Spreads Bootstrapping Strategy

This is a what-if page, suggesting a general stragegy for generating cash flow from option trading for growth.

Background

After 2 years of trading stocks with improving gains.  For some of that time we were trading simple (Level 2) option strategies with limited success and greater losses than gains.

We spent 2 months studying credit spreads, entry and exit strategies, and salvaging bad spreads to reduce losses and even recover gains from bad spreads.

We spent 4 months virtual trading spreads averaging about 75% successful trades, always making more money that lost in bad trades.

In March 2006 we closed our first month of trading credit spreads, with 8 good trades out of 12.  Of the 4 trades which turned into the money, two would have finished out of the money.  We broke even on 2 of those trades and lost on 2.  Based on the paper trading we consider these to be average results for this kind of trading.

Basic Strategy

The strategy uses Credit Spreads, placing a certain percentage of the portfolio at risk for each cycle.  It assumes selling credit spreads on 2-month cycles allowing entry of relatively conservative spreads expiring in typically 9 weeks or less.  For example starting after December options expire you would sell credit spreads for February.

Rather than making a few large trades, you will make several smaller trades, distributing the risk.  If a trade goes bad you will unwind it and possibly enter another trade to replace it.

In the last month or so of a cycle it will be hard to replace a bad trade for a reasonable gain, let things stand and move into the next cycle.  A variation I am not accounting for here would be to enter a new trade for the next month, the formulas and projections below are simpler than this.

Assumptions

First is each spread is based on a $5 difference in strike price with at least 2 contracts per spread.  To maintain the same level of risk on a $10 difference in strike price sell only 1 contract, and if the strike difference is $2.5 then sell 4 contracts.  This maintains the same level of risk on each trade.

At any time no more than 80% of the portfolio is comitted to spread obligations, allowing a reserve pool to recover from trades that go bad.

There is a target of 10 spreads for each cycle, and no more than 15 to keep things easier to follow.

An average return of 8% per trade is made, an average return of $0.40 on a $5 spread.  Assuming 1/3 of trades go bad your target is $0.60 or more for each spread if you at least break even on all trades that go bad.  Considering you may lose money on some trades a better target is $0.75 for each $5 spread.

It is possible to be more aggressive and greater risk provides greater rewards as well as greater chance of setbacks.

Remember that as you establish short term capital gains, you will probably need to make estimated tax payments per quarter.  It is suggested to use the method of annualization described in Publication 505.  This will allow you to pay as you go instead of having to anticipate how much you will gain for the entire year before reality strikes...

Formulas

The magic numbers (assumptions) are:

1. $500 is Risk per $5 spread where each contract is 100 shares.
   
2. Minimum of 2 contracts per trade
3. Target of 10 trades per cycle
4. Average gain of 8% per trade
   

The number of $5 spreads is based on the risk comitted for the cycle times the investment base:  N$5 = Base * Risk / 500

The number of contracts is at least 2 but based on the number of $5 spreads with a target of 10 trades:  Nc = MAX(2,INT(N$5/10))

The number of trades is the number of spreads divided by the number of contracts:  Nt = INT(N$5/Nc)

Profit for Cycle is based on Number of Trades, Number of Contracts, Risk Per Contract:  Pcy = $500 * Nc * Nt * 8%

Each cycle the profit is added into the base and included for consideration in the next...

Before Starting

Before you begin Phase I it is recommended you paper trade the strategies for at least 6 months until you are competant in entering strategies, and slavaging strategies when they go bad.

A key to making these projections work is minimizing losses when trades go bad.  If the average gain is 8% the average risk is 92%, you can lose far more than you gain doing nothing.

Phase I

In this projection Phase it is assumed to start with $10000, investing 80% of the portfolio in trades of at least 2 contracts every other month, which makes it possible to run 6 cycles a year.

Using the formulas above, the risk per cycle is 80%, and an average 8% gain per trade:

At the end on Phase I the Basis has doubled and the pland moves to Phase II...

Phase II

In Pase II you effectively divide your base in half and enter trades for each month.  Investing 40% of the portfolio in trades of at lest 2 contracts every month, running overlapping cycles every month of the year.

Using the formulas above, the risk per cycle is 40%, and an average 8% gain per trade:

Project this forward as far as you wish or need, until the spread gains are (conservatively) 50% more than your gross income...

Phase III

This has been your goal all along, you can begin to cut back on work, or quit altogether, maintaining your income without tapping into the basis of your income portfolio!

There are infinite variations you can apply to these what-if projections, starting with a larger base, starting at Phase II, taking greater risk, making better gains, and so forth.