While the proof is outside the scope of this blog, we will state that implied volatility tends to be more rich than realized volatility. As such, we will tend to be net sellers of volatility. By being net sellers of volatility, we will be net short vega and necessarily net short gamma and net long theta. Being net short vega (and therefore net long theta) also allows us to have a portion of our portfolio function as passive income, with time working in our favor. This is not to say that we will avoid long vega positions (i.e. backspreads), but that if forced to choose between a long and short vega strategy, we would choose the short vega one.

Vega v. Delta

Because we will try and carry short vega, we need to understand our tail risk moving forward. What is our worst case scenario? Carrying net short vega exposes us to sharp upward moves in volatility. When do these types of moves tend to occur? Comparing the SPX to the VIX, for example, we see that volatility tends to spike on rapid moves downward. We can see then that we have delta risk to the downside, and thus if we are net short vega we should also carry some negative delta to offset our vega risk.

Duration

By looking to maintain net positive theta as our primary portfolio metric, we should also look to optimize it. When should we enter or exit positions to maximize our profit if we intend to be net positive theta? Because option decay is initially very slow, and then grows exponentially into expiration, we can infer that the best time to take advantage of decay is sometime in the middle. Taking a look at theta vs. days to expiration (DTE) graphs (easily found online or derived yourself) shows a clear acceleration zone in the 30-60 DTE area. As such, we will look to establish our short short vega positions between 30 and 60 days to expiration, and our long vega positions a bit farther out. Taking on short vega in shorter timeframes may expose us to unacceptable gamma risk and make it more difficult to manage our trades quantitatively. The same idea applies to long vega positions.

Second and Third Order Greeks

As retail traders, the only second order greek we will consider is gamma. With the exception of gamma, I don’t feel it’s necessary to get too bogged down in second order greeks, and perhaps more importantly very few retail brokers (if any) even provide them. If you feel the need to have third order greeks available for making trades, your strategies are well outside the scope of this project.

After a few years trading spot forex, which I still do, I found that focusing on a small number of pairs allowed me to stay more focused and better identify opportunities than watching 40 minor and cross-pairs. Many of the ground rules I follow trading options come from my forex experience and apply just as well.

Liquidity and Slippage

As in forex and equities, when trading options liquidity should be your primary focus, especially trading a smaller account. Suppose you decide to trade options on a stock where the ATM markets are $0.20 wide and you can only get filled at the bid or offer. If you’re trading a credit spread for a $1.00, you’re giving up 20% of your win right off the bat, and for what? Is the opportunity really that much better that you’re willing to give up a fifth of your possible win to play? I doubt it. With a small account, we’re already pretty tied down on capital and can’t afford to give up a single penny on a trade. As such, we will start by narrowing down the hundreds (thousands?) of optionable equities and ETFs down to our Top 10 listed in a previous post. These underlyings have very tight markets and will allow us to get in and out with a minimum amount of slippage.

Volatility Screens

There is a strategy for every volatility environment, and as such the term “screen” for vol measures is kind of a misnomer. First, we will look for high or low implied volatility (IV) relative to itself over the past year, measured in the form of IV percentile. IV percentiles of <30% and >70% will stand out to us as opportunities to buy and sell volatility, respectively. IV percentiles at these extremes show us that implied volatility is much lower (higher) than usual and a possible opportunity to buy (sell) vol.

Second, we will consider IV versus historical, or realized, volatility (HV or RV). Remembering that IV is the volatility implied by options prices determined by the market, if IV grossly overstates or understates the actual (realized) volatility of the underlying, we would expect the two to converge and thus a vol arbitrage opportunity to be present. For example, if IV grossly overstated HV, we might look to sell options and vice versa.

Finally, we will consider volatility skew. If call options on a certain underlying happen to be relatively more expensive than puts, we would look to sell those calls. If puts, on the other hand, appear to be relatively underpriced, we might look to buy volatility on the put side and take advantage of the pricing discrepancy.

Before we send off our first order, I’d like to spend some time discussing some of the finer details of how we will screen for good trades. Due to the fact that we will be trading volatility and not direction, we will be focusing on vol-related statistics rather than things like moving averages, ADR’s, and RSI’s.

Why Trade Volatility?

Volatility, unlike price, is mean reverting (see Natenburg’s “Option Volatility & Pricing” for a more thorough discussion). Most popular options pricing models assume returns to follow a lognormal distribution, but I have yet to see strong evidence showing this to be true. On the other hand, volatility can be easily shown to oscillate around a mean, making it much more reliable to trade than price.

Speaking qualitatively: would you rather short a stock that just tapped an ATH or sell volatility at the top of its 52-week range?

Volatility Measures

Another thing that makes trading volatility different than trading price is how we measure it. When it comes to price, we have a single absolute number (or time series) with which we derive our entry/exit points, trends, indicators, etc. With volatility, we have two values (implied and historical/realized) with which we compare to both each other and themselves over a longer time horizon. For now, we will look to take advantage of divergences between implied and historical volatility and implied volatility versus itself. The absolute volatility value is not in and of itself useful, rather, the relationships between volatility measures is where we will find our edge.

Will and Won’t

We will be looking to take advantage of the above listed opportunities as well as things like vol skew. For a small account, we won’t be doing higher level strategies like gamma scalping.

In keeping with the previous post, the following will be the underlyings we will focus on with this portfolio. To begin, I’d like to focus on 10 of the most liquid underlyings, inferred from the CBOE’s list of highest options volume.

1. SPY
2. QQQ
3. IWM
4. GLD
5. TLT
6. AAPL
7. PG
8. BAC
9. FB
10. BABA

I’m open to altering this list after we get rolling, but for now I think this is a pretty diverse selection of underlyings to trade, including indices, bonds, metals, finance, tech, and consumer products. With a small account, we’ll avoid volatility products (VIX), bigger index products (SPX), and very expensive stocks (AMZN, CMG).

To help make sure this portfolio is as successful as possible, we need to lay out a few ground rules. Most of these were born out of my own (expensive) mistakes, the rest are lessons taken from various other sources.

1. No lottery tickets. A common pitfall for new options traders is buying far OTM options hoping for a huge payday, or buying extremely expensive options leading into earnings hoping for a big beat. I started out doing this and learned this lesson the hard way.
2. No chasing bad trades. If we put on a spread and the underlying goes against us too quickly to defend, we will close the spread instead of rolling and widening the spread to try and chase the win. This has been my biggest options trading mistake by far!
3. Only trade liquid products. Poor spreads ensure an automatic loss as soon as we enter the trade and no guarantee we’ll get out at a fair price. There’s so many liquid products out there that there’s no reason to throw money away chasing illiquid products
4. No opinion on direction. If you’re an expert technician and can call tops and bottoms like a pro, you don’t need my advice. I’m not, and every time I have a directional opinion I’m proven wrong. We will trade volatility instead.
5. Don’t become overleveraged. This is sometimes challenging with smaller accounts, but taking on too many positions and becoming overleveraged can result in your account becoming hog-tied — that is, your account value dips below $2,000 and into a liquidation only status. I don’t have a hard number of percent capital tied up but it’s something I want to keep a sharp eye on.

That’s it for now. Perhaps we’ll add more later.

I have been trading off and on for the better part of eight years now and with very little to show for it. I started at 18 with penny stocks, then mutual funds, individual equities, spot forex, and now options. Like most traders, I’ve blown up more than my fair share of accounts by taking on way too much risk with way too much leverage and way too little knowledge. The purpose of this page is to develop a sober, calculated approach to equity options trading grounded in theory and risk management. As I learn, hopefully you will too.

The Inspiration

Over the past year I have spent a lot of time listening to the guys at TastyTrade, who if you’re not familiar are former floor traders that run a really informative 8 hour long online TV trading channel (or as they put it, “alternative financial news network”). They have a ton of great insight and knowledge that they share every day and I highly recommend you tune in if you don’t already. The problem I have is that I feel my small account size makes it impossible to trade like they do. It seems like most of their viewer base has accounts in the $50,000+ range, so it’s understandable they wouldn’t spend all day catering to the broke boys in the crowd. We’re going to try and fill that gap here.

The Setup

Every broker I know of requires at least $2,000 in capital to trade spreads. We will start this account with $2,500, which is no small amount for me but in my experience is the absolute floor on capital. Anything less and we are restricted to what is what is often referred to as “level 1” permissions; that is, long puts/calls only. The leverage available with options makes the risk/reward tempting, but these types of decaying, directional bets often turn into lottery tickets that hardly pay out. The extra $500 buffer off the floor will allow us to put on an initial couple of trades and still have some wiggle room. If you don’t have that kind of money available, I get it. Start saving and keep learning until your account is ready. If you try and rush it (like I did), you’ll end up throwing money away.

The Plan

We will initially focus on non-directional strategies (i.e. trading volatility) on a small number of highly liquid underlyings. It is very difficult with options to be profitable in the long run with directional strategies, and I have found over the last year that these have been my worst performers.

The Goal

The initial goal is to grow the $2,500 initial capital outlay into $25,000. At that point we will be at the PDT threshold and have other strategies and markets available to us. The longer term goal is to become better, smarter traders.