This post is about how any size account, even a relatively small one, can increase the efficiency of their trading method while alternating from full-risk to reduced-risk over and over again. Travis @RaadiaCapital has been kind enough to add important context to this post and his comments are in red. Get ready to learn some things!
My current position is a July SPX Call Condor. Long 1.34 Deltas and $7.68 in Theta. Total cost is $2,211 with no margin requirement. The Theta currently represents an approximate ROI of 1.75% per week.
[A side-note about the PDT Rule: If trading a sub-$25k margin account, it’s critical to know how your broker treats multi-leg spreads. Most, like TD, treat spreads as a single trade for purposes of the PDT Rule, as long as those spreads are executed as a unit. So if you open a condor and get stopped out of it the same day, it counts as one trade. But a few brokers, like IBKR and Fidelity, count spread legs as separate trades, even if they are executed as a spread. A condor has four legs. So, if your broker counts each of those legs as separate spreads, then opening and closing the position on the same day will result in an immediate PDT flag (i.e. four or more trades in a rolling 5-day period). There are four ways around this problem: (1) switch brokers, (2) don’t trade condors, (3) make sure your opening position is gentle enough that you can afford to keep it open until at least the next trading day, even if the market moves hard against you, or (4) plan to “stop out” of the position by morphing it or adding hedges that you can hold for at least one trading day.]
The position consists of two components:
A Call Vertical Debit Spread.
A Call Vertical Credit Spread.
Back to looking at the original positions with two potential adjustments. Both adjustments downsize the position and alters the Delta (directional) risk.
If the chart indicated SPX in a downtrend I’d sell the debit spread. That would result in owning a Vertical Call Credit spread that would be short Deltas.
If the chart indicated SPX in an uptrend I’d buy back the credit spread. That would result in owning a Vertical Call Debit spread that would result in being long Deltas.
[An important note about planning your trades: Most of the advanced strategies we discuss here at Vega Options involve starting out with a relatively high risk position and progressively hedging that opening risk out of the trade. Those strategies are very powerful, but they can be challenging for inexperienced or small-account traders to manage properly because they require the most risk at the most vulnerable moment — the beginning of the trade. That’s why we preach good trade location and discipline with stops!
The approach that I’m showing you today basically turns our standard approach on its head by starting with the gentle, fully hedged position (like a condor) and then gradually adding exposure as opportunities arise. This approach may be less intimidating for inexperienced and small-account traders. The opening starts with much gentler and easier to manage. Our opening condor is relatively cheap and very forgiving. And you could trade these positions successfully without ever bothering with adjustments; just open, take profit, take stops.
But nothing in the market is free, so what’s the catch? The catch is that executing the adjustments discussed in this post involves adding risk to your position. And any time you’re talking about adding risk, you are also talking about adding cost – either in the form of debit or margin.
So when you’re thinking about opening a trade like this, it’s important to think a few steps ahead. Don’t just ask “Can I afford this condor?” Also ask “Can I afford the adjustments I might eventually want to make to this position?” Let’s take a look at how we might answer those questions in the case of our example trade.
Our opening condor cost $2,211 per spread, and there was no margin requirement. So as long as your account had at least that much available cash, you could open this trade. But what if you wanted to make one of the adjustments discussed above?
Let’s say the trend turned bearish, and, as illustrated above, you wanted to add short deltas by closing the 4500/4600 debit spread and holding the 4700/4800 credit spread? Well, first you have sell to close the 4500/4600 debit spread. At the time we initiated this trade, we could have sold the debit spread for a $6,310 credit to our account. Nice! But keep in mind that if SPX has already moved against your position, the debit spread may be worth much less. And once you’ve closed the debit spread, you’ll be left with a 100-point wide credit spread. You got a credit to open that position and didn’t have to pay margin because the credit spread was hedged by the debit spread. But now that you’ve sold the debit spread, your broker is going to impose a margin requirement for you to continue holding the credit spread (Margin is required because credit spreads can lose more money than the opening credit, and your broker wants to make sure that you have cash set aside to cover that risk.) Most brokers will calculate that margin as the width of the spread minus the credit receive. In our example, that works out to $5,986. In that case, the overall cost of your position would actually be reduced, after factoring in the $6,310 credit for selling the debit spread. But other brokers impose a margin equal to the max width of the spread. In that case, the margin on our 100-point wide credit spread would be $10,000. In that example, the net cost of your position after adjustments would be $5,901 — 266% the cost of our original condor.
And what if the trend turned very bullish and you decided to make the adjustment shown above and add positive deltas by closing the 4700/4800 credit spread and holding the 4500/4600 debit spread? Well, first you have to buy back the credit spread. The price of that spread will depend on how the price action has developed since you opened the position. But if you wanted to execute this adjustment immediately, it would cost $3,740. And if SPX had already moved higher, the credit spread could cost a lot more. Plus, once you’ve bought back the credit spread, you’re left with a 100-point wide debit spread. There is no margin for that spread, but you now have to pony up the full cost of buying it, since you can no longer offset that cost with the credit collected from the credit spread. At the time we opened the trade, the debit spread cost $6,225. And again, if SPX has already moved up, this spread may be significantly more expensive than it was at the beginning of the trade. All told, executing this adjustment even in the relatively favorable circumstances at the beginning of the trade could easily cost you least $9,965 — or 450% the cost of the original condor.
So as you can see, if you’re planning to adjust your cheap opening spread, you need to think carefully about what those adjustments might cost and then keep enough cash on hand to comfortably cover those adjustments when the opportunity strikes.]
I would suggest a limit of one trade per day to avoid excessive commissions. The only exception to that rule would involve being stopped out of a trade that was placed during the session. That would be considered a day trade and accounts under $25k would be limited to 3 of those over a 5 business day period. While SPX is trending no trades are made until the trend reverses. A method of determining trend on a daily chart could be as simple as being long Deltas on a close above the HB line and short Deltas on a close below the HB line. Having both positions on will lower Delta risk during periods of choppy/trendless trading.
One important note: while this method works well for any stock or ETF, I typically only use it on index options, primarily SPX, due to the wash rule exemption for index options. If you don’t know what the wash rule is, google it!