Acceptable Results—The Risk and the Reward

There are a few other topics we want to examine concerning non-seasonals,and option writing in general. It’s all very well to talk about ROC in the abstract,but I’m not abstract and neither are you. We’d like to know what sort of return on our capital we can reasonably expect to see in a typical carefully selected non-seasonal trade, and what levels of percentage and dollar risk we should consider tolerating.

The fact of the matter is that there aren’t hard and fast answers to these questions, for a couple of reasons. We know perfectly well that the markets are going to move around to some degree during the trade. By definition, then, the SPAN margin requirement (plus our comfortable margin cushion, which is absolutely essential) is going to float around also.

If the trade is what I call a “flier” and works in our favor right from the starting gate, the average margin and cushion we’ll have to employ will be well less than indicated by our pre-trade analysis, and the ROC will be correspondingly higher. If the market behaves contrarily, we will certainly employ more capital than originally anticipated and our ROC will fall, sometimes a lot, if the adverse market move becomes extended.

Short of keeping detailed daily records of margin and cushion levels and crunching quite a few numbers at the end of the trade, we cannot obtain a precise ROC for a particular trade.Now, I’m not lazy (well, not too lazy), but this amount of record keeping is more trouble than it’s worth, as far as I’m concerned. I’ll compute the capital usage and cushion figures once a week or so, more often if the trade even seems as if it may work against me, and live with the approximate ROC result very happily.

This is probably a sensible way to go about it, but if this is too Bohemian for you, then by all means track your capital-usage-per-trade on a daily basis. I’ll wager you’ll change your mind about doing this within 60 days. Or less.As for the general question of typical or average ROC over a series of disciplined non-seasonal trades, this will be a function of the markets in which we actually do make a trade.

ROC will tend to be higher in markets that normally have higher volatility on an absolute basis: coffee, natural gas,possibly gold or cocoa, lumber, crude oil and its products not infrequently, soybeans when they’re active. Equally, we’ll anticipate a rather lower ROC when trading non-seasonals in currencies, bonds and notes, and usually the metal markets.

Except when the goldbugs have one of their occasional the-world-is-about-to-die-and-we’ll-all-be-poor-forever-unless-we-buy-goldright-now orgies . . . in which case, if we simply wait until their own fervor and their trading losses tire them out, we will see our ROC dancing at stratospheric levels.In any market, 5% net potential ROC per month is the least I’ll accept, and 7–9% for carefully selected and disciplined non-seasonals is a perfectly normal prospect.

If the non-seasonal trade should happen to begin right when the market’s options’ IVs are to the high end of their 6-month range and option premiums are correspondingly high, such a trade can easily return 13–15%, even more, per month. This is sort of the best-of-all-worlds case, though. I’ll tell you this right now: if you undertake non-seasonal trading and consistently take out 12, 15, 18% net ROC per month for a while,first, I’m delighted for you and, second, you are selecting striking prices that are too close to the market price when you enter the trade.

Back it off some, be more conservative in your selection of the option strikes to write in future. You’re tempting fate, my friend . . . and that’s just never a good idea.So much for our goals for profit. What about risk, much the more important consideration in the long run? The Duchess of Windsor once famously remarked that one can never be too rich or too thin. In trading, one can almost never be too cautious, and, speaking for myself only, I try to be a professional coward.

To this end, I must match an approximate potential dollar risk and its likelihood of occurrence against the theoretical positive dollar return.In short, I have to keep the old eyeball on, what else, expectation. At the end of our example HUQ trade, Table 6.2 shows that we have a nicely positive expectation on option expiration day.

Fine, and we certainly wouldn’t even undertake the trade if the expectation weren’t positive, but this approximate figure is only valid at the very end of the trade. During the life of the option, suppose HUQ rises, say, 6.00 cents in the first 10 days of the trade and our short options rise in price from, say, 80 points to 190. Should we exit the trade? What is a reasonable level of interim dollar risk to assume?