My approach to a methodic options trading strategy and profit goals

Content

1. Introduction
2. Setting My Financial Trading Goal
3. Developing the Trading Strategy to reach my trading Goal with Success
   • Portfolio Parameters & Portfolio Targets
     • Net Liquidation Value – Net Liq
     • Theta
     • Delta – SPY Beta Weighted Delta
     • Volatility
     • Delta-Theta Ratio
   • Account Managing principles & Account Targets
4. Conclusion

1. Introduction 

Options Trading without a clear financial trading goal and an effective pre-determined thought out trading strategy to reach that goal, is just as a ship without a captain or without a compass. It lacks direction and purpose, and so are option traders without clear goals and strategies. They lack guidance and a sense of purpose in their actions. They may drift aimlessly, making impulsive decisions, without a coherent plan, often based on short-term guesses often leading to unfavorable outcomes.

After a few years of being active in the world of options, and almost daily intensive learning, practicing and managing my trades, I have come to realize that I haven’t clearly written down “my goal and my path” as well. I have learned plenty about options trading from very different convincing and educational sources and all that valuable information has led me to my current approach to options trading. Although I have always formed a good and clear idea, more or less, about what I was aiming for, I was not really acting in a systematic way in order to reach my desired targets. 

Defining a well thought out system of trading principles for opening, managing and closing new positions and managing the trading account, and its parameters as a whole, would certainly, if well and consistently executed, result in better if not much better trading results.

Hence my need to put my goals and targets in writing, and turn it into a guiding document, allowing me to parameterise my options trading. And as always I like to share how I do this and the result of this exercise “to develop my methodic options trading strategy and profit goals” with you all. 

I would like to have a comprehensive approach to developing the trading strategy I will apply : with factors such as financial trading goals, accepted risk levels, selection of trading products and coherent management principles at the individual position level and at portfolio/account level are paramount in forming an effective trading strategy.

In option trading having the wrong plan can result in serious losses. Conversely, a well-executed trading strategy can yield significant profits.

For any strategy in option trading to be sustainable, it has to provide clear parameters to guide trading actions, and these parameters need to be understood by the trader and defined based on empirical studies and research and not on wishful outcomes or gut feelings. 

I must add as a warning to the reader of this article, that I will not explain all the concepts and all the parameters inherent to option trading in detail here. You should have studied and understood them first to completely grasp what I am writing here.

2. Setting My Financial Trading Goal

A financial trading goal is a precise amount of profit you want to get or earn as a return on your reserved capital for trading.

When I started trading (stocks at first), my financial goal was clear and simple in my mind : I wanted to preserve my capital (yes I know). After learning options trading and studying the research provided on the Tastytrade platform, I have started to apply a more probabilistic approach to option selling for creating cash flow. My returns improved drastically and, even more important, the good results have grown my confidence to handle different trade situations.

After starting my options trading journey and having experienced some very successful naked put trades in a rising market, I have added a second goal besides preserving my capital : I wanted (hoped for) to generate about 35 % yearly return or almost 3% monthly return on a consistent basis to generate income (wow what a difference, and a challenge). 

And after experiencing a down market, it was clear that it was a lot easier to make good profits in a bull market, and I absolutely did not reach my desired target return. The reason why I did not reach my desired target, is almost certainly because my target was not backed by a well thought through trading strategy on which I could act.

And this has changed from this moment forward. It am committed to write my strategy, and plan and execute my trading based on this strategy. That is my commitment.

My financial trading goal is fixed at 2% of Net Liquidation Value Monthly return, on average throughout the year. 

This will make it an ambitious target of 24% of yearly return, but also a realistic target because of the underlying developed strategy based on parameters, principles and risk management. My reasoning behind this targets is explained in the next chapters of this article.

3. Developing the Trading Strategy to reach my trading Goal with Success

How to be confident that this previously set goal is realistic ? By developing and building an underlying strategy based on sound understood parameters guiding my trading actions.

The two main parts of my trading strategy, we need to reflect on of are : 

1. Portfolio Parameters & Portfolio Targets
2. Managing Principles 

a. Portfolio Parameters & Portfolio Targets

What parameters do I want to know and follow at portfolio level?

First of all, let me clearly state that I will not explain the meaning of the different options trade and portfolio parameters. I expect you to have done that research so that you can follow along.

Net Liquidation Value – Net Liq

So, it all starts with having a clear idea what our trading capital is, the amount that I can put to work. 

With no positions open, the trading capital is equal to the cash in the account. 

With stock and options positions open, we will rather use  the notion of “Net Liquidation Value” or in short Net Liq, as the value equal to our trading capital.

The Net Liq = Total cash value + stock value + options value (+ bond value)

In other words, it’s the theoretical value of your portfolio if you liquidate all of your positions at the mid-price. To demonstrate the different reasoning and parameter calculations , I will work in the examples given with an account with a 50.000 USD capital or Net Liq. 

With Net Liq given I can calculate my desired profit targets : 

• the monthly profit target : 50,000 USD x 2% = 1,000 USD
• the yearly profit target : Monthly x 12 = 12,000 USD =(24% ROC – Return on Capital)

You know option traders can profit from short option positions in 3 ways : being directionally right, the passage of time and a drop in volatility and thus options prices. 

Let me start by setting my Theta goals first.

Theta

The general idea of many option trading strategies is that Theta is the main bread and butter, the main source of profit. This is not different for me. It is all about execution.

Theta is the Greek that measures the rate of decay of an option’s extrinsic value relative to the passage of time. 

“Extrinsic value” = time value and volatility value. While “intrinsic value” is value that does not decay and is static, based on where the stock price is relative to the strike price. So we get our profit from “time decay,” because all else being equal, options lose extrinsic value as they get closer to expiration. And “we don’t know anything” but I can be sure of one thing : the passage of time !

Theta is calculated using complex mathematical models like the Black-Scholes model, but we can have the broker’s platform perform these calculations for us and we can get the theta values there. Theta is positive for short options, indicating that time decay is theoretically beneficial for the option seller.

While the deployment and management of individual positions is very important, strategic control of theta at the portfolio level can be equally critical. Portfolio theta is the sum of the theta of all individual positions in the portfolio. A portfolio theta of $100 would mean that a trader theoretically collects $100/day in decay. 

So how much Theta am I aiming for then?

Let’s put my reasoning in writing here . What we’re going to do, is we are going to look to target a specific percentage of Net Liq (or net liquidating value) in daily theta. Generally speaking we get this percentage to fall in a range of 0,1 % to 0,5 % of our Net Liq, in daily theta expressed in valuta (USD) amount.

Target numbers on the lower end of this spectrum like 0,1 %, these are more conservative whereas numbers on the higher end of the spectrum like 0,4 or 0,5 % are going to be a lot more aggressive. Numbers in between of course like 0,2 or 0,3 percent these are kind of middle of the road.

Let’s make it practical : a theta of 0,1 % on a 50,000 USD account translates to 50 USD in daily theta decay, whereas 0,5 percent on that same 50,000 USD portfolio would be 250 USD in daily theta.

Research shows that it is a fair and realistic approach, to expect to capture with our short options positions (and the way we like to manage early) about 25% of the daily theta on average. This expected average number accounts for all the bigger winners and all the bigger losers. The strength of having this number determined, is that it allows us to have a great reference point for estimating returns, when it comes to our daily theta capture. So let us assume 360 days in a year and imagine 0,1 % in daily theta. This would be result in (360 days x 0,1 % =) 36 % return for the entire year. In our fair expectancy approach that assumes that we only expect to capture 25 %, this would mean to arrive at (36% x 0,25 = ) 9% return per year on average from theta decay.

Now, you can notice this number scales with the target theta %, eg. theta with 0,2 % arrives at 18% on average per year and so on. In the table below, I calculate what this means for different account sizes and different target theta levels.

Theta % of Net Liq Portfolio	Theta Value (50,000 USD)	Exp Capture of 25% of Theta Value (360 days)	Exp Return	Position / Risk factor
0,1 %	50 USD	360 x 0,1 x 0,25 = 9% of Net Liq	4,500 USD	Conservative
0,2 %	100 USD	360 x 0,2 x 0,25 = 18% of Net Liq	9,000 USD	Low – Normal Risk
0,3%	150 USD	360 x 0,3 x 0,25 = 27% of Net Liq	13,500 USD	Normal – More Risk
0,4 %	200 USD	360 x 0,4 x 0,25 = 36% of Net Liq	18,000 USD	Increased Risk
0,5%	250 USD	360 x 0,5 x 0,25 = 45% of Net Liq	22,500 USD	Aggressive

These numbers look spectacular at first , don’t they, but I need to take pay attention to the last column ! You need to understand that it’s never going to be as simple as just putting on your half a percent in daily theta and sit back … Markets move and so does option parameters and the position risk factors.

Delta – SPY Beta Weighted Delta

You and I, we know that traders should follow the market and also stock evolutions to have “a good idea”, based on overall trends, where a good strike price for a new option position should be, and if we should open a trade or not.

But remember, I said that I am a believer of the saying : “Nobody can predict what is next and where the stocks and stock market is going !” 

This means that playing directional is not my main bread and butter for making a profit trading. I really prefer to be directionally neutral, also known as delta neutral. And this, as much as possible at individual position level with strangles for example, and most importantly at portfolio level.

Now let’s focus now on how this delta option parameter, besides the theta parameter plays a role in the results of the options account.

Since I have decided to stay non-directional, meaning I want to protect myself against market movements, up and down, by keeping my delta as neutral (in theory 0) as possible all of the time, and have, in theory, a theta as large as possible. In practice, keeping the portfolio delta to zero all of the time is not achievable, because the delta moves as the price of the underlying moves. And you don’t want to be constantly (over-)adjusting your positions either.

In order to know if I am delta neutral, I need to track the price impact of a position. I can do this by tracking the SPY Beta Weighted Delta of that position on the result of my portfolio. And as stated, I prefer to have this parameter as neutral as possible (I don’t know anything about what the market or what the stock will do).

The sum of all the SPY Beta Weighted Delta of my individual positions will give the overall SPY Beta Weighted Delta of my account, of my portfolio.

Beta weighting to the SPY allows me to assess all of my positions relative to a move in the market (SPY). In other words, it tells me the theoretical dollar move of my portfolio or position given a $1 move up in the underlying, that we are beta-weighting to, the SPY in my case.

When the beta-weighted delta is positive, then, in theory, your portfolio or position is positively correlated to the underlying. However, when the beta-weighted delta is negative, then it indicates that your portfolio or position is negatively correlated with the underlying. 

So, since I have no bias related to market direction, I want to keep my delta’s in line – as neutral as possible = as close to zero as possible – at portfolio level. It is obvious that at the position level, it is for some strategies (eg. naked short puts) impossible to have a neutral delta. And in practice, because we can’t make adjustments continuously to keep the delta at 0 (unnecessary high fees), I will of course focus on a relatively neutral delta at portfolio level, let’s say more like a neutral range.

It is my job as a trader to monitor and try to keep my Portfolio SPY Beta Weighted Delta in “the Delta Neutral range”, being between -0,1 % of Net Liq and +0,1 % of Net Liq.

This means with an account of 50,000 USD :  Portfolio SPY Beta Weighted Delta is between” – 50 USD en + 50 USD”. So when the SPY moves up or down $1, the impact on my portfolio is limited to + 50 USD and – 50 USD.

Let me be clear again: my aim here is to remain relatively independent of the market direction. And this means that when opening new positions and/or adjusting positions that I will try to improve my Portfolio SPY Beta weighted Delta in the direction of zero, or back into the preferred delta range. Or when the market moves against my positions, I may need to adjust my existing positions to get my portfolio delta back into the desired range.

As a quick side note, I must add that I even have a small preference for being short delta (under 0) because historically market crashes occur faster than the steady slower positive drift rise of the market. So a small short delta at portfolio level will protect me better to such a down move.

So without a crystal ball (like all hedge funds managers and investment advisors have) it is hard to predict market direction. I will need to profit as much as possible from the two other parameters influencing my profit potential : we already spoke about theta, or Passage of time. The other one is Volatility, so let’s take a look at that one now.

Volatility

Volatility plays a pivotal role in determining option prices and as a consequence significantly impacts the results and strategies of option sellers.

The general public understands the notion of volatility as “a tendency to change quickly and unpredictably”. Volatility can be a very important factor in deciding what kind of options to buy or sell.

Historical volatility reflects the range that a stock’s price has fluctuated during a certain period in the past. When we are strategising our option trading, we are more interested in the future volatility, aka Implied Volatility (IV). IV is simply an estimation of the future volatility of a stock or index, based on the current traded option prices and which reflects market expectations of future price swings of the underlying stock. IV is a part of the option pricing model and this means it is a crucial consideration for option sellers.

When market uncertainty (IV) is high, this is reflected in option prices. And this is beneficial for me as an option sellers, it means more premium for the same strike compared to a low IV environment, or the ability to select a strike further away from the stock price while still collecting a decent premium. So I seek to sell options at a high price, preferably when implied volatility is relatively high to maximize the premium received.

Research shows that, historically speaking, Implied volatility has shown mean reversion characteristics : IV tends to revert back to its average value. So when we see a spike in IV, we can use this spike to sell for higher premium and strategise for a contraction towards the mean.

If you look at the VIX, which reflects the 30-day S&P 500 implied volatility, you can clearly see a trend of mean reversion: every spike in implied volatility, which implies a spike in the extrinsic value of option prices, tends to be followed by a contraction in IV, or contraction in the extrinsic value of an option’s price. This characteristic of mean reversion of the IV is a typical characteristic for stocks and impacts the option pricing.

As IV has the tendancy to revert to its mean overtime, as option sellers, we can benefit from selling options with high IV (above the mean) for two reasons : first of all, with an already high volatility, it is less likely to get a high volatility expansion which results in less risk and secondly, a volatility contraction will lead to lower option prices, all other parameters remaining equal, which is beneficial for option sellers, because they aim to close their positions by buying back the options at a lower price, and having a higher probability of profit when doing so.

With this being said, it is clear that understanding Implied Volatility (IV) is probably the most important concepts to learn and grasp when you want to become a skilful and successful option trader. And it is probably the most important parameter that will guide you in deciding what options to sell or buy. Implied volatility can be seen as an accelerant to expected option price decay, assuming IV contracts after we enter a short premium trade.

In order for expanding IV to be used as an accelerant to our potential returns, we need to be very selective with trade entry. If we enter a premium selling trade in low IV and IV expands just a few days later, this expansion is now a nuisance, considering the fact that our options extrinsic value has now increased, and we will probably have a losing P/L. This is why, in periods of low IV, it’s not uncommon to see premium sellers sitting on the sidelines, waiting for a better opportunity.

In order to know when volatility is high or high enough, I use, as most option traders do , use the parameter Volatility Rank (IVR). IVR is measures the current level of implied volatility in a given underlying compared to the last 52 weeks of historical data. IVR is on a scale between 0-100, where 0 represents the low IV% print for the year, and 100 represents the high IV% print.

So in my trading strategy, I will try to open positions at high IVR. And I prefer to look at an IVR above 50%, which can be indicative of an attractive opportunity to sell options. But also here, profit in mean reversion trades is by no means guaranteed, because IV can remain high for longer periods too.

Delta-Theta Ratio

I use the Delta-Theta ratio of my portfolio as a tool or a metric to assess the balance of risk and reward in my options trading portfolio.

Theta represents time decay, which is the rate at which the value of an option decreases as it approaches its expiration date. And Delta represents the sensitivity of an option’s price to changes in the price of the underlying asset, and is in fact a measure for directional risk.

The Delta / Theta ratio, compares the rate of change of an options position’s delta to the rate of change of its theta. A high ratio indicates that the position or portfolio is more sensitive to changes in the underlying asset’s price, while a low ratio indicates that the position or portfolio is more sensitive to changes in time decay. In other words, a high ratio means I am relying more on price movements for profit, and a low ratio means I am focusing more on making money from time decay

eg. Imagine my portfolio with a SPY Bw Delta of 20 USD and a Theta of 80 USD : The Delta/Theta Ratio is 20/80 equal to 1:4 or 0,25. A couple of weeks later the SPY Bw Delta of 50 USD and a Theta of 90 USD : The Delta/Theta Ratio is 50/90 equal to 5:9 or 0,55. In this latter case I am twice as sensitive to changes in the market (SPY), and I am more dependant on price movements for making profit than from time decay

Now, the goal is to find the right balance between these two forces. In theory, as a non-directional trader, I would like the theta-to-delta ratio to be zero. That means time decay (theta) is working to offset any changes caused by price movement (delta). However, in reality, the underlying asset stock prices move an so does the delta of option prices. And the challenge is to maintain the balance at an acceptable level because delta keeps changing, as is the price movement continuously every day.

So, keeping an eye on the preferred ratio allows us to choose effective options trading strategies that suits our desired risk-reward profile and or financial objectives and profit goals.

My strategy, as a non-directional option trader, is to aim for a delta-theta ratio at zero, and in cases of a probable market direction or trend maximum 1:2 or 0,50. This way I keep my focus on theta and for a lesser part on delta.

b. Account Managing principles & Account Targets

Being kind of a Tastytrader by heart, my managing or guiding principles are :

At position level:

• Opening new positions
  • DTE between 45-60 days
  • IVR high (relative to the market)
  • A prior no earnings before 21 DTE (not keeping positions through earnings)
  • PoP > 70% for undefined risk strategies (UR)
  • Stay Small principle : Margin or Buying Power Requirement/position < 5% (DR) – 7% (UR)of Net Liq (depending on size account)
  • High liquidity

• Managing positions:
  • Adjusting on strike breached – rolling the untested side
  • Rolling or closing at 21 DTE

• Closing positions:
  • Close early at Max Profit 50 % (or even closing earlier depending number of days, profit and strategy)
  • Closing at 21 DTE
  • Closing decision point set at loss > 200% of premium received for UR

At portfolio or account level:

• Target Theta : 0,15% of Net Liq (Min 0,1% and Max 0,2%)
• Target Delta : 0 % of Net Liq (Between -0,1 % of Net Liq and +0,1 % of Net Liq)
• Target % of Capital Allocation : 25% (low IV) – 50 % (very high IV) (depending on VIX level !) of Margin/Buying Power
• Delta-Theta Ratio : 0 to Max 0,5 (1:2)
• Underlying diversification : Mix Stocks & Indexes
• Strategy diversification (when appropriate) : 50% Defined Risk Strategies (DR) – 50% Undefined Risk Strategies (UR)
• Watch List of 30-40 underlyings to follow
• Trade often principle : get in as many occurencies as possible to reach statistical positive averages

4. Conclusion

With defining these target parameters and guiding management principles for my account, I have a clear financial trading goal and an effective pre-determined thought out trading strategy to reach that goal.

This account has a captain now and he is holding his compass.

I hope this info is helpful and inspires you to do exactly what you need to do as an option trader : make your own strategy, plan your trades , be serious about the follow up (I use this options trading journal spreadsheet on a daily basis) and adjust and manage appropriately.

If you have any questions, please send me an email or put it in the comments below.

K&P

Reminder: It is important to note that the information provided is not be considered financial advice. I encourage you to consult a qualified professional for specific financial questions or recommendations. Please do your due diligence before making any financial decisions.

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