In the first week of this new year, I will be looking back at 2022, my first year of options trading. What did I learn, which books did I read, which sites did I visit, and which videos I watched?
I seemingly started in the tail of a long bullish period and was immediately confronted with a declining market, possibly in 2023 going into recession. I believe this has taught me more than of I has started when things were all going well.
Table of Contents
- Rationale and Set-up
- Trial by Fire
- Time Needed
- What I Learned Until Now
- My Options Trading Goals and Adjustments Required
- Options Strategy Risk Management Rules
- Underlyings traded
- Rules for the remainder of 2023
- New To-Do’s
Rationale and Set-up
I started looking at options one year ago, after (actually by accident) downloading a PDF on options trading for beginners. Until then I considered options trading to be too complicated for a retail trader like me. But the strange names like ‘iron condor, broken-wing butterfly, strangle, straddle, vertical spreads, etc.’ drew my attention and I wanted to know more.
I began doing my first research and started searching on the Internet for more information. Sites that really helped me in the beginning were:
- Tastytrade, now called TastyLive was and is one of the best places to start. Especially its learning center. This is by far the best free source for information on options trading, for beginners, intermediate and advanced traders.
- The videos by Seth Freudberg, the Head Options Trader of SMB Capital
- Gavin McMaster’s articles on OptionsTradingIQ
- Tony Zhang’s OptionsPlay videos
- Kirk du Plessis’ courses on OptionAlpha.
And many more. My main message is that as a beginner you don’t need to spend money on learning about options trading. Although you will have to accept a lot of advertising, as soon as you subscribe to sites, newsletters, etc. Actually, this is another advantage of TastyLive: their model is not based on advertising, so you will not see much of that, but of course, they would like to see you onboard the Tastyworks platform.
I also set up my trading plan and all my trading tools like a financial plan, a trading journal (this website), Excel sheets, and charts, making use of paid subscriptions for TradingView and Barchart.
While looking at the videos and reading the articles on options trading, I meanwhile started to get more information about books I should read. And these are some of the books I read until now (mostly on Kindle):
- Technical Analysis: Is Mostly Bullshit – Why Flipping a Coin is a Better Strategy than Using Technical Analysis in the Financial, Stock, and Forex Markets by Tim Morris
- Options with a cherry on top: by Vicki Lee Dillard
- The Unlucky Investor’s Guide to Options Trading by J Spina
- Mean Reversion Trading: Using Options Spreads and Technical Analysis by Nishant Pant
- Master 76 Option Strategies by Russell A. Stultz
I am reading now:
- Options as a Strategic Investment: Fifth Edition by Lawrence G. McMillan
- Trading Evolved: Anyone can Build Killer Trading Strategies in Python par Andreas Clenow
And on my list to read next:
- Option Volatility and Pricing: Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg
- Trading Options Greeks: How Time, Volatility, and Other Pricing Factors Drive Profits by Dan Passarelli
- Keene on the Market: Trade to Win Using Unusual Options Activity, Volatility, and Earnings by Andrew Keene (Format Kindle)
- Frequently Asked Questions in Quantitative Finance by Paul Wilmott
Trial by Fire
I looked at paper trading and set up an account with Tradestation. However, I found Tastytrade and the Tastyworks platform, and already very early into my option ‘career’ decided I wanted to use that. Unfortunately, Tastyworks does not provide any paper trading, so I had to learn options trading by ‘trial by fire.’
In April I took the bold step to set up an account on Tastyworks and placed my first trades in May.
I gave myself up until September to learn more about options trading, set up a plan, and financial goals, and identify what would be my first options trading strategies.
And I did burn myself in the first months. It takes time to get used to a platform. Tastyworks is set up with the user in mind and therefore easy to learn. But I made several stupid mistakes in setting up trades merely due to the fact that I didn’t yet completely understand all the moving parts.
I also started in what turned out to be one of the most choppy periods if the past years, with a market turning from bullish to bearish and possible into a recession, global supply chain issues, worsened by Russia attacking Ukraine, and closing down gas supply to Europe, etc.
In my first post, describing my first options trades, I explained the rationale of my decision to start with options trading. The main goal was to find a way to start earning additional income. Reading the article back now I see that I am still using the words ‘passive income’.
Meanwhile, I have found out that if you really want to be successful in options trading, you need to be prepared to spend a lot of time (months rather than weeks) in learning about all the nuts and bolts involved. And then continue to learn more.
You also really need to regularly spend time for managing your trades. And by regularly I mean a few hours per week. And if there are major market changes, even per day. Despite what all the ‘gurus’ on the Internet tell you when they’re selling their courses to you.
What I Learned Until Now
- Keeping option strategies simple, and focusing on liquidity, volatility and probability
- Understanding why my orders sometimes are not filling
- Realizing it is generally more difficult to buy or sell a security when the volume is low because there are fewer buyers and sellers in the market. This can lead to wider spreads between the bid and ask prices, which can make it more difficult to execute trades. It can also mean that it takes longer to complete a trade because there may be fewer counterparties available to trade with.
- Better understanding volatility : when implied Volatility (IV) is higher than Historical Volatility (HV), then short premium selling works well. When HV is higher than IV, then buying premium works better.
- The 20 Tastytrade commandments
My Options Trading Goals and Adjustments Required
Based on my goals, and given what I learned I need again to update my financial planning.
In 2022 I moved over $11,000 from to tastyworks account.
My options trading goals and rules
The main goals I started with were to learn everything about options and futures trading, algorithmic trading (including programming), and see whether I can build up extra income of on average $2.000 per month from options trading on top of my retirement funds and pensions.
I learned about options trading in the first months of this year and started with my first options trades in April of this year. Immediately I was punished for not having a clear plan, not following the rules, and in general, a total lack of discipline. Up to September, I lost up to $1,500.00. Learning the hard way ‘on-the-job’! But I do believe this is the best way to quickly learn a skill.
To supplement my retirement and other funds I aim to generate $2,000 in extra income by the time I will retire, which is about five years from now. I want to start paying myself during the year 2027 a total of $24,000 per year. [Note: this will now be 2028; see this post]
I ‘formally’ started keeping track of my trading as from September 2022 and now have around $11,000 (net liq) in my tastyworks account which is around $700 up from such formal start. So after I lost the $1,500 and started using a plan, and rules, I immediately started to generate positive cash.
Adjusting my financial plan
The drivers of my cash as also used in my financial planning Excel sheet, are:
- The amount I end the year with (I use NetLiq)
- Any deposits or withdrawals during the year
- Portfolio allocation (max cash in the account used/at risk for trades)
- Allocation per trade (max cash/at risk per individual trade)
- Average RoC/RoR per trade
- Average max profit (e.g. 50% rule)
- Average max loss (e.g. max 100% rule)
- Average commissions/fees per trade
- The number of trades made
- The average duration of trades
- Probability of Profit (win)
Year 2023 Financial Goals
- My NetLiq on Jan 1 2023 was close to $10,680
- This is around $1,668 below what I had planned as end result for 2022 ($12,348.72); so I start with a deficit of $2.168
- On Dec 31, 2023, my trading account’s balance should have around $4,000 more: so a total net liquidity value of $17.321.14(‘Net Liq‘).
This leads to the following actions needed for adjusting my financial planning:
- End of year/deficit: I will deposit an extra amount of of $2.168 to my tastyworks account to enable me to reach my goals; however, I also need to look at the other variables.
- If possible, I will deposit more over the year (but I am buying a house in Provence so may not have extra cash for that).
- I will do no withdrawals during the year.
- Maintaining a portfolio allocation (max cash in the account used/at risk for trades) of 60% is obligatory.
- Allocation per trade (max cash/at risk per individual trade) will be 3-4%.
- Average RoC/RoR per trade must be at least 35% of spread/risk taken.
- I have to make sure the average of my profit is around 50%.
- The average max loss should stay around 100% rule.
- Average commissions/fees per trade should not go higher than $5.00.
- The average duration of trades (DTE 45-21 rule) should be not longer than 4 weeks.
- Probability of Profit (win) should be at least 70% for spreads and condors and 50% for the rest.
- Taxes are around 30%.
4% of Net Liq position size may be slightly too high from a risk management perspective, and I should downsize the risk per trade to a max of 3% of Net Liq per trade [note: it is 4% now].
I will continue to use the VIX-based position sizing guidelines I found in The Unlucky Investor’s Guide to Options Trading by J Spina mentioned above.
Going down lower than 3% in position sizing would mean I would have to increase trades from 10 to 30, and this will mean portfolio management will demand more time and probably be more complex.
Of course, when and where possible, I can always decide to increase the number of positions open (as long as I don’t go beyond the 50% portfolio value barrier I have set up).
Also, position sizes below $300 (3% x $9.000) may yield too few opportunities and too low premiums too low to make progress. So I can better start reducing from 5% to 3% when my Net Liq has considerably grown.
Every quarter, I will adjust the forecast based on actuals and monitor whether the above percentages are realistic and achieved. For instance, if I see the average ratio between wins and losses deteriorates, or my achieved profits are lower, or losses are, on average, higher, which is structural, I will have to adjust the input.
If the ratio of wins versus losses drops to 2:3, I could try to minimize the max loss I take (halving it to 50%).
If the trades, on average, take longer than 4 weeks and, therefore, the number of trades per month decreases over the year, I need to see how I can up my win rate to compensate.
As a last resort, I will have to (continue) add cash to my account to achieve my goals.
Monthly financial Goals 2023
- In 2023, I will trade not less than 15 contracts active per week.
- Mostly, I will continue to trade vertical (credit) spreads, iron condors (defined risk) and to a lesser degree staddles or strangles.
- Entry around 30 – 45 (credit) – 60 to 90 days (debit/iron condors); exit 14 -21 days.
- So each trade will be on average 4 weeks in play: between 3+ weeks for credit spreads and sometimes (not more than) up to 7 weeks for debit spreads.
- I will also start experimenting with (more risky) earnings trades, but this should be at a very low percentage of my total portfolio for options trading.
Weekly Goal: USD 250 per week
- Continue with Vertical Bull or Bear Spreads and Iron Condors to reach at least 10 contracts per week
- Once per month, an earnings (calendar spread) or straddle/strangle trade
- Max risk: per trade max loss starting with a max of 5% of Net Liq (=$450) [note: it is 4% but amount is the same due to the largest deposit I made]
- POP: 70%
- Trade mostly on Tuesday, and Thursday
- Wait until 10 AM (so don’t trade immediately after the bell), and no trades after 9 pm (so just before the end bell)
- The anticipated trade profit of the low-risk positions I trade must come with an average gain of about 40% of max profit (40 % ROR/ROC), minus fees per contract.
Options Strategy Risk Management Rules
- Sell options to collect premium income while spreading the risk over various expiration dates (staggering dates to avoid expiration density).
- Sell options on tickers that are liquid in the options market (to open and close positions easily and ensure trades can be filled with narrow bid-to-ask spreads for optimal option pricing ).
- Sell options across tickers with broad sector diversity across uncorrelated sectors to spread risk (too much concentration into any given sector runs the risk of stocks auto-correlating in the same direction and potentially jeopardizing all trades within the sector-specific bucket of trades ).
- Sell options at high IVR (>30) to extract high (overpriced) premiums (‘overpriced’, since predicted volatility is nearly always overestimated, and stocks are less volatile than predicted so implied volatility implosion or IV reversion to the mean allows for profits to be taken early when stocks fail to be as volatile as predicted).
- As much as possible (given a small account) stick to risk-defined trades (put spreads, call spreads, and iron condors) to mitigate risk and reduce the amount of capital required for any given trade.
- Probability of success (P50 in Tastyworks platform)> 70% to ensure a statistical edge
- Closing the trade and realizing profits at >50% premium early in the option lifecycle and re-invest the capital made free towards additional trades.
- Closeout trades prior to expiration (before strike price gets challenged just before expiration (high volatility and higher loss probability!).
- Maximize the number of trades to allow the expected probabilities to play out (trade small, trade often).
- Size position/portfolio allocation to manage risk exposure (worst-case scenarios always need to be considered therefore I conservatively use small allocations to options trades, so only 4% of my portfolio should only be used for any given trade).
- Keep an adequate amount of cash on hand (~40% in my case) to protect your portfolio against any major market downturns (i.e., Covid-19 and Q1 2022, 2023 recession(?). Cash also gives me the possibility of buying of stocks/long equity at heavily discounted valuations.
I have created a series of rules to select the right underlyings for my options trading based on (high) liquidity, volume, open interest, spread width (ideally $1-$5), expiry dates (ideally weekly all year round) and more. Here is my ‘faves’ watch list with in bold my favourite symbols that I mainly trade today:
Rules for the remainder of 2023
- At any time max of 60% of the Net Liq of my portfolio will be at risk
- Max risk of loss per trade will not be higher than 4% of net liq
- The ratio of max loss versus max profit at the set-up of a credit spread trade should be no more than 2:1 (about 65%: 35%, s a 2:1 ‘risk-reward ratio’)
- PoP (Probability of Profit): close to at least 70%
- alternatively, the P50 (probability you will reach at least 50% profit): close to at least 70%
- Target average profit overall is at least 50% per trade
- I will close, roll, or (‘early’) take profit per trade at 75% at 21 days to expiry
- I will never let a trade come to an assignment
Probability of Profit (POP): POP stands for the probability of profit. POP is the probability of making at least $0.01 on the trade at expiration. For trades performed at a credit, it’s the probability of the break-even price expiring out-of-the-money. For trades performed at a debit, it’s the probability of the break-even price expiring in-the-money. Source: tastyworks
As a rule, I want my P50 (probability of 50% profit) to be at least 80% to improve my chances of achieving an average of at least 50% profit for my winning trades.
P50: P50 is the probability of reaching 50% of max profit before expiration. It is calculated by taking a trade, running it through a Monte-Carlo style simulation, and calculating the theoretical probability that your position will reach a 50% profit over 10,000 occurrences. Source: tastyworks
- Learn more about quantitative finance, algorithmic trading, and using Python.
- Expand my playbook (calendar/diagonal spreads, undefined risk strategies).
- Be more disciplined on the exit strategy.
- Introduce rules for portfolio allocation (defined vs undefined, diversification)
- Show more discipline in updating the trading journal.
- Start comparing to the performance of the S&P 500.
- Understand better what tape reading (if not market awareness) is: is its is first looking at major indices (/ES, /NG, Dow, Russel, etc), then at VIX/VIXX/VXX (performance relative to market movement, then at currency (yen, euro, dollar) and commodity markets (gold, oil), I am already doing that. If it means looking at intraday events to be aware of: order flows, particular strengths/weaknesses, areas of congestion, unusual price movement or volume (looking for potential pairs trading around some movement), looking at individual equities: volatility/vol. crush, short covering, binary events, large gaps up/down, then I need to understand how I can get access to such data