In this post we’ll take a look at trade occurrences, capital efficiency and the Micro e-Mini Futures product.
Looking for the basics? Check out Part 1. Part 2 focuses on the utilization of leverage, capital allocation, overstatement of delta premium, overstatement of duration premium and tax-efficient scaling.
Let’s get started!
Consider the historical performance of trading 1SD strangles on SPY 45 DTE:
Should we expect to make $67 and win 83% of our next few trades?
When it comes to probabilities we need to consider statistical significance. In essence, the more data points in a calculation the closer we get to realizing the stated probability.
Flipping a fair coin expects a 50 / 50 outcome of heads and tails. If we evaluate after just one flip and it’s heads, it will appear as though the odds are 100 / 0. As the number of flips increases, we begin to realize the actual probability.
So it is with options trading. We make our first 16 delta strangle trade. Volatility (also known as variance, luck, risk, etc.) is unfavorable and we’re unprofitable out of the gate despite expecting to win 83% of the time. However, if we continue placing trades, we will begin to realize the expected outcomes.
Ok, so we know we need to have a high number of occurrences to realize the stated statistics. How do we go about doing this in practice?
Suppose we intend to open 20 positions. The way we open those positions could be any of the following:
If we place a single order of 20 contracts, the options will all be at the same delta, strike and have the same IV. It’s essentially one big trade. This is not what we want.
The objective is to diversify across time, deltas and IVs.
Instead of deploying all our capital in a single trade, perhaps sell one or two options over the span of a day or week. It could mean selling in the morning then selling again in the afternoon if the market moved. If we’re targeting 16 delta puts, consider trading at 15.5 or 16.2.
I’m not suggesting we take all trades and make them one-lots just for the sake of increasing occurrences. The idea is to create a number of diverse trades for the purposes of realizing probabilities.
Winner: trade often and across time, deltas and IVs
Taking profits is all about increasing capital efficiency, reducing risk and locking in gains.
As we learned in part 1 of this series, 16 delta put options reach 50% max profit, on average, about 61% sooner than expected (14 days vs 23 days). We also observed the average duration to reach respective profit targets.
Let’s graph this to see if there are any trends we can easily identify.
Options reach the smaller profit targets in an accelerated, nonlinear fashion. The trend levels off significantly after reaching 50% max profit.
Is this something we can use to our advantage?
Suppose we sell a 16 delta 270 PUT on SPY with 45 DTE and collect $1 in premium – an actual trade I could have made while writing this post. Assuming the trade is profitable, holding till expiration will give us the equivalent of a 3% annual return on capital (ROC).
Calculation: [(premium / strike) / (days in trade / days in 1 year) * 100 to convert to percent]
Calculation: [(1 / 270) / (45 / 365) * 100]
Managing at different profit targets and durations yields different annualized ROC values. We can see the outcomes in the table below:
This can also be depicted as the increase or decrease relative to the 3% baseline of holding till expiration
By managing the position at 10% max profit after 2 days, we have improved our ROC by a factor of 2.25x – from 3% to 6.8%, a 125% improvement!
Also keep in mind, the average performance is to achieve 20% max profit after 2 days. Who knew more than doubling our ROC could be considered an underperformance!
Having earned the equivalent of a 6.8% annualized return over two days, our capital is now free to either standby risk free or be deployed in another trade.
Winner: managing earlier [than even 50%] can improve capital efficiency
Micro E-mini Futures
There’s a new kid on the block. Actually, there are several new kids but we’ll be focusing on just one: the Micro e-Mini Futures.
What is the Micro E-mini Futures product? It’s a solution fully-fungible with the E-mini futures at one tenth the size, launching early May 2019.
The initial offering will not have options available but I anticipate options will be added once product stability has been achieved and liquidity has ramped up.
Why do we care about a product 1/10th the size of /ES? Glad you asked.
First, this allows smaller accounts to participate in naked put writing without incurring outsized risk. Consider a 270 SPY PUT:
Second, this allows smaller accounts to realize the tax benefits of section 1256 – any capital gains and losses are treated 60% long term and 40% short term, regardless of holding duration. Check out my post on the Ultimate Guide to Taxes in Early Retirement to learn why having a portion of the gains classified as long term is beneficial.
Winner: consider selling MES options if/when the product becomes available and liquid
Increasing number of occurrences allows us to realize stated probabilities. Occurrences should be diversified across time, deltas and IV.
Efficiency of capital can be increased by managing trades early. Consider using 50% max profit as the ceiling for any trades placed, being open to manage trades at profit targets less than 50%.
MES is the ticker for a new futures product equal to /ES but 1/10th the size. If/when options become available and liquid for this product, smaller accounts will be able to write naked puts without incurring outsized risk and can take advantage of section 1256 tax rules. These rules classify capital gains as 60% long term 40% short term regardless of holding duration.
How often and large do you trade? Do you take profits early or hold till expiration? Share your approach in the comments below.