Last week, I referenced a 1998 Option Investor article, "Top Ten Rules for Option Trading," updating a couple of those top ten rules or guidelines. One warned against devoting too high a percentage of one's trading capital to a single trade.
I was even more conservative than the original writer of that article. I like to keep plenty of cash in an account for adjustments or hedges I might employ as a trade progresses. I thought a current example from my own trade allocations might be helpful.
As most of you know, I have long been an iron condor trader, routinely trading 75-90 iron condors a month, with the trades split between the RUT, SPX, and OEX or XEO. Those have been my main income trades for years, but I've long been on a quest to broaden my repertoire, varying delta and vega risks. I have other goals, too, including finding trades that are easy to adjust using contingent or conditional orders, so that I don't have to stay at the computer watching my trades each moment. I'm trying out several methods of using alerts, including think-or-swim's delta-based alerts. Unfortunately, the market upheaval thwarted my achievement of my trading goals. Moving into less familiar trading strategies in any size during the last two years has been made more difficult by strange market action at times, so that I decided to participate in a mentoring program for experienced options traders to prod myself to do so.
Currently, I'm allocating $10,000 to vary those risks with live trades while maintaining my larger accounts for the purposes of trading iron condors. My allocation for this month for those $10,000 portfolio trades can be found below. Remember that these are not trade suggestions. Two of these trades were entered several a couple of weeks ago, for example, and certainly wouldn't have the same setup or viability now. I apologize in advance for the colored background. I know some of you like to print up the articles, but this is the lightest color scheme allowed on the platform I'm using to track and chart my trades.
My $10,000 Portfolio's Current Trade Allocations:
As you can see, I've so far allocated only $4,631.86 of that $10,000 for November trades. Why?
Real-life examples might pinpoint the reason. For example, the MNX rose sharply on October 21, requiring an adjustment to the MNX double diagonal according to my trading plan. That adjustment required cash, and I had that cash available, resulting in the small current loss in the portfolio. However, the cash required was small so far. Perhaps the answer to the "Why?" question posed in the previous paragraph might best found in my trading plan for the OEX iron butterfly.
Strategy Summary for OEX NOV Iron Butterfly:
The total credit for establishing this position was $1740, as shown as a negative debit in the table. This one-contract position had 30-point wings and I paid $14.75 in commissions for the iron butterfly plus a call to flatten the deltas. [Note: The extra call is the reason for the "Infinity" as the possible upside to this trade, although I don't think it likely that the OEX will go to infinity!] Therefore, my total investment or net margin withheld by my brokerage would be $30-point wings x 1 contract x 100 multiplier/contract - $1740 credit taken in + $14.75 commissions = $1,274.75. This figure is shown as "Total Investment."
I keep a separate sheet for each of these trades I make in this portfolio, including the OEX NOV Iron Butterfly. That sheet details my plan for taking profits and also for adjusting the trade if it goes wrong. On the day I initiated the trade, I typed out these notes in the plan:
Adjust when the expiration breakeven is approached. Adjustment possibilities include moving out the in-trouble spread, lifting up the whole butterfly and replacing it, or adding a second butterfly. If an expiration BE is approached, I will look at all three on the graph, but my preference is to add a second butterfly, as it's the easiest approach. I've left the money to do that, deliberately putting on the trade with only one contract so I'd have the money to add the second butterfly. It was always in my plan to add the second one if the need arose.
This trade is so far performing nicely, but imagine that by October 30, the OEX has dropped to 482.89, the expiration breakeven. According to my own plans, the first adjustment I would consider would be adding another iron butterfly, with the short strikes likely centered at 480. The pricer I used returned a theoretical credit of $1710.20 for 510/480/480/450 OEX NOV iron butterfly on October 30, with the OEX at 482.89. The value might be slightly different due to volatility changes, but we're going to use this theoretical value to calculate the margin required to open the new position. The formula $30 x 1 contract x 100 multiplier/contract - $1,710.20 + $14.75 commissions returns a $1304.55 margin requirement for that adjustment.
Added to the margin already held for this $10,000 portfolio, the total margin requirement would then be $5,936.41, and that's assuming that neither of the other two positions had also required adjustments. Once a position requires adjustment, it's likely that you'll be in that trade longer than you would otherwise have been before you can exit with your profit, so cash needed to be kept available for a December trade or two, if those become available. And, while it's unlikely that a portfolio made up of an iron butterfly, a double diagonal and a calendar would suffer a total loss in case of a catastrophic event, I make it a practice to make sure I have cash left over in case that such a catastrophic event should wipe out an unrecoverable percentage of my trading accounts.
So, that's it. Looking at my own examples hopefully demonstrates why it's not a good idea to tie up all an account's cash in one trade or even in several. I thought last week's general comments might be more practical if viewed against the requirements of an actual portfolio. Before you trade, think about how you'll diversify your trades. Decide--before you even enter a trade--how you'll likely adjust if that trade should go wrong and how much money you'll need to do so. Think about leaving cash still available for those adjustments, any other trades that might come up during the period those trades are open, and a little start-up money should the unthinkable happen. I have heard of traders who did not leave enough money for adjustments, so that they were either limited in the adjustments they might make to a trade or had to take it off and suffer a loss, without being able to make the adjustment that might have saved the trade.
I hope this helped to see specific examples. Through the years, I've always invited readers along as I explore new ways of managing my trades and my trading life.
Have a great weekend, everyone.