My options trading profit targets are – to say the least – ambitious. But are they realistic? How can portfolio allocation and RoC help?
Table of Contents
- Profit Drivers
- Portfolio Allocation Size
The drivers of my cash as also used in my financial planning Excel sheet, as further explained in this post, 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 per week/month
- The average duration of trades
- Probability of Profit (win)
Portfolio Allocation Size
I have now set the maximum amount for options trading I am prepared to put at risk to be 60% of the cash I have in the account. Actually, I use NetLiq since that represents the actual value of my portfolio assumed at the mid-price. It is the theoretical value of your portfolio if you liquidate all of your positions at the mid-price. The cash balance in my account is higher than the net liq since I am most of the time net short.
The 60% is based on the following calculation:
To reach an extra income of $2,000 in 2028, I need to:
- use 60% of my portfolio for options trading, and
- make an annual profit of around 40%, and
- go for an average trade RoR/RoC of 40%, and
- have at least 15 trades outstanding all the time, and
- have a win rate of 70%, and
- on average spend no more than $5 on each grade (entry and exit)
- actively manage my options for adjusting and closing
to make a 40% profit per year.
My goal is to place many high probability trades, while using my available capital as efficiently as possible, given that I am for now reading a small account. In addition to finding the right underlyings and plays, I need therefore to select right probability and returns within the boundaries of my portfolio and strategy.
The question however is whether these numbers are realistic? Especially the profit target (40%) which compared to standard stock investing (15% is considered already very good) seems too high?
The other question is whether I really need 60% of my cash to be allocated to options trading to reach my goals?
Options Trading Portfolio Returns and what RoC/Day or Theta/Day do I need
There is, of course, a direct relationship between probability of profit (POP) and return on capital (ROC).
Return on Capital (ROC)
Return on Capital (ROC) is calculated by taking the max potential profit (for a short position) and dividing it by the total amount of capital used.
As a metric, ROC is useful in that it allows us to equate trades into a “single currency”. Showing how leverage is being used to enhance and maximize returns, e.g. pay 0.5% per month to make 0.5% per day, allows for the most efficient use of capital.
Annual RoC = ROC/day*365.
Based on a video I saw on Tastytrade, I took an alternative look at total return based on RoC per day I need to achieve to reach my goal of at least 40% profit per year (‘expected portfolio return’).
The expected portfolio return = percentage of capital allocated (I use NetLiq) * average RoC/day.
So if my target annual return is 40%, what is the RoC per day I need to reach (by active trading) suc target?
Or, alternatively, given that I am mostly using short premium strategies, what time decay (theta) per day is needed to see what we need to achieve reaching the annual return for the year?
Note: I will not be looking at the allocation between defined and undefined options trading strategies here.
Number of Days Required
Return of Capital/Day (and Days needed to achieve Target Annual Return)
Target Annual Return
So to reach my annual target of 40% I need to at least to have an average RoC/day of at least .50% (of my total portfolio cash amount, so for instance .5%*$11.000 (today’s net liq) to reach my target in 320 calendar days. This doesn’t mean the target is or should be .50% per day (because for instance theta will go up closer to expiration). It’s an average. Note: I have to find out how Tastytrade calculated the above figures.
Percentage of Portfolio Required
We can also look at total return using a limited amount of the overall account and target a specific RoC/Day. So here I am calculating what the maximum amount is I have to allocate for options trading if I want to reach a 40% profit per year.
Percent of Portfolio (and percentage needed to achieve Target Annual Return)
So in my planning and based on a .50% average RoC/Day, the percentage portfolio I need to allocate to my options trading to reach my total profit target should be (only) somewhere between 20% and 25%. I am using up to 60% (!) now.
So if I capture .50% per day on 60% of my portfolio * 365 days my average return would be close to 110% (!).
However, I have not (yet) reached .50% on average per day at all, and I (only) for now need a 40% annual return I (only), so if I calculate it based on 40% it would be .18% (which is today $11,000 * .18% = $18/day so $126 per week) is more in line with my present performance.
Theta or Time Decay
Another way to look at it is using theta or time decay.
So on a portfolio total 0f $11,000 time decay would be 0.1% * $11,000 = $11 per day.
If I could collect close to 0.11% in theta per day, my annual return would also be around 40%.
The remainder of my account is cash. I am keeping an adequate amount of cash on hand (~40%) because:
- Cash at hand provides the ability to rapidly adjust when faced with extreme market conditions, because it protects your portfolio against any major market downturns (i.e., Covid-19 and Q1 2022, confluence of inflation, rising interest rates and geopolitical tensions and a possible recession in 2023).
- Cash enables opportunistic buying of long equity to build the foundation of the options portfolio at heavily discounted valuations.
What About Long Equity?
As you can see, at this stage I have no long equity in my portfolio. This may change in 2023. Especially if there are heavy sell-offs there may be new market opportunities to buy cheaper stock. I would be looking at affordable broad-based and liquid ETF stocks I am not yet options trading in (so other than QQQ, SPY and IWM). T
his will allow me to participate in market movements in areas that are not covered by options and broadens my market coverage and its recommended and that will give me dividend payouts that I can reinvest in order to lower the cost basis of the stocks over time. Individual stock positions are encouraged when market opportunities present themselves during heavy sell-offs (i.e., COVID-19 and Q1 2022).
Anyway, at this stage, the long equity part of my portfolio will remain quite low.
I will update my portfolio allocation later this year, so stay tuned!
As far as I can see now, my profit targets and other variables I use for my financial planning are not unrealistic. However, there are many (other) factors that can influence the return. I will continue to monitor and track my performance over time and once in a while revisit my planning.