Growing an Options Account Sustainably

Investors that are starting to trade options tend to have smaller trading accounts. In this post we will discuss the challenges with growing a smaller options account and the strategies to do so sustainably. While smaller accounts are more challenging to grow, there are best practices and strategies that investors can use for accounts under $10,000. Investors with larger accounts should still follow the same best practices, but have more leeway on the rules. In this post we will lay out a single strategy suitable for newer options traders to grow a trading account and build confidence in the markets. 

There are some strategies that are better suited for smaller accounts but the most important aspect of growing a small account is discipline. Having discipline when trading helps build confidence, gain consistency and provides a clear understanding of the strategy. Using a simple options strategy with repeatable steps is the best way to go for smaller accounts. Credit Spreads are a powerful strategy for small account holders to control risks and gain confidence with a higher probability of profit. 

Account Requirements

To use the Credit Spread strategy, investors are required to have an options account with Level 3 clearance. This allows investors to trade spreads. Investors are also required to have a margin account. Account sizes that are less than $2000 can be difficult to grow due to the contract sizes.  Arguably the most important requirements are access to education, practice and tools. This empowers investors with the knowledge, best practices and confidence to gain consistency in their options trading.

The Strategy: Credit Spreads

Credit Spreads are a powerful income generating strategy for options traders. This strategy tends to have a high probability of profit as it is quite forgiving in that the strategy can remain profitable, even if the underlying stock remains neutral. While Credit Spreads do limit the maximum profit to the credit received when selling the spread, the high probability of profit can provide the consistent returns needed to grow a small trading account and also gives the investor confidence by being profitable in the majority of the trades when used correctly. Credit Spreads are a limited risk and limited reward strategy. Should the underlying make a significant adverse directional move, the investor is protected and will not lose as much as selling a naked call or put option. 

A Credit Spread is a 2-legged option strategy that involves selling a near or at the money option and buying an out of the money option. This results in a net credit received which represents the maximum reward of the trade. The aim is to buy back the Credit Spread at a lower price than what it was originally sold for. There are 2 types of Credit Spreads:

Put Credit Vertical Spread – Bullish/Neutral

• Sell an at the money Put option
• Buy an out of the money Put option
• Moderately bullish/neutral directional view

Call Credit Vertical Spread – Bearish/Neutral

• Sell an at the money Call option
• Buy an out of the money Call option
• Moderately bearish/neutral directional view

Example: Stock Canadian Pacific (CP) is trading at $90. The investor has a bullish outlook on the stock and will therefore sell a Put Credit Spread:

• Sell to Open 1 $CP $90 Put @ $3.90
• Buy to Open 1 $CP $84 Put @ $1.65
• Net credit received = $2.25 (max gain)
• Max loss = $3.75 (vertical width – net premium received) ($6 – $2.25)
• Breakeven stock price = $87.75 (short strike – net premium received) ($90 – $2.25)

Image: CP Credit Spread Example

Source: OptionsPlay

If the $CP rallies higher, the value of the spread will decline and the investor can buy to close the Credit Spread at less than $2.25, resulting in a net profit. The long strike ($84) represents the cut off point for the maximum loss If the stock were to decline, losses are capped at the spread width minus premium received. In the example above, even if $CP declined significantly below $84, the spread will still have a maximum loss of $3.75 at expiration. The maximum profit is achieved as long as $CP stays above $90 by expiration. If it expires between $90 and $87.75, a partial profit is made from the trade. In the event that $CP expired between the long strike, $84 and the breakeven stock price, $87.75, a partial loss is incurred. 

It is important to note that Credit Spreads are a short Theta strategy – they benefit from time decay eroding the value of the spread. Therefore, Credit Spreads are still profitable even if the stock does not move. 

When to use Credit Spreads

Generally, Credit Spreads should be used in areas where a price reversal is likely as it provides a better risk/reward trade setup. In our example we used CP after it had held the $90 support level for over a month and expected a potential rally from that support level. However, even if the stock simply holds the support level and does not advance, the strategy will still be profitable. This is the “forgiving” nature of a credit spread. Other opportunities to sell credit spreads include:

• Support and resistance – Put Credit Spreads should be used near support levels as they are a moderately bullish strategy that will become profitable should the stock rally. Call Credit Spreads should be used at areas of resistance where a decline lower can be expected.
• Overbought and oversold indicators – these indicators give a sense of whether a stock has rallied or declined too far and a price reversal is likely to happen. An example of this type of indicator is the RSI. It is always best to prioritize the price action of the underlying and use the indicator for confirmation rather than only relying on the indicator itself.

Best Practices for Credit Spreads

Using the following best practices is key for investors to achieve sustainable and consistent growth in their trading accounts:

• Optimal Expirations of 45 days to expiration – this timeframe provides a balance between higher premiums and acceleration in time decay that occurs for shorter dated options compared to longer dated options.
• Optimal strike prices are to sell the At-the-money Call/Put and buy the 25 Delta Call/Put. Our research shows that using this combination of strike prices collects the highest premium while providing a balance to reduce the overall risk of the trade.
• The 1/3 Rule – investors should always look to collect a minimum of 33% of the vertical width in premium. A $10 credit spread should receive at least $3.33 in premium for it to be considered optimal. This has to do with the relationship between risk/reward on a credit spread. When you collect 33%, that translates to risking 67% of the vertical width. The goal is to collect as much income as possible, which also reduces risk. However if you’re collecting less than 33%, you are typically risking too much for every $1 in potential reward.
• Stop Loss and Take Profits – The general rule of thumb is to take profits at 50% of Max Gain and cut losses at 100% of the Max Gain. If a Credit Spread is sold for $3, the rule to  take profit is at $1.50 Debit and the stop loss is at $6.00 Debit.
• The 21 Day rule – this refers to always closing a Credit Spread at 21 days to expiration (if the take profit or stop loss level has yet to be reached). This reduces assignment risk and gamma risk of the strategy as expiration approaches.

Risk Management

Even by using a powerful strategy like Credit Spreads, growing a small account can be challenging and utilizing sound risk management principles is arguably more important than the options strategy itself. Proper risk management is usually the differentiating factor between profitable traders and traders that blow up their account. In addition to the best practices for Credit Spreads, investors should also follow a set of rules that govern their risk tolerance and how they trade:

• Choose credit spreads on stocks under $50 for smaller accounts
• The maximum risk of a trade should not be more than 2-3% of your total account value
• The maximum number of open trades should not exceed 5 (10% total risk)
• Do not roll a losing position. Learn to cut your losers and move onto the next trade
• Think longer  term. Prioritize trading another day over making the largest profit possible.

Summary

Growing a small account takes patience, discipline, confidence, and a good understanding of the options strategies you want to use. Use strategies that can be forgiving on the directional view, yet still control your risk and rewards at the same time. It is always best to keep things simple and keep your trades small to avoid account blowups from one or a few bad trades. Practice your strategies using OptionsPlay’s paper trading and trade often to gain a fundamental understanding of how these strategies perform. By using the best practices mentioned above and keeping risk management top of mind, growing a small account becomes that much easier!

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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