In order to enhance profitability over time, I've been thinking about the factors that go into one's rate of return. For example, one might sell a straddle for 1.00 premium, but it's relative juiciness varies since a trade on a 5.00 stock would consume less buying power than a trade on a 20.00 dollar stock. On the other hand, if the duration of the first trade was 5 months and the second 1 month, perhaps they're somewhat equivalent. So it seems like there are 3 factors here: +-premium buying power reduction (tied up capital) duration I was playing around with some real trades and came up with: (premium/margin req)*40 = A value that allows me to capital usage. #of weeks to expiration 40 was an arbitrary number to get me a result between 1 and 10. Has anyone devised a formula that could be applied to trades so that their relative efficiency in the use of capital could be compared?
Opportunity cost & risk evaluations. Monte Carlo simulations can help if you know how to use it. VaR would help immensely if you trade any sort of option strategy.
Ok. I Googled those topics and read until one eyeball rolled out of my head. I think finding worthwhile trades and maximizing capital use is a little different than managing risk over the life of the trade. But I appreciate the input and such information may help along my journey at a later date.
I wouldn't worry about efficiency until you are profitable. That is the hardest thing you can possibly do. Sorry for giving you tough reads, but hey if you happen to take this seriously you'll need to know them. VaR & Risk based haircuts are very very important. Portfolio margining is also important to an extent. You can't ever trade for a living without one of those accounts. An assumption of course, but based on experience.
# of shares = (account balance * risk per trade) / (Stock price - Stop loss price) Example: Account balance $20,000 Risk per trade 1% Stock price $10 Stop loss at $8.50 (20,000 x 0.01) / (10 - 8.50) = 200 / 1.50 = 133.33 Buy 133 shares
Robby, that seems like a useful way to size stock trades. However, I only trade options and am looking at ways to optimize margin buying power based on premium and trade duration.
There isn't a single simple formula... It seems that what you want to do is dollar return per unit of margin per day. This might work for you, but, obviously, any such approach has all sorts of flaws.
Two wrongs. Let's see if we can make it right. First, "return/risk//day" seeks what all of your economics classes tried to turn you towards: marginal return -- and even better, marginal risk-adjusted return -- and even better-better, PV(marginal risk-adjusted return) That is the understanding that each of us should have, for each and every trade, *before* we put it on, *and* after. Capital efficiency -- like capital preservation -- is the shit. And to put money AT RISK before you even know how that trade will affect your portfolio (on its own, and as compared to all *alternative* uses of your capital) -- is NOT what you want your money manager to do -- even if YOU are your money manager. {stepping off soapbox now....} Second big thought: To the OP: don't confuse position reward/risk, with portfolio reward/risk -- these terms are conflated all over the place, and they are starkly different. But you'll still hear people raving/comparing numbers that are completely and truly, apples to oranges. If I pursue 50ยข on a $5 spread, I can claim a 10% reward-to-risk on that trade. But what will be my annual return on portfolio capital? We have no idea until we disclose how much total capital was available. Algebraically, there are many different ways to get to the same result: time-weighted risk-adjusted marginal returns. End of story.
Do you mean "Portfolio margining" or "managing"? Yes, I already learned "profitability is difficult" the hard way. But my question speaks to increasing profitability--I'm looking to both increase the number of trades I can do as well as the premium I collect by improving the way I leverage margin/buying power. Of course, picking the right trade within a set of possibilities is certainly difficult. One problem with my rudimentary formula is the absence of an accounting for probability of profit/risk. In the example below, the premium on the 10 strike is 4-6 times higher than the 9 strike but the effect on my buying power is only a 10% difference between the two. My forumla says going short the strike 10 is a 6x better use of my buying power, but selling the OTM 9 strike is certainly a trade that's more likely to win. I suspect I'm reinventing the wheel and may have to circle back to the brain numbing reading topics you suggested.
tommcginnis, Just saw your post. You said it better than I. My previous post suggests analyzing capital efficiency probably can't be done without consideration of capital preservation (risk). Staring at my trade screen and making educated guesses seems like a weak strategy. But I also am not looking to get lost in strategic theory and calculus.