My Options Trading Approach explained

Newsletter – My Options Trading Unlocked : Insights for Tomorrow’s Profits

My overall portfolio trading process explained. The content of this post was the initial inspiration to a more extensive description of my options trading strategy that you can find also on my website : https://www.tradingoptionscashflow.com/my-approach-to-develop-a-methodic-options-trading-strategy-and-set-profit-goals/

Selling options for a premium

I have learned a lot about options trading by studying, reading and watching plenty of online content the last 4 years. One of my favourite content providers is Tastytrade, whos content have taught me lot and basically has provided me with a sound set of option trading principles which has increased my overall profitability.

And this without the need to predict the market !! We do this by selling options instead of buying options.

Remember : “When we engage in smart option selling strategies, we have the potential to increase our probability of profit considerably.” Option selling, also known as writing options, is a strategy where an investor sells options contracts to earn income from the option premium.

Even for traders with a couple of years of experience, just like me, it is very wise to refresh the basic knowledge about options and options trading regularly by re-reading articles and beginners guides. I do this frequently.

A while ago, I have written a beginner’s introduction to selling options , that I would advise you to read if you are a beginner. In this article, I explain a lot of the basics of options trading to more advanced strategies for selling options. Here are some of the key takeaways:

• Selling options can be a profitable strategy for traders looking to generate cash flow and limit their risk.
• Choosing the right options to sell is crucial and depends on your risk tolerance, investment goals, and market outlook.
• Risk management is essential when trading options, and strategies like stop-loss orders and position sizing can help limit downside risk.
• There are several popular options trading strategies that involve selling puts and calls, including the covered call, cash-secured put, and iron condor.

So, let it be clear, I am an option seller.

But where do I start and how?

First of all, you can not replace real trades and real trading experiences, but I do believe I need to have a plan or at least a well thought approach, using some sound principles.

I have picked up my trading principles from the research done by Tastytrade – yes I am a tastytrader 🙂

Determining the portfolio goals

So I was going to explain my overall portfolio trading process (briefly and to the point). So here we go.

A process is defined as “a systematic series of actions directed to some end”. In our case as option traders, that end is to make a profitable return. The actions are opening and closing positions and adjusting when necessary.

The key benefit of a trading plan is that it will help to remove the emotions of fear and also greed (!) from the decision making. 

To explain the trading process I use and my general approach in this newsletter, I will assume that you are at least familiar with the basics of options trading, how calls and puts work, the greeks delta and theta and the notion of buying power or maintenance margin.

If you don’t, that is ok too, but then I would advise to study these basics and notions first. I have links to articles and resources about it on my start here page of my website. And come back later here for a second read.

The first thing I do, when building or evaluating my options portfolio, is to figure out what value I want to have for my portfolio on overall time decay (theta), and what directional bias (delta) I want to have in the overall market?  These two parameters will largely determine the kind and the number of positions I will keep in my portfolio.

But the portfolio values of these two parameters are mainly determined by the portfolio size (or NetLiq – net value after liquidating all positions – of my portfolio) at a given moment. The portfolio size will determine portfolio parameters and goals.

In this (realistic – about the size of my portfolio) example, I will work with a NetLiq or portfolio size of $50,000.00

1. Let’s start with determining the portfolio theta

Theta measures the expected change in option price resulting from daily time decay of the option value. Portfolio theta is the sum of the theta of all of the portfolio positions.

Remember we are option sellers, so we sell the option for a premium we receive and we want to buy it back after a while for a lower price – so a lowering price due to time decay is beneficial for option sellers.

Because we consider to not be able to predict the way the market or the direction of stocks, the decay of time value of the option price is our bread and butter when selling options!

The portfolio theta level is of course also determined by the risk posture you want to hold. This is demonstrated in the table below:

The risk profile or posture that I have is for me largely determined by the value of the VIX, the volatility index of the market. When the VIX is high I will have a posture where I can take on more risk, than when the VIX is low. For premium sellers, a higher VIX generates more premium and it also decreases the possibility of losses by a sudden increase of the implied volatility of the option market.

In general, my aim is to be between 0,1 % and 0,3% in theta of the NetLiq of the portfolio.

Research (tastytrade) shows that we should be able to capture 25 % on average of the full theta value (because theta is not the only parameter).

For example : a portfolio theta of $150  (daily time decay) ->  (30x $150)*0,25 = $1125 / month time decay.

This means that on a monthly basis, my positions in my portfolio will lower about $4,500 in value, of which on average, I should be able to capture 25% as a realistic profit, being $1,125/month.

This would result in an annual value of theta return for a 0.3% goal : (0.3% of net Liq) x 360 days x 25% = 27% of my Net Liq or $13,500.

Not bad (great) for an annual return to aim for !

Do understand that these values are just reference points. It is clear that my positions may not always work out as intended or hoped for. But this approach gives me a goal to aim for when building positions.

I will show my theta value in my weekly newsletter overviews of my portfolio. I have deliberatly build in these parameters in my trading options journal spreadsheet.

At the moment of writing this article the VIX has been very low for multiple weeks now (14%), so this means I am very careful not to take too many positions. And I am closer to 0,1% that 0,3%.

2. Next step is determining the portfolio delta

Delta measures the expected change in the option price given a $1 increase in the price of the underlying (when all other variables stay equal).

Delta ranges from -1 to 1 and is a measure of directional risk (sign and magnitude), at position level and at the portfolio level via the “Beta weighted delta to SPY”

For delta there are three different pathways that we can choose. Based on my market assumption, I can make a directional market estimate and set portfolio delta (Beta weighted to the SPY) goal accordingly :

• Bullish -> positive drift -> positive (long) delta

• No direction preference -> neutral -> neutral delta

• Bearish -> Big moves hedge -> negative (short) delta

My overall preference (because I do not pretend to be able to predict the market) is to keep a relative neutral bias regarding the market direction.

3. Determine Buying Power Reduction / Maint Margin

Another important step in building the options portfolio is to determine the maximum allocation of the buying power to held positions.

The maximum portfolio allocation = the capital required (to be set aside in the account) to place or maintain a short premium trade is called buying power reduction or margin maintenance.

If you don’t have reserve buying power (or cash on top of the required Maintenance Margin), you risk to not be able to cover the raise in margin or required buying power capital in case of an outlier (a trade gone very bad), and you risk to have the position eliminated with big losses.

I typically use also the VIX as an indicator for my Max allocation and to manage exposure to outlier risk.

In the tastytrade approach it is essential to maintain small position sizes and limit the amount of allocated capital to short premium in relation to the VIX :

Another good general guideline for using the allocated capital to short premium is have a planned distribution of strategies :

• 75 % Undefined Risk strategies (Max 7% of portfolio Buying Power to a single position)

• 25 % Defined Risk strategies (Max 5% of portfolio Buying Power to a single position)

Although with smaller accounts this is harder to keep or maintain. And I have been opening very often undefined risk positions.

Building the options portfolio

Now with the portfolio parameters determined, we can start building with opening new positions.

1. Using stock indexes first

To start, it is smart to open new positions on market indexes, such as SPY, QQQ, IWM or TLT (and there are plenty more such as sector indexes) to give us broad market or sector exposure. 

By using market indexes before individual stocks, we’re positioning ourselves to have a smoother ride in generating portfolio returns or controlling portfolio risk from opening to closing.

Because these indexes are comprised by hundreds of different individual stocks. This way I am exposed to the systematic risk of the market (economic data, global growth, interest rates) and not to the unsystematic risk of individual stocks (earnings, company news).

I usually have positions in IWM or some sector indexes such as SMH.

When you are new to options trading and still learning how to apply and manage the different options strategies, using indexes is a great way to start building experience without individual stock risk.

2. Adding individual stocks to obtain the portfolio goals

it is very likely, that it is not possible to achieve my portfolio goals in portfolio theta and portfolio delta using indexes alone. 

As a result, individual stocks are required to do so.

The most important factor for stock selection, that I use to open new positions, is IVR (Implied Volatility Rank) of the selected stock.

IVR looks at the one-year range of implied volatility and sets the highest reading at 100 and the lowest reading at 0. Then, it expresses the current volatility reading as the Implied volatility Rank (IVR), as a percentage of that range.

I try to find good stocks with an IVR as high as possible and of at least >25.

This is important, because high IVR means higher option prices (you should study what elements determine the option price). We, option sellers, want option prices to fall over time, so we sell high and buy back low. And research shows that volatility does revert to its mean, which indicates that high volatility will go down to its mean over time and this means that option prices will go down to, and that is what I want as an option seller.

One note of caution, we never now how long “over time” will be, so it can be quite rapidly, but it can also take a longer time than we will hold on to a position too.

A second parameter for stock selection are earnings announcements. I prefer to avoid holding positions through earnings because stock can fluctuate heavily after earnings calls. My biggest losses have been related to earnings, so I have learned my lesson.

I use the tastytrade platform to sort stocks by IVR and to filter out stocks withe earnings announcements.

Management of portfolio positions

While most portfolios will have a mix of undefined-risk strategies and defined-risk strategies, these two categories must be approached differently when it comes to portfolio management.

For the daily management of the portfolio, I can encouter two types of problems.

On the stock position level, I have to watch out for huge stock moves, strike prices which are breached and the number of days to expiration (DTE). I typically manage the position around 21 days DTE, the best moment according to tastytrade research.

At the portfolio level, I keep an eye on the “theta level” and the “delta level” of the portfolio and I adapt accordingly when it is appropriate to keep on track towards my portfolio goals. The priority for possible adjustments goes to the position level first and then to the portfolio level.

I have included these parameters in my trading options journal so that I can track these parameters very easily.

The management of options strategies will be addressed in later articles and newsletters because they require an in-depth study and knowledge for each of the used strategies. The management requires some time to study and with executing real trades you will get to practice and you will learn fast.

Conclusion – Weekly overviews

This brings me to the end of this article and I really hope this overview of my overall approach of my portfolio trading process gave you some new insights and maybe some great ideas too.

The content of this post was the initial inspiration to a more extensive description of my options trading strategy that you can find also on my website : https://www.tradingoptionscashflow.com/my-approach-to-develop-a-methodic-options-trading-strategy-and-set-profit-goals/

You will receive future newsletters with the weekly recap of my portfolio, where you can see how much I stick to my approach as I have just described.

Please never hesitate to write a reaction or question in the comments below or contact me by email if you have any questions

Let’s generate cash flow together !

P & K