position represents is very similar to the number of shares a position represents. Delta is displayed as a decimal or percentage of 100 but is referred to in whole numbers. An option position with positive .25 deltas would see a change in value as the price of the underlying moved very similar to a position of 25 shares of the same stock. The option trader might say “I’m long 25 deltas in XYZ stock”. It’s the same as saying I’m long 25 shares in XYZ stock. Or, holding -.25 deltas is like being short 25 shares of the underlying stock. Remember it this way, delta stands for direction.
Delta Match is a Profit Effect term which simply means each trade must be evaluated against the current portfolio to see if adding the deltas, or shares, whether long or short, fit the desired plan for the portfolio. If the position will complement or enhance the portfolio then it has Delta Match and is worthy of placing from a Delta Match perspective. However, there is another hurdle to cross called beta weighting deltas.
All deltas or shares are not created equal. Some markets move together in varying degrees, which is called positive correlation and other markets move opposite of each other in varying degrees, and this is called negative correlation.
The movement or volatility of a market can be measured against another market to compare the historical relationship or degree of correlation the markets experience over time.
This is done by using a measure called Beta. Beta is a measure of the volatility or systematic risk of a security or a portfolio against the market as a whole.
Most US investors use the S&P 500 composite as the “whole market” to measure against. This index can be traded just like a stock via the “SPDR ETF” ticker symbol SPY. It contains 500 of the largest companies traded in the US. A stock that has perfect positive correlation has a beta of 1.0.
If the stock has positive correlation but moves in excess of the market, it would have a beta higher than 1.0. For example, if it is 20% more volatile than the market it’s being compared to, it will have a beta of 1.2.
On the other hand, if it generally moves in the opposite direction of the comparison market, it will have negative correlation. The beta number will be displayed as a negative number. Perfect negative correlation is -1.0.
To sum up beta, beta tells you how correlated your portfolio or an individual trade is with the broad market. Using beta to weigh a position or portfolio against the market allows you to measure the directional exposure. The delta of the option or if shares are held, the shares of the position or portfolio are used to weigh their directional correlation compared to the broad market.Doing this, allows the trader to pick and choose how they want to position the portfolio from a directional standpoint.
The directional bias of the portfolio compared to the broad market can be custom tailored to fit the plan for the account. A portfolio can be designed to lean either bullish or bearish in varying degrees or it can be designed to remain directionally neutral compared to the broad market. A portfolio designed to lean very bullish and correlated with the broad market carries high positive deltas when beta weighted. On the other hand a bearish portfolio design carries high negative beta weighted deltas. Portfolios designed to stay directionally neutral the broad market maintain beta weighed deltas near zero.
Many short premium traders, including myself, keep the directional bias or the beta weighted deltas of the account neutral or just slightly bearish. Creating a portfolio that is relatively neutral the market in a directional sense, and is made up a variety of high probability, well managed, credit style option positions, throwing off daily positive Theta, is the ultimate goal for an account designed using the principles discussed today. A portfolio that is not necessarily positioned to lose a lot or gain a lot from a directional move in the market overall. Instead, the portfolio is positioned to follow the market with a relatively neutral directional stance, collecting money along the way from the option premium.
Directionally speaking, whichever way the individual trader chooses to position the account, using short option strategies to create the positions provides a means to derive income from the account. The two key indicators discussed today, Theta and Beta can be used to manage the account and maintain the plan intended for the account.
The monthly income target and general risk of the portfolio is measured using the daily Theta value of the holdings. Remember, the Theta number was created by first choosing the level of risk planned for the account in terms of monthly income target. Dividing the monthly income target by 30 for a daily theoretical profit target and then doubling that number to create the Theta target value for actual use.
As we just covered, the directional bias of the portfolio is measured using beta. Beta can be used to measure the the directional weight the deltas or shares in the portfolio have. This measure is used to custom tailor the directional bias an account has.
A trader can easily use these two key indicators to build and manage an income account using short option strategies. We’ll go to the platform and look at an example account with a small portfolio of holdings. The example is a trading account of mine with around $90,000 in it. The monthly income goal is in the 2.5% range. That translates to a profit target of around $2500 per month in this account. Using the formula from earlier you divide the goal by 30 for a daily value and then double it for real world use. 2500 divided by 30 = 83. 83 X 2 = 166. 166 is the Theta number to maintain for the best chance of reaching my 2.5 % per monthly profit target for this account.
The directional bias goal of for the account is neutral to slightly bearish.
I will say, at the time of recording this screenshot, we are in the first week of February which is the peak of earnings season. I am feasting on higher volatility trades that are available thanks to earnings releases. For this reason, my Theta number is a bit higher than I would normally carry. Also, there is a bit of a skew because of the very short duration earning trades which are currently among the holdings. This pushes the theoretical number a bit higher than actual. I do follow my own rules but at the same time I’m purposely being aggressive during this earnings season because I’m afraid the volatility is going to remain low and they’ll be slim pickens’ in a few weeks.
To monitor the portfolio indicators, go the the platform monitor page. Here the various greek values associated with the positions are displayed.
Here is the Theta value, use this number to guide the profit target for the account. (Figure 1) This number is the theoretical daily profit from Theta decay expected. As covered earlier, in real trading, the actual profit tends to run around ½ the theoretical number. This portfolio currently has a $200 theoretical daily Theta value. If this number was maintained I would expect $100 dollars per day of income from the account on average. There is of course no guarantee of making anything and if risk is not managed properly you can certainly lose money so make sure to manage the positions, both winners and losers and contain risk.
The account is using about ⅔ of the funds available. (Figure 2) The positions are presently a mixture of bullish and bearish credit spreads, short iron condors, strangles and straddles. I don’t like a ton of positions to manage, so you’ll see there is just over a dozen or so currently being held. (Figure 3)
The directional bias is near zero. It is negative just about 160 (Figure 4) deltas and when beta weighted just a bit more at about negative 280 deltas (Figure 5). The goal is to soak as much premium out of the positions with the least amount of directional, systemic risk or broad market risk as possible.
Again, for me, 75% to 80% of focus and funds in an active account is doing exactly what I’ve covered in detail for you today. Outside of that, when opportunities develop for directional trades, I’ll typically use a longer term chart and debit style option strategies to take advantage of the move. Directional trades that work out can definitely provide a nice kicker in terms of P&L.
The main takeaways from today are First, Theta can be used to manage profit targets and risk for the account. Understand higher Profit targets bring higher risk and can lead to margin calls. Always have cash reserves no matter what and consider lower targets, especially when new.
Second, Beta weighting can be used to measure risk in correlation with the broad market. In essence, it’s the measure of how much your portfolio should rise and fall with the broad market based on historical behavior. Beta can be used to manage the directional bias of the portfolio.
Third, the directional bias for the account can bearish, bullish or neutral. Using short option strategies to create the positions creates income from the option decay, or Theta decay.
As you probably know, all the major market indexes have broken out again to higher all time highs. Things are looking good for the bulls. Trend traders who took the bullish trades when the markets traded into the entry zones are in good shape and should be taking some profits as the upper bollinger band is pierced. At this point that’s all that can be done in the broad markets.
This week we do have a lot of high impact reports coming out, maybe we’ll see some action created from one of them:
Tuesday February 14th - PPI Producer Price Index which is supposed to be an inflation indicator and Fed Chair Janet Yellen is speaking
Wednesday February 15th - CPI, which is the Consumer Price Index, another inflation indicator. Also, the retail sales numbers are due out, Janet Yellen is testifying and as is usually the case, the Crude Oil Inventory numbers are released on Wednesday.
Thursday February 16th - Building Permits, Philly Fed Manufacturing numbers, Housing starts and Unemployment Claims
A big week of reports, so stay safe out there. Expect volatility to rise a bit because of the Fed chair activity and speeches.
A Look Ahead
Looking ahead to next week in Profit Talk. The process of managing risk using stock will be covered. This technique is often referred to as stock neutralization. This tactic is a great tool for managing directional exposure in a position and ideal for debit style directional trades. We will also revisit the subject of capitalizing on directional market moves with the use of debit style option strategies.
I hope this has been helpful for you. Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.