How to Build a Portfolio using Complex Options Strategies

[Music] [Applause] [Music] hello everyone i'm tom sasenoff and uh this is a segment that we're doing on um i call this an option symposium this is kind of a compliment to the piece that tony batista did on strategy and his piece is talking about building all the strategies and my piece hopefully is going to be to discuss more specifically how these strategies are applied using the tastyworks software and using the tastytrade kind of methodology we are a quantitative derivatives think tank i know that sounds a lot of big words there but basically we study options and we study strategy and we study building strategic portfolios for retail investors so i've got um today it's a little bit heavy but we're going to build a strategic portfolio using a forty thousand dollar account now you say why forty thousand dollars and the and and by the way this the portfolio that we're building today can be a portfolio for a individual margin account can be a portfolio for portfolio margin account and it can be a portfolio for an ira account all of those qualify everything you can do um everything that i'm talking about today you can do in any kind of account that we offer but forty thousand dollars tends to be one of the about the industry average for an active trading account so that's why we used a 40 000 account and today for this specific portfolio we're not going to use futures we're just going to use stocks stock options we're going to use etfs and indexes so just as a little kind of idea about capital usage because it's one of the first questions we get all the time generally speaking when the vix which is the implied volatility of the s p 500 when the vix is between 20 and 30 where it is right now and this this the research done for this particular piece was done on august 14th of 2020. so the vix currently trading just about 24 23 and a half 24 in that range we like to see an account allocation of about 35 so again i'll go through some of the numbers if the vix is between 10 and 15 generally we'd like to see a minimal account allocation of about 25 if the vix is between 25 and 30 about 30 percent and these are just generalizations optimal and if the vix is between 20 and 30 where it is now about 35 allocation between 30 and 40 about 40 and if the vix is over 40 we'd like to see an allocation of about 50 the reason you allocate more when the vix is higher is because when you have a higher vix you have the opportunity to make more money it's not that you have a higher probability of profit because you don't but you you receive more credits bigger credits and therefore you have an opportunity to make more money on those strategies so it's risk one for the same probability of profit but potential to make more than you would if volatility is lower so with the vix currently between 20 and 30 we are going to use a 35 allocation implied volatility rank which measures implied volatility against itself for the last 52 weeks and liquidity are the single most important requirements to open a trade what we want to see is high implied volatility rank and tons of liquidity if something's not liquid we won't trade it if something doesn't have a high implied volatility rank which the term high fluctuates based on kind of what we're experiencing and in the current marketplace because of the pandemic meltdown in march um in the current marketplace anything over 10 would be considered high but we're using in for the case for the arguments make today we're using ivr should be at least 20 and the bid ask spread should be reasonable with respect to stock price so in other words if you're talking about a 50 or 100 stock or 150 dollar stock we're looking for very tight markets like penny wide if you're talking about a thousand dollar stock like in the case of amazon or google or something like that you know obviously we're looking for markets where the spreads trade in pennies so we picked eight underlyings for today's discussion and again i promise you it's going to be heavy but it's an evergreen piece you can go back to it as much as you want and you can review kind of the strategies and we're going to use eight different underlyings we're going to try to apply almost eight different strategies to this and we're going to build a portfolio up so you can see what it's like to build a diversified non-correlated um and when i say diversified i mean diversified by underlying diversified by strategy diversified by duration and diversified by volatility so the eight underlyings we chose based on current implied volatility rank and liquidity slv which is silver it's a silver etf because silver's in play right now apple largest stock in the world facebook microsoft qq gdx because gold is in play that's gold mining stock um xle and iwm these are random selections based on high implied volatility and liquidity we'll be building a diversified portfolio like i just said with varying durations varying volatilities varying products strategy and also capital exposure one of the big things for us and a big takeaway about building a portfolio is capital usage and capital exposure so we are going to also include a discussion of defined and undefined risk strategies so undefined risk strangles defined credit spreads undefined ratio spreads defined iron condors undefined could be naked options like for example naked call or naked put we're going to stick with those five food groups for now so strangles credit spreads ratio spreads iron condors and naked options now what i'm going to do at this point is start to build a portfolio and using a small percentage of that forty thousand dollar account so we think about forty thousand dollar account and we think about using we said thirty five percent of that account you know that's where my that's where i'm going to try to end up and so i'm going to mix and match different underlyings and the strategies i use for different underlyings um based on the notional price of that underlying and how much capital it takes to make those trades and all along kind of planning for just a certain amount of capital usage you know certain amount of capital usage in the end now rarely would you put on eight different trades or seven or eight different trades in a single day with it with the intent of building a portfolio up all at once this is something that should be that should be staged or staggered in or laddered in over time but again all these prices are as of august 14 2020 so they're everything's pretty accurate so the first trade we're going to look at and i'm going to try to mix and match this up and i'm going to explain why in a few seconds is the first trade is a ratio spread and ratio spreads by definition mean you are buying buying us the smaller quantity and selling a larger quantity for example a call ratio spread you buy one at the money call you sell two three four could be any ratio it could be two by three it could be three by five it could be one by two for the purposes of this discussion we'll do one by two you buy one um bigger call or at the money call you sell multiple out of the money calls so in slv we're gonna buy one 35 data expiration 40 delta call um and we're going to sell two 35 data expiration we're using the same expiration cycle 30 delta calls and in this case we're going to um we're going to receive a credit of 58 cents that's a net credit of 58 cents so we're buying one selling two tony went over the greeks a little bit on this um but in the end we're going to receive a credit of 58 cents the buying power reduction because what is a what is a ratio spread one by two it's a long vertical with a naked short out of the money option so the buying power reduction in this case is eleven hundred dollars the things we like about ratio spreads the main thing is an extremely high probability profit ultimately you're long a call spread and short an extra out of the money call so in this case the probability of profit is 88 and that's the theoretical probability of profit the actual is going to be obviously much higher than that it could be it could be as much as 93 to 96 so the s p correlation because silver is not that correlated to the s ps is only 0.3 and the beta weighted delta is -1 so there's very little directional risk in the spy where the mark goes up or down and the correlation is very low to the regular market and the daily decay is only three dollars and the easiest way to do this on the tasty work software is you you you click on the option that you want to buy and generally you start like one or two strikes out of the money and then you go a couple more strikes to find an option that you want to sell and you double click on that option just so you can change the quantity and you do this as a single trade it's not you you would never leg into this trade you do it as a single trade you pick the credit you receive let's say on the mid price is 59 or 60 cents you move this move the prices by about one or two pennies and in this case it's since since the since the strategy itself has no delta risk the counterparties apt to make this trade within one or two pennies of theoretical value the next trade we're going to show you is an iron condor in apple and what we're going to do here is this is a defined risk trade because apple's an expensive stock and it it hasn't split yet so it's still a 430 or 450 dollar stock so we're gonna sell a 25 delta strangle we're gonna buy the wings twenty dollars away that's an iron condor we're gonna receive a credit of six dollars and sixty cents we do not leg into iron condors we do not sell the call side first and then the put side later we do them all as a single trade like we said this is highly liquid underlying the correlation to the s ps is 0.65 the delta on this position is going to be zero because we're doing this as a um we're doing this as a dynamic iron condor based on delta this receives nine dollars a day in decay which is a big decay number and the buying power reduction is thirteen hundred and forty dollars i think most people understand the concept of an iron condor which is a short call spread out of the money a short put spread out of the money virtually no directional risk and just hoping the stock stays in between then we're going to go over to facebook which has had a monster rally and we are going to sell a call credit spread above the market so what's the difference between a call credit spread and an iron condor well iron condor is the sale of a call credit spread and a put spread requires no additional capital and straight call spread just means you don't want to take any put spread risk and you receive less credit so the credit received in this case is only three dollars and 10 cents the buying power reduction is only 690 dollars the pop is 65 percent the s p correlation is even less than apple which is 0.55 there's very small beta weighted deltas because you're just selling call spread so it's going to have some short deltas and the daily decay is obviously less than the apple trade it's only two dollars what's interesting here is in the first three trades we've used a ratio spread an iron condor and a credit spread in each one of those spreads the ratio spread has a long uh has a long vertical spread embedded in it the the iron condor has two short credit spreads and the straight call credit spread is one credit spread you see in option trading everything is kind of a a derivative or a variation of the same stuff and on the first three trades alone they all have debit or credit spreads or all what we call vertical spreads trade four we're going to do a naked strangle and we're going to do you do the naked strangle in microsoft microsoft is a less expensive stock than the other ones that we've looked at so far and that's one of the reasons it's obviously highly liquid because it's a 1.5 trillion dollar company hard for me to even say that we're going to receive a fairly large credit because the implied volatility of microsoft is is large right now we're going to receive um uh an 8.85 credit that's 885 the buying power reduction is 3200 the pop is 58 percent when you have a pop of 58 on a naked strangle your actual probability success could be closer to 70 percent it has an s p correlation of almost 0.7 has delta of zero notice how we're doing a a very what we call delta neutral um we're building a very delta neutral portfolio it has a daily decay of twenty dollars now facebook had a daily decay of two dollars apple had nine dollars microsoft has a daily decay of twenty dollars and the reason has twenty dollars is because there's no we didn't buy any options to protect our position or to um or to define our risk on the platform in the case of microsoft just click on whatever option you want to again this is the dynamic straddle so i'm sorry dynamic strangle so you click on the 30 delta call the 30 delta put comes up as one number we don't leg into strangles move the move the price about two cents or three cents off of mid price and you should be filled because of the liquidity in microsoft now in the queues because they've had such a huge huge rally we're going to look at what we call a reverse jade lizard yes this is a liz and jenny type trade they came up with the jade lizard the jade lizard is the sale of a put and the sale of an out of the money call spread it's a sale of an out of the money put and out of the money call spread it's a bullish trade but because the qqq which is the nasdaq etf has had such a huge rally the fifth trade we're looking at is what we call a reverse jade lizard a reverse jade lizard is the sale of an out of the money call and then an out of the money put spread so it's a little bit different it's it's um um it's a bearish play now in the case of a reverse jade lizard we are going to in this case put up 4 700 it's a big it's a big buying power reduction um the pop though is going to be really high 73 because we're selling it out of the money call the correlation to the s ps is going to be kind of max for us about 80 86.86 the daily decay because we have a naked call is ten dollars which is pretty significant and what we're doing here is you can define it a couple of different ways but we're selling an out of the money put spread the 262 258 and selling the 284 calls naked and that's kind of our selling above market 30 delta call 35 days to expiration and selling a out of the money put spread starting with the naked short i'm sorry with the short put at the 30 deltas as well again this is a defined risk trade to the downside meaning no downside risk on this trade and no downside risk on the trade but obviously you have undefined risk to the upside trade six is another trade with some undefined risk this is in gdx which is a gold miners um etf and in this case because gold's had just a crazy monster run we're playing the the game of extremes and for smaller accounts that don't have a lot of capital we're using this trade only uses 500 to sell a naked call it has a really high pop at 76 percent it has a really low correlation at 0.42 and virtually no spy weighted delta the daily decay is three dollars and the credit received for one contract is 129 so when you think about that 129 dollars putting up 500 dollars it's you know over 35 days the potential roc which is return on capital is pretty strong um and this is just a classic short call and before you get nervous about short calls just remember you know short calls short puts undefined risk trades to find risk trades you have to mix and match in order to be a successful trader there's no such thing as all defined risk there's no such thing as all undefined risk you really need to mix and match to be successful trade seven we're looking at the exact opposite of the short call we're doing a short put in xle um energy stocks have been on a relative basis much weaker than the precious metal stocks so we're taking the exact opposite position in xle we call this if you looked at xle and gdx you'd almost think of this like as a customized or bastardized strangle but or or you know using using we would call that an inter market strangle xle looking to sell 35 days to expiration of 35 delta put we would receive a in this case a credit of 125 very similar to the last trade with a buying power reduction of sixteen hundred dollars a pop of sixty seven percent a correlation of point four one and a spy weighted delta of plus five it actually offsets the gdx position with a similar daily decay of two dollars see so we're not all just on one side of the market this gives us a little long delta this offsets some of the risk in in gdx even though the correlations are you know inverse and and offsetting this is what we mean by building a balanced truly diversified portfolio and the last trade trade 8 is a strangle in iwm because we wanted to get another etf strangle in there for you the buying power reduction is 2500 the pop is 57 percent we would look at the dynamic 30 delta strangle 35 days to expiration the buying power reduction is 2500 bucks the correlation in this case is only 0.63 which is almost an historical low and the beta weighted delta is zero the daily decay is rich because the ivr in iwm is the richest of all the index etfs so it's 13 bucks now here here's where we get here's the good part this is what gets to be a little bit exciting so if we look at the credit received from um from all these trades it's 31.83 now you multiply that by 100 so it's thirty one hundred and eighty three dollars that's what we built on a portfolio basis using eight different underlyings so to build that thirty one hundred and eighty three dollars using this is using um buying power reductions which are minimal requirements by finra sec we used in this case 15 500 bucks let's just say in that neighborhood and the overall pop on the whole portfolio is about 67 percent so we did as we went for two thirds one third so that means you know two thirds of the time we're going to be right one third of the time we're going to be wrong and hopefully we can manage those trades that we're wrong on and manage those trades that we're right on to obviously increase that number because the defined risk trades that number is static the undefined risk trades that number is too low so we have to hope for is that we don't get burnt on the the fat tail risk and that we're able to keep everything else in a manageable position how do we do that we manage early at 21 days so 3 100 almost 3 200 of total credit using about 15 500 with a 67 probability of profit we have an s p correlation of 0.56 now for most people when they buy a portfolio of stocks your s p correlation is going to be much closer to 0.7 or 0.8 meaning if the market goes down you're in a you're in a heap of doo-doo if the k what we're looking at here is we have a much lower correlation we would consider this a much more diversified portfolio add a futures portfolio to this and you can really knock that number down to the 20 or 30 to the 0.2 or 0.3 level but we'll talk about that more later the beta weighted deltas in this whole portfolio are minus 34. that means 34 shares of spy and i don't think there's a single person listening today that that wouldn't be or couldn't be comfortable with the equivalent of 34 shares of spy long or short and the amount of daily decay that we make on this position is 62 a day and when you look at that when you start to look at that now i'm going to extrapolate out and i'm going to extrapolate out some of the totals so you're going to get some a really good view of what that all means so total capital use 15 360 total credit received 31.83 total delta 34 total starting theta because the theta is going to grow every single day so what starts at 62 dollars a day is going to grow and grow and grow and double and maybe even triple by expiration but for now it's probably going to grow to 21 days to expiration by by maybe 20 or 30 dollars from 62 to 72 to 82 to around 90. the theoretical pop on the whole position is 67 hopefully that gets stronger over time the monthly premium decay is 1400 the expected monthly p l is 25 of the credit received or 25 percent of 3 200 or 800 which means in a perfect world the expected monthly return on capital for the positions we put on is five point two percent and the expected monthly account return because remember we're only using fifteen thousand dollars of a forty thousand dollar account so the expected monthly account return perfect world twenty is two percent or twenty four percent annualized so this is not some outrageous crazy you know back of the envelope prediction suggesting that we've got some secret formula this is a very reasonable potential risk reward for the amount of risk you're taking for a potential return you're using 35 of your account remember in this case we're using fifteen thousand three hundred sixty dollars on a forty thousand dollar account the expected return on that fifteen thousand dollars is five point two percent in a perfect world the expected monthly account return is about two percent and we're not even using 25 000 of the capital so zero is factored into that number into the other 25 000. so why take an active approach well first of all because by by by design and by definition making more decisions makes you make better decisions and improves your decision-making skill it gives you the ability to process things your brain processing speed picks up as you make more and more decisions your brain processing speed um moves exponentially in the favor of making even faster and faster and faster decisions you never go backwards when you're making quick decisions and when you're processing decision making skills strategic engagement strategic engagement is really important in life there are very few things that we can be strategically engaged engaged in most of the stuff that were that we do in life is kind of there's a little brain dead aspect to it there's very three very few strategic engagements and strategic challenges and learning about probabilistic risk assessment there's nothing better because it doesn't just apply to trading it applies to everything you do it applies to any other kind of job you have it applies to any of your personal skills it applies to any kind of personal investing it applies to everything that you do in life it also makes you appreciate math and finance and those are things that we can't get those challenges those that strategic engagement or that strategic challenge anywhere else and and learning about risk and risk reward and speeding up your pro the processing the the your ability to process decision making and process change and process brain speed man it doesn't come anywhere else the portfolio benefits are these are returns potential returns independent of market performance we've been in a bull market now for 12 years someday that bull market's going to end and when it does you're going to need to learn how to generate returns independent of market performance this is how it's an inverse opportunity to implied volatility and uncertainty if there's fear out there this is the complement to fear this is the strategic complement to fear and true multi-level diversification comes from a strategic portfolio with diversified underlyings diversified strategies diversified dates that's duration and diversified volatilities and then this is something that is executable um and it's realistic these aren't crazy returns this is not something that is completely subjective this is just math now does it mean that if i do this every time i'm going to end up with it with these returns of course not doesn't mean any of that what it means is we're just taking the math we're using we're using a quantitative math-based strategic approach to to portfolio building portfolio management and hopefully financial engagement i'm tom sosnoff thank you so much you

Channel: tastytrade

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Keywords: tom sosnoff, brokerage firm, options, trading, professional, strategy, portfolio, return on capital, capital, diversification, market, investing, money management

Id: TyUuB7z8z3o

Length: 26min 28sec (1588 seconds)

Published: Thu Nov 19 2020