Al’s Calls of the Day

09/26/2014
Can you say “tone change?” The market, despite what I would normally
consider a blip in volatility in an otherwise bullish market, is starting to smell
a bit rank to me. As you may know, I have been long the market for well over
a year now. Though I was a bit late to the party, I did attend. So what has me
squirming? Well, it is not the recent Skew action (which I will comment on
in a minute.) Rather, it is the end of QE3.
First, to the recent Skew action. A week ago, the CBOE SKEW index hit
its high of 146.08. At that point, the VIX was in the upper 11 handle. Very
cheap. Many have asked me if the SKEW popped because traders in the know
saw the down draft coming. My feeling is “not at all!” Remember that the
skew measures the IV of the out-of-the-money puts relative to the IV of the
“at the money” options. When VIX gets very cheap, the out-of-the-money
puts trade cheap enough on an absolute price basis that they become desirable
insurance. But the IV of a 25-cent option may be high compared to the at-
the-money IV, thus “artificially” making the skew look expensive. When IV
started to rise, the IV of the out-of-the-money puts did not rise in lockstep.
It lagged, causing the SKEW to fall. In short, this was all irrelevant market
information and not a “tell” of things to come.
What I do find relevant is QE3 coming to an end. I first want to say I was
not a proponent of the extraordinary quantitative easing we went through
and am leery of the unwind from the incredible flood of liquidity the market
received. And, the market seems to have the same feeling. QE1, which saw a
market rise of 74 percent and ended in March of 2010, with a bang. In the
three months after it was declared over, the market fell 13.2 percent. A fluke?
Well, QE2 saw the market rise 24 percent, and in the three months after it
ended, in late June/early July of 2011, the market fell 18 percent. Now, QE3
(the longest of all the QEs) has seen a 78 percent rise in the overall market.
With it due to end in October (or December at the latest, reportedly), I
think the market is starting to get nervous. Will a rise in interest rates be a
bad thing for the market? I actually think the first couple of smallish hikes
will be good for the economy and therefore good for the markets. But, the
huge liquidity of quantitative easing 1, 2, and 3 (and huge deficits) we have
been experiencing are still sitting there ready to rear their ugly heads. How
will it play out? I am not sure. And that, my friends, is a bad sign. The market
despises uncertainty!

both01  1 19 February 2015 4:27 PM

 What am I doing about it? I am still selling premium every time I see
what I consider to be good edge. But, I have considerably reduced my long
deltas and, in fact, have gone pretty flat deltas. I am also buying more insu­
rance when it is cheap. I know that insurance is a losing proposition. That’s
why I am a premium seller. But, I am spending a small portion of my overall
theta to buy VIX out of the money calls and also am aggressively selling /VX
calendar spreads each time the contango steepens.
So, it is no time to panic. But, be aware of what is taking place and plan
accordingly. If I am wrong, I bought some unnecessary insurance and will
make a little less on my short premium plays. If I am right, I will get to keep
most (or all) of the profits I have been making on my long delta, short pre-
mium positions from the past 14 months.

Al’s Calls of the Day

08/29/2014
I had a number of responses and questions from my last blog that basical-
ly asked, “Why didn’t you scale into more SPX positions when VIX popped
to 17?” A fair and excellent question. As it turns out, I added a few extra SPX
strangles at that point. However, I added a lot of extra short equity premium
when volatility popped. Since I trade mostly indices, why did I change my
stripes (and I did change my stripes) with the SPX around 1900? I want to
briefly explain how I view risk.
There are two basic types of risk involved with an underlying: unique
(or specific) risk and systematic (or macro or systemic) risk. Unique risk is
borne specifically by that underlying. Examples might be that the company
gets sued, the CEO suddenly resigns or passes away, fraud in the company is
alleged, the company is taken over, earnings are awful, and so forth. Though
there may be bleed-over into a few highly correlated stocks, for the most part,
these events basically affect one stock. Systematic risks are more global in na-
ture. Examples might be 9/11, a surprise rate hike, a sudden and dramatic oil
price increase due to unrest in another part of the world, and so forth. These
events pretty much affect every stock.
We deal with the two types of risk differently. Unique risk can be diversi-
fied away by trading many noncorrelated (or inversely correlated or lightly
correlated) underlyings at the same time. This large population of trades (30
is generally agreed to be the magic number) effectively allows the unique risks
to cancel each other out. This is the purpose of having a diversified portfolio

both01  2 19 February 2015 4:27 PM

 of stocks. For this reason, the SPX (an already diversified portfolio of stocks)
trades for a much lower volatility than the average of its component stocks’
options. But, diversification does little to protect against systematic risk. You
have to mitigate that risk separately (but that is a story for another day.)
Getting to the point, when the market craps out hard, the relative cost of
SPX options as compared to its component equities rises significantly. This
can be seen, and is measured, by the CBOE implied volatility index KCJ. So,
with the SPX at 1900, I wanted to sell premium due to the volatility pop.
But, I knew if the market continued to fall, though both trades would be-
come losers, there was more risk in being short index premium since implied
volatility of SPX would rise more than that of the individual equities on a
relative basis. And, if the market rebounded, both would be winners. I felt the
risk versus return favored selling the individual equities.
I hope that answers the questions from the last blog (though I am sure
it opens up another can of worms!). Happy Holiday and have a nice, long
weekend.

Al’s Calls of the Day

08/22/2014
Today, I want to talk about a difficult decision many of us recently faced.
More specifically, I want to discuss what happens when you make the wrong
decision (as I may have)!
Prior to the recent market selloff, I had on my usual short strangles in
both the SPX and the RUT. As the S&Ps fell toward 1900, the market had a
decision to make; break through the century mark (and continue its slide) or
rebound back up. It was my opinion that we would bounce. But I am not a
directional options trader, so I did not want to overweight my deltas, which
were getting long at this point. Instead, I concentrated on my positions and
what could be done to take advantage of the implied volatility expansion the
move had provided. Looking at the RUT strangle, I saw the short calls were
trading for $0.20. This was my one nod to my directional bias, as I bought
those back and left my short puts on. I do not frequently buy back one side
of a strangle. I usually sell them as one trade and buy them back as one trade.
And, with my deltas starting to get long, I knew I was actually adding to my
downside risk, but just a little.
My SPX strangle was an entirely different story. I was short the Sept.
1680/2075 strangle for $4.65. My strangle was trading for a small loser at this

both01  3 19 February 2015 4:27 PM

 point with the puts trading for five times my calls and the put deltas starting
to grow teeth. I did not want to buy the strangle back with VIX high, so I
chose to roll my calls down to better balance my risk and take advantage of
the higher IV. I sold the Sept. 2025/2075 call spread for $1.05, leaving me
with a short 1680/2025 strangle for $5.70. As you know, we did rebound
and we rebounded hard. Though I felt $125 was enough buffer on the call
side when I rolled, I started to get tested on the call side early this week. My
response was to roll the put side up. Though I felt this was not as good a trade
as rolling the call side since volatility was much lower now, I wanted to rebal-
ance the position a bit. So, I sold the Sept 1680/1745 put spread for $1.10.
This placed my short put back to a 5 delta (my original delta). The net effect
is that I was then short the 1745/2025 strangle for $6.80. The strangle is cur-
rently trading for $5.70.
What now? I have a small winner, but my risk is growing. I thought
about rolling the put side up one more time, but to get any decent premium
out of it, I would have to sell the 1745/1825 put spread. This would reset
my put at the 5 delta mark. But, my SPX short strangle would now be only
$200 wide. That is getting a bit tight for my liking with 29 days to expiration
remaining. And, if the market continued its climb, with my short call sport-
ing a 22 delta, the extra $1.10 does not buy me much upside protection any
more. I have rolled myself into a dilemma! Why tell you all this? Here is my
lesson for the day. Though I am a mechanical trader, there are times when
a trade becomes “uncomfortable.” The risk seems to outweigh the potential
return. Though I have strict exit rules for my trading, this “new” trade is not
to my liking. So, instead of holding out for the over $3.00 profit I was hop-
ing for, I settled for the $1.10 profit and moved on. I can now sell the next
expiration cycle strangle, as its days to expiration are in my trading range.
Again, my point is, no matter how mechanical you are, if your assumptions
on a trade change, or the trade is “massaged” into being something you no
longer like, get out. Break your “rules” and reboot your trade! Though this
sounds obvious to many, you would be surprised how often I have traders
come to me with large losses in trades in which they long ago lost confidence.
Trading is no place to be stubborn! I promise you, the market will win . . .
not you! Listen, keep an open mind, and react. Take off trades immediately,
or sooner, if your assumptions change or your trade starts barking at you that
something is wrong.
As I have said before, the first thing I was taught as a trader is “You will
have your share of winners. The probabilities dictate it. If you control and
limit your losers, you will be successful!”

both01  4 19 February 2015 4:27 PM

 Al’s Calls of the Day

07/18/2014
Occasionally, an equity’s options behave in a way that is difficult to inter-
pret. Such was the case with Dunkin’ Donuts (DNKN) yesterday. Its options
volume exploded to 22 times normal. The volume was so large that the com-
pany felt compelled to comment, which is something few companies will do.
Their response was that the volume spike was related to the upcoming earn-
ings announcement. My response is “bull.” They would have been better off
not commenting. I am skeptical for two reasons. First, earnings are not until
next Thursday morning and any kind of abnormal volume spike would likely
be closer to the earnings date. Second, and more important, the nature of the
volume looks like anything but earnings related. You see, most of the volume
was in upside (out of the money) calls that expire in January of 2015. With
the stock at $43.89, 2,000 Jan 45 calls, 9,000 Jan 47.5 calls, 5,000 Jan 50
calls, and 3,000 Sept 45 calls traded. If the volume were earnings related, the
volume would be in much shorter dated options, in my opinion. This upside
buying not only has the IV percentile at 99 percent, but the volatility skew has
now inverted and upside calls are trading for a higher implied volatility that
the at-the-moneys. So, if not earnings, what could cause this type of picture?
My guess would be that DNKN is being viewed as a takeover target since the
upside skew inversion is usually seen mostly in breakout stocks and takeover
targets. The stock is only in its 23rd percentile of its 52-week price range, so
it certainly is not a breakout stock. But, again, a take-out candidate is gener-
ally played in shorter-term options. So, the only explanation I can come up
with is someone believes the company is in early stage talks that might take
months to play out. Since DNKN has been a rumored target for years, this
makes sense. My response was to sell some Sept 45 calls and some Dec 47.5
calls. I delta hedged them, but if I am presented with a pullback, I might turn
them into covered calls or even collars if implied volatility pulls back enough.
If I believe it is being played as a takeover candidate, why would I short calls?
Aren’t I tempting fate? From my experience, a vast majority of rumors are
false. The implied volatility and inverted skew present a trading opportunity
of which I wanted to take advantage. Selling the high IV and skew made sense
to me. If I get nervous, I will turn it into a covered call immediately. But the
expiration cycle being purchased gives me no reason to panic. Of course, if
the stock gets taken out before I do so, I will be looking at a nice loss. I like
my odds though, and that is what options trading is all about!

both01  5 19 February 2015 4:27 PM

 Al’s Calls of the Day

06/13/2014
I generally try to keep my blogs both instructive and useable in the short
run. Today’s takes a bit longer view of our markets.
As you may know, I am big on correlations. When macro level events
occur, they do not occur in a vacuum. And, their affects are often wide reach-
ing and somewhat predictable. Though there is no “certainty” to this cause
and effect relationship, I believe an understanding of typical correlations can
improve the odds in my trading. After all, all trades are nothing more than a
probability game in which we hope to turn the odds in our favor. Why these
ramblings today? I have been watching the correlation between oil and bonds
for the past year with some interest. Why?
Perhaps above any other single instrument, oil prices may have the most
affect on inflation. Oil is not only used for heating and transportation, it is
also used in the manufacturing process for many products. As such, when
oil prices rise considerably, we often see inflation pick up. With our current
interest rates so low, a large spike in oil prices could be problematic for our
bond prices as inflation causes higher rates, which in turn cause lower bond
prices. This means that oil and bonds should be inversely correlated. Logical,
right? Let’s take a look at their correlation and see if this plays out in the mar-
ket. Here are the results of a quick correlation study I put together. (If you are
unclear how to do a correlation study, please see the “Al on Video” section of
my website.) This is the correlation between oil prices and bond prices over
various time frames.

8 years: –56.88 percent

5 years: –48.87 percent
3 years: –41.63 percent
1 year: 18.36 percent
6 months: 76.42 percent
3 months: 72.10 percent

As you can see, in the long term, the products are inversely correlated as
we predicted. But, in the past year, this correlation has not only broken down,
but reversed! Why? I can only guess at the reasons, and here is my best guess.
The Fed has been holding interest rates low for a long period of time.
This has kept bond prices (artificially?) high regardless of what the rest of the
market is doing. This could easily uncorrelate the two products as the pricing
of the two products is being driven by different forces. And, over this same

both01  6 19 February 2015 4:27 PM

 period of time, oil is up almost 14 percent. So, the products appear to be
positively correlated.
You may be asking, “interesting, but, so what?” As traders like to say,
no one party is bigger than the market. That includes our government. If oil
continues its upward trend, as we are seeing with the unfortunate events oc-
curring in Iraq at present, I believe this inflationary pressure will find its way
into the bond market and our inverse correlation should return. Reiterating
the statement that nothing occurs in a vacuum, weakness in our economy,
housing market, and employment situation could prove to counteract some
of the effects of high oil prices on inflation going forward. So, I am watch-
ing all these catalysts and lining up a correlation play in the future. What
play? Depends on too many things to venture a guess at the present moment.
But, when I see it, I will blog again, and that blog will be timelier than these
musings.

Al’s Calls of the Day

05/06/2014
I just wanted to say a few words about liquidity. You will often hear op-
tions educators say, “the first rule of trading is to trade liquid products.” First,
I want to reinforce that statement. But, second (look away, children), I want
to say there are times when rules are made to be broken.
One of the most frequent questions I get from people I coach is “how
do I get my commissions lowered?” I do not mean to minimize the ques-
tion as any time you can cut your costs, it is money in your pocket. But, by
comparison, the width of the bid/ask spread is far more important to your
profitability than an extra 25 or 50 cents in commissions. Let me illustrate
this point with an (fictitious) example. XYZ and ZZZ are two stocks that are
both trading for around $30. XYZ is a very liquid stock and its $29 puts are
$0.45 bid and $0.47 offer. ZZZ is illiquid and its $29 puts are $0.40 bid and
$0.55 offer. Assuming I need to buy the offer and sell the bid, I will give up
$2 per contract, crossing the spread on the liquid XYZ stock and $15 on the
illiquid ZZZ stock. A few things should jump out at you.

1. The difference in the slippage between the liquid stock and the illiquid
stock is enormous when viewed as a percentage of the option price.
2. If you believe the edge in trading options is generally 2–5 percent, the
spread on the illiquid stock most likely renders trading that option
unprofitable.

both01  7 19 February 2015 4:27 PM

 3. Both spreads are far more costly than the commission differential between
the lousy commission structure you have and the fantastic commission
structure you are hoping to obtain.

Another point is you have a far better chance of bettering the bid / offer
spread when you trade liquid options. There are far more participants and
thus, a better chance someone will trade in the middle. And, perhaps most
important (and you will not realize it until you have the misfortune of experi-
encing it), when the crap hits the fan, it will be next to impossible to get out
of the illiquid option (if you are short), as all offers will seemingly disappear!
Finally, when a bid/ask spread is tight, the market is efficient. That is, you
can buy or sell the option at very close to the same price. It is virtually a “pick
’em” market. You can trade what you want with very little slippage.
Convinced? Great. Then why am I short NSR May 20 puts? The front
month, at the money puts are 40 cents wide and the options are certainly il-
liquid! Well, once in a while, they give you so much perceived edge, that you
just might want to play! On April 16th, Neustar Inc. reported good revenues
but a small miss on earnings. The stock moved down to new 52-week lows.
Downside put buyers moved in, and due in part to the illiquidity of the op-
tions, the buyers moved the implied volatility of the May 20 puts (25 percent
out of the money with 17 days to expiration) up to 176 percent on April
30. They continued to purchase the May 20 puts in bigger than normal size
through Cinco de Mayo and I continued to sell them. I understand that the
stock was near its 52-week low, but I could find nothing but decent reports
on the stock. Nothing dire seemed to be coming and the only thing that
could explain that high of implied volatility (in my mind) was an upcoming
announcement, of which I could find no hint. If the crap does hit the fan, I
will be forced to defend my position with stock, as I know the put sellers will
run for cover. At least until the current put buyers decide to take profits. And,
when they do, they will probably drive the implied volatility down at least
100 percentage points to get filled. I will be waiting, in that event, and close
out my stock and puts when the sellers (current buyers) reach near the end of
their positions, as determined by the open interest.
A dangerous game? Perhaps. But, once in a while, the very thing that
makes illiquid stocks a “bad meal” can set the table for a feast. It forces some-
one who insists on taking a large position to give up so much edge via the
bid/ask spread and by driving the implied volatility so far afield, that all the
downsides of trading illiquid options make it worth the risk.
Now, I am not proposing you run out and start trading illiquid options.
But, every trade is a transference of risk. If you pay me enough that I feel the
risk is worth the potential return, I may break a few “rules” and make the trade!

both01  8 19 February 2015 4:27 PM

 Al’s Calls of the Day

03/25/2014
I want to make it clear that I never ask anyone to accept my directional
assumptions. So, why do I ever speak about them? Well, I try to do so rarely.
But, I find the hardest thing to convey to people is how to read the market.
On occasion, I see something in the market that is odd and makes me think,
“What is that trying to tell me” or “what could possibly cause that scenario”?
I saw one such instance yesterday and illustrated what I saw via a directional
assumption. I happened to have the privilege of appearing on Bloomberg TV
yesterday with Julie Hyman and took that opportunity to discuss it.
Again, it is not my directional assumption that I hope you take away.
Rather, it is the thought process that a trader should go through. You can see
what I see and come to a completely different conclusion. In that case, you
have a 50 percent chance of being right, in my opinion. It is the fact that
you see it at all, and what you do with it once you have thought about it that
makes you successful. To what am I referring?
In the past 12 months, the market has moved up in its ebbs and flows, or
stair-step fashion, in seven distinct waves. At the top of the first six of those
waves, the VIX had fallen to the 12 handle before the market pulled back.
(Actually, I think one of those bottomed at 13.05, but why let facts get in
the way of a good story?) This shows a great deal of complacency and may
have contributed to the reversal. But, as we like to say, this time it’s different!
At Friday’s high, when the SPY hit $189, the VIX was still in the 14.50 area.
Why the change? I can think of three possible explanations.

1. We are not at the top yet and have more upside to come.
2. The overall market is starting to trade like a breakout stock. If so, this is a
rare occurrence as I can only remember one other time this has happened.
What I mean by that is in normal times, as a stock rises, IV drops and vice
versa. But when a stock breaks out to new highs and starts to run (due to
short covering, new interest, or whatever), a stock’s volatility path inverts
and IV rises as the stock rises. If you look back at the last 40 SPX handles
of this rally, the VIX has actually risen during the run. Strange, indeed.
If this is the reason for what we see, the market is (again) signaling more
upside to come, and possibly explosive upside at that.
3. I think most traders will tell you VIX is higher because the market is
due for a correction. Though entirely possible, I think too many traders
jump to that conclusion without considering other possibilities. That
is the purpose of this blog: to challenge you to think things through
thoroughly and to think outside the box.

both01  9 19 February 2015 4:27 PM

 I have been leaning long the market since mid-July. I will stay leaning
long until the market tells me otherwise. When is that? Possibly after a 6 or 7
percent pullback. But, if I read “change” earlier, I react to what I believe the
market is telling me.
So, again, I do not want anyone to lean long at my behest. I do, however,
want to encourage you to think for yourself and to allow yourself to think
freely. Please do not let my directional assumption get in the way of that! I
have never found that lemmings make very good traders. Think for your-
self and trust your instincts. Just abide by a good mechanical approach with
proper position sizing to give you every chance to succeed.

Al’s Calls of the Day

03/13/2014
A week ago, I wrote about how the historical volatilities of many of the
underlyings I watch were starting to rise. And, though I may be in the mi-
nority, I believe that this often leads to an uptick in the implied volatilities.
Rising historical volatilities cause rising implied volatilities. Subtle “tells” like
these can help you avoid tough situations.
One week later, the S&P’s are just over 2 percent lower. Keeping that in
perspective, it is really not a big deal. But, it is a start and certainly feels like a
bit of a tone change from the relentless up market we have been experiencing
for so long. The VIX, on the other hand, is up almost 15 percent in that time.
And the contango is almost gone once again.
Jumping back to my first thought, I spoke about how the rising HVs
can keep you out of trouble by foreshadowing things to come. But, for short
premium traders, it is the other side of the coin that provides the real oppor-
tunity. Many of you have not been trading long enough to have experienced
a several-month-long period of high volatility, where short premium traders
often “get their faces ripped off,” as we used to say on the floor. If you like
the VIX at 20, will you love it at 40? Not necessarily. The advantage we enjoy
as premium sellers is that IVs are generally higher than HVs. But, during
these extended periods of high volatility, this pattern often reverses and HVs
explode beyond the IVs. Why? Because IVs, as mean reverting “indicators,”
look forward and look for the underlying movements to slow (mean revert).
But, because most of us trade in a 30–50 day window or shorter, this HV-
higher-than-IV pattern can lead to big losses for short premium positions
as the pattern may hold long beyond the expiration of our positions. Then

both01  10 19 February 2015 4:27 PM

 how do we know when it is safe for us to sell premium again to avoid this? I
wait for the HVs to roll over. When you start to see chart after chart of your
underlyings with the HVs curling downward, it is time to sell premium. You
will not be selling the top of the IV move by any means. But, a continuing
wild ride will also not whip you nearly as often as volatility ebbs and flows on
the top of the cliff.

Looking at the above example from September 2008 to January of 2009,

you can see the point fairly clearly where the SPX HV’s rolled over. I have
(quite clumsily) marked it as “sell” (blue is IV, pink is HV). The IV at that
point was actually 48, down from a high of 77. Why not sell the 77? Even if
you knew that was to be the high tick, it bounced back there three times. All
that time, the HVs were dominating the IVs and short premium positions
were getting trounced. But, if you sold when the HVs were clearly giving up,
you never took any pain on your positions and enjoyed very healthy profits.
Remember that the above chart is only the SPX. I look for a similar pattern
in many of the underlyings I trade before I jump in. These opportunities do
not happen often but when they do, you can make a year’s income in one or
two expiration cycles.
So, I never underestimate the power of watching the historical volatilities
in conjunction with the implieds. Keep your eye on it as things unfold in the
coming weeks.

Al’s Calls of the Day

03/06/2014
Generally, when the market is moving up consistently, as it has been of
late, we see most underlyings with falling historical volatility trends. Or, at a
minimum, we do not see rising historical volatility trends. What do I mean
by “historical volatility trends”? As you may know, historical volatility is the

both01  11 19 February 2015 4:27 PM

 standard deviation of an asset’s returns over a past period of time. If the stock
closes at the same price every day for 20 days, its 20-day historical volatility
is zero. I find that to be intuitively obvious. What I find to be less obvious is
that if the stock rises (or falls) 5 percent (or even 20 percent) each and every
day for 20 days, its historical volatility is also zero. So a stock that is trending
steeply will have an historical volatility that is lower than one might expect.
Industry standard HV is calculated for 20 days or 21 days, which is just less
than one month of trading. But, I find stocks have inertia. Once they begin
moving swiftly, they tend to continue to do so for some period of time. The
same can be said when they begin to slow after a period of wild fluctuations.
So, I like to look to see how a stock’s 5-day HV compares to its 10-day HV,
and how that compares to its 20-day HV. This tells me if a stock’s movement
is slowing or picking up speed, or doing nothing of note, as the shorter period
is more sensitive to changes and reacts first.
In rising markets, not only do I expect VIX to be dropping, but when
I sort my watch list to see if HV trends are rising or falling, I expect to see
a long list of stocks with falling HVs and a short list of rising HVs. And,
last week, this was the case. But, as of this writing, with the S&P futures up
$6.00, VIX is actually up on the day and, more important to me, my list of
rising HVs has grown to be the same length as the list of falling HVs. This is
a huge change and something I do not see often in a rising market. In fact,
this may be the first time I have seen this since 2008. Also of note is that the
RUT is one of the underlyings with a rising HV. Yes, an index! It’s 20-day HV
is 12.97, its 10-day is 14.29, and its 5-day is 19.36. Interestingly, the 5-day is
actually higher than RUT’s 18.97 IV.
What does this mean? Tough to say. But, for my money, I have purchased
some protection today by means of some long straddles in cheap stocks.
Smells to me like a tone change is coming!

When to Take Profits and Losses

11/01/2013
A word about when to take profits and when to take losses . . .
This has to be the most confusing topic in options trading, yet math gives
a very clear answer that is often overlooked. I will attempt to clarify it here.
One cannot give a precise answer to the question “At what percent of my
maximum profit should I close my winning trades?” without also answering,
“At what percent of my maximum profit do I take my losers off?” The two are

both01  12 19 February 2015 4:27 PM

 intertwined. It is the ratio of the two answers that will give you a clue as to the
potential profitability of the mechanical strategy you design.
First, a little history. In 1950, as a result of statisticians’ work on how to
manage signal noise issues in long distance phone calls, a formula called the
“Kelly Criterion” was born. Quickly, they realized there were applications of
the formula for gambling and it gained in popularity. Its application for trad-
ing is one of position sizing. It helps answer the question “How much of my
account should I risk on a given trade?”
Rather than go through the more complex math, traders have simpli-
fied the formula to a good approximation of the more complicated original
method. It boils down to “Edge divided by odds” and is mathematically rep-
resented by:

Kelly % = W – ([1 – W]/R);

Where:
W = percentage of winning trades
R = avg. gain of winners / avg. loss of losers

Using this formula, let’s solve for the average win/loss ratio that provides
us with a breakeven scenario. From there, we can get a feel for what makes
sense. Our first order of business is to define a probability of profit for our
portfolio.
Let’s say our portfolio normally consists of 85 percent defined risk trades
at around 65 percent probability of profit. That is, we sell credit spreads or
Iron Condors for around 35 cents per dollar spread. And, let’s say 15 percent
are undefined risk trades at around 83 percent. This would mean our portfo-
lio probability of profit is around:

(.65 × .85) + (.83 × .15) = .5525 + .1245 = .677

This is our “W,” .677. So, setting Kelly % to zero, we now have:

0 = .677 – (.323/R),

And solving for R, we get:

.677 × R = .323 or
R = .477

both01  13 19 February 2015 4:27 PM

 So, what does this mean? It means that if you take off your winners for
47.7 percent of your maximum potential profit, you need to take off your los-
ers at an average of one times your maximum profit potential! Since we often
do not manage our defined risk trades and the losers will often get to close to
two times our maximum profit (to sell for one third the width of the strikes
means we can lose two times the width), it appears taking winners off for half
the potential profit is an untenable strategy!
A couple of further points to be made:

1. You cannot let your undefined losers run forever and expect to make
money unless you have a very small percentage of your portfolio in
undefined risk trades and you take your profits at a fairly large percentage
of maximum profit. Play with the numbers (Kelly Criterion formula) to
see how you might fare. Pick a winner-to-loser ratio, use 0 for the Kelly
percent, and you can back into the probability of winning you would
need to break even.
2. If you take winners quickly, it is true you will most likely improve your
probabilities, but not by enough to make some strategies profitable.
3. It is also true that we generally do 2–4 percent better on our percentage
winners than probabilities at trade time predict. This is because IV is
generally higher than HV.

By way of a quick example, let’s look at the following scenario. Let’s say
you like to take your winners off at 30 percent of maximum profit, that you
let your defined losers go to maximum loss and that you take off your unde-
fined losers only if they get to three times your maximum profit. Further, let’s
say you use undefined risk for 25 percent of your trades (naked puts, covered
calls, and strangles or straddles). What probability of profit would we need to
achieve to break even?
First, let’s calculate our R from the formula. We will assume that we sell
our average spread for .35 the width of the strikes and that not all our los-
ers are maximum losers. Taking some rough estimates, that would make our
contribution from the defined risk as:

.30/1.75 × .75 = .1286

For our undefined risk trades, let’s assume we get a rare big loser and
a bunch of two times losers. We will take a rough-cut guess by saying our
loser’s average 2.5 times our maximum profit. Our undefined risk trades
then yield:

both01  14 19 February 2015 4:27 PM

 .30/2.5 × .25 = .03

This makes our total ratio .1586, which we will round to .16.
Putting that into the equation and solving for the percent of our trades
that have to be profitable to break even, we get:

0 = W – ((1 – W)/.16); solving for W we get:

W = 86.2%

So, using the design we chose with the assumptions we outlined, you
need to make money on 86.2 percent of our trades just to break even! That
is a tall order!
You can improve your odds of success by either taking your losers earlier,
by letting your winners run longer, or by some combination of the two. Per-
sonally, I do both with undefined risk trades and I let my winners run longer
for defined risk trades. Play with the formula and find an answer that fits you!

both01  15 19 February 2015 4:27 PM