Win when you’re right and win when you are wrong. Can this be done?

Trade Allocation, Trade Sizes and Reserves

Options are more for week-trading or month-trading and that would be a difficult
transition to make for day traders unless they had a framework from which to
build an overall game plan.

Realistically, you put an options trade on and have wait a few days, at least,
because it is a play for a longer time horizon and a different trend dynamic (Sidewaysish
or Explosivish in addition to bullish or bearish plays).

Unfortunately, people believe what they want to hear. For example, an instructor
that I know used to say in his presentations that he often legs butterflies for
credits. Of course this simply means that he had a hunch and was correct. He
would buy a call vertical (bull spread), the market would rally and later when
the adjacent vertical just above his original strikes was trading at a greater
value than
what he paid for the bull spread, he would do the bear spread resulting in a
butterfly for a credit. What the student hears is that you can put butterflies
on for credits (can only make money) and subsequently enters a bunch of orders
just that. He is left to wonder why none of his orders get filled. In the early
’80s we could do it on the Philly, but today’s market maker would ignore the

Model Portfolio of Options-Only Strategies

Objective: to Achieve 25% per Annum

Ideal world: Win when you’re right and win when you are wrong. Can this be done?
High probability trades that take advantage of time erosion.

Also nice: Never getting scared out of a trade. How? Limited risk spreading.

Certain spreads have sort of, built-in stops. But what is better is that you’re
not actually “out” of the market, meaning that if the market moves back your
way, you can get back some or all of the loss and even better, win.

Out of the 20-plus options spread strategies only about 4 or combinations of 2
or more of the 4 are worth trading. You are more than half way home when a
position has a high probability of winning (more ways to win than lose), never
getting scared out of a trade. That is my belief but there are those that
believe keeping it simple by just buying calls when you are bullish and buying
puts when your bearish is a better way to go.

For about a 25% annual return I suggest a diversified approach of carrying 10 or
so simultaneous strategies limited risk strategies:

3 Bullish candidates

3 Bearish candidates

3 Sidewaysish candidates

1 Explosivish candidate or 1 Cheap shot lottery ticket type play occasionally.

For example, as a rough guideline, put no more than 7% of your account at risk
on any one play. For a $25,000 account that means no more than risking $1750

per trade. In the table below, the size per trade (qty) is rounded down to the
nearest whole number and it is assumed a round turn commission at the rate of
$1.50 per contract plus a $10 ticket charge. The execution prices are sort of
what you look for but it will vary so adjust the size accordingly.

Here are some relevant dicussions I’ve had recently with traders in my RD3 message board:

13:01:21 {K3} Last week you mentioned that we all someday want to
increase the size of our positions to much larger. What would change in our
analysis and selection if our position size in bfly for example would go from 10
contracts per side to 100 per side. I know I would change my analysis.

{Ri$k Doctor} As your profits grow consistently, you want to increase your size
commensurately with it and retract size when in a trading slump.

13:02:39 {K3} Just a couple of thoughts, and I know these are inconsistencies in
psychology, but I would probably trade larger bflys in very liquid markets
primarily indexes and be happy with smaller profits on the larger position.

{Ri$k Doctor} That represents an adjustment to your strategy/methodology. As you
develop consistency then increase.

13:02:59 {drsynthetic} Odds don’t change when size does only perceptions of
reality. A good hand is a good hand for a buck or a million.

{Ri$k Doctor} Agree

13:04:50 {K3} I don’t think the size can change in a straight linear fashion.

13:05:11 {K3} As a market maker, how did size influence your trading.

{Ri$k Doctor} I new what I knew and what I did not know. As I became more
confident that what I was doing was consistently profiting, I increased to
achieve the same objective, multiplied.

13:06:39 {K3} Yes, but when all of us might not take a profit on a bfly for .35 on ten contracts I know I would look differently at that .35 on a
hundred contract bfly.

13:08:23 {Tharma} K3, I think you are right in saying that there are
inconsistencies in your psychology possibly. Sometimes if you are trading larger
sizes and taking smaller profits you might be fundamentally changing your own
trading rules for what is cheap option and what you may consider an expensive
option. This may mean your whole trading style may be changing because your
trading rules regarding risk and reward are changing so it would be important to
keep this in mind.

{Ri$k Doctor} Tharma: I could not have said it better.

13:11:00 {K3} Yes but the size affects how the position feels when you are right
or wrong.

{Ri$k Doctor} Revamping your methodology to going for a .35ish profits as
opposed to your current consciousness of going for a buck or two represents a
big shift. You need to prove to yourself for a while with an even smaller size
than you currently use to see if you can do it because your timeframe is greatly
reduced as well. You are getting closer to ‘day-trading’. Your going from
‘month-trading’ down to perhaps ‘week-trading’, which is fine but recognize it
for what it is, perfect your methods, develop a track record with this new
trading tool (you will still use the longer timeframe butterflies at your
current size and increase as your track record warrants). Consider it a totally
new type of play event though this is also a butterfly because it is for a
different timeframe.

13:12:34 {Tharma} you might only be focusing on what you need to make a certain
earnings target is this correct?

13:10:36 {Ravi} Is there an issue here of % return and dollar return?

13:11:44 {K3} Ravi: Great point, make 10% a good return unless it is on a
thousand compared to 10% on one hundred thousand.

13:12:41 {K3} The reason I mention this is when we review the different
positions, I find myself reacting to the trades differently.

13:13:10 {janus} I would have thought the main difference other than psychology
is the mechanics of getting fills for small vs larger positions.

13:14:21 {janus} Can you go after 0.35 profit on larger positions due to better
fills/less commission impact?

{Ri$k Doctor} janus: At the same commission structure it would not be a huge
factor but your bargaining power for cheaper rates can make a difference. Also a
.05 edge on 100 spreads is more attractive to a market maker than .10 on 10
spreads. Good point.

13:18:18 {K3} The size issue transforms the percentage issue into total dollars
returned issue.

Ohlala: This is a very interesting and informative discussion, I was of the
opinion that if we used a % profit/loss figure we could be more consistent in
taking off/leaving on positions whether the position size was 100, 1000,10000 or
even higher. If you we are comfortable and come to rely on a certain % mark you
take your profits it would be the same level you would take your gains whether
you put on $1000 or $10000. It could lower the “Fear Factor” of loosing bigger
when trading larger sizes and also exiting the positions prematurely. Like to
get your feedback on this.

RD: Personally, I have never agreed with the percentage profit/loss rules
because I think it makes you lose track of the bigger picture. I look to put on
plays based on forecasting an expiration range.

Let’s say that a particular strategy could sometimes cost .50 or 1.00 or 2.00.
Let’s also say that I make the trade for .50 debit. With the ‘100% Profit Rule’,
if it goes to 1.00, making 100%, then I would have to get out. However, that
1.00 debit (to buy anew) may be desirable entry point. That is to say, it is
desirable to keep the money where it is, to continue the play.

This is why I prefer to look at each situation and ask myself at each juncture,
“Would I do the trade at the current price?” If I would put the trade on at
1.00, what would be the point of liquidating it at perhaps 1.90 and reentering
it at perhaps 2.10 just so I can follow the arbitrary 100% rule? Unnecessary
commissions and edges to give up.

Charles Cottle

Charles Cottle is a veteran professional options trader and the co-founder of
Thinkorswim, Inc. the second largest brokerage firm in America specializing in
options. From 1981 to 1989, Mr. Cottle’s pit trading experience included trading
in the General Motors options pit, the Bond options pit, the T-note options pit
and the Grain Options. His exchange membership included the CBOE, CBOT and CME.
In 1989, as a member of the CME Mr. Cottle was the local market maker in the,
Currency Options Eurodollar Options, Meat Options and S&P 500 options. Starting
in the late 1980s to the Mid 1990s, Mr. Cottle was the Director of Instruction
at the International Trading Institute, Ltd. where he wrote the manuals, trained
instructors, market makers and programmers when exchange-based electronic
trading was in its infancy.

Between 1999 and 2003, Mr. Cottle co-founded Thinkorswim, Inc. a brokerage firm
specializing in options. In addition to his role as co-founder, he served as the
firms “RiskDoctor” and mentored clients and associate brokers on how to properly
apply hedging strategies and manage complex options positions.

Mr. Cottle is also the author of Options: Perception and Deception, primarily at
those training to become professional market makers. He is also the author of
Coulda, Woulda, Shoulda, a book that was designed to teach
institutional-level options strategies to the retail side trader. Mr. Cottle is
the inventor of several hybrid options hedges including the SlingshotHedge. He
also invented and patented Dynamic Adjustable Risk Transactions (DARTs).

In in addition to trading, Mr. Cottle teaches options strategies through
webinars and forums at his websites