This week I conduct a bit of an experiment – stick with me on this. Basically, as i’ve discussed previously, I know that on average two thirds of my trades end up in a loss (using my long term trend following strategy). The strategy is highly profitable overall because the losses are cut a lot shorter than the wins.
This got me thinking. Surely if I know that most of my trades end up losing, I must be able to profit from this by betting that they would lose. How I go about doing this though is another matter.
Solving the problem
Simple maths says that if you set the amount you lose or win to be the same, and you win on more occasions than you lose, then you will end up in profit (as long as fee’s are reasonable). So if I ran a separate strategy to my main strategy and bet on each trade to lose, and roughly 2/3 rds of them did lose, I would make a profit.
Sticking with what I know I immediately looked at spread betting as the solution. If the main strategy signalled a buy on say the ASX 200, would it be possible to place a sell trade at the same starting price and place a stop loss say 2% away. There is a possibility that this could work but what if the market moved higher initially, stopped out the sell trade then moved lower. This would create a much bigger loss overall. Whatever way I looked at it, this was too risky.
So rather than giving up there I started to look into options trading. Options are completely new to me but I did a bit of research to see if they could solve my problem.
What are options?
Options allow you enter a trade on a market at a set price (strike price) at some time before the expiry of the option (say one month time, three months time etc). In addition you do not have to take up this position if you do not want but you have the right to. You pay a premium to the seller of the option to do so.
For example, the DAX 30 is currently trading at 13395. If we believe the price will go higher over the next month then we could buy a call option at 13395 for a premium (cost) and if the price moved to say 14200 at the time the option expired, we would make a profit. If the price fell below 13395 at the expiry date then we would lose our premium but no more.
There are two types of option, calls and puts
A buyer of a call believes the market will rise. A buyer of a put believes the market will fall.
To further complicate matters we can buy or sell both a call or put
Selling an option means you are on the other side of the transaction. If you were to sell the call in the option above then you would receive that premium from the buyer. If the market was to stay below the strike price by the expiry date you would keep the premium however if the market rose above the strike price you would still keep the premium but lose money for every point the market finished above the strike price.
This works the same for a put. The buyer of the put pays the premium and the seller (also known as the writer) keeps the premium.
How could this work for me?
So if going back to the example above on the ASX 200, the obvious thing to do would be to buy a put option (known as a naked put) at the same price as my long term spread bet buy trade was placed. The problem with this is the premium is very expensive although there are potentially unlimited profits to be made if the market was to tank within the defined period.
Another way of looking at it would be to sell (write) a call option at the same price and hope to collect a healthy premium if the price did fall below this strike price within the defined period. The issue here is a potential unlimited loss if the price was to rise steeply during this period.
As you can see I haven’t managed to achieve much so far and it is not appearing too easy to put my theory into practice.
Combining options strategies to minimise risk
Finally I am looking at combining options to reduce the risk of unlimited losses. The main way of doing this is with whats called a vertical spread option strategy.
This is where I could sell (write) a call option with the strike price the same price as the long term strategy is triggered and collect the premium for doing so. I could then buy a call at a higher price, which as it is whats called ‘out of the market’ (above the current price), the premium (cost) would be less than the premium (gain) I collect for writing the lower option. The difference between these premiums is the potential profit.
If the market finished below the lower strike price this would achieve the maximum profit which is the difference in premiums.
If the market finished above the higher strike price then I would realise a loss as follows:
= collect a premium from writing the call – the quantity of pips above this strike price – the premium for buying the call + the quantity of pips above the higher strike
This reduces the maximum profit potential but also limits the loss potential.
If I could ensure that the potential profit and potential loss were pretty even then I would generate a profit overall.
The next step
Now I have a potential plan in place I need to test this using a paper trading strategy (demo account). I have backtested all of the markets I trade and calculated the following for each:
- The average period of time between trade open and the loss being realised
- The average loss as a% of the open
- The average number of wins to losses
I need to establish if the vertical spread strategy is viable using an expiry period that fits the average period of time between trade open and the loss being realised for each market bearing in mind the win to loss ratio.
I will update on this next time.