The Reward of Profit and the Risk of Losses for retail option trading needs to be managed at 2 related levels of performance: Portfolio and Trade Specific.
At the Portfolio level for online options trading, there are 3 types of Targets that must be set, even before you trade.
Maximum Return Target: complete achievement of the “ideal” measure. Dream of the “ideal” that stretches you beyond what is practical. For example, earn 2-3 times your monthly living expenses with the monthly trading profit. This is to stretch your imagination well beyond mediocrity. Even if you fail, you just might end up with more than your original target.
Minimum Return Target: the lowest acceptable measure, achievable under most conditions, excluding a catastrophic market event. Use the historical annualized return of the S&P 500 between 10%-12% (prior to the 2008 financial pandemic), as the lowest acceptable boundary. The S&P 500 being a widely accepted benchmark for trading equities is adequate to base the minimum target off, though your portfolio needs to be profitable – being ahead of the $SPX in negative territory does not count. Below the historical annualized return range of 10%–12%, is the 3 Month T-Bill, presently near zero. While the T-bill theoretically represents an “absolutely” zero risk investment, even the safest investments will still carry a residual amount of risk no matter how small that risk is. The point is this. You got into options and all that Greek terminology, not to make salads; but to beat the performance of equities as an asset class. If your portfolio's return is between what is near zero-risk and 10%–12% per annum, you are just delaying reaching a point of pain that marks failure in grasping the base-line ability to control risks. If the returns of your portfolio are between 0%–12% and you plan to continue trading options, processes within your trading process will need to be re–engineered.
"Halt Trade" Target: cumulative losses reach an absolute amount below the Minimum Return, making it necessary to stop trading altogether for a stated period. 10% of [(60% x Cash Balance at the start of the year); or Net Liquidating Value]. Example, for a $50,000 trading account, 10% x (60% x $50,000) = $3,000 of losses in total, is the absolute amount to halt trading. Why 10%? Blowing up your self-funded capital is final. There is no bail out package, as a home options trading business does not have access to bank loans; or, shareholders’ equity to finance your personal trades.
Now, drilling down to Trade Specific performance measures.
Even before you calculate the metrics, characteristically, what makes for a consistently managed portfolio are these traits:
- The largest loser does not wipe out the largest winner. The largest winner should be in multiples of the largest loser, for e.g. 2-3 times more.
- Above the largest loss, there are many more winners with progressively higher profit values than the value of the largest loser.
- The profits should step up gradually, depending on the size of your account. If it’s in the tens of thousands, the profits should step up consistently like a ladder from the low hundreds, to the higher hundreds; then, move up from the higher hundreds into the thousands. If your account is above $100K, profits should step up from the high hundreds into the thousands. Profits that jump from low hundreds into the thousands signal an over-reliance on gapping plays, which fail to help you step up consistently profitable results.
Where can I see this step up function in a consistently profitable portfolio, with these portfolio measures and trade performance metrics? See Trading Profit | Consistent Results to view a model retail option trader’s portfolio that shows these traits.
Moving onto the hard metrics. There’s 2 ways to count the Return on your trading capital.
- The first way is to take the Total Profit of the trading account and divide it by the Start of Year Cash Balance, as of 01/01/YYYY.
- The second way is if you take the Total Profit of the trading account and divide it by the ongoing Net Liquidating Value.
In both cases, you can minus the Total Cost of Commissions from Total Profit, to get a Total Net Profit number. Then, divide the Total Net Profit by the Start of Year Cash Balance; or, Net Liquidating Value. Net Liquidating Value is how much your entire trading account is worth, which is equal to Total Cash + Options Value + Stocks Value + Commodities Value + Bonds Value. The Start of Year Cash Balance is straightforward – it is the money in the account at the beginning of that trading year. Cash increases when you are short securities; but, cash decreases, as you get long on securities.
To review your performance, calculate these metrics using the Profit (wins) and Loss (losers) from your account:
- Win/Loss Probability: is the number of wins divided by the total number of trades. The other way to express this Win/Loss ratio is to take the number of wins and divide it by the number of losers. The Win/Loss Probability; or, Wins per 1 Loss measures your ACCURACY in selecting trades.
- Average Win is equal to the sum of all profits divided by number of wins.
- Average Loss is equal to the sum of all losses divided by the number of losers.
The Average Win divided by the Average Loss measures how RESPONSIVE you are in taking profits and cutting losses.
Combine the Accuracy ratio with the Responsiveness ratio to get your Performance Ratio.
Performance Ratio = (Win/Loss Probability) x (Average Win / Average Loss). Always aim to maintain the Performance Ratio above 1.00. Why? The commonly known money management rule is to allocate 2%-5% of (60% x Net Liquidating Value of the account) per trade. What is not commonly practiced is the discipline of moderating a +/- 1% in trade allocation between the 2%-5% allocation.
- If you are allocating 2% per option trade, you would increase this by +1% to 3%, if you can sustain your Performance Ratio above 1.00 for the next month. Subsequently, you would increase +1% for each month that you exceed 1.00, until you reach the upper limit of 5%.
- If you are allocating 2% per option trade, you would decrease this by -1% to lower it down to 1%, if you fail to sustain your Performance Ratio above 1.00 for the next month. You would keep the allocation per trade at 1% for every subsequent month, until you are able to fix your Performance Ratio above 1.00 to raise the allocation per trade again by +1%.
This is how to achieve a ladder effect in stepping up profits and stepping down losses. This mechanism of stepping up/down is an indispensable tool for rewarding profit and to discipline the risk of losses. It forces you to improve both ACCURACY and RESPONSIVENESS before raising your position size.
Where can I learn more about portfolio measures and trade performance metrics as part of a total trading system? See details of an Original Curriculum, for 55 hours of video-based learning of online options trading from home.
Posts
