I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Friday Flash, I share an epiphany or aha moment from the past week.
My huge epiphany this week was that you don’t succeed as a market trader by picking the best trades; you succeed by creating a reasonably good probabilistic trading strategy and then following it slavishly.
A trading system must include:
- Focus on a particular market
- Screening rules for what tickers you will consider for trading at a point in time
- Entry rules for when to open a trade based on technical (chart-based) or fundamental (data about the business) criteria
- Exit rules for when to take profits or cut losses
- Trade management rules about setting automatic loss or profit closes, about rolling options contracts, about scaling into positions, etc
- Position sizing rules to manage trade size to control risk
- Exposure rules that tell you how much of your overall portfolio to expose to a particular set of trades at a given point in time
- Diversification rules about how much concentration you allow yourself in a particular sector or factor
- And, possibly, rules about what you do and do not trade during different kinds of market regimes — bullish, bearish, choppy
These rules cannot guarantee that every trade will be a winner, but you hope to define a particular set of rules that produce winners more often than losers, or, more accurately, that produce gains over time that more than adequately cover the losses.
What doesn’t appear here? Analysis of macroeconomic reality. Basing trades on conviction or belief. Buying and holding according to a fixed allocation.
My evolving trading system
I’ve been most successful with the options wheel trading system, in which I earn income by selling put option contracts on large-cap U.S. stocks and also on ETFs such as $EFA (large and mid-caped developed market equities outside U.S.), $GLD (gold), $XLE (energy companies), and $SPY (S&P 500 index fund).
Because I’m a natural bear and intellectually insecure, I’ve experimented with ways of ameliorating the big risk with selling short puts (the core part of the options wheel) — trading spreads instead of one-legged short puts and using long puts as hedges. For now, I’ve decided to just go back to short puts and accept the risk that comes with them: I may get assigned (be required to buy) a particular stock or ETF at a price far below where it’s trading. I can develop stop-loss approaches for limiting this risk, but many wheel traders simply accept assignment and start selling covered calls to make premium on the position as they’re waiting to be able to sell it for a profit. That’s what makes it the wheel, that you sell puts, maybe eventually buy the stock, and then sell covered calls until it gets called away.
Here are the rules I’m following right now.
What to trade
I sell puts on large cap U.S. stocks with market cap $50B or greater and on ETFs with greater than $10B assets under management.
I’ve set up screeners in TradingView to find stocks that:
- Have closing price from previous day greater than the closing price from one month, three months, and six months ago.
- Have a price greater than $15 and less than $300. I may reduce the upper bound on this because of exposure rules, see below.
- Have average volume over the past 90 days of greater than five million. I want stocks that have liquid options chains and this is the first filter for that.
- Market cap $50B or greater.
- RSI (a measure of overbought/neutral/oversold) less than 70.
For ETFs:
- Same performance requirements — last closing price higher than one month, three months, and six months ago.
- Passive management style.
- Assets under management $10B or greater.
- Price $300 or less, except for broad market indexes $SPY, $QQQ, and $IWM.
- RSI less than 70.
Position sizing
The theoretical amount you can lose on a short put is the entire value of the stock you might be required to buy, less the premium collected.
Realistically however, none of the shares I’m potentially required to buy are even remotely likely to go to zero, as I’m focusing on large cap stocks and large ETFs with recent good performance.
So I use delta dollars to characterize and quantify risk I’m taking on with each position. Delta dollars represents a probability-weighted position size. It is computed as:
- Number of shares * delta of the position * current price of the asset
Delta represents, in percentages, how much the position is likely to increase or decrease in value relative to the underlying stock or ETF. It is 1.0 for a long stock position. The puts I buy often have a delta of -.20, indicating that the put premium for that put will go down by 20% of the stock value if the stock price goes up by a dollar.
I limit delta for each position to 1%. This means the maximum share price I can trade is $300, except for broad market indexes, where I limit delta dollars to 5%.
When to enter
If a stock or ETF appears on my screener, then I consider it for short put entry. First I consider whether its sector already has representation among my short puts, and how much.
I do a manual check of its chart and options chains to see if it meets these requirements, using a spreadsheet with cells that turn orange if the stock doesn’t meet the criteria:
- Next earnings date – will not sell a put if the contemplated expiration is past it
- Open interest for the put I would consider buying (30 to 45 days out, .20 to .30 delta) – must be greater than 500
- IV rank > 20 (this is a measure of how volatile the options chain is, and how much money I can make in premium) – could put a requirement on how much premium I will make relative to risk
And I consider if this diversifies my holdings of short puts or not, based on its sector. I need a better way of identifying sector, because the sector shown on TradingView is too broad.
Entering a trade
If a stock or ETF passes the spreadsheet-based screening, I check it for entry. I want to enter a short put trade with these requirements:
- DTE 30 to 45 days. Right now we’re in a window where the next monthly expiration 7/17/2026 is 28 days away and the one after that is 63 days away. Because I roll puts at 21 days, it doesn’t make a lot of sense to enter new short put trades for any tickers that don’t have weekly expirations.
- Delta .20 to .30. I have been using .20 but that is probably too conservative, and with portfolio-wide risk management I can increase this and look at .30.
- Premium should be 1% or greater relative to exposure, calculated as the strike price multipled by the number of contracts multiplied by 100.
Trading rules
- I plan my trades in the morning using closing prices from the previous day.
- I decide which trades I’m making before the trading window and I do not look at the market to decide which to do.
- I establish a trading window each day in which I enter the trades — usually 11 am to 1 pm but sometimes earlier if I have plans mid-day.
Exiting and rolling trades
- I set up a good-til-cancelled buy-to-close order just after I enter the trade to buy back the option at 50% profit (thinking of adjusting this to 75% for the first week of the trade to capture quickly improving stocks).
- At 21 DTE, I roll the put for a net credit if possible, being careful to get 30 days past any upcoming earnings reports.
- If I can’t roll for a net credit, I hold the put and am ready to accept assignment although it may recover and I may not be assigned.
- This is where the biggest risk arises with the wheel, but cutting losses at a certain delta or loss or breakdown of a stock chart means you don’t always hold through ups and downs, which is where much of the power of the options wheel arises. More on that in a later post.
When assigned
- If assigned, look to sell covered calls to earn premium but careful not to lock in losses.
- I haven’t had to do this yet so this is a bit of an unknown for me.
Risk management across the portfolio
I allocate 50% of my income portfolio to the options wheel. The money that secures the puts is kept in $SWVXX so I earn yield on it in addition to the premium I collect on short puts.
Leaving 50% out means that in case of a big market crash I am ready to take advantage of new opportunities as volatility increases and share prices come down.
I keep my sector bets to less than 10% of the overall exposure per sector. I am overexposed to semiconductors right now.
I’d like to add either short selling of stock or put spreads or some other bearish trade strategy to work. I learned a lot with my hedge management experience but determined I don’t want the drain of ongoing hedges. So I need something that is more reactive and just-in-time, when either I find a ticker or sector doing poorly or the broad market enters a period of weakness.
Next steps
Last week I began migrating to the new strategy, closing out positions that didn’t conform to it, and adding positions that did.
This week I’d like to close out some semiconductor exposure, assuming its in profit, and reallocate to other corners of the market.
I’d also like to come with my plan for capturing bearish trend, whether that is with short selling, long puts, or debit put spreads.