This year presented many interesting challenges for me both with trading and events not involving trading. One of the more interesting challenges that I had this year was the opportunity to participate in a somewhat informal and friendly “trading competition”. Details of the trading competition can be found here. All of us that were involved in the competition utilize option selling strategies of one variety or another. The final results have not yet been tallied, and are not the focus of this post. What is important though is how being part of this competition changed my trading – and I think for the better.
Trading is a competitive sport. The trader is trying to make as much money as possible with as little risk as possible. But so many times, we get caught up in the first half of the statement (make as much money as possible) and we forget about the second half (with as little risk as possible). Henrik Santander, the proprietor of The Lazy Trader blog and also the host for the competition, proposed that rather than select the winner solely on their return for the year of 2016, the winner would be determined utilizing a weighted calculation that took into effect the amount of capital that was at risk in the account at any given time. This required that we not only keep track of our trades, gains and losses, but also calculate our capital at risk on a daily basis. He developed a spreadsheet to accomplish this and we each took it upon ourselves to input the data daily for the entire year. What an eye-opening experience that was. However, it also provided a whole new perspective as to the advantages that we, as options traders, have over buy-and-hold investors.
At first glance, my 13.76% return on capital for 2016 would seem respectable, but not a home run when you consider that the S&P 500 index returned 9.84% for the same one year period. Why spend all of the time researching, placing trades, managing trades, etc. just to make a few more percent of a return. I could have just dumped it all in an ETF and forgotten about it. Think of all the commissions that I could have saved – I paid nearly 42% of my gross profits to TD Ameritrade in the form of commissions and fees. However, on average, I only had 29.75% of my capital at risk at any given moment – less than one third of my account value. Think about the power of that for just a moment. Buy-and-hold investors have 100% of their capital at risk when they put it into the S&P 500 index fund or ETF. I had just shy of 30% of my capital at risk and I made a return that was nearly 40% more than what I would have made in the S&P 500. That is powerful!
Of course, since the competition was taking into account the capital at risk, I carefully monitored this and was vigilant to make sure that I did not trade “too large” at any given time. This is another basic tenant of options trading – “Trade Small”. If you have been involved with options trading for any period of time, you have heard this before. It is very tempting, however, to increase trade size when we see continued winners one after another, which is typical with premium-selling strategies. And then… that one time you trade really large is when the trade goes against you and you do “blow up” the account. I would encourage all options traders to challenge themselves to track their average capital at risk on a daily basis. Early in the year, I traded way too large. At some points I had 80-90% of my capital at risk. As I started to realize how this was hurting me in the competition (and the risk I was putting myself at), I reduced the amount of capital at risk substantially, getting the average down to just about 30%. It also made my think harder about the trades that I was putting on. With only a small portion of my capital at risk, I had to think about which trades did I really think met my trading plan rules.
The proof is in the results. I made a smaller return in 2016 than in 2015. However, except for the drawdown early in 2016, my trading was much more consistent. In fact, 85% of my trades were profitable with every month being profitable except for January and February.
Where do I go from here? Well, there may not be a trading competition for 2017, but I still plan to track my capital usage going forward. I wish my fellow traders a Happy New Year and profitable trading in 2017!