Watch HowardCohodas Trade Index Options Credit Spreads

[HowardCohodas]

At the end of every month I publish an equity chart for the stakeholders of my trading; myself, my wife, friends and family that I have taught and now my readers here.

 

[HowardCohodas]

Completed Iron Condor # 12 today.

Options involving three spreads will expire tomorrow. Must consider whether to close spreads or let expire.

See signature for link to Dashboard.

 

[DionysusToast]

At the end of every month I publish an equity chart for the stakeholders of my trading; myself, my wife, friends and family that I have taught and now my readers here.

Nice bar chart.

Is this 40% growth of initial equity you are showing or is the percentage based on amount risked.

Also - we saw a $160 win based on a $2500 risk. Let's say I wanted to follow this method as a way to make a living. Let's also say I wanted to earn $8000 per month. By this measure, would we need to risk $125,000 per month in order to make the $8000 ?

What account size would you recommend in order to make a living this way ? What's your expectation of maximum losing trades in a row ?

Also - as you are trading spreads - when you are risking $2500 to make the $160 - what is your brokers opinion of your risk? I know some brokers are reasonably dumb when it comes to figuring out margin requirements on spreads.

 

[HowardCohodas]

Nice bar chart.

Is this 40% growth of initial equity you are showing or is the percentage based on amount risked.

Also - we saw a $160 win based on a $2500 risk. Let's say I wanted to follow this method as a way to make a living. Let's also say I wanted to earn $8000 per month. By this measure, would we need to risk $125,000 per month in order to make the $8000 ?

What account size would you recommend in order to make a living this way ? What's your expectation of maximum losing trades in a row ?

Also - as you are trading spreads - when you are risking $2500 to make the $160 - what is your brokers opinion of your risk? I know some brokers are reasonably dumb when it comes to figuring out margin requirements on spreads.

The chart is on account equity and I am never "all in." How much I reserve is not set in stone, but is about 10%-20% of the account size. On my to-do list is to look at this more analytically.

By using the number of calendar days since the account was established I am operating a bit above a 10.5% growth per month. I have not yet suffered a serious loss, so that bounds the upper end.

Just looking at one spread only tells part of the picture. Additional income can be earned by forming an Iron Condor without committing additional margin. With my methods, an Iron Condor is not always formed.

Part of individualizing my methods for another trader is to determine the trader's risk tolerance. This then determines an upper bound on the credit one can expect at the time the spread is entered.

All this to get around to answering your question. If we assume that 10.5% is an upper bound and that I will suffer a loss of around 20% of what is at risk once in 10 months. That leaves an expected rate of a little more than 7.5% per month. Rounding here and rounding there, I get about $110,000 to earn $8,000 per month.

 

[DionysusToast]

OK - so for each $8000 return we need $110,000 in the market - but as our win:loss ratio would be $8000:$110,000 - we'd need a larger account than just $110,000 as one loss would wipe us out.

As you say, you are never all in - only 80-90% in the market.

So - how large an account would we need here ? We can re-build the capital from a loss in approximately 14 months but in that 14 months, we'd need to not spend any money as it needs to go to re-building capital.

Obviously as the required account size grows, then the percentage return on the account would inevitably fall.

From the discussions so far, I would guess your probability calculation shows you that 2 consecutive losses would be a rare event. What's your maximum expectation of consecutive losses ?

 

[meanreversion]

Howard's chart looks just like the beginning of the NAV of LTCM at the beginning of the book "When genius failed".

 

[HowardCohodas]

OK - so for each $8000 return we need $110,000 in the market - but as our win:loss ratio would be $8000:$110,000 - we'd need a larger account than just $110,000 as one loss would wipe us out.

As you say, you are never all in - only 80-90% in the market.

So - how large an account would we need here ? We can re-build the capital from a loss in approximately 14 months but in that 14 months, we'd need to not spend any money as it needs to go to re-building capital.

Obviously as the required account size grows, then the percentage return on the account would inevitably fall.

From the discussions so far, I would guess your probability calculation shows you that 2 consecutive losses would be a rare event. What's your maximum expectation of consecutive losses ?

Just to review, the $110,000 account size to earn $8,000 per month is based on the following:

1. 10.5% account size growth in successful months
2. 1 in 10 chance of an unsuccessful month
3. 30% loss of entire account in an unsuccessful month (more on this later)
4. No estimate of the probability of consecutive monthly losses

The 10.5% upper bound is based on my actual performance. My testing results show a higher return is possible. Since I'm in preproduction (small money) in some areas, the actual results may be somewhat diminished. And four months is not yet statistically significant.

The 1 in 10 chance for an unsuccessful month is below what I saw in testing, however it is more reflective in the Probability of Touching level I choose. I choose the more conservative number in my estimates to account for possible failures not anticipated.

The choice of 30% loss of the entire account rather than the funds at risk actually assumes two consecutive months of failure. That is because I generally enter a trade right after the expiration of current months options when the funds quarantined by margin requirements become available. The new spread is entered around 60 days before expiration in order to catch the time-value decay curve before the knee. Thus I am leapfrogging the following month's options, which I'm already in, for the one after that. (Gosh, that's a messy explanation. I'll have to work on making easier to understand)

I feel this is an overly conservative approach to estimating draw-down as I never saw two consecutive monthly losses in testing, but I like to stay on the safe side of things when discussing the possibilities.

I know that I did not answer some of your questions directly because I did not attack the problems as you stated them. If you feel more explanation is needed, ask away, and I'll do my best.

 

[HowardCohodas]

Howard's chart looks just like the beginning of the NAV of LTCM at the beginning of the book "When genius failed".

Part of the reason I choose to expose myself in such depth is to avoid such disasters by having those with wisdom beyond mine continue to ask questions that force me to think deeper and be more cautious.

There is a period of time in the training of pilots after they begin to feel comfortable at the controls and have made a few successful landings that they are the most dangerous. We used to call this the "they think they can fly the box it came in" syndrome. Those destined to be good pilots soon recognize that they have so much more to learn. I aspire to be a good pilot (trader).

If my becoming a good trader is possible, I believe this thread in particular and this forum in general will help me do it.

 

[sj8070]

Howard,
From what I have read so far of your system is that it seems to me that you have no "edge" as it were.

The expected value of an Iron Condor, must be zero, otherwise you are claiming that markets are not perfectly competitive or liquid in this way. If you believe that an Iron Condor will produce a positive return in the long run you are taking the view that the underlier is actually less volatile than the markets have priced in.

Perhaps I have misunderstood your work.

It may be easier to answer this question:
"Do you believe that this strategy would be successful in a Simple Random Walk Environment, whereby the underlier is totally random, and if not, what inferences from the market to you make to ensure that your long-run expectations are positive?"

 

[Hotch]

Liking this Howard. Assuming 160/2500 is average, 10% risk, we're looking at 15 trades a month if you compound right (give or take)?

 

[HowardCohodas]

Howard,
From what I have read so far of your system is that it seems to me that you have no "edge" as it were.

The expected value of an Iron Condor, must be zero, otherwise you are claiming that markets are not perfectly competitive or liquid in this way. If you believe that an Iron Condor will produce a positive return in the long run you are taking the view that the underlier is actually less volatile than the markets have priced in.

Perhaps I have misunderstood your work.

It may be easier to answer this question:
"Do you believe that this strategy would be successful in a Simple Random Walk Environment, whereby the underlier is totally random, and if not, what inferences from the market to you make to ensure that your long-run expectations are positive?"

The fundamental principles that my strategy takes advantage of is that time moves forward and that options have a finite life. If they are OTM they must expire with a value of zero.

The use of a spread offers two additional advantages. First, the downside is limited at the cost of a limited upside. Second, margin requirements are to my advantage because the loss is limited.

The formation of an Iron Condor is just icing on the cake. A second spread can be sold without the need for any additional margin than was required for the original spread. There is some additional risk, compensated for by the additional credit.

The only unique added value (as far as I am aware) that I bring to the table over what others have written about is the use of Probability of Touching as a key to choosing how far OTM the short option must be.

Another technique I use has been mentioned by some others but does not appear to be widely used. That is, actively managing the spreads throughout their lives. I do not consider credit spreads a "set it and forget it" strategy. If I have formed an Iron Condor and the market begins trending, I can frequently close the spread that achieves most of its value and enter a new spread reforming the Iron Condor. I have referred to this elsewhere as rolling. On one NOV 10 expiration Iron Condor, because of trending, I had a small loss of the CALL spread but had three nice profits on the PUT side. The trending market is often cited as problematic for Iron Condor traders. I have frequently gained more profit from a trending market than if the market had just moved sideways and the initial two spreads expired quietly.

 

[HowardCohodas]

Liking this Howard. Assuming 160/2500 is average, 10% risk, we're looking at 15 trades a month if you compound right (give or take)?

I'm not quite able to connect the two ideas you mention. Permit me to ramble a bit in the hope that I will answer your question.

I scale by selling more spreads.

Were I not planning to teach this material formally, I would stick to one index rather than the three I trade. I chose three to cover the range of account sizes that might be found among the students. Showing real examples is more meaningful for several reasons. It better engages the student. And it illustrates that different indexes present different challenges in terms of bid/ask spread, likelihood of prompt fills, etc.

The basic approach would have four spreads open at any given time for a single index. Two for the next expiration and two for the one after that. I'm in two monthlies at once because I like to open the spread before the time decay curve reaches the "knee" so that I get a generous credit. Rolling opportunities add to the number of total spreads, but not to the simultaneously open ones.

Adding weeklies and quarterlies, available on some indices, adds two more spreads per period. At the moment, weeklies and quarterlies are in the preproduction phase (small money) of qualification.

The example that has been bandied about (160, 2500) was in fact one of my preproduction weeklies and not the production spreads I trade with serious money.

 

[Hotch]

I was just attempting to get some handle on the figures. I didn't see that you scaled in, but the simple thinking was:

10% risk, on such R:R gives 0.64% return, 1.0064^15 = 1.1 ish, so 15 trades a month makes your 10%.

 

[HowardCohodas]

I was just attempting to get some handle on the figures. I didn't see that you scaled in, but the simple thinking was:

10% risk, on such R:R gives 0.64% return, 1.0064^15 = 1.1 ish, so 15 trades a month makes your 10%.

See if this post clears things up a bit.

 

[brettus]

I'm guessing you short iron condors most of the time. I find this interesting as in a ranging market you are basically legging the options to get the most out of the premiums? Is this right?

So if FTSE is in a range 5600-5800, you buy a call at 6000 when the market is at 5600 and sell a put 5500. Then when the market is at 5800 you buy a put at 5400 and sell call at 5900, and that makes a perfect iron short iron condor? somewhat anyway. and obviously because of the wings your margin is lower than a strangle.

 

[HowardCohodas]

I'm guessing you short iron condors most of the time. I find this interesting as in a ranging market you are basically legging the options to get the most out of the premiums? Is this right?

So if FTSE is in a range 5600-5800, you buy a call at 6000 when the market is at 5600 and sell a put 5500. Then when the market is at 5800 you buy a put at 5400 and sell call at 5900, and that makes a perfect iron short iron condor? somewhat anyway. and obviously because of the wings your margin is lower than a strangle.

My strategy is to trade credit spreads as a unit. The price of the legs is immaterial. By specifying the credit required, the fill does not take place unless that price, or better, is obtained.

The Iron Condor is just the icing on the cake. The spread that completes the Iron Condor must be able to stand on its own. The icing part is that no additional funds are quarantined (margin) to put on the second spread of an Iron Condor. This provides a nice profit boost with some small additional risk.

 

[brettus]

My strategy is to trade credit spreads as a unit. The price of the legs is immaterial. By specifying the credit required, the fill does not take place unless that price, or better, is obtained.

The Iron Condor is just the icing on the cake. The spread that completes the Iron Condor must be able to stand on its own. The icing part is that no additional funds are quarantined (margin) to put on the second spread of an Iron Condor. This provides a nice profit boost with some small additional risk.

Ok. So you trade two credit spreads to create an iron condor. I get it now i think. So if you think the ftse range is 5600-5800. and the market is trading 5800. you sell a call at 5900 and buy a call at 6000 at the same expiry. When the market is trading 5600 you sell a put at 5500 and buy a put 5400.

 

[HowardCohodas]

Ok. So you trade two credit spreads to create an iron condor. I get it now i think. So if you think the ftse range is 5600-5800. and the market is trading 5800. you sell a call at 5900 and buy a call at 6000 at the same expiry. When the market is trading 5600 you sell a put at 5500 and buy a put 5400.

Unfamiliar with options on FTSE. See FAQ in signature for description of what I trade and the related distance between the short option strike and the long option strike.

If that fails to make things clear, give me another go.

 

[DionysusToast]

Over time, my guess is this will blow up Howards account, although I hope this does not happen.

The trades are based around a mathematically derived probability of certain prices being hit. From what I understand so far, It appears that no market analysis is being performed, rather that if a TOS indicator says that the probability is below a certain threshold then the trade will be taken.

Remember that I have not studied the indicator in question but my presumption is that it will be such that it implies the probability of a losing streak is extremely low - perhaps 1 in a million. Whatever it does imply, it is just a formula and we have seen time and time again the way these formulas fail in real life.

When going over them in retrospect, there appear to be 2 common flaws, certainly in the models that have caused major crashes. The first flaw is in the assumptions fed into the model, these models need inputs and the way some of those are derived looks fairly dumb in retrospect. Obviously the inputs are based on what worked in the past. But assumptions like "house prices will rise 12% per annum indefinitely IS dumb". The second flaw is in failing to grasp the impact the use of the model has on the markets, a model that gets adopted industry wide is never adjusted for the fact that this new model is now going to impact the markets. I presume the TOS model is not used industry wide - so perhaps that issue is not going to be important here.

It appears this trading approach cannot sustain a losing streak. Howard mentions a 30% drawdown if he has a bad months. What about 3 bad months ? It may be statistically impossible but that hasn't stopped these things occuring in the past.

I hope I am wrong - both for Howard and his students but this to me sounds like a Black Swan waiting to happen.

If I am wrong, then Howard has found the Holy Grail. A purely mathematical approach to trading the markets with no technical or fundamental analysis required that will yield a consistent 10% a month.

Good luck.

 

[HowardCohodas]

Over time, my guess is this will blow up Howards account, although I hope this does not happen.

The trades are based around a mathematically derived probability of certain prices being hit. From what I understand so far, It appears that no market analysis is being performed, rather that if a TOS indicator says that the probability is below a certain threshold then the trade will be taken.

Remember that I have not studied the indicator in question but my presumption is that it will be such that it implies the probability of a losing streak is extremely low - perhaps 1 in a million. Whatever it does imply, it is just a formula and we have seen time and time again the way these formulas fail in real life.

When going over them in retrospect, there appear to be 2 common flaws, certainly in the models that have caused major crashes. The first flaw is in the assumptions fed into the model, these models need inputs and the way some of those are derived looks fairly dumb in retrospect. Obviously the inputs are based on what worked in the past. But assumptions like "house prices will rise 12% per annum indefinitely IS dumb". The second flaw is in failing to grasp the impact the use of the model has on the markets, a model that gets adopted industry wide is never adjusted for the fact that this new model is now going to impact the markets. I presume the TOS model is not used industry wide - so perhaps that issue is not going to be important here.

It appears this trading approach cannot sustain a losing streak. Howard mentions a 30% drawdown if he has a bad months. What about 3 bad months ? It may be statistically impossible but that hasn't stopped these things occuring in the past.

I hope I am wrong - both for Howard and his students but this to me sounds like a Black Swan waiting to happen.

If I am wrong, then Howard has found the Holy Grail. A purely mathematical approach to trading the markets with no technical or fundamental analysis required that will yield a consistent 10% a month.

Good luck.

Appropriate concerns all. Like any business I've run, I have a process of quality control of myself and my strategy. Some of these I've mentioned earlier in this thread, but they likely bear repeating. However, lets discuss each of your points in order and see where we go from here.

Probability of Touching
I can't speak to the TOS proprietary model, but I can speak to the one I developed that came close enough to the TOS one to abandon mine and adapt theirs. My inputs were, current price of underlying instrument, strike price, interest rates, days to expiration and volatility. These are the same inputs that TOS reports that they use.

There are quite a few probability models used in options trading, all of which answer slightly different questions but all of which use the same inputs. I don't think the one I am using is any more magic or any less magic than the others.

These models are tools to be used carefully and with attention to the quality of the result they produce to see if the tool is still effective. If the quality assurance process is effective, any change in quality should be detectable before disaster occurs.

Loosing streak
From what I have learned from you, you are probably better at probability stuff than I. My understanding of these probability models is that they can be used as a proxy of the chance of the event happening. If I start with a probability of touching of 10%, then my understanding is that there is only a 10% chance, given the current market conditions, that the underlying instrument price will reach that level.

Were I to use a "set it and forget it" approach to trading, then it's pretty simple to calculate the probability of two successive failure events taking place. Since I actively manage the spreads, the probability of my loosing my maximum limit is less than is implied by the initial probability of touching would indicate. And so is the probability of two successive monthly losses.

Perhaps my explanation of how I derived my estimates was too convoluted because the 30% example was to represent only one half of the funds at risk. To reach the 30% level, would require two consecutive failure months. I tried to use this worst case (one that I never saw in testing) to provide a very conservative estimate of the expected return when losing months were included.

Common flaws in models
All models are based on assumptions and the one I use is not immune from that. All models must be monitored to see if they are effective under current market conditions. The model I use is not immune from that either. I fail to see how my model is more or any less susceptible to these challenges.

Quality Assurance
In my first post in this thread I described the reason for and the use of the journal. It is to monitor the two key components of a trading system, the strategy and the trader. There is a formal process for detecting degradations of performance of the trader separate from the model. These are designed to identify problems before they create a financial disaster.

Conclusion
Will this all continue to work as it does now? Will I be able to detect system failure before there is serious impact on my account? Have I thought of everything?

I don't know. I believe so. I doubt it. In that order.

One of the primary reasons that I started this thread was to learn from those with more experience and wisdom than I. The more I'm challenged, the deeper I have to think, the more I understand the strengths and weaknesses of my approach.

I greatly appreciate all the thoughtful questions that come with this thread.