OptionsVet.com
By Juan I. Sarmiento
2011
the market opens) when you cant do anything about exiting your position. Selling call options will not protect your stock position against a strong decline, but you could use the capital you derive from the sale of the call to buy a put (see the Collar strategy below). B. The Married Put. This strategy involves the purchase of 1 put as insurance to protect your existing 100 shares of stock. Buying a put option increases your capital invested, but you could use it when you feel uncertain about your position. Ironically, when you feel uncertain about your stock, other investors might feel uncertain, too, and rush to buy puts to protect their positions as well. This increased demand for options may be estimated by a derivation of an option pricing model known as the Implied Volatility (IV). The large institutional investors that cannot short markets are the big put option buyers and they can easily cause the premium of the put option to increase. To estimate when an option put is expensive, look at the options IV. I consider an option to be expensive when its IV is above 40%. However, if you sell a call and buy a put simultaneously, the cost might be mitigated. C. The Collar. This strategy is the combined selling of a call and buying of a put, and it can be done simultaneously in an options trading account with advanced orders, provided that you have 100 shares of the underlying stock (check with your broker). A collar is not going to be very satisfying if the stock rallies strongly. You may actually call it a pre-sale of your shares of stock. The call that you sell in a collar has a strike price above the current stock price, and the put that you buy in a collar has a strike price below the current stock price. The collar affords you limited gain with limited risk, and that may be all you want to do during times of uncertainty, or when you are forced to hold a stock position that is too large to fit your comfort zone. Before entering a collar, consider whether it would be easier just to sell the stock and use the capital to enter a bullish vertical spread, which is the synthetic equivalent of a collar (more on this later). D. The Naked Put. This strategy is the simple selling of puts without the stock shares, hence the name naked. Selling a put may be used effectively to enter 100 shares of stock at a bargain price, or at least to collect a premium. Naked puts are traded commonly, but this may be dangerous if you dont do it wisely. If you want to buy 100 shares of a stock, that you feel is undervalued but is currently moving sideways, you may want to sell a put that is slightly out of the money (OTM 2 ). Do not attempt to sell more than one option put per every 100 shares you can afford to buy; otherwise, you may be assuming a risk that is beyond your tolerance. A naked put has a high risk/ reward ratio if the stock gaps down well below the strike price. Since any stock can gap significantly down, I do not recommend this strategy. However, it needs to be mentioned here because it is commonly used. The best case scenario is that the stock does not move at all, and you keep the premium of the option you sell. If the stock goes down,
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OTM Out of the money, means that the option has no intrinsic value. This applies to a put option with a strike price below the current market price or a call with a strike price above the current market price.
you will be assigned the stock at the strike price, which is a bargain price in your mind. However, if the stock goes up significantly, you do not gain additional profits, you simply lose the opportunity. The naked put is the synthetic equivalent3 of a covered call without the original capital outlay of a stock purchase. Keep in mind that whether you sell a naked put or own 100 shares of a stock (with or without a covered call), both strategies have a risk of losing the value of the stock x 100, if the price of the stock goes to 0. The more puts you sell, the larger your potential loss. Since 2000, holding stocks has been very hard and unpredictable. Even if you are a well trained, self-directed investor, you have seen your share of frustrations and losses even with the use of these simple option strategies. This is because buying a put, selling a call or both requires advanced knowledge and forecasting abilities that are quite difficult to master even by the seasoned trader. As you gain experience in your investing career and learn more about options, youll probably realize that owning stock is a capital intensive and high risk strategy. In conclusion, a stock portfolio for the selfdirected investor may be partially protected during times of uncertainty by the option strategies discussed. Stock buying is capital intensive and the most attractive stocks may be too expensive for the beginner to buy and protect. Next we will discuss a basic options portfolio, seeking to reduce the risk and maximize the reward in a limited time frame of under 6 months.
Synthetic equivalent: Option position with a similar risk/reward profile to another option position or stockoption combination.
learning such approaches. This is why you might consider using options, rather stockoptions combinations.
Figure 1. Candlestick chart of AAPL between Sept. 1999 and January 2001. Note the overnight decline in the stock price from $26.75 to $14.09 at the opening of September 29, 2000. AAPL only closed above $26.75 again on November 3, 2004. Options strategies come in many forms, and you do not have to put out the amount of capital that a stock portfolio requires to accomplish the very same thing: a portfolio of limited risk, though with a limited time to accomplish your goals. By now you may have taken some basic options courses, either as paid workshops or webinars, some of which are provided free. OptionsVet includes a large archive of many webinars on the basics of options that explain in detail many commonly used option strategies. A. The Long Call: This is simply a call purchase. If you are convinced that you can forecast the price and time targets for a stock, then buying a call instead of the stock may be right for you. The problem with this approach is that if the stock goes in your
direction, but does not exceed the break even point (BEP)4, you may lose money. The BEP may be quite high, particularly in momentum stocks, and it is derived from the extrinsic value5 of an option. Be sure that you consult your option chain and calculate the BEP before you buy a call. Incidentally, the extrinsic value or the premium you pay for the privilege of owning an option call depends on the IV or demand for that option (see page 2). Naturally, the demand for an option is higher in momentum stocks, so their IV is high, usually above 40%. Still, if you are confident about your target and price, the conditions may be appropriate for the purchase of a call. I use other techniques to reduce my BEP (see CRC later). The best features of the long call include the limited risk and unlimited reward. We can buy the equivalent of 100 shares of stock or even more with just the fraction of the cost of the shares. However, if you are lucky and the stock has an explosive gain before the expiration of the option, you may make considerably more money than you would have expected, particularly if you bought more than 1 option call. If you are wrong, as often happens, your loss will be limited to the price of the option, so be wise and decide upfront how many options to buy based on your risk tolerance (more on this later). B. The Long Put: This is simply a put purchase. The same considerations about the BEP, extrinsic value and IV that apply to the long call also apply to the long put. Naturally, you will use the long put when you have a bearish outlook in a stock, presumably in the short-term (a few weeks). This is a great alternative to selling stock, which can be very costly, if you are wrong. The long put has limited risk and we can use wise risk-tolerance techniques to avoid unacceptable losses. The good thing about buying puts is that stock prices tend to decline fast during corrections, and the IV tends to increase when fear enters the markets, quickly adding to the value of an option put. However, the gains can quickly turn into losses, because as quick as the declines can be during a bear market, so are the rebounds. Here again, I offer an alternative advanced option trading strategy that allows you to hold your position during the roller coaster bear market or correction (see PCR later). The main limiting factor eroding the value of your long calls and puts, even when the stock goes in your forecasted direction is time decay (Theta). Calls and puts may be well suited for swing trading, but as a self-directed investor transitions to a self-directed options trader, it may be difficult to trade single options as they require much attention. This is because you need to be watchful to exit the trade before Theta takes over your position. This is the reason why so many options education outfits focus on vertical spreads.
Price below which an option call expires worthless, or price above which an option put expires worthless.
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This extrinsic value is the price traders are willing to pay beyond the intrinsic value of an option. The intrinsic value is the difference between the market price of the stock and the strike price of the option, never to be less than zero.
C. Vertical Spreads: These strategies involve the purchase of a call or a put and a simultaneous sale of a call or a put, respectively, at different strike prices. The resulting trade may be bullish or bearish, with a limited risk and limited reward, and also a time limit to expiration. One good reason to use vertical spreads is that you can hold them for extended periods of time (from 3 months to 2-3 years). These may be attractive for a self-directed investor making the transition to option trading. The bullish vertical spread is the synthetic equivalent of the Collar, and could be a replacement for holding stock for prolonged periods, particularly when there is a great deal of uncertainty, as we have had since 2001. Unfortunately, a bullish vertical spread is not going to take advantage of a runaway stock movement, as the maximum profit is limited. Additionally, if you enter a vertical spread too far out into the future, you may not see a great deal of profit even if the stock moves strongly up. The vertical bearish spreads should not be projected too far out in time, because bear markets are usually quick and dramatic. There are 4 types of vertical spreads. The long call spread (also known as bull call spread), the short put spread (or bull put spread), the long put spread (or bear put spread) and the short call spread (or bear call spread). The short spreads are credit spreads, meaning that you receive cash for them at entry. Since they have a margin requirement, credit spreads are not really much better than their debit spread cousins. In fact, the credit and debit bull spreads are synthetic equivalents, and so are the credit and debit bear spreads. One advantage of credit spreads over debit spreads is that you may not need to pay a commission to exit them, provided that all legs expire worthless. However, it might not be advisable to hold the trades to expiration. When you have a portfolio of stocks that is not protected with options, you could theoretically lose it all, if every single stock declined to zero. If you have a portfolio of options and option spreads, you can also lose it all. In fact, it is more likely that every one of your option positions ends at the maximum loss at expiration, than every stock in your portfolio would decline to zero. So it is not advisable to have a portfolio in which 100% of your positions are either long options or vertical spreads. However, you could set aside a portion of the cash in your portfolio of stocks to trade long options and vertical spreads to speculate. Although this still does not mitigate your risk. All you can do is set a maximum loss tolerance. For example, if you lose 30% of the capital youd have to quit trading and start over, reviewing your approach. If you are planning to move from being a self-directed investor to becoming a basic options trader, the transition should include some basic training including: a. Create (or copy) a strategy that includes entry and exit rules. b. Test the strategy using back-testing software that allows you to try out your strategies in the past. c. Paper trade your strategies for at least 3 months, counting from the time they prove successful. If they are not successful at first, you may require a longer training period. d. Start with a small capital position, perhaps a 1% risk per trade is sufficient to confirm that you can make your trade work in real life. e. Calculate the aggregate risk of all option positions and limit that to 30% of your portfolio, but start small at first, and then build to 30%. The smaller the aggregate risk,
the smaller the drawdowns will be during periods where your forecast is wrong. The cost (or margin requirement) of each of your trades should be a 2-3% of the capital available in your account, which means that the size of your trades should decrease during drawdown periods. With almost two decades in the stock market and 17 years trading options, I have come to understand that, as good as your strategy might be, it makes sense to measure your success in profitable years. This is because any good technique may not be profitable every day or every week or even every month. Hence you need to persevere and make sure that you have thoroughly tested your approach before giving up.
Delta measures the change in the price of an option relative to the change in the price of the underlying.
traders do, too. This increases the demand for those options and increases their IV. In plain English, the IV reflects the demand for such options, and when there is an increased demand, the option prices rise. If you enter a straddle before the rush occurs, you may not even have to wait for a strong move, the IV increase alone might make both your puts and calls profitable even before the news release. Dont get the idea, however, that you could buy long-term straddles in stocks with low IV and expect that the IV will increase sometime in the future, as such straddles are normally very expensive, particularly if you add a lot of time value. Further, the time value slowly deteriorates over time as Theta decays. There is at least one way to deal with Theta decay with straddles that is the basis for the PCCRC7 strategy (more about this later). Another interesting fact is that long-term options are very sensitive to rises in IV, but as already discussed, long-term options are expensive and still susceptible to Theta decay, although much less than the front month options. So why not sell front month options and buy back month options? B. The Calendar Spread: This spread, also known as the horizontal spread, profits from the passage of time, provided that the stock price remains within a trading range until expiration. A calendar is entered by simultaneously selling a front month option and buying a back month option of the same type (put or call) with the same strike price. However, there is something contradictory about the calendar spread: while the trade has a positive Theta, it also has a positive Vega, which means you profit when the IV of the back month options rises. On one hand, you expect that the stock will not move, but on the other hand, you expect that everyone else would think that the stock is about to move strongly, so they would buy options so that the IV would increase. If what I just said seems complicated, this is the very reason most traders should either avoid calendars spreads, or be prepared to spend much time learning and understanding their nuances. If the IV is too high, then perhaps the calendar spread is not a good choice. There are Delta-neutral trades that benefit from Theta decay, which are ideal for situations when the IV is already high. C. The Butterfly Spread: As the name implies, this trade has wings that determine the BEPs. A Butterfly Spread includes: 1. The sale of 2 ATM options. 2. The purchase of one option with a strike price above the current stock price. 3. The purchase of one option with a strike price below the current stock price. If the IV of an option is high, then you can spread the wings a little further out, and this increases your probability of a profit. Entering a butterfly during a period of high IV increases your potential reward, everything else being equal. As you can imagine, setting these butterflies to fit your expectations is hard, then your expectation has to be met narrowly. In addition, the profits in a butterfly change very little, even if the stock does not move at all until 10-4 days to expiration. Then the profits begin to mount quickly. However, if you do not close the trade before 4 days to expiration, your Delta risk increases and your profits may vanish, and exiting the trade may become difficult then. On the up side, butterflies are
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good instruments when you expect volatility to decline. I use the Analyze tab in the TOS platform to estimate my probability of success. If you make the wings too narrow, your probability of making money will be very low. If you make them too wide, your potential profit may be low. This risk/reward ratio is probably the most important factor in designing your butterfly. What I do often is a modification of the butterfly that introduces a bias to the upside or the downside. However, these are advanced trading techniques (more about this later). D. The Iron Condor (IC): The IC is composed of two vertical credit spreads, that should be equidistant from the current stock price, with the call credit spread above and the put credit spread below. I let the probability of success determine how wide the wings should be. I am looking for a 60% probability of success. This means that the higher the volatility, the larger the wingspan. However, if the IV is low, I might not even enter the trade. The IC is ideal for indices, such as the SPX, because even with rallying or declining strongly, they tend to stay within a range most of the time. This is why ICs are sometimes used as income producing trades, as one can easily enter an IC every week, so that the risk is spread over time. Because the chance of turning a profit is high, it makes sense to trade this way. However, the risk/reward ratio is usually 2:1, and if you have a series of failed trades, you can easily give back your gains of several months. The ICs and butterflies are good trades when the IV is high, and they can be used for premium collection when volatility is high. Yet they are relatively safe. In summary, Delta-neutral trading profits from Theta and Vega changes. At entry, Delta is nearly 0. In the case of the straddle, you would hope the stock moves strongly, but in the case of the calendar, butterflies and condors, you want the market to be stable. These strategies are the launching pad to understand and learn more sophisticated techniques that I will discuss below. I do not recommend these strategies, as discussed above, except for the IC with options in the SPX, provided that the IV is high enough to produce an IC with a wing span of more than 140 points. Remember that all of these trades can lose ALL the capital you put into the trade, and that in the case of the IC, you may lose all the capital you receive and then some (consult your broker about the margin requirement). Be sure that you understand how much you stand to lose on each trade, and do not exceed 3% of your account at risk on any single trade.
account at play while fitting my conservative risk tolerance of 30% of my account at any given time. Here I will focus on the Put-Call Calendar Ratio Combination (PCCRC) and other trading strategies that limit risk, maximize reward, and control time decay in a conservative portfolio. By now you have mastered the most common types of option strategies, but noticed that your drawdowns are rather large, but cannot explain why. Probably the most important consideration for anyone wanting to trade for a living is to keep the money you make. The beginner thinks that losing money is his fault, and that he has not worked hard enough to understand when to buy and when to sell. The trader making the transition to advanced strategies needs to focus on Risk Tolerance. If you have a portfolio of stocks without any option hedging, your theoretical risk is 100%, if the value of every stock you own declines to $0. In a portfolio of option strategies, the risk can also be 100%, and the loss can occur even faster than in stocks, since option positions have a limited time horizon. All option strategies have a risk on capital of 100%. All except one: the PCCRC (Put-Call Calendar Ratio Combination). This is a strategy that allows you to put all the capital of your account to work, with only a small fraction of the risk per trade and overall risk to your portfolio of options at any one time. The risk per trade is small or 2% of your account. Further, a portfolio of 10 PCCRCs would generate an overall risk to your account of 20%. Yet the potential profit is unlimited and the probability of success per trade is high, provided that you follow a set of rules. Is it realistic to have 10 PCCRC trades as the only trades in your portfolio? I have done it since 2007 in a paper trading account that I manage once a week during the OptionsVet Thursday webinar. The account started in mid 2007 has grown from $100,000 to $270,000. What is significant about this is that OptionsVet has a set of simple rules to locate, enter and exit trades. Any options trader that understands the strategies covered above can easily follow this approach without attending one webinar by becoming a member of OptionsVet and following the PCCRC Manual. The PCCRC is Delta-neutral at entry, but like the straddle has unlimited reward potential, provided that the stock declines or rises strongly. Also like the straddle, the PCCRC profits from any increase in IV. Unlike the straddle, however, the PCCRC can benefit from Theta decay. The name Calendar Straddle may be used, because it accurately describes the principle behind it: selling one front month straddle and buying two back month straddles. The trade effectively limits the risk from Theta decay, because the short front month straddle erodes quickly while the back month straddle is less susceptible to Theta decay. If you follow the rules of entry, you set yourself for large Vega profits, whether IV spike or increase slowly. In essence you have 7 out of 9 chances of making a profit (see Table 1). This is because when IV declines, either Theta decay or Delta gains compensate and make the trade profitable and vice versa. Losses are maximal, if the stock declines with low volatility, but even then the risk is limited to 2% of your account. However, stocks usually decline with spikes in volatility, which turns a profit. As with any form of trading, the PCCRC can produce losers, but a careful and thorough set of instructions and the discipline to follow them limits the risk to a minimum.
Table 1. Likely outcome with a PCCRC trade based on the stock price and IV changes.
IV Increase
Price Increase Price unchanged Price Decrease Prot Prot Prot
IV unchanged
Prot Prot Limited loss
IV Decrease
Prot Limited Prot Limited loss
A Portfolio of PCCRCs vs. a Portfolio of Stocks. The PCCRC is more than an adequate substitution for a stock position, because it has the potential for great profits, whether the stock in question declines or rises significantly. Since stocks have 100% of theoretical risk, a position with 20% risk is an excellent instrument for traders with low risk tolerance. If you have a mixed portfolio with option spreads and stocks, consider that every stock position takes a large portion of your accounts capital compared to the equivalent option position. This is what is usually called capital intensive. Think instead about the amount of risk assumed by individual trades, and calculate your profits at the end of the year by return on risk. This is important, because if you have gained 10% of your account by buying stocks on margin, buying and selling futures and shorting puts, you were in a more precarious position than if you had gained 10% in an account where you owned married puts, covered calls, and of course, PCCRCs. So focus not on the return on capital, but in terms of return on risk, while trying to put to work as much capital as possible. If you do this, the advantages of the PCCRC will become abundantly clear to you. A Portfolio of PCCRCs vs. a Portfolio of Options. If all you wanted to trade were option spreads, your account would be 100% at risk, and that is why we are routinely told that options are risky, not because of the inherent risk per se, but compared to a stock portfolio. Yet a stock portfolio is also 100% at risk, so the only explanation for this cliche is that you could hold stocks forever, until they go back to the price you bought them at, so you could break even, while with options you can lose all your capital in one trade in a very short time. Other than that, the cliche that options are risky is an overstatement. You could protect yourself against losing your whole portfolio of options in a very short time by diversifying it with bearish, bullish and delta-neutral trades. In addition to that, you can limit your risk per trade to 2%, 3% or up to 5% of your portfolio. But if you do this, youd need to monitor 20 to 50 trades in order to use all of the capital in your account. For most retail traders, this is a big load and requires full attention to search for, enter, monitor and exit each trade. Sometimes a surprising move in the market might turn our profitable trades into losing trades, because we did not have time to react and exit the trade at a profit. Multiply that by 20-50 trades and it can get very frustrating
very soon. Yet we want to use most of our capital with the minimum effort possible, particularly if we have another occupation or even a full-time job. With the PCCRC, a sudden movement in the market in either direction does not have immediate deleterious consequences, and we can easily manage to search for, enter, monitor and exit each trade with no more than 1-2 hours a week. I show how to do this in my Thursday 1-hr webinar, the only time I trade the PCCRC portfolio. Each PCCRC trade could be about 10% of your account, but risk only 2% per trade. That means that you could easily put your attention to a 10-position account and risk only 20% at any given time. Yet each PCCRC has the potential to double in value (sometimes more), but most often each trade returns 20% in a month or two. In my view, the PCCRCs are not capital intensive (in contrast to what some beginners might believe) for three reasons: 1) the capital at risk is minimal, and 2) they may be used as stock substitution trades, and 3) portions of the capital in each trade can be often be freed by rolling over the shorts from the first to the second month (more details about this in the PCCRC manual for OptionsVet members).
No matter how bullish you are when you consider T.A. and fundamental analysis, you have a steep hill to climb with that long call. The greater the possibility of a large move, the greater the intrinsic value of the options, due to their high IV (Vega), and the higher the cost of a call. Therefore, buying simple options is a low probability game. I have a different approach that will significantly reduce the BEP and that will reduce the impact of IV in your option trades. Increasing Your Probability of Success. Assuming that you have an account with $100,000 of capital, 100 shares of AAPL would cost you almost 39% of your capital. If you want to have a portfolio of 10 stocks, you could buy 25 shares, but then you could not effectively sell 1 call and/or buy 1 put for protection. If you entered a vertical spread, youd limit your potential gains and finally, as above, your probability of success would be low. In essence we want to reduce the BEP in the case of bullish trades, or increase it in the case of bearish trades, but not to the extent that we would limit our profit potential as happens when we enter vertical spreads. In a portfolio of options my goal is to limit our risk per trade to 2-3% and the overall risk of the account to 20-30%. Yet we want to put most (if not all) of our capital to work. We can accomplish this with a number of PCCRCs. Yet I am going to suggest a few directional trades with a maximum risk of 3% of your account per trade. Our goals could be easily accomplished with a few of the following directional positions with a probability of success of 50%-60% and unlimited profit potential:
Figure 2. Risk graph for a simple call option with about 1 month to Expiration on AAPL. Note the high break even point ($408.1 blue line).
A. The Call Ratio Calendar (CRC). By buying a number of calls that are more than one month to expiration and combining these with a lower number of short calls that are nearly 1 month to expiration, we can create the right proportion of options to meet the 50%-60% probability requirement, and that meet our required maximum risk exposure (not to exceed 3% of the capital in our account), while reducing the BEP to at or below current market price. Example: For the AAPL trade, we could buy 2 ATM calls that expire in January 2012 and sell 1 ATM call that expires in December 2011 for a debit of no more than $3,000 and a probability of success of more than 50%. Keep in mind that this arrangement depends on the IV, strike price, and time to expiration of the options (among other factors). The BEP is actually lowered to 387.70, below current market price. It is not difficult to enter a position that fits these requirements. I would prefer a 55-60% probability, and no more than 2% of my account of capital at risk. Keep in mind that the probability is theoretical and it is calculated at entry, but might increase or decrease as time progresses. The trade is Delta-positive, and Theta becomes positive as expiration approaches. Very importantly, there is a way to adjust this trade as the stock rallies by selling the outstanding calls (number of long calls in excess of the short lot), and buying the same number of calls at a higher strike price. For more details, please sign up for the Tuesday webinars, as I enter many of these trades routinely.
Figure 3. Risk graph for a Call Ratio Calendar (CRC) with less than 1 month to expiration on AAPL. Note the relatively low break even point ($387.95).
B. The Put Ratio Calendar (PRC). The rationale of the PRC is the same as that of the CRC, i.e. to trade directionally with unlimited profit potential and increased probability of success over the simple long put option. The PRC is a Delta-negative, Theta-positive trade and has a higher BEP than that of the simple put with enough flexibility to limit the risk to 3% of your account capital per trade. Your job, of course, is to find the candidates that have a chance to decline in price before expiration. CRCs and PRCs are Vega-positive, which means that they are susceptible to changes in IV. A spike in IV causes the trade to increase in value, while a decline in IV may cause a decline in value. If you pay close attention to the probability of success, and adjust the number of shorts to fit the probability of success requirements of 50-60%, then the effect of IV will be reduced, and the effects of Theta and Delta increased or decreased, so play close attention to make sure that the Greeks meet your expectations. But what if the IV is too high to create a PRC or CRC what would make sense? C. The Biased Butterfly. By buying a butterfly with more long options than short options in total, we create a bullish (call butterfly) or bearish (put butterfly) trade. There are a variety of butterflies we could enter depending on the number of contracts we buy on each wing or sell in the body of the butterfly. These are advanced trades that are difficult to fit exactly to your expectations, but when successfully done, the probability of success is large (>55%). When the IV is high, I tend to favor this approach, but only if I cannot find a good PRC or CRC candidate at the time. D. The Unbalanced Butterfly. This trade has an equal number of short and long options, but the number of long options in one of the wings is larger than in the other (usually 2 times as many). The result is a directional trade with high probability of success, but limited reward. The advantage is that if your target price is met precisely at the center of the cone (point of maximum profit in the risk graph), you can get a return of several fold in your investment. The goal of these trades is to increase the probability of success and take advantage of, rather than work against, Theta decay, while keeping the potential for excellent gains if your expectations are met. A portfolio of these trades can be quite profitable, provided that your expectations of directional movement of the underlying stock(s) are met. In my experience, these trades are relatively safe to trade even compared to the low risk/high reward PCCRC.
I would suggest that you trade a portfolio of up to 9 PCCRCs, so that the overall risk does not go far beyond 20%, and then add a few CRCs, PRCs, biased and/or unbalanced butterflies that, because their maximum risk is 100%, are going to increase the overall risk of your account to 30%. Modify this number according to your risk tolerance and also adjust the cost of your trade to your current account value. Note that the maximum risk on the PCCRCs is 2% and the maximum risk on the other trades is slightly above 1%. You could easily adjust these percentages based on your risk tolerance, but I would not exceed 3% on any individual trade. If the value of your account has been decreasing, so should the cost of your trades. That way you are not going to lose all of your account. If you lose 30% of your account at any time, stop trading, review and question your methodology, and start again from back testing to paper trading before you begin to trade again. Then start small, i.e. no more than 1% risk on any trade, and when your account is growing again and your confidence is back, then increase your risk per trade. This is the end of this guide. My goal has been to show you how options can be used both for leverage and risk management in a stock-free portfolio without margin requirements. I believe that this goal has been met, but please make sure that you test the assumptions made here before you use all of the capital in the account, and that you have the skill set necessary to understand the Greeks and the use of the facilities available in your computerized trading platform. If you still are unsure on how to trade using these techniques, please join one of my weekly webinars.
Figure 4. Low risk portfolio or options with 9 PCCRCs and other directional trades for a total of 28% with $100,000 of capital.