We are in the game of protecting capital. Trading defensively. This is why I love diagonal spreads.
Here is the definition of diagonals:
Diagonal Spread
Any spread in which the purchased options have a longer maturity than do the written options as well as having different striking prices. Typical types of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads.
Diagonal Spread Income:
When not called out, there is 1 stream of income coming from the credit on the short leg you sell.
When called out, there are 2 streams of income:
1) the difference between the 2 strikes
2) the credit you bring in on the short leg
DIAGONAL TRADING RULES:
1. Do not trade until after 2pm, unless it is an emergency adjustment that still fits with all my trading rules. Remember, the first hour is "amateur hour," then the last 2 hours are for the pros. This is when institutional money, hedge funds, etc. sweep in and "clean house."
2. Size each trade within 5% of total portfolio size (this 5% is calculated from your max loss which is the same as your stop loss)
3. Buy 3 strikes in the money (ITM) and 3-4 months out into the future. Sell at-the-money (ATM) or out-of-the-money (OTM), depending on which one has the higher premium and extrinsic value you can sell.
4. If the stock's trend is moving against you, exit the trade. If the
The following rules for diagonal spreads are from www.insanemoney.com. I have been following these rules in addition.
1) Always have a stop loss on your long position no greater that 20% of the underlying cost basis. 10% per Jesse Livermore.
2) Look for trades that are in between strike prices .
3) Make sure the delta on your long strike is at least .80.
4) Look for a 5% return in the front month or better.
5) Make sure you have a good bullish trend.
6) Buy long call 2 to 3 months out and 3 to 4 strikes ITM.
7) Sell the call to cover that has the most time value in the front month and will still be profitable. This will give the best downside protection.
8) If you want to hold a long call DITM for some straight line appreciation then put a 10% stop loss on it.
9) Make sure that you don’t make up more than 5% of the total open interest on a option. Especially the long, DITM option.
10) Buy back your short option once 70% of its time premium has decayed. Look to roll out to a new month if its time decay vs. underlying movement of the stock. If it is stock price (like a sudden decline) buy back the call and place a stop loss on your long position.
11) Buy back your short option once the delta of the short reaches .25 or less. At that point your short option is only covering 25% of your potential loss to the downside. Sell another ATM short option for protection.
12) If all other things are the same and you can’t decide which strike to sell, sell the OTM strike for the most profit and the ITM strike for the most adverse protection.
Showing posts with label Trading Rules. Show all posts
Showing posts with label Trading Rules. Show all posts
Tuesday, January 1, 2008
Calculating ROI
If called out, you get 2 sources of income.
The 1st is from the difference between the 2 strikes, because you have to buy back your short position and sell your long position.
The 2nd source is from the credit that you earned when you sold your short position to get into the trade (whether initial or roll).
Called Out Formula:
((Difference between 2 strikes) - Cost Basis (or Adj. Cost Basis if you've already rolled)) /
divided by Cost Basis (or Adj. Cost Basis if you've already rolled)
If you are not called out, you get 1 source of income.
This comes from the credit that you earned when you sold your short position.
Not Called Formula:
If 1st time doing the trade:
Credit/ Debit (from purchase of long position only)
If Rolling to next month or Rolling to adjust:
Credit/ Adjusted Cost Basis
The 1st is from the difference between the 2 strikes, because you have to buy back your short position and sell your long position.
The 2nd source is from the credit that you earned when you sold your short position to get into the trade (whether initial or roll).
Called Out Formula:
((Difference between 2 strikes) - Cost Basis (or Adj. Cost Basis if you've already rolled)) /
divided by Cost Basis (or Adj. Cost Basis if you've already rolled)
If you are not called out, you get 1 source of income.
This comes from the credit that you earned when you sold your short position.
Not Called Formula:
If 1st time doing the trade:
Credit/ Debit (from purchase of long position only)
If Rolling to next month or Rolling to adjust:
Credit/ Adjusted Cost Basis
Position Sizing
This post is from a very savy trader I know that is showing me the ropes with diagonal spreads. His online trading journal can be found at http://www.insanemoney.com. Position Sizing has saved me so I want to share this with you as it can save your portfolio as well. Read below...
"Help with Position Sizing"
Mojo
8:46am, November 30, 2007
I put together my thoughts on position sizing and would like to your feedback. Here it is:
If there is one thing I would say that has made the most significant difference in my success and stress level as a trader I would say "Position Sizing". What is position sizing? Its determining the maximum number of contracts allowed per trade based against your total portfolio size. Why is this important? Because it determines how many losing trades in a row your portfolio could stand before you lose everything. Professional gamblers call this your "risk of ruin". Remember your job is not to make money, but to protect your capital and extract the most experience out every dollar.
Here's a simplistic example. Let's say your portfolio is 100K. We will flip a coin 100 times with heads representing a "win" and tails representing a "loss". This gives you a 50/50 chance for each trade. Here are the results:
WLWLLLWWLLLLLLWWLLWWLWLWLWWWWLLLWLWLWLLLLWWLLLLWWL LWLWLLWWLWWLLLWLWLLLLLLLLLWWLWLLLWLWWWLLWLWLLWLWLL
Notice that in this random sample there are several consecutive wins (heads) and losses (tails). These streaks are completely normal and expected in a random sample. These streaks are where your position sizing becomes important. In trading there is something called "surviver bias". Basically its the idea that only the profitable traders survive and only those traders that survive the first three years will be profitable over their entire trading career.
If you are risking 20% on each trade and you have 2 losses in a row your portfolio will be down 40%. Mentally, are you prepared to hold the faith and stick to your trading rules once you've wiped out 40% of your account? Most people aren't (including me!). How would your wife or husband feel about a 40% loss? Would they continue to support your trading? Remember, we are trading to make our lives work for ourselves and for everyone around us.
Since most people's pain threshold is no more than a 40% loss, let's look at how many trades it will take to get us to quit trading and end our trading career.
If you are risking 15% per trade it will take 3 losing trades in a row to generate a 45% loss.
If you are risking 10% per trade it will take 4 losing trades in a row to generate a 40% loss.
If you are risking 7.5% per trade it will take 6 losing trades in a row to generate a 42% loss.
If you are risking 5% per trade it will take 8 losing trades in a row to generate a 40% loss.
At this point you might think "That's impossible, I will never have 8 losing trades in a row!". Well, look at the random sample (line 2). There's a losing streak of 9 loses in a row. Ask any trader with sufficient experience and they will tell you that this is not only possible, but even likely to occur.
If you are risking 2% per trade it will take 20 losing trades in a row to generate a 40% loss.
If you are risking 1% per trade it will take 40 losing trades in a row to generate a 40% loss.
Does this make sense? Yes? OK, good. What percentages do I use? I use the following percentages based on the underlying security (stocks vs. industry ETFs vs broad based ETFs) and the type of trade. These are hard fought rules that I'm constantly refining so I'm always open to feedback.
Single Stock (XOM) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Industry ETF (XLE) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Broad Based ETF (SPY) + WOTM Vertical Spread <= 5% [limited news risk, stop loss at 3x initial credit]
Single Stock (XOM) + Put Calendar <= 4% [stocks crash down not up, good salvage value on long puts (50% or better)]
Industry ETF (XLE) + Put Calendar <= 5% [industries crash down not up, good salvage value on long puts (50% or better)]
Broad Based ETF (SPY) + Put Calendar <= 10% [markets crash down not up, good salvage value on long puts (50% or better)]
Single Stock (XOM) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Industry ETF (XLE) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Broad Based ETF (SPY) + Diagonal <= 3% [use a 20% stop loss so your initial position is up to 15%]
Single Stock (XOM) + Iron Condor <= 0% [I don't do Iron Condors on individual stocks, too much event risk]
Industry ETF (XLE) + Iron Condors <= 2% [use a stop loss of 3x initial credit]
Broad Based ETF (SPY) + Iron Condors <= 5% [use a stop loss of 3x initial credit]
Remember, our goal is to reduce all risk we can and mitigate everything else. Position sizing is one of the "free lunches" we get so take advantage of it.
Mojo
==========================================================
If the format doesn't work you can see it at http://www.insanemoney.com/?page_id=150
"Help with Position Sizing"
Mojo
8:46am, November 30, 2007
I put together my thoughts on position sizing and would like to your feedback. Here it is:
If there is one thing I would say that has made the most significant difference in my success and stress level as a trader I would say "Position Sizing". What is position sizing? Its determining the maximum number of contracts allowed per trade based against your total portfolio size. Why is this important? Because it determines how many losing trades in a row your portfolio could stand before you lose everything. Professional gamblers call this your "risk of ruin". Remember your job is not to make money, but to protect your capital and extract the most experience out every dollar.
Here's a simplistic example. Let's say your portfolio is 100K. We will flip a coin 100 times with heads representing a "win" and tails representing a "loss". This gives you a 50/50 chance for each trade. Here are the results:
WLWLLLWWLLLLLLWWLLWWLWLWLWWWWLLLWLWLWLLLLWWLLLLWWL LWLWLLWWLWWLLLWLWLLLLLLLLLWWLWLLLWLWWWLLWLWLLWLWLL
Notice that in this random sample there are several consecutive wins (heads) and losses (tails). These streaks are completely normal and expected in a random sample. These streaks are where your position sizing becomes important. In trading there is something called "surviver bias". Basically its the idea that only the profitable traders survive and only those traders that survive the first three years will be profitable over their entire trading career.
If you are risking 20% on each trade and you have 2 losses in a row your portfolio will be down 40%. Mentally, are you prepared to hold the faith and stick to your trading rules once you've wiped out 40% of your account? Most people aren't (including me!). How would your wife or husband feel about a 40% loss? Would they continue to support your trading? Remember, we are trading to make our lives work for ourselves and for everyone around us.
Since most people's pain threshold is no more than a 40% loss, let's look at how many trades it will take to get us to quit trading and end our trading career.
If you are risking 15% per trade it will take 3 losing trades in a row to generate a 45% loss.
If you are risking 10% per trade it will take 4 losing trades in a row to generate a 40% loss.
If you are risking 7.5% per trade it will take 6 losing trades in a row to generate a 42% loss.
If you are risking 5% per trade it will take 8 losing trades in a row to generate a 40% loss.
At this point you might think "That's impossible, I will never have 8 losing trades in a row!". Well, look at the random sample (line 2). There's a losing streak of 9 loses in a row. Ask any trader with sufficient experience and they will tell you that this is not only possible, but even likely to occur.
If you are risking 2% per trade it will take 20 losing trades in a row to generate a 40% loss.
If you are risking 1% per trade it will take 40 losing trades in a row to generate a 40% loss.
Does this make sense? Yes? OK, good. What percentages do I use? I use the following percentages based on the underlying security (stocks vs. industry ETFs vs broad based ETFs) and the type of trade. These are hard fought rules that I'm constantly refining so I'm always open to feedback.
Single Stock (XOM) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Industry ETF (XLE) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Broad Based ETF (SPY) + WOTM Vertical Spread <= 5% [limited news risk, stop loss at 3x initial credit]
Single Stock (XOM) + Put Calendar <= 4% [stocks crash down not up, good salvage value on long puts (50% or better)]
Industry ETF (XLE) + Put Calendar <= 5% [industries crash down not up, good salvage value on long puts (50% or better)]
Broad Based ETF (SPY) + Put Calendar <= 10% [markets crash down not up, good salvage value on long puts (50% or better)]
Single Stock (XOM) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Industry ETF (XLE) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Broad Based ETF (SPY) + Diagonal <= 3% [use a 20% stop loss so your initial position is up to 15%]
Single Stock (XOM) + Iron Condor <= 0% [I don't do Iron Condors on individual stocks, too much event risk]
Industry ETF (XLE) + Iron Condors <= 2% [use a stop loss of 3x initial credit]
Broad Based ETF (SPY) + Iron Condors <= 5% [use a stop loss of 3x initial credit]
Remember, our goal is to reduce all risk we can and mitigate everything else. Position sizing is one of the "free lunches" we get so take advantage of it.
Mojo
==========================================================
If the format doesn't work you can see it at http://www.insanemoney.com/?page_id=150
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