Expected Returns for your Trading System

We look at the expected returns for a simple trading system of a limited risk/reward option strategy, and figure out its expected return. Then we figure out how we can improve it given our 30 Day Rule constraints.

This material is based on some external research from TastyTrade, so don’t want to take credit for it – we are just adapting it for our 30 Day Rule. If you are interested on the research source behind this post, we would recommend looking their Mechanics of Risk Reward video. The rest of TastyTrade is worth looking at too, because they have tons of FREE options and futures education that you have to pay for everywhere else. Plus they are generally quite entertaining to listen to :-)

What is the strategy?

The trade we will create a strategy from is the Iron Condor 2 or 3 point wide, sold with 45 days to expiration (DTE). This is limited risk risk/reward strategy, that is risk $2 to make $1. You can also adapt this approach for other trades as well, not just an Iron Condor.
For this discussion you don’t really need to understand exactly HOW the Iron Condor works – just that will be assuming that we place a trade that has the following expected outcome if you hold it all the way to expiration:

Trade Scenario
Max Profit / Loss
Probability of Profit/Loss
Executed results on 100 trades
BAD RESULT! ----->-$2,660
Max Loss on Trade-$26640%-$10,640
Max Gain on Trade$13360%$7,980

So given that this appears to be a losing system – why bother to trade it?

Well, the above table has the following built in assumptions:
1 We hold everything to expiration and don’t do anything at all
2 The trade loss is ALWAYS the max loss – in practice that is not true.

Fortunately we can modify the assumptions
1 We do not need to hold to expiration
2 We can take winners early – if during the trade lifetime a profit target is reached then the trade can be exited.
3 We let the losers go and do not try to exit – but we can assume that not all of the losers will be max loss

So what does that look like ?
It turns out that with Iron Condors (and many other trades) that although a trade might ULTIMATELY end up being a loser AT EXPIRATION, and at some point in its trade lifetime you have the chance to exit with a winner.

Mechanics of Risk Reward video showed that the optimal time to exit is at 50% of max profit, and if you do that you have an 88% chance of exiting with a winner. Which is much better than the original 60% that the expiration probabilties would imply. To repeat the same thing differently, because its important – you have an 88% chance exiting with a 50% of max profit.

The above is based on being able to exit an anytime during the trade – but we have to work with the 30 day rule. So we would need to estimate the chances of exiting with a 50% after holding for 30 days inclusive. You can see the values we selected on the spreadsheet below (screenshot below) which allows us to model the concepts relatively easily:
Trading Strategy Analysis - Iron Condor - 20160204


The more times the strategy is run, the results should converge towards a much more predictable outcome – therefore theoritically the more you trade, the more likely you are to get the expected results.

Exiting winners with required trade exit profit % (e.g. 50% ) can be automated with Good Til Cancelled (GTC) orders (importantly after the 30 day holding period has passed).

Wait ? What ever happened to “Cut your losers and let your winners run”. Generally good advice for stock trading, but this is limited risk/reward system – and we know the risk on order entry (so one trade cannot take us out of the game).


This was to try and improve the results of our existing Iron Condor in our IRA accounts. So far in 2016 markets are cooperating with high implied volatility, which is great for Iron Condor strategies you can get more credit on trade entry. We are still working on verifying the above system but plan to refine it and actively use it with more capital in 2016.

Trading Small with Futures Options

Futures are very large principal products and the underlying value of a single futures contract can be anywhere from $23,000 for natural gas /NG and up to $160,000 for US Treasuries /ZB. This means that for many accounts trading them is prohibitively expensive. However fortunately there are options on these underlying futures, that provide a good amount of leverage. Using futures options it is possible to create trades that only risk a hundred dollars or less to make a few hundred dollars or more. These can have a risk reward of for example 1 to 3 (risk $100 with max profit of $300). This means that you can easily construct trades to work within a portfolio of smaller size for example $50,000. using futures options also allows you to benefit from time decay and also high implied volatility on the underlying (similar to standard equity options). this gives you a lot more flexibility than just trading the futures out right long or short.
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OIH – Trade Entry – 19-Dec-2014

OIH150123P34PUT (OIH) MARKET VECTORS ETF JAN 23 15 $34 (100 SHS) Long 5 contracts $0.62/Share $308.92
OIH150123P35.5PUT (OIH) MARKET VECTORS ETF JAN 23 15 $35.5 (100 SHS) short -5 contracts $0.95/Share $473.11

Total income: $165
Total risk: $575
Risk reward: Approx 3.5 to 1

Trade was a little rushed into due to work commitments and only got it on at the close on Dec 19th.

The right direction, but poor execution in a weekly context (better execution available almost anytime this week). However IV is high enough and it is 40% OTM and direction in Oil should be “up” into the new year. Probably will be ok, but may give some stress next week.


VLCCF – Trade Entry – 19-Dec-2014

VLCCF has sold off massively into year end, mainly due to oil price. All small cap shipping stocks have been destroyed. Fortunately we sold 200 shares for about $14 earlier this year, so we have about $1000 profit to play with. So in Nov 2014 started selling puts against the position, with a view to getting either extra income or being assigned. Vol was high, so was a good play, however was still “early”. Sold $7.5 Dec 2014, when VLCCF was approx $8 in mid Nov, but got totally caned in Dec (but still better than buying stock outright). Put will be assigned (deliberately) today on 19th Dec at expiration on the close today.

Table below summarises our stock position, which has an unrealised loss of approximately ($8.08 average price - stock close price $4.71 x 560 shares = -$1887). However we realised a gain earlier in the year (May 2014) of $1011, selling 200 shares at $14.15. So our total loss on the stock is about  -$876. However we have dividend reinvested, so that is lowering the average price as well (hence the 60 or so extra shares, over the original 500 share position). Original cost basis was 500 shares at $9.79 = $4895. So loss is -17%, however given that stock price is down -%52 since purchase, that could be claimed as a small victory.

Our aim is to try and get out of this position, with a patient long term approach coupled with option trades and tactical stock sales to reduce overall cost basis.

Stock Position
Cost Basis /
Average Price
Cost Basis Principal
Existing VLCCF position3608.873193.2
Dec 2014 $7.5 put assignment (deliberately assigned on 19th Dec 2014)200$6.51300

The implied vol is 140% (very high) in Dec 2014, so are looking at volatility strategies, namely selling options. The stock is cheap enough (under $5) to consider very conservative put selling strategies, which when coupled with high IV makes it a good candidate for the philstockworld.com style trade (or longer term premium selling). We havent done this trade before, so will be conservative on the first one.

Look at the option chains for June 2015 shows the $7.5 and $2.5 puts. This trade was executed by selling puts and selling calls (premium on both sides).

VLCCF150619C7.5CALL (VLCCF) KNIGHTSBRIDGE JUN 19 15 $7.5 (100 SHS) -5 $221.07 $0.44/Share
VLCCF150619P2.5PUT (VLCCF) KNIGHTSBRIDGE JUN 19 15 $2.5 (100 SHS) -5 $313.12 $0.63/Share

This makes $221.07 (call premium) and $313.12 (put premium) for a total of $552 if VLCCF finishes in between $2.5 and $7.5 in 6 months time. What are the possible scenarios in Jun 2015:

Closes Below $2.5: This is effectively committing to buy 500 shares at about $2.5 – total option premium of $1.07 (or about $1.43 per share). This would be a bad outcome, and would have average price of about $4.75 on 1000 shares. Assuming stock would not go bankrupt (!) would have to look at option premium trades again (to further lower cost basis), or just buy and hold and wait it out. This would not be good, but would be way better than buy and hold from $9.79 to $1 to $2 range.

Closes Between $2.5 and $7.5: since the IV is VERY high there is a higher likelihood that vol reduces over the lifetime of the trade, so that will also give a way to profit even if stock doesn’t move anywhere over the next 6 months. This is like a “psuedo” dividend assuming the stock stays in a ride range – the options market currently prices this at about at 50% chance of happening, but if the IV comes down the percentage chance of it happening will be reduced as well. The “normal” IV for this stock is about 40% and that would price it at about a 75% of chance of happening (much better odds). The P&L here would be the stock P&L, plus about 5 contracts x $1.07 option premium or about $535 (the “pseudo” dividend). If stock price is over $7 by Jun 2015 expiration then this is breakeven on the currently unreleased open positions, however if you add the $1011 profit from earlier in the year, then the breakeven since position inception is approximately $5 (which looks achievable, and is not a bad outcome given that the position was started at $9.79).

Closes above $7.5 : If the stock is above the $7.5 strike in 6 months, then the entire position will be assigned for a profit:   –  $8.08 average cost basis + $7.5 strike assignment + $1.07 option premium = about $0.49 profit on 500 shares. That would make a small gain on $250, which added to $1011 from earlier this year, would give about a 25% profit on original position (and would have exited with VLCCF position with a decent gain, not having given up on it when it was a loser as it is today).

Note: There are an extra 60 shares that have been acquired due to reinvested dividends, but that would just be bonus profit (e.g. if closed at $10, then would get $2.5 * 60 shares = $150 of extra profit). But that was not included above to keep calculations simpler.


AGNC – Bull Put Spread – Trade Postmortem

Quick update, on our AGNC trade exit just before the close on May 21st (yesterday). Like we stated there was significant event risk for mortgage REITs today with Ben Bernanke’s speech at 10am.

There would have been significant volatility in the position, and it would have been down a few hundred dollars during the morning spike (see chart). In the end we were proven wrong, and would have made money if we had held on to the close, then closed out the position a day later. However it probably wasnt worth the risk of AGNC running higher, for the limited gain.

We are a little fixated on getting our $100 back that we lost on this trade, but AGNC looks like technically it could go a lower relatively quickly. Looks like the lowest close since March 2012. So we’ll keep an eye on it for now, and probably add the same style of put spread trade at lower levels in a few days or a month or so.

AGNC – Bull Put Spread – Trade Exit

Agnc moved down, and relatively quickly from May 2nd $33.10 to May 21st $29.55.

The June strike 30 put option has protected us relatively well. However getting closer into June expiration there is battle between negative time decay in the near term Jun (losing money if agnc doesn’t move down) and the positive downtrend in the agnc stock price (making the overall position money). The position is now slightly short agnc with an approximate delta of -0.10.

If we are to hold this position we need an increasing swift agnc decline into June expiration. We took the position off today on May 21st because we got a nice 1.5% downdraft. We still exited with approximately a $500 loss on all 2 option legs position.

Any bounce up in AGNC of more than $1.5 (to $30) could cause losses over $500, so the risk/reward to holding the short for the 30 days to June expiration is skewed to it moving down increasing quickly. AGNC standing still will lose the position money. Any time you *need* the market to move in a particular direction in a relatively short timeframe or you will lose money every day, it is usually not a good risk/reward trade.

There is also significant event risk for mortgage REITs tomorrow May 22nd with Ben Bernanke’s speech at 10am. This will likely be market moving for AGNC based on the FED’s bond buying program.

Overall the position lost about $100, which was unfortunate. However our original investment thesis was that AGNC would remain stable over the summer was proven incorrect. Agnc declined from trade entry $33.20 on March 16th, to $28.55 on May 21st (-14% decline). By way of a simple comparison, only 100 shares of agnc would have lost -$465 + $125 dividend = -$340 (and we were trading 8 contracts, controlling equivalent of 800 shares).

We can roll the entire structure down to lower agnc strikes and try again to make our $100 back. This wasn’t a positive result, but at least we get to try again without significant losses.

Remember we have to hold each option leg for 30 days, which is why we sometimes adjust (add legs) when selling would be easier.

TSLA – Trade Update – May 2013

TSLA beat expectations and is currently up big after hours. This should have a large volatility collapse tomorrow AND went in right direction for the spread (bullish), so this trade is likely a quick winner tomorrow.
Based on tomorrow’s indicated open it will be about 30% OTM, so it is likely safe to hold for a few trading sessions to let the volatility drain out of the position (after all the earnings excitement fades)

After Hours: 63.15 +7.40 (13.27%)
May 8, 4:58PM EDT
(this is an indicative quote – but after hours is moving around so much don’t put too much sway in it, however it is definitely up big)

SPY Short Put Butterfly – May 2013

We have been running long SPY butterflies for the last 6 months, and on average have lost a small amount of money so far. Mostly because of a continuously rising market for the last 5 months with little downside volatility. THe advantage of a long butterfly placed for a small debit is that typically only that small debit is lost if we are “wrong” on direction.

This month we figured if you can’t beat em join em., and will try some short put butterfly to bring in some premium. Trade Entry right at the close on Fri May 3rd:

    Sale PUT SPY 160 Jun 2013 SPY1322R160 contracts -10 2.42   2,405.50	  - short "head"
Purchase PUT SPY 157 Jun 2013 SPY1322R157 contracts  10 1.54  (1,554.45)  - long "wings"	
Purchase PUT SPY 157 Jun 2013 SPY1322R157 contracts  10	1.54  (1,554.45)  - long "wings"	
    Sale PUT SPY 153 Jun 2013 SPY1322R153 contracts -10	0.85     835.53	  - short "tail"

Total credit : + 0.19 (or $190)

This is a much safer way to sell premium than a traditional put credit spread. The options tend to move all together in the first few days of the trade, showing little p&l for the overall position. However after about 10 to 30 days in a butterfly position the “tail” (lowest option leg) of the butterfly should start to decay faster than the “head” and the “wings” together (the top three option legs). The “head” and “wings” option legs typically follow each other relatively closely until about 10 days out from expiration. With about 10 days to go to expiration, the direction of the underlying starts to make a much bigger difference to the overall position p&l.

Note: if the market crashes more than about 10% this position will still actually make a small profit. So want the position to go up or remain flat, or crash very hard and very quickly. A slow drift downwards would likely be bad for position over next 45 days to expiration.

This short put butterfly is also a long volatility position – that should make money if volatility picks up, so it is good for this very low volatility environment. Long butterflies (the opposite trade to this one) are great trades when volatility is higher, but they don’t always make sense when vol is this low (unless you are using them to hedge a stock position).