Essay #1 – Premium Capture Rate

The first topic I’d like to talk about is premium capture % or premium capture
rate. This is a concept I came across recently and have not heard anyone else talk
about before, at least not in this much detail. Premium capture % is the percentage of
all premium sold that a trade keeps as net profit. If I sell a put for $1 and I close it for
$0.25, then I have a profit of $0.75 and also a premium capture rate of 75% (for the
purposes of this post, I am ignoring fees and commission). If I sell a strangle for $1.5
and close it for $0.75, I have a profit of $0.75 and a premium capture rate of 50%. If I
look at the combined metric of the two trades, I’ve sold a total of $2.5 and have a total
profit of $1.5 and a premium capture rate of 60%. There are a number of reasons why
this metric is very interesting to me and has become the metric I monitor the most
closely.
1) When you use premium capture % as a forward looking metric, it basically is a
measure of a trade’s expectancy or potential profitability. TT talks a lot about managing
winners as a way to boost POP but not so much about cutting losers since they
encouraging rolling and other ways to manage/defend trades. I myself use stop loss
orders and won’t get into which approach is the right one but want to just look at the
math with an example. Suppose I place a trade with a 75% pop and a max profit of $1
and a max loss of $3. If we assume all losses are max loss then the expectancy on the
trade is basically 0 ([0.75*1] – [0.25*3] = 0) Granted not all losses will be max loss but I
don’t think the true expectancy is much higher. So the expectancy, in other words, the
expected premium capture rate is 0%. If we were to use a 1x stop loss and set the max
loss to $1, we can boost the expectancy, even if the pop drops. Suppose now the pop is
60%, max profit is still $1 but max loss is also $1. Now the expectancy is $0.2 ([0.6*1] –
[0.4*1] = 0.2) which also means the expected premium capture rate is 20% in the long
run for this trade. So you can use this metric as a way to gauge the profitability of your
trades and decide whether or not to implement loss management in addition to profit
management.
2) When you use premium capture % as a backward looking metric and analyze your
past trades, you can determine if you are over performing or underperforming your own
expectancy. This can serve as a gauge of how well you are managing your positions. I
once heard Tom say on the air that a trader can expect to keep about 25% of their daily
theta. This basically boils down to a long term premium capture rate of 25%. I don’t
think this is just an arbitrary number since I have heard other traders also agree that this
is a reasonable expectation. I once went back through the backtest of a 7 DTE IWM put
selling strategy I run myself to analyze the overall premium capture rate and guess what
it came out to be? Just above 25%! There are some years which it was over and some
higher (2018 was a big 0) but the average was very close to 25%. So if you keep a
trade log and are able to parse out the total premium sold vs the total net profits, you
can analyze your own trading performance. If the premium capture rate is low then
something is holding back your performance. Maybe the commission is too large
relative to the size of your trades. Maybe you are over managing and losing a lot on
slippage. Maybe you simply need to implement some loss mitigation to prevent big
losers.
3) I no longer roll my trades and treat each one as an independent occurrence. I had
already been doing this for a while but looking at things with a focus on premium
capture helped to validate my decision. Again, I won’t argue for or against the merits of
rolling trades but want merely look at the math. Suppose you sell a put for $1 and are
forced to roll the trade 2 times (for a total of 3 puts sold total) before the last put you sell
final expires. You have netted a profit of $1 and a profit of 100% (assuming you track
the entire process as 1 “trade). What about your premium capture rate? It is NOT 100%.
Let’s look at an example sequence of credits and debits. Opening trade (STO @ $1),
Roll 1 (BTC @ $2, STO @ $2), Roll 2 (BTC @ $3, STO @ $3), Trade expires. In this
case, you’ve sold a total of $6 in premium but only had a net profit of $1, so the
premium capture rate is only 16.66%! Depending on the total time it took this trade to
play out, you’ll probably notice also the overall P/L per day would be lower than if the
trade had been closed for a profit much sooner. So premium capture rate is measure of
the efficiency of your trading. P/L per day can also tell you this but I like having a single
percentage number that is normalized (0-100%). Going back to the example we just
used, had you had a stop loss when the first position moved against you, you may have
been able to enter 2 more high probability trades that boosted your overall premium
capture rate.

Essay #2 – How to not give up your edge

The subject I want to talk about today stems from a single fundamental fact,
which is that the ONLY mathematically guaranteed edge is from the overstatement of
volatility. There is nothing a trader can do to boost the performance/expectancy of a
single trade. For short premium position, the expectancy and probabilities are all baked
in at entry. This is also when the expectancy is at its MAX! I’m not saying that I know,
or that anyone can know exactly how much positive expectancy/edge there is in a given
trade but whatever that value is, it is at its peak at trade entry. In order to not disturb the
probabilities, the trade has to run all the way to expiration. This is the only way to
capture the full expectancy in the long run. Any kind of adjustments will incur costs in
the form of fees and slippage which will chip away at and reduce the expectancy and
overall P/L.
What about managing trades? Doesn’t that boost expectancy? No! But
managing trades can serve to reduce your portfolio volatility and when done correctly,
can still achieve a decent expectancy and premium capture (25% premium capture rate
is a good target). We are going to look at a few management techniques in this context
to examine why they work or don’t work and how they affect our expectancy.

1) Selling a naked put with no management – This has the highest expectancy
long term, let’s call it X%.
2) Selling a naked put and managing winners with no loss management – This
will increase your win rate but also decreases your net P/L since your winners are
smaller. That means when the occasional blowout happens, you are wiping out a larger
portion of your profits. So you may have longer win streaks but your overall P/L will
decrease due to the occasional large losses.
3) Selling a naked put and using a stop loss only – This will lower your win rate
and cap your losses. However it is subject to being whip saws and also slippage occurs
when you are stopped out. This will also lower your net P/L long term but is good for
controlling the volatility of your account.
4) Selling a naked put and then selling a call against it when the put is tested to
reduce deltas – When you initially sell the call, you haven’t touched the put yet (a good
thing) and you have placed an additional trade that is presumably high probability as
well (also a good thing). This gets a little more interesting and there are a few
outcomes:
a) The stock recovers and stays inside the strangle and expires. Great,
you basically placed two trades and both were max profit and you have 100%
premium capture. Great but don’t count on this happening all the time!
b) The stock recovers and goes inside the strangle and you close the
strangle for a winner prior to expiration. You’ve basically managed both the
winners and in theory lowered the expectancy on each. However, while the
premium capture as a % is lower, you now have an additional trade with
additional credit so it’s a lower % captured of a HIGHER overall credit. The net
effect is that you’ve boosted the net P/L of your strategy over if you had done
nothing.
c) The stock continues down and you close the strangle for a loss. In this
case you’ve stopped out the put side (bad) but you have a winner on the call
side. The call side may be a partial or almost a full winner so you have a high
premium capture on the call side to balance out the low (possibly negative)
capture rate on the put side.
d) The stock recovers too much and breaches your call which becomes a
loser. You close the strangle at a loss. This is basically the reverse of outcome
c), but the put side has a higher capture rate while the call side has a lower one.
5) Selling a naked put and rolling it out in time and further OTM when it is tested
– You have effectively stopped out your original put (bad) but opened a new put that is
at a higher probability. If the new put becomes a winner then similar to the strangle
situation above, the winning trade has a premium capture rate that raises your overall
capture rate when averaged with the lower one on the losing trade.
6) Selling a naked put and rolling it out in time to the SAME strike when it is
tested – You have stopped out the original put (bad) and placed a new trade that is
probably low probability (especially if it is ITM). The new trade probably has low
expectancy to begin with so I don’t think this really can meaningfully and reliably
improve your premium capture rate and expectancy.

So as you can see from the above examples, the key is to recognize that what
we think of as adjustments are really a series of additional trades. So while managing
winners or stopping out losers serves to lower the expectancy of the ORIGINAL trade,
correct management techniques increase occurrences and thus increase the overall
pool of premium from which you can capture while also adding new trades that end up
with a higher capture rate. Each time you want to adjust a trade, before you do, think
about the probabilities of your new overall position and try to see if you will be improving
or hurting your overall expectancy.

Essay #3 - What is the “Tastytrade” method really?

Here are what I believe to be the “why” and the “how” of the Tastytrade method of
trading:
Why: Make as much money as you can while taking the least possible amount (or an
amount within your tolerance) of risk.
How: Consistent evaluation and execution of high probability trades.
The two statements above for me summarize the entire essence of the Tastytrade
methodology. People like to focus on the mechanics that TT teaches but I think what is
often overlooked is the huge motivation behind the mechanics which is risk control. I
have heard that TT doesn’t focus enough on the aspect of risk and merely encourages
traders to put on position after position and at one point believed this to be true myself.
It’s been a year and a half since I found TT and I know a LOT more about risk now than
I used to. What has become apparent is that the idea of risk management is actually
FRONT AND CENTER of the TT message. Why should we trade small? So that no
single trade can do significant damage to your account. Why should we trade often? So
that your risk is spread out across multiple positions with possibly different underlyings,
strikes and expirations, etc. What’s the deal with the whole 21-45 DTE thing? To slow
down the rate at which your risk changes (gamma) so you have time to properly
manage it!!
The more that I think about it, the more I realize how the concept of controlling risk is
actually ingrained in the entire TT philosophy. Yet in online forums the majority of what I
hear traders discuss is about topics like rolling for a credit, how much buying power they
like to use, whether or not they can beat the market with options. Rarely is the focus on
how much risk they are taking with each trade. How can this be? I now believe the fault
lies not entirely with TT but with what I call the “shiny object syndrome”. Less
experienced traders (myself included) tend jump from one idea/strategy to the next
searching for the holy grail and not taking the time fully learn any particular one in detail.
There is also a tendency to gravitate towards “silver bullet” concepts that make trading
seem easier than it really is. In my mind, there are three primary pillars to the TT
methodology: Sell premium, delta neutrality, trade small trade often. I will give my view
on each of these concepts should be applied along with a few additional topics that
newer traders see to pick up on.
1) Sell premium – This is based on the idea of volatility risk premium and the edge that
is derived from the overstatement of volatility. I myself believe in this and rely on
premium selling as the primary means to generate consistent returns. Because of the
way that options pricing works, especially with time decay, this allows high probability
trades to be constructed. Who wouldn’t want to be able to make money even if the
market didn’t do anything? This is one reason why trading options CAN be “less risky”
than stock since they can produce better risk adjusted returns. Of course one has to still
be mindful of the risk they are taking since the margin system also allows you to get
way more leveraged than you may realize.
2) Delta neutrality – The idea of being able to profit from any kind of market movement
and not have to “pick a direction” seems so enticing. But this doesn’t mean you can put
on a bunch of strangles and iron condors and expect to make money. Positions that
start out as neutral almost always become direction at some point. A trader either needs
to have the patience to allow the position to work itself out or the proper mechanics to
manage it. Delta neutrality at the portfolio level is probably the goal for those that want
to follow this method. This means you are aware of the delta exposure of all of your
positions combined when placing new trades or adjusting existing ones in order to
maintain neutrality. Rather than being an “easy mode” where you just throw on a ton of
positions and profit, this approach is intended to control the volatility of your account
and requires a lot of skill, patience and discipline.
3) Trade small trade often – This is of course the primary TT mantra and I believe a
philosophy that is often misinterpreted. Regarding trading small, it’s true that trades
should generally be sized small so that no one single trade can wipe out or do
significant damage to your account balance. Then with properly sized positions, trading
often allows more occurrences which allows the probabilities to play out over the long
run. Again, the purpose is to reduce risk you have tied to any single position and also
spread out your risk across multiple positions.
These three core pillars seem so simple but that’s what also makes them so potentially
dangerous when misapplied. Since most traders start with small accounts, the most
obvious approach to limiting the size of a trade is with credit spreads. If they feel
advanced enough to trade delta neutral, the trade of choice them becomes the iron
condor. So they trade “small” via tight credit spreads and trade “often” by having way
too many positions and then expect to print money. However, spreads can often times
be more risky than undefined trades and require consistent management in order to
have a positive expectancy long term. Another issue is that what is “small” or “often” is
different for each trader and really depends on their individual risk tolerance and trading
plan. At the end of the day, there isn’t really a Tastytrade strategy so much as there as
there is a Tastytrade philosophy. The concepts they teach can be used to guide a trader
in developing their individual trading plan. However, they should NOT be taken as a
substitute for the time and commitment it takes to obtain mastery as is true of anything
in life.
There are a few other topics/concepts that come up quite often which I’ll give my take
on:

A) Mange winners at 50% - Managing winners is one form of risk control that will
increase your win rate by not allowing winners to become losers. Winners can be
managed at any profit target but TT has found 50% to provide an optimal risk reward
tradeoff. Just be mindful that managing winners will lower your average win size so you
need to manage your average loss size as well otherwise you may end up with very low
or even negative expectancy.
B) Enter at 45 DTE and exit at 21 DTE – This time period is one that TT prefers to trade
in because what they believe is the optimal tradeoff between higher return (high theta)
and lower risk (low gamma). Again, this is to control risk!! There is nothing hard and fast
about this and trades inside this time frame don’t have any extra edge. And of course
trading at longer or shorter DTE is totally fine!! Trading at longer DTE slows down the
action a bit so you have time react and make a decision to adjust your trade (or not)
when one moves against you. Trades with a shorter DTE can profit more quickly but
also move against you more quickly. The opposite is true of trades with a longer DTE.
You can even place the same trade with the same mechanics at different DTEs and see
how they behave differently. 21-45 DTE is what TT prefers but each trader should
decide for themselves what they are comfortable with.
C) Collecting a credit equal to 1/3 of the width of the spread – The reason this came up
is probably because you are able to set up what appears to be a reasonable risk/reward
trade off. You risk 2 to make 1. What is often loss is that in order to collect 1/3 of the
width as a credit, you’ll more than likely end up with a pop less than 70%, maybe less
than 60% even. With these probabilities, the math just doesn’t add up to a positive
expectancy trade. These types of trades take skillful management in order to improve
the probabilities enough that a long term profit can be expected.
D) Rolling a trade and “keeping the dream” alive – This is another very attractive idea
for newer traders or those that psychologically do not handle losses well. If you truly
believe in a position and want to hold out for a recovery, it’s ok. But if over time a
majority of your positions become losers are you are just rolling them over and over,
your capital will just get tied up without generating any returns. I prefer to think of rolling
as taking a loss on a loser and opening up a new position. In that context, you can
better decide if the new position is one that you actually want to be in and whether it will
be a benefit to your overall portfolio.
E) Always roll for a credit – The fixation with credits of course originates with the idea of
selling premium in the first place. First, it seems neat that you can be paid ahead of time
based on an outcome that may or may not happen. Second, if it seems like the outcome
may be a bad one, you can delay it by some amount of time and get paid again for the
delay! It seems like magic. But one must not miss the forest for the trees. What matters
is not how much credit you collect but how much credit you get to keep. Who cares that
you collected $100 if you have to pay $200 to close the position. More importantly, who
cares if you are collect hundreds of dollars a week if your account balance is going
down by thousands of dollars! When you roll for a credit, your account balance does not
magically increase by the amount you collected. That’s because you’ve only changed
one position for another and maybe adjusted the greeks a bit but it still takes time for
the new position to make back the money you lost from the first one. Again, it’s ok
sometimes to hang on to a loser if you really believe in a position. But look at rolling
more as a chance to change the course of your portfolio. Whatever money you’ve lost
(or made) up until that point is all baked into the individual positions. Don’t get so fixated
on credits and debits, those are just by-products of the transaction and a distraction. By
choosing to make adjustments that place your portfolio in a more advantageous
position, your account balance will gradually head in the right direction.

Essay #4 - How to Design a Trading Plan

The most important part of designing a trade plan is to have a well-defined goal.
Without one, it’s difficult to gauge your success. At the end of the day, we all trade to
make money. But how much do we want to make? As MUCH AS POSSIBLE right?
Sure, but how much risk are you taking? Do you even know? In the beginning you
might be simply satisfied with making a decent return (what is decent?) but at some
point the two primary emotions of greed and fear start creeping in. Could you have
made more if you just traded a little larger? Should you sit out for a bit because you are
feeling bullish/bearish and don’t want to risk a loss? Emotions cloud your judgement
and hurt your decision making skills. But if your trading plan has a well-defined goal it
should be easier to simply ask if your trading results have met the goal or they haven’t.
And if not, then you can try to figure out what’s causing your plan to fall short of the goal
(since you kept a detailed trade log, right!) and refine or make adjustments to your plan
as necessary. I’m going list a few questions that I believe every trader should ask
themselves when define their goal(s) and why they should help to guide the decision
making process.
1) How much do you want to make? – Ok, if your goal is really to just make AS
MUCH AS POSSIBLE, that’s fine. There’s a few other things you’ll need to
consider so skip to the next question. However, there’s always a tradeoff and the
more conservative your goal the more likely you will be able to achieve it. Maybe
you are trading for income and based on your account size and income
requirement you need to generate about 10% a year. Or maybe you want to
double your account every 5 years so aim for 15% growth per year. Just
remember that the more ambitious you are, the harder it will be to achieve your
goal the more risk you will have to take.
2) How much risk are you willing to take? – If you are starting with a small account
and just learning, you might be ok with losing the entire account in the process of
learning. If you are trading with a bit more money and are serious about trying to
grow it you obviously don’t want to blow up the account but you may be ok with
the occasional 10% or even 20% drawdown if you have a long investing horizon.
If you are trying to generate and depend on income from your account then you
probably don’t want even a 10% drawdown. Your risk tolerance will determine a
lot of things from the type of products to the types of strategies you should trade.
For example, a conservative strategy might stick to only trading ETFs instead of
single companies like Tesla or Roku. The amount of leverage you use is another
thing to consider but a key point I want to make is that you have to first
understand how much leverage/risk you are actually taking on. Certain spread
strategies that have a low buying power requirement may be riskier than you
think (I’ll address this topic in another essay).
3) How much time do you have to trade? - Certain types of strategy require more
management which means more time spent in front of the screen. If you can only
trade during certain hours of the day, you need to use a strategy that does not
require constant monitoring to not risk a catastrophe. Trades with higher DTE
tend to move more slowly so give you more time to react when they move
against you. Same with trades that are lower delta (don’t ignore gamma though!).
If you can only check your portfolio once or twice a day you probably want to
have slower moving trades. Even if you have the spare time, maybe you don’t
want to spend all day watching the market. You can consider using stop orders.
There are arguments for and against stop orders but I see them as a cost of
doing business. Sure they lower your win rate and ultimately your overall P/L but
as long as your expectancy is still positive and it frees up your time to do other
things it may be worth the trade off. Time is money!
4) Do you like to take chances? - This might seem like a dumb question since
trading is all about taking chances but I want to focus on the psychological
aspect of trading. You may find it appealing to find opportunities based on your
own judgement. This may include making directional bets based on technical
analysis or looking for underlying with high IVR to trade. Even if there is a set of
rules you follow or a setup that you look for, you still have to decide whether or
not to place the trade. Whenever your decisions pay off, it feels great but
conversely when you make the wrong choice it may be hard to move on. There’s
nothing wrong with taking a loss but some people may have a hard time dealing
with the emotionally. One way to potentially distance yourself from the emotions
is to use a more mechanical/quantitative approach. Find a strategy that has
favorable probabilities and simply apply it over and over. Stick to the plan, be
mechanical and keep pulling the trigger despite how you may “feel” about the
market. Even if a trade here or there ends up losing, you can still be confident
that you are on the “winning” side of the strategy in the long term. Of course
doing the same thing every day can get boring so feel free to take a chance once
 in a while. Your trading doesn’t have to be entirely mechanical or entirely
discretionary. By taking into account your personality and how you deal with
losses emotionally, you can choose to focus on strategies that are more suitable
for you as an individual.

The answers to these questions above should hopefully guide you in setting a
goal that is realistic and uniquely suited for you as an individual. Ultimately you can
more clearly define the success or lack thereof of your trading results? Did you make
the return you were hoping for? If so, great, but what did it cost you? Were there
large drawdowns that made you lose sleep? Were you sitting in front of the screen
all day when you could have been doing something more productive with your time?
Strive to balance out your expectations with the potential costs (financial, emotional,
time) and you may just find the success you are looking for.

Essay #5 – Is trading naked really more risky?

Before we address this question we need to define and understand theoretical
risk and practical risk. Theoretical risk is the amount of risk a position can incur in the
absolute worst case scenario. For example, if you buy a stock for $100, your maximum
loss is $100 (if the stock goes to zero). This is similar for selling a naked put option with
a 100 strike. If you sell a naked call option, the theoretical risk is unbounded (the stock
can keep going up) and thus infinite. Practical risk on the other hand is the amount of
risk a position can be reasonably be expected to incur depending on the probabilities of
the trade. If you sold a naked put on SPY, should you expect the stock to go to zero? 
Conversely if you sold a naked call on SPY, should you expect the stock to double
(much less increase infinitely)?  Obviously the answer to both of these questions is no.
That means that while the idea of trading “naked” seems highly risky, you are almost
never taking on as much risk as it looks like on paper. In fact, there are a few reasons
why trading defined risk may be MORE risky.
1) Single legs are much more liquid than spreads so entering/exiting trades as
well as adjustments are less subject to slippage. Rolling a naked position
becomes a two legged operation and rolling a spread becomes a four legged
operation, which is exponentially more illiquid. This means you’ll be losing more
money to slippage in general trading defined risk and in the worst case you may
simply get stuck and unable to exit.
2) Some people may assume defined risk trades that are tested can be left alone
with no management but tight spreads have zero or very low expectancy long
term if left alone. Here is an example of a put credit spread I just setup: 318/321
put credit spread on SPY that has 46 DTE and is trading for $0.51 credit. The
short leg is 29 delta and the long leg is 24 delta. Max loss is $2.49 and
Tastyworks says the POP is 72%. We can do some quick math to approximate
the long term expectancy of the trade with no management.
 (0.72% * $0.51) – (0.28% * $2.49) = -$0.33
So this expectancy is actually negative $0.33. I realize that not all losses are
going to be max loss. For simplicity sake let’s assume that anytime the
underlying ends up between the short strike and the long strike you take a
scratch (even though it would be a partial loss) and you only take max loss when
the long strike has been breached, then the equation becomes:
(0.72% * $0.51) – (0.24% * $2.49) = -$0.23
The expectancy is still negative! If you manage winners, you can boost win rate
but that will reduce the actual P/L for winners so they will still be outweighed by
the losses. This means that in order to successfully trade defined risk, especially
tight credit spreads, a loss management plan is required. Naked trades also
require a loss management plan but as I pointed out earlier they are more liquid
so easier to manage.
3) Trading defined risk can ironically lead to overleveraging, not from an absolute
risk stand point but from a portfolio volatility stand point. Let’s suppose there is a
stock ABC trading at $10. Trade A is a 1 contract naked short put at strike 10.
Trade B is 10 contacts of a 9/10 put credit spread. Which trade is more risky?
They both have an absolute (notional) risk of $1000. However, stock ABC would
have to go all the way to zero for trade A to incur the max loss of $1000 whereas
the stock only has to drop to $9 for trade B to incur the max loss! Furthermore, it
is clearly more likely for the stock to drop $1 down to $9 than it is to go all the
way to zero. If you think about it, since you have 10 contracts for trade B, during
the time from which the stock is dropping from $10 down to $9, you are losing
money at 10 times the rate of trade A where you only have 1 contract! So while
the absolute risk may seem the same between the two trades, having multiple
tight credit spreads will magnify both the profit AND loss potential.

This does not mean there’s no place for defined risk trades nor that new traders
should jump right into doing naked trades. For example if you’re doing a speculative
trade like an earnings play on a volatile underlying, it may make sense to cap your tail
risk. The important thing is to KNOW the risk you are taking both in theory and in
practice for any trade you plan to make. Don’t assume that just because your risk is
defined, you are taking “less” risk.

Essay #6 – What’s the deal with 45 DTE anyway?

Along with delta neutrality and trade small trade often, the idea of trading at 45
DTE is often mistaken as part of the tastytrade recipe for guaranteed success.
However, a trade placed at 45 DTE isn’t necessarily better than a trade at 30 or 90 DTE
and it certainly doesn’t have a higher probability of success. So what exactly is so
special about 45 DTE and why is it talked about so much by TT? In order to answer this
we need to talk about the risk/reward tradeoffs that occur at different durations. As
premium sellers (mostly), we like to focus on theta and on that fact that theta increases
as a trade gets closer to expiration. This means that all else being constant, the
potential for profit per day increases with each passing day. So why not just sell
premium at 7 DTE to extract the most reward from your capital at risk or 2DTE or even
0 DTE? This is due to increasing gamma risk, which basically means a position gets
more sensitive to movements in the underlying the close it gets to expiration. There is
plenty of content/videos on gamma risk so I won’t get too much into the details but will
instead move to the opposite end of the spectrum.
What if we place a trade at 90 or 120 DTE? In this case, gamma will be low
meaning the delta will change more slowly as the underlying moves. Basically, I see
DTE as a time machine. The shorter the DTE, the faster trades move and the longer the
DTE, the slower they move. If your daily schedule does not allow time for constant
monitoring of your portfolio, trading longer durations is a way to stay in control. Outside
of binary events like earnings, trades at high DTE are unlikely move in way that requires
managing more than once a day if even that much. This means that you have time to
think through your management decisions when a position is being tested. You can
deliberate and proactive with your adjustments as opposed to being reactive and forced
to act. There is of course a trade-off, which is that vega is much higher. The trade is
more sensitive to changes in IV which can work for or against you. You can try and take
advantage of this by putting on positions where IVR is high since a subsequent crush in
IV could have you hitting a 50% price target rather quickly. On the flip side, rising IV
would result in your position showing a heavy marked loss even if the underlying has
not moved much against you. This may not be too big as long as you understand what
is causing the negative P/L and have budgeted for the increased buying power
requirement (assuming the position is naked). Remember that time is on your side and
higher IV also means theta will have gone up.
So now that we have gone through all of that… what’s the deal with entering at
45 DTE and closing at 21 DTE? As demonstrated by the examples above, there is no
perfect trade. There are pros and cons to consider and it boils down to risk/reward
tradeoff. Through their various back tests, TT has determined the period of time
between 45 DTE and 21 DTE is optimal in terms of the reward (higher theta) provided
for the risk (higher gamma) taken. Again, please don’t assume this means the trades
will have a higher POP or anything like that. Your win rate is ultimately a function of
delta and your management of winners and losers. What you SHOULD experience is a
decent RATE of profit from your positions without having them move too quickly that
you lose control.
Should you NOT enter any trades above 60 DTE? Sure you can. There may not
always be expirations right at 45 DTE when you are looking to place a trade and
depending on how many cycles are available for a given underlying, you may opt for a
slightly longer duration. Additionally depending on how restrictive your trading schedule
is or your experience level, it may be preferable to have slower moving trades. You may
want to enter at 90 DTE and exit at 60 DTE, for example. Furthermore, it’s ok enter
trades with less than 21 DTE, but make sure you understand the risk and how to
properly manage it. Just remember that 45 and 21 DTE is not a magic formula. It’s just
another tool that can used to construct a trade best suited for you.

Essay #7 – Notional risk and Using Leverage Responsibly

Leverage allows traders to more efficiently use capital and allows the
amplification of both gains as well as losses. It is a powerful tool that should be carefully
studies and understood prior to being used. Some people assume it is “too risky” or
simply don’t want to take the time to learn and thus avoid it altogether. While I think this
is a lost opportunity, at least they will avoid getting themselves into TOO much trouble.
However, there are those that apply too much leverage without fully understanding the
risks involved or even worse, they do not even realize how leveraged they are. In this
essay I will try to provide clarity on various topics related to the use of leverage and
hopefully prevent a lot of unnecessary losses and hard lessons learned.
Firstly, one has to understand the concept of notional risk. When your notional
risk exceeds the net liquidation value of your account, YOU ARE LEVERAGED. For
short call and put options, a simple way of calculating the notional risk is to multiply the
contract size by the strike price by 100. For example, if you sell 3 contracts of an option
for stock XYZ at strike 50, the notional risk is 3 * 50 * 100, or $15,000. Under normal
circumstances, the margin/buying power required (BPR) for the position will be
approximately 20% of this or roughly $3,000. This is the first point that often leads to
confusion because traders are taught that if you keep your buying power usage under
some amount such as 30 or 50% then it is “safe”. Not only can BPR expand in volatile
markets but if you are trading only naked positions and using more than 20% power
then you are more than likely leveraged. While being leveraged does not by itself mean
you are taking huge risk, it is important to KNOW how much risk you have on so you
can have a reasonable expectation of potential losses. Suppose your account is
$10,000 and you sell 3 naked puts on stock XYZ at strike 50 as in the above example.
The BPR of $3,000 is only 30% of your available capital but you are in fact leveraged
1.5x or 150% in terms of notional risk. Does that mean you can lose $15,000? No,
because you don’t have that much money and your broker will liquidate your position
before your account can go negative. However if stock XYZ takes a sudden dive and IV
is expanding, your account can start to decline at 1.5x (or more!) the rate at which XYZ
is declining even if the price of XYZ has not gone below the strike price of 50! Try to
have a rough idea of your notional risk and don’t go over 200-250% leverage until you
have a solid understanding of the risk and are sure it’s within your tolerance.
 What about spreads and define-risk trades? Aren’t those safer? Not necessarily
and most of the time, no! There are a multitude of reasons why trading naked is
beneficial (see my previous essay) but I want to focus on the risk for now. Let’s take the
three following scenarios with an account of $10,000 and stock XYZ trading at $100:
A) Sell 1 naked put at strike 100
B) Sell ten 90/100 put credit spreads
C) Sell 100 99/100 put credit spreads
For spreads, the notional risk is simply the width of the spread multiplied by 100
(ignoring the credit received). In each scenario, the notional risk is $10,000. Does that
mean they all have the same level of risk? Even without diving into it, we know that that
this can’t be true. This is where we differentiate between risk in theory and risk in
practice. If stock XYZ went to 0 then of course we lose $10,000 in all three scenarios
but that’s probably unlikely to happen. What is stock XYZ went to 99 at expiration (once
again ignoring credit received for simplicity)? Trade A loses $100, trade B loses $1,000
and trade C loses $10,000!!! The credit received will pad the loss obviously, especially
for trade C but you get the idea. As the spread gets tighter and you sell more contracts,
the trade is becoming more leveraged since EACH contract will incur a loss for the
same move in the underlying. If stock XYZ went to 90, even trade B would lose
$10,000. All three trades are in fact cash secured with no actual leverage being applied
but credit spreads are basically SYNTHETIC LEVERAGE. For trade A, your account will
lose at the same rate 1-for-1 with the stock as it goes down. With trade B, your account
will lose at 10x the rate of the stock and with trade C your account will lose at 100x the
rate! One way to tell trades B and C are more risky is that they will both have a BPR of
almost the entire $10,000 (spreads utilize buying power equal to the width of the spread
minus credit received). So while all three trades have the same notional risk, trades B
and C have roughly 10 and 100 times the risk in practice respectively of trade A and
thus will be 10 and 100 times more volatile. One good way to avoid overleveraging
when using spreads is to calculate the notional risk of JUST the short strikes as if all the
trades were naked. If all the positions were naked, would you be comfortable with the
amount of risk? If not, then it is probably too much for your risk tolerance and you
should reduce contract size.
Leverage seems risky, so why even bother? It’s true that leverage at its core
allows you to amplify performance and produce larger wins/losses. However, there are
some nuances that can be applied as well. For example instead of simply taking MORE
risk to generate more returns, you can take LESS risk to generate the same level return
as you can without leverage. In this case when I refer to risk, I mean risk in practice.
Suppose you can A) sell one 15 delta put at strike 200 for stock ABC or B) sell one 2
delta put at strike 1450 for stock XYZ, both for $5 credit. Which trade is “safer”? Based
on the strike price alone, trade B is over 7x the notional risk of trade A but the delta is
also much lower. As long as the risk is properly managed, it’s possible for trade B to be
safer since it will have a higher probability of success. I do want to emphasize that
PROPER RISK MANAGEMENT is required since in a tail risk type of event, trade B
certainly has the potential for much larger losses simply due to the size of the
underlying. My point is just that higher leverage alone does not always equate to more
risk in practice and there are even ways that leverage can be applied (besides the
example above) to create a SAFER trade. The most important thing is to educate
yourself and fully understand the AMOUNT of risk you are taking both in theory and in
practice.

Essay #8 – How to Start a Hedge Fund

I decided to write this essay because there seems to be a lack of readily
available, concise information online on how to start and operate a hedge fund. (Either
that or I am just really bad at searching for it). This is by no means a comprehensive
guide but should be enough to get you started or at least decide is the endeavor is
worth your time and money. Note that the various costs mentioned below are based on
my personal experience and they may differ depending on your choice of service
providers. For starters, there are no requirements (at least in most states as far as I
know) in terms certifications, designations and licenses required in order to be a fund
manager. The three service providers needed to launch a hedge fund are an attorney,
an administrator, and an accountant. That’s it. Let’s look at each of these three and the
role that they play:
1) Legal – In order to create the fund, an attorney will register the business
entities as well as draft legal documents. The fund itself is set up as a limited
partnership with an LLC (owned by the fund manager) as the general partner.
All investors in the fund including the manager themselves if they choose to
invest are limited partners. The legal documents that are prepared include a
private placement memorandum (PPM), limited partnership agreement (LPA)
and subscription documents. The PPM is essentially the fund’s prospectus
and goes over its business plan and/or strategy. The LPA is the contract
between all partners and spells out the authority of the general partner and
the rights of all limited partners. Finally, the subscription documents are what
investors fill out to contribute capital and includes a questionnaire to ensure
they meet the qualifications to invest. The cost for all the legal work to get
started is around $15,000.
2) Administration – Within the fund, all investor capital is combined and
managed as one large account. Profits and losses are distributed to each
partner pro rata based on the size of their investment relative to the total
AUM. Thus, everyone has the same return as the overall fund regardless of
the size of their contribution. The administrator’s job is to keep track of each
partner’s individual balance and properly allocate profits and losses based on
the monthly brokerage statements. The cost of administration is around $500
per month.
 3) Tax and Audit – The accountant prepares taxes for the partnership itself, the
general partner/LLC as well as K1 statements for each limited partner. Hedge
funds are exempt from registration and mostly unregulated, with one of the
few requirements being that they provide investors with an audited financial
statement annually. Thus, the accountant will also perform the audit and
produce the financial statement for the fund. The cost for these two functions
depends on the number of partners as well as the number of transactions and
is around $8-9,000.
That’s really all you need to start a hedge fund. The entire thing can be setup in
about 3 weeks starting with engaging the attorney to draft the legal documents and set
up the legal entities. Next you create a hedge fund brokerage account with the broker of
choice and provide administrative access to your administrator. From that point you can
start taking investor money and proceed to trade. So is it all going to be worth your time
and effort? As mentioned above, the startup cost is $15,000 and the annual overhead
between administration and tax/audit work is also around $15,000. So your breakeven
point as a business will be a function of your fee structure and how much funding you
think you can raise. Regarding the fee structure, it’s possible to negotiate different fees
for each investor but the fund’s official track record will be based on the fee structure
stated in the PPM. Each investor may join at various times and/or make varying
contribution amounts so their personal returns will differ. From the date of inception, the
administrator will use a dummy account (with a starting balance of $100,000 for
example) to track the fund’s performance and this becomes your permanent track
record. So if you decide to put a high fee in the fund’s documents and give your
investors a “discount” to attract capital, it can create a permanent and undue drag on
your official performance.
If you are not able to afford the full startup cost and/or don’t think you can raise
enough capital to afford the overhead, it is possible to start with an incubator fund. The
cost would be around $4,500 and the attorney would only set up the business entities
without drafting the rest of the legal documents. At this stage, you are not allowed to
take investor funds but can trade your own capital in order to develop a track record.
There would be no ongoing overhead costs and you can stay as an incubator fund as
long as needed. Once the decision has been made to fully launch the fund, you would
pay the rest of the $10,500 startup costs and proceed as mentioned above.

Essay #9 – Options Trading May Be a Zero-Sum Game…and That’s Fine!

One of the primary reasons I was drawn to options trading was the concept of
volatility risk premium (VRP), which is the insurance-like premium that options sellers
primarily exploit as their means of profit. There are some who argue that VRP does not
exist in an efficient market and it is all a zero-sum game. When one person wins,
another person loses. Personally, I believe that VRP does exist since there is always
uncertainty in the market place (not to mention the possibility of black swans) which
leads to the mispricing and typically overpricing of options. This in turn implies there is
an inherent edge to selling options. The purpose of this essay is not to argue the
existence of VRP one way or the other but rather to express that it may not matter at all.
Let’s look at a short straddle, which starts off collecting the maximum amount of
extrinsic value possible. If volatility is truly overstated, simply selling short straddles
regularly and holding them to expiration should yield a positive expectancy. In fact there
are back tests which show this is the case albeit with bouts of high volatility to p/l. Does
this mean that it is a viable strategy even if the probabilities suggest so? I would argue
no since as you may have heard before “the market can remain irrational longer than
you can stay solvent”. A series of or even a single large outlier move can potentially
wipe you out or set you back so far recovery is all but impossible. That’s not to say the
probabilities won’t play out in the long run. But who knows how much time the “long run”
actually will end up being. One month? One year? Ten years? Twenty? The point is
that regardless of whether or not an inherent edge exists with a strategy, it doesn’t
matter if your portfolio is subject to unreasonable volatility. In order to profit consistently
and have longevity, traders need to define their own edge through proper risk
management. Your profits (or losses) are an accumulation of all your decisions starting
with trade entry and most importantly how you manage the risk.
One belief held by supporters of the options trading as zero sum idea is that for
every winner there is a loser. I tend to believe this myself and whenever a strategy is
going too well it actually makes me question the validity. Does it make sense
mathematically why my expectancy should be positive? If so, who is taking the other
side? WHY are they taking the other side? Obviously there is multitude of participants
in the market including market makers and they can have any number of reasons to
take the other side of your trade. However I want to walk you through a thought
experiment with a specific example. One of the strategies I use is a 7 DTE short put
option on IWM that’s between 10-20 delta. This trade is put on every Friday and held to
expiration unless stopped out at 3x the credit received for a net loss of 2x. Those are
the only mechanics, and backtests as well as live trading have shown this to be a
positive expectancy strategy overall. Why should such a simple strategy be able to
make money long term? Is someone out there consistently losing money, either
deliberately or unintentionally? Let’s look at a few scenarios that can result when I sell
a put option.
1) The option expires - I have profited by some amount and some else has lost by
the same amount.
2) My stop loss is triggered and the market continues decline past my strike price –
This is what I consider a “good” stop. I don’t get to profit from it since I bought a put to
close my position but it prevented a larger loss. Whoever sold me the put to close out
my position would be the one incurring the loss as the market continues to move down
further ITM. In this case I’ve still lost money but it is limited to 2x the credit received and
someone else has become the “bigger” loser.
3) My stop is triggered prior to the option being ITM or the market reverses and the
option ultimately expires worthless – This is the worst case scenario and why everyone
hates the use of stops. In this case I would have paid a debit of 3x my original credit to
“buy to close” the position and since the option eventually expires, that becomes the
profit of whoever took the other side and sold the put.
Now that I have described the three scenarios above, the expectancy of the
strategy is simply a function the frequency at which each occurs. What’s interesting is
that we can see there is in fact a winner and a loser in each situation. Note that I have
simplified things a bit for illustrative purposes and will dive a little deeper in a later
essay. In scenarios 2 and 3, I’ve lost the same amount and whoever is on the other side
could either become a small winner or large loser depending on what the market does.
My long term P/L is thus an accumulation of the profits and losses that result from each
of these individual occurrences. Regardless of whether or not there is any edge inherent
in selling options, you will make money as long as your net profits outpace your net
losses. Remember to maintain balance between your win rate and the ratio of loss size
to win size. By properly managing risk, you can create your own edge.

Essay #10 – The Market Can Stay Irrational Longer Than You Can Stay Confident
So most traders have heard the phrase "The market can stay irrational longer
than you can stay solvent". This serves as a warning against trading too large and
having a strategy based on "hoping" that the market will accommodate your position.
Even if the supposed probabilities are on your side, a market that continuously moves
against you will eventually bankrupt you when proper risk management is not employed.
Practically speaking, this simply means you run out of capital. However, there is a kind
of capital not related to the cash in your account that many traders fail to consider. I'm
talking about mental capital, or more precisely, mentally having the confidence and
conviction to continue trading your strategy despite taking multiple losses. Even a well
thought-out strategy is nothing without execution. If you lack the conviction to pull the
trigger when your plan calls for it then you may as well not have a plan at all. What are
some ways that a trader can build their confidence and develop the conviction to follow
through with their strategies?
1) Take the time to get educated and learn about options. Having at least a basic
understanding in the Greeks will help you evaluate how a strategy will respond to
various market forces and identify where an edge may exist. If you are simply following
another trader or a signal service, things may go fine as long as you are winning. As
soon as things start going wrong, you will lack the conviction to press forward or will be
apt to write off the strategy as no longer working.
 2) Run a backtest, but don’t only focus on the P/L of a strategy or even the win
rate. You should look at the max drawdown over a given period of time and whether
there are steady returns or huge runs of wins and losses. The idea is once again not
just to see if something works or not but WHY it works. Rather than simply evaluating
the profit potential, try to draw some qualitative conclusions from the test results in order
to set proper expectations and determine if the strategy is a good fit for your portfolio
and for your temperament.
3) Trade smaller. While this has no direct impact on the success of a strategy,
large losses are demoralizing. You should always be aware of the loss potential of a
strategy and size trades as appropriate for your risk tolerance. In fact, you should
probably size even smaller to account for the possibility of multiple sequential losses.
Too often, traders quit because they mistakenly equate large losses with a strategy
being ineffective. They fail to realize the loss may be within normal parameters for the
strategy and in fact the position size was not calibrated for their risk tolerance.
4) One of my favorite methods is to keep a "normalized" trade log of a strategy.
Oftentimes after experiencing some success, a trader will increase their position sizing.
However, this may also coincide with a string of losses simply due to bad luck, with no
bearing on the validity of the strategy. Even if the trader is aware of the luck element,
large losses skew the long term P/L and are always quite discouraging. A normalized
trade log will include the same trades that were actually made but adjusted such that all
positions are sized consistently. This allows the trader to see how a strategy should
have performed once the timing luck of variable sizing is eliminated. Another use of
normalized trade logs is to isolate out pilot error. Suppose one day you broke your own
rules regarding risk management and ended up with a bigger loss than usual. The
normalized log would assume the trade was executed per your plan and thus result in a
loss size within normal parameters. Note that the intent is not to simply forget about
your mistakes. The point is to show how the strategy would have done had it been
followed precisely with no deviation. To that end, both an actual trade log along with the
normalized log should be kept concurrently. You are in a sense running a perfect
“backtest” using your own trades as the input data. Thus, you can not only learn from
your mistakes but also be encouraged by how much better the results are had the
mistakes not been made.
Hopefully, by keeping these principles in mind, you will have the mental staying
power to trade through the drawdowns that are inevitable for any strategy.

Essay #11 - The Secret to Trading the Tastytrade Way

As I have mentioned in a past essay, many traders have come to view the
Tastytrade approach as a magic formula for making money. I actually tend to agree.
The key components of the formula include selling premium, being delta neutral,
entering trades around 45 DTE and exiting at 21 DTE, trade small trade often, and
managing winners at 50%. However, almost all traders are missing the single most
important ingredient which is unfortunately also one that doesn't seem to be
emphasized enough. The missing component is bankroll management, and it makes
the difference between having a positive or negative expectancy.
No matter what your style of trading, in order to profit consistently you need to
generate positive expectancy. For sake of example, assume you make 100 short
premium trades collecting $1 each. If all winners are managed at 50% profit, your
average win amount is $0.5. If you are able to achieve an 85% win rate, your win
expectancy is 0.85 x $0.5 or $0.425. However what is your loss expectancy and total
net expectancy? For pure premium selling strategies, a proxy for net expectancy is the
premium capture rate and 25% is a solid number so let's use that as the objective and
work backwards. Just like the win expectancy is the win rate times the average win size,
the loss expectancy is the loss rate times the average loss size. We can set up the
following equation: (0.85x$0.5) - (0.15x$?)= $0.25. The "?" represents the allowed
average loss amount and when we solve for it, we get $1.17. This means the average
loss size needs to be $1.17 or less which represents 2.34x the size of the average win.
So do we simply set a stop loss on all trades to cut off at $1.17? Well we can, but this
will severely drops the win rate which in turn reduces the allowed loss amount and we
are no better off. So how can we keep the high winrate and still cap losses at the
required amount?
Continuing with example above, with 100 trades and an 85% win rate we are left
with 15 losing trades. Of those 15, suppose 5 end up being small losers (closer to a
scratch) and 5 end up being moderate sized losers within the 2.34x threshold. What
about the remaining 5? These are potentially the rip your face off losses that wipe out
dozens of trades worth of profit and basically push your expectancy into the negative.
What is a trader to do about these in order to keep the total average loss amount under
control? This is where the concept of rolling to keep the dream alive comes in. If you
roll a trade enough times, eventually the underlying recovers in your favor or you simply
salvage the trade through brute force by collecting enough credit. However, many argue
(myself once included) that rolling trades is simply locking in losses on one position and
opening a new arguably worse one which ties up capital and leads to large drawdowns.
This is in fact... true! But it can be overcome with proper bankroll management which
involves both proper sizing at the trade level and proper buying power allocation at the
portfolio level. If you were to only allocate 2% or less of your buying power to any
individual trade, then tying up the capital even for an extended amount of time is not
necessarily such a big issue. Furthermore, a small buying power requirement by
extension generally means any resulting drawdown from the position will be relatively
small. Lastly, by limiting the amount of overall buying power you allocate in the first
place, you can afford to inventory and continue to nurse the big losers since there is
fresh capital to deploy into new trades. Given enough time, you can work the losers
back to maybe a scratch or a smaller loss such that your average loss falls within the
required threshold and all of a sudden, your expectancy is positive.
 So in summary, the key to trading the Tastytrade way is trading SMALL enough
that you can inventory the large losers and work then until the loss is reduced to a
reasonable size. At the same time, these positions temporarily become dead weight in
your portfolio so you want to keep enough capital available to deploy on new
opportunities. This requires low overall capital allocation during normal periods. In this
way, you can keep drawdowns in check while continuing to generate profits.