My Millionaire Goal

A delta neutral trade, simply stated, refers to a trade that will make money regardless of market direction. Thus, a delta neutral trader need not be concerned about the market direction. The strategy I mentioned in my previous post: the Iron Condor, is an example of a delta neutral strategy.

Suppose AAPL is currently trading at $180. To sell an Iron Condor, I may sell a $160 PUT and a $200 CALL (and at the same time buy a $155 PUT and $205 CALL to protect myself). As long as AAPL stay within the $160 and $200 range, it can fluctuation up and down within that $40 zone and I will still make money.

The main advantage of the iron condor is that there is no need to predict market direction. I always believe that unless you have a crystal ball, it is not possible to predict where the stock market will go the next day… or even the next minute, for that matter. Instead of being bullish or bearish on the stock, and predicting the direction of the stock, I predict where the market WILL NOT go. Personally, I found the latter a lot easier to do than the former and have had a much higher success rate.

Another advantage of a delta neutral trade is that your losses are normally lower. This is because only one side of your trade can be wrong. Put another way, at any time, at least one side of your trade will be profitable. For me, it is nice to know that I am at least ‘half’ correct.

For instance, suppose AAPL moves up to $199, threatening the $200 CALL position that we sold. If we are still a few weeks away from expiry day, our $200 CALL position will probably show a paper loss. However, even though we lose money on the CALL position, the $160 PUT that we sold will show a paper profit. Although this profit may be lower than our loss in the CALL position (resulting in a NET loss), the loss will be much lower than if we have only sold the $200 CALL. In fact, if the position has already been opened for a few weeks, it is often possible to exit at a very small loss.

Thus, unless a stock is trending very strongly and I am convinced that the direction will continue, I would prefer to enter a delta neutral position.

In my previous post, I talked about compounding money at a rate of 5% per month… This may not sound like a lot, but if you understand the power of compounding, you’ll appreciate that with 5% per month, your money will grow by about 79.5% in one year!!! I don’t know about you, but I’ll be pretty satisfied with such growth rate… imagine getting a 79.5% increment in your wage every year….

So, the million dollars question (no pun intended) here is: How to grow your money at 5% per month…

My answer? SELL IRON CONDORS….

What are Iron Condors?

An iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit. It consists of a combination of a bull put spread and a bear call spread*. It is best used when one predicts that the underlying asset (e.g. a company’s stock) will not move beyond a certain price range.

For instance, let’s consider an actual iron condor position in GS (Goldman Sachs) that I had in the month of August.

Using options expiring on the same expiration month (August in this case), I created an iron condor by selling a lower strike OTM Put ($145), buying an even lower strike OTM Put ($140), selling a higher strike OTM Call ($175) and buying another even higher strike OTM Call ($180). This results in a net credit of $131 per lot (before commission).

Notice that an Iron Condor ONLY involves OTM options. Since I sold a OTM Put and a OTM Call, I have no risk of being assigned as long as GS trades within $145 to $175. That’s a pretty wide range for a stock to move within a month. In addition, the 50% and 61.8% Fibonanci levels of GS was at $149.14 and $173.35 respectively. So I was pretty confident when putting on this trade. Eventually, the trade went well and all the options expired worthless.

(How I view Iron Condors….)

Why do I love Iron Condors?

Limited Risk

Maximum loss for the iron condor spread is limited, although significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.

For instance, in the example above, if GS does not stay within the $145 to $175 range, I will start to lose money.

Case 1 (GS stock price is $178 on expiry date)

If GS goes above $175 and continues to rise to $178 on expiry date, I will lose ($178 – $175)*100 = $300 per lot (1 option lot = 100 shares). This is because the buyer who bought the $175 CALL option from me will now exercise his option and ‘demand’ that I sell the GS stock to him at $175. Since I do not own any GS stock, I’ll have to buy it from the market at the market price of $178, resulting in a loss of $300. However, since I received a premium of $131 when I sold my Iron Condor, my final loss is actually $300 – $131 = $169 per lot (still a very ugly loss).

Case 2 (GS stock price is $20000 on expiry date)
If GS starts a mad rally and suddenly shoots above $175 to $20000 on expiry date, my loss, fortunately, is not going to explode through the roof. Since I bought a $180 CALL to protect myself, I’m not gonna lose my pants… I do not need to buy the GS stock at the market rate of $20000. I can exercise my CALL and buy the stock at $180, resulting in a net loss of $500 – $131 = $369. Good luck to the seller who sold me the $180 CALL ;p.

But seriously, although my loss in this transaction is capped at $369, I’ll freak out if I really lose such an amount… (well, not really, but I really don’t consider it worthwhile losing $369 when I could have reduced the loss if I acted earlier)…

I am extremely risk-averse… which explains why I never busted my account… Therefore, I will never allow my Iron condor positions to go against me to such extent… I’ll probably close the position at breakeven or a small profit once the stock gets too close to my “defense lines”… I’ll talk more about my exit strategies next time…

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* If you are totally new to options, do check out my “Options Trading 101” guide. It’s largely incomplete at the moment, but I’m working on it…

Over the years, whenever I tell my friends that I am going to be a millionaire, none of them really believe in me… But at least they are polite enough not to laugh at me in my face… though I seriously think most of them think I am dreaming an impossible dream… But, am I?

Is it really possible for an average individual (i.e. an individual not born with a golden spoon, doesn’t have Bill Gates’ IQ, and doesn’t have the looks of Angelina Jolie/Brad Pitt) to become a millionaire?

The answer is a definite YES…. why so? The method is actually very simple….

drum roll please….

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through

“COMPOUNDING” your money

Albert Einstein once said:

The most powerful force in the universe is compound interest.

I worship this statement, because I know that this simple truth is the only answer I need in my quest to becoming a millionaire… Being a Math nerd like I am, I naturally translated this statement into numbers…

Assume I start with $10,000…

If I can compound this amount at 5% per month,

After 1 year, I would have $10,000*(105%)^12 = $17, 958.56..
a pretty decent growth… but still miles away from a million….

After 2 years, this $10,000 would have grown to $32,251…
Still far from a million….
but notice that in the second year, my money has grown from $17,958.56 to $32,251… an increase of $14292.44…
whereas in the first year, the money only increased from $10,000 to $17,958.56… an increase of a mere $7,958.56….

That’s the beauty of compounding your money… the longer you compound it, the faster it’ll grow…

If you can leave the money alone and let it continue to compound… after 8 years, this $10000 would have compounded to $1,081,864.10… That’s $1 MILLION…!!!!!

So, plainly speaking… If we can set aside a certain amount of money and let it compound… our money will grow at a faster and faster rate until it eventually becomes a million dollars!!!!

Of course, the above example assumes

1) You have $10,000 to start with
(which I have.. and I think most people should be able to accumulate if they are frugal and hardworking enough)

2) You do not need to touch this $10,000 for the next 8 years (not a problem as long as you still keep your job)

3) You are able to compound this amount at a constant rate of at least 5% per month…

Now, point 3 is where it gets ugly… that’s the challenge… which is why I explore options trading… cos only with options trading (or other forms of trading that offers some form of leverage*) can I hope to achieve this growth rate… I’m glad to say that my performance is so far pretty decent… maintaining a growth of about 5-10% per month….So, will I become a millionaire one day??? Time will tell… although I can’t imagine why not… maybe not by 2012, maybe not in 8 years time… but definitely one day….. and I don’t intend that one day to be when I am in my 60’s…

So, join me in my quest… and we can learn and strive together…

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*Leverage: Another ugly word… a double edged sword… I’ll talk more about that in another post…