My Millionaire Goal

Back in 2006, when I was introduced to options trading, the first thing I did was to hit the library to find out more about this exciting financial product.

I forgot the title of the first book I read, but I remember it gave a very simple and nice introduction to what options are. One thing I distinctively remembered about that incident was that after reading the book, I thought to myself: “Why are options considered dangerous?”

I mean, since options are much cheaper than stocks themselves, and the most you can lose is the premium you paid, why are they dangerous? Aren’t they the safest way to bet in the stock market? Yet, I also recalled how Nick Lessen broke Barrings, since that happened in my country, Singapore… I left the library feeling perplexed, but nonetheless hopeful… I guess, like many other newbies, I was “lured” by the concept of limited risk, unlimited potential… Years later, I would reflect on that moment and laugh at my own naivety….

Coming from a mathematical background, I understood the concept of leverage easily. I understood how leverage can be risky, so I figured that I would only buy one lot each time. Even if I lost 100% of my premium, it would only be a small percentage of my account… However, what I did not understand at that point was how the odds are heavily stacked against an options buyer….

Now, I understand that buying options is pretty much like buying lottery… both promise a CHANCE to win big with only a small investment… but the chance of winning is so slim that eventually in the long run, we’ll end up losing…. we may convince ourselves otherwise, thinking that with all those fanciful technical analysis, we are not gamblers… but that is so wrong…

If we consider the odds of buying options, we’ll realize that 80% of the time, options expire worthless. As an options buyer, you only have a 20% chance of winning…. that means, your average profit must be 4 times your average losses in order for you to just break even… and that is without considering commission… if you add in commission, your chance of breaking even is even smaller…

In contrast, an options seller is like the lottery company, they can afford to pay out millions of dollars to winners each month, because only a small (probably negligible) percentage of lottery buyers will win… the odds are so much in their favor… the amount that they collect from those who lost, more than cover for the winning payout… Similarly, options sellers have a high chance of winning, and their frequent profit will more than cover for their occasional losses…

I learnt about the odds of options trading for some time before I fully appreciate it… In the beginning, I traded options like stocks, buying CALLs and PUTs to bet on the market direction… I won some, I lost some… but after 1 year and $1000 down, I was finally convinced that options buying is too difficult a game for me… To win, you need to be right about the direction AND the timing… Now, I don’t predict market direction… I spend less than 15minutes trading each night, and after selling options for about 6 months, I’ve made back what I lost and some more….

So to answer the question in the title…. SELL!!!

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…