Author: Clinton Lee.
The Reward of
Profit and the Risk of Losses for retail option trading needs to be managed at
2 related levels of performance: Portfolio and Trade Specific.
At the Portfolio
level for online options trading, there are 3 types of Targets that must be
set, even before you trade.
Maximum Return
Target: complete
achievement of the “ideal” measure. Dream of the “ideal” that stretches you
beyond what is practical. For example, earn 2-3 times your monthly living
expenses with the monthly trading profit. This is to stretch your imagination
well beyond mediocrity. Even if you fail, you just might end up with more than
your original target.
Minimum Return
Target: the lowest acceptable
measure, achievable under most conditions, excluding a catastrophic market
event. Use the historical annualized return of the S&P 500 between 10%-12%
(prior to the 2008 financial pandemic), as the lowest acceptable boundary. The S&P 500 being a widely accepted
benchmark for trading equities is adequate to base the minimum target off,
though your portfolio needs to be profitable – being ahead of the $SPX in
negative territory does not count.
Below the historical annualized return range of 10%–12%, is the 3 Month
T-Bill, presently near zero. While
the T-bill theoretically represents an “absolutely” zero risk investment, even
the safest investments will still carry a residual amount of risk no matter how
small that risk is. The point is
this. You got into options and all
that Greek terminology, not to make salads; but to beat the performance of
equities as an asset class. If
your portfolio's return is between what is near zero-risk and 10%–12% per
annum, you are just delaying reaching a point of pain that marks failure in
grasping the base-line ability to control risks. If the returns of your portfolio are between 0%–12% and you
plan to continue trading options, processes within your trading process will
need to be re–engineered.
"Halt
Trade" Target:
cumulative losses reach an absolute amount below the Minimum Return, making it
necessary to stop trading altogether for a stated period. 10% of [(60% x Cash Balance at the
start of the year); or Net Liquidating Value]. Example, for a $50,000 trading account, 10% x (60% x $50,000)
= $3,000 of losses in total, is the absolute amount to halt trading. Why 10%? Blowing up your self-funded
capital is final. There is no bail
out package, as a home options trading business does not have access to bank
loans; or, shareholders’ equity to finance your personal trades.
Now, drilling down
to Trade Specific performance measures.
Even before you
calculate the metrics, characteristically, what makes for a consistently
managed portfolio are these traits:
❑ The largest loser does not wipe out
the largest winner. The largest
winner should be in multiples of the largest loser, for e.g. 2-3 times more.
❑ Above the largest loss, there are
many more winners with progressively higher profit values than the value of the
largest loser.
❑ The profits should step up gradually,
depending on the size of your account.
If it’s in the tens of thousands, the profits should step up
consistently like a ladder from the low hundreds, to the higher hundreds; then,
move up from the higher hundreds into the thousands. If your account is above $100K, profits should step up from
the high hundreds into the thousands.
Profits that jump from low hundreds into the thousands signal an over-reliance
on gapping plays, which fail to help you step up consistently profitable
results.
Where
can I see this step up function in a consistently profitable portfolio, with
these portfolio measures and trade performance metrics? View Consistent Results to see a model retail option trader’s portfolio that shows these traits.
Moving onto the
hard metrics. There’s 2 ways to
count the Return on your trading capital.
❑ The first way is to take the Total
Profit of the trading account and divide it by the Start of Year Cash Balance,
as of 01/01/YYYY.
❑ The second way is if you take the
Total Profit of the trading account and divide it by the ongoing Net
Liquidating Value.
In both cases, you
can minus the Total Cost of Commissions from Total Profit, to get a Total Net
Profit number. Then, divide the
Total Net Profit by the Start of Year Cash Balance; or, Net Liquidating
Value. Net Liquidating Value is
how much your entire trading account is worth, which is equal to Total Cash +
Options Value + Stocks Value + Commodities Value + Bonds Value. The Start of
Year Cash Balance is straightforward – it is the money in the account at the
beginning of that trading year. Cash increases when you are short securities;
but, cash decreases, as you get long on securities.
To review your
performance, calculate these metrics using the Profit (wins) and Loss (losers)
from your account:
❑ Win/Loss Probability: is the number
of wins divided by the total number of trades. The other way to express this Win/Loss
ratio is to take the number of wins and divide it by the number of losers. The Win/Loss Probability; or, Wins per
1 Loss measures your ACCURACY in selecting trades.
❑ Average Win is equal to the sum of
all profits divided by number of wins.
❑ Average Loss is equal to the sum of
all losses divided by the number of losers.
The Average Win
divided by the Average Loss measures how RESPONSIVE you are in taking profits
and cutting losses.
Combine the
Accuracy ratio with the Responsiveness ratio to get your Performance Ratio.
Performance Ratio =
(Win/Loss Probability) x (Average Win / Average Loss). Always aim to maintain the Performance
Ratio above 1.00. Why? The
commonly known money management rule is to allocate 2%-5% of (60% x Net
Liquidating Value of the account) per trade. What is not commonly practiced is the discipline of
moderating a +/- 1% in trade allocation between the 2%-5% allocation.
❑ If you are allocating 2% per option
trade, you would increase this by +1% to 3%, if you can sustain your
Performance Ratio above 1.00 for the next month. Subsequently, you would
increase +1% for each month that you exceed 1.00, until you reach the upper
limit of 5%.
❑ If you are allocating 2% per option
trade, you would decrease this by -1% to lower it down to 1%, if you fail to
sustain your Performance Ratio above 1.00 for the next month. You would keep
the allocation per trade at 1% for every subsequent month, until you are able
to fix your Performance Ratio above 1.00 to raise the allocation per trade again
by +1%.
This is how to
achieve a ladder effect in stepping up profits and stepping down losses. This
mechanism of stepping up/down is an indispensable tool for rewarding profit and
to discipline the risk of losses.
It forces you to improve both ACCURACY and RESPONSIVENESS before raising
your position size.