I have created a trading strategy that seems to be about 68-70% accurate. It involves trading the SPX on a daily basis. Basically, my strategy identifies for the day if the SPX is going up or down. No targets in sight, just an up or down. From there it buys the appropriate direction of the index at open and at the end of the day sell it. My system has been pretty accurate but where I'm getting killed is on the bid/ask spreads. Initially I was using Canadian ETF's (HSD and HSU) to buy the appropriate direction for the day. They are both 2x ETF's. At the end of the day my direction would be correct, but in *some* situations I would not get the desired financial outcome. In particular the days that the market goes up 0.3% or something like that and it gapped in the morning. Then I started not buying right away noticing that there was a retracement (usually) in the morning after opening so I waited a little bit. It helped, but then there were some days where it gapped up but then didn't retrace so my overall numbers didn't improve much because I ended up going into those too late and missing some of the gains. Then I started using options, just normal calls/puts based on the direction. It's been going okay with that, at least the bid/ask spread isn't as much of an issue because of home much more responsive they are. However, I did not properly anticipate the amount of volatility involved and after a couple of days of doing 1-2 contracts, I bought 50 contracts (25, went down and bought 25 more). I managed to come out with my head above water (on FOMC day) but I almost had a heart attack that day with the ride considering at 2pm when the announcement hit, I was down a LOT! It then started coming back up and I sold my second 25 contracts for a small profit and held the original to end of day neting about 20% for the day. As a result the next day I said no more with that number of contracts... Go for the smaller profits, but then I mis judged the next day and bought 10 and 10 (when it went down). I was not as lucky and it did not come back above water on that day and I was down, ultimately chewing up my profits from the previous day plus about 3-4% more. It's a small account that I'm starting with. There is only about $13K in the account. I'm thinking that the appropriate number of contracts is 2-3 contracts ultimately targeting about $200-$300 per day. Yesterday I bought 2 contracts, was correct again with the direction but sold mid-day. So, I cleared about half the profit that I could have made if I had of held it to EOD but I was a little gun-shy from the day before so I wanted to lock in my profits early setting a trailing stop on the put which triggered around 11am or so. So, I'm curious about my risk management plan going forward. I'm comfortable with the risk associated with HSD and HSU because there is no chance that those are going to $0 by end of day. If that happened, I would have a lot more problems than my account value. However, I am not comfortable with the losses resulting from the bid/ask spreads on those ETF's. I am very confident that my strategy will work long term but there will be down days in there (about 70% accurate). I've backtested it pretty thouroughly using excel and historical market data. So, my direction picking I think will be pretty good but I need to improve my entry/exits. How can I properly estimate what the price of the option should be in the morning. For example, lets say that the S&P has gone up through after hours trading and is looking at gapping up 10 pts. Lets also assme that my system has indicated (in the morning) that the direction for the day will be up. How can I estimate what the calls will (or should) be priced at when the market opens? Also... Does it sound like utilizing 2-3 contracts per day sounds reasonable as far as risk management. I know that 20-50 is definitely too much!
To me, saying that you have a 70% win rate should already incorporate some sort of risk management. If someone states that they have a certain win rate, it means that on this percentage of trades, price hit their target before it hit their stop. To just say "the market will go up today" and see that you're right 70% of the time is meaningless because as you're seeing, you haven't defined your risk. If 1% of the time it drops so low that you've lost over half your account or more, it doesn't really matter than you are right 70% of the time otherwise. So, if you're targeting $200-$300 per day, that is your profit target. Lets say $300. Now if in order to get this $300, you had the trade go against you by $600 before it turned around, you're still counting this as a win, right? But this would mean that you only have a 70% win rate with something like twice as much risk as reward. If you would always use twice the risk as reward, you more than likely need over a 90% win rate for this to have positive expectancy. Now if you tell me that you are only risking $150, so that is your stop, and $300 is your target, and you hit this 70% of the time, well now you have something. But as you can see, saying you have a 70% win rate means nothing if this isn't based on already having picked risk and reward targets. Caveat: I'm not up to speed on options, so I'm not sure how this mixes in with your discussion about buying ETF's, but by either buying ETFs, stocks or Futures, this is how the win rate would work.
In my humble opinion, you should keep using the options and trade however many contracts you can get for about $260. Why $260? That is approximately 2% of $13k. If you really feel comfortable with a bit more risk then maybe go up to 5% ($650/trade) but I wouldn't go higher than that. Remember trading isn't a get rich quick scheme, but it can be a get rich slowly method.
That's what I was thinking. Althought, that would be 1 option ($260). I was Just because something goes down by $600 does not mean that is how much you risked. Risk is how much you invest, not how much it fluctuates. How much it fluctuates is volatility. That said, high volatility for a relatively low payout doesn't make sense, which is what I discovered with 50 contracts LOL, and subsequently 20 contracts.
Thanks, that what I was thinking... Although, your 2% is a little lower. I can get 1 contract for $260 per day typically. The only thing that I didn't like about 1 contract is the commissions. My broker (Questrade) charges $10.95 per trade for 1 contract plus $1 for each additional contract. So, if I invested $260 that would be 8% that I need to make on it before I breakeven. That shouldn't be difficult with options, but if I get 2 contracts contracts that lowers it to 3% of the trade value, which I think is much more attainable long-term. Thanks for the advice though. Do you have an idea how I can calculate a reasonable entry price on the days that it gaps? Right now I'm just waiting for the market to open and selecting the bid price.
Yeah commissions don't really help small lot traders as you can see. If you feel comfortable with risking 5% of your account per trade with the trade off being needing significantly less of a move to become profitable, then go for it. As alternatives you might also consider switching brokers. TOS (TD Ameritrade) has Option Trades for $9.99 + $0.75 per contract which isn't a lot better. Tradeking has $4.95 base and $0.65 per contract. I used to use these guys before I moved to ToS for the platform. MB trading has $0.95 per contract for the first 10 contracts and it goes down from there. So trading 1 contract would only need a $0.95 commission which is spectacular. I have never used them though so cannot speak to fill quality and such.
Questrade has an option of going with $6.95 + $0.75 per contract. But that is only if I'm racking up $400 in commissions per month. But that gives me Level 2 as well. Who is MB? $0.95 seems really cheap and might be a good way to go. Although, will they accept Canadian customers?
here is an EW count on ES im following now. not sure if your familiar with it and while i dont consider myself a pro at it, it does seem to be following the count i have so far. when i cant get a decent count i will scale down my position size till i get a clearer picture
The first reason is that I'm trading within a registered account so futures are not eligible. The second reason is because my system is based on the daily s&p 500 (cash). The third reason is because I'm just really starting to understand options much more and I'm able to trade with a defined risk. With futures the only defined risk (that I know of) is me setting stop losses. My experience with stop losses has only been negative so I don't like using them except to lock in profits.