Profit Expectations as a Retail Trader ( part 1)

How much money can I expect to make? What monthly yield is reasonable? These are questions I’m asked weekly by prospects and retail option traders alike.

Before I address this, allow me to have a brief Kung Fu moment. In the TV series Kung Fu, before David Carradine would start a fight in a small village with the local bad guys, he would have a flashback to his training by Master Po at the Kung Fu Monastery. This flashback caused him to meditate and reflect on some of the nuggets of wisdom from Master Po. These nuggets guided him through his latest challenge.

As I think back to my early options training by Jon Najarian ( I’ll make him my Master Po), when he was training me at Mercury Trading, would say “ Grasshopper, ( just joking) focus on the craft and risk management, and good things will come"! Those weren’t the exact words, he never called me grasshopper, but it sounds good! The point is, we never discussed yields! We focused on the strategies and what to do when they went against us. We focused on trading a few vehicles and really learning them. Jon taught me that a good trader was simply a good risk manager. If you applied and practiced good risk management principles and focused on the craft, you would get better. And as you stayed disciplined and focused on a few vehicles, and learned from your mistakes, profits would start to follow. The process from rookie to independent trader in the PIT at Mercury trading might take 1 ½- 2 years for some. Many didn’t make it. But those with passion, discipline, and a bit of humility ( ability to admit your wrong on a trade), usually lasted quite a few years and found some success.

In the retail arena, unrealistic expectations are sometimes fueled by aggressive marketing by newsletter writers and option educators. They sometimes discuss yields like they are talking about annuities. They seem to be missing a very important step, learning the craft!

In the retail world, yields can be confusing. Do you have a normal brokerage Reg T account or do you use a portfolio margin account? Portfolio Margin accounts require less capital per position because the requirements are based on your loss or gain if the price moves up or down say 12%. Regular brokerage accounts require you to put up dollars sufficient to cover the entire risk of a trade. In a trade like a credit spread, Portfolio margin requirements might be 30-40% less than regular brokerage accounts at the beginning of a trade. Therefore, yields are different depending on the account type. Also, some people calculate yield based on the total capital in the account. Other traders base the yield only on the capital applied to a trade. For example, if I have a $1000 calendar on and make $100, that’s 10%. But if my account size is $10,000, some people might say I made $100 on $10,000, or only 1%. You can see that a conversation about yields has to begin with getting on the same page.

Another important factor affecting your potential yields is the strategy you choose. Let’s use AAPL as an example. The stock is currently at $336. If trader A buys 100 shares of stock at 336 and sells 1 July 350 call at $4.60 , that is a covered write. Trader B buys 1 October 260 call at $80 and sells 1 July 350 call at $4.60. This position has a pretty similar graph to the covered write using stock, with one big difference, it’s much cheaper. Trader B bought an $80 call ($8000) instead of buying 100 shares of stock and paying over $33,000! Trader A won’t have the potential in a good month to make as much as Trader B because of the huge dollar outlay in a covered write with stock. Similarly a trader who does far out-of-the-money credit spreads for a small credit, wouldn’t have the potential yields of someone who did credit spreads closer to at-the-money. Far out-of-the money credit spreads have higher probability of success than at-the-money credit spreads, but at-the-money credit spreads have higher potential yield. An example would be to compare last Friday the SPX June 1340-1350 call credit spread to the 1380-1390 call credit spread. With SPX around 1332, the 1340-1350 call credit spread has a maximum potential 70 % return at expiration. The 1380-1390 credit spread has a maximum potential return of about 16%. Obviously, there is a trade off with credit spreads between probabilities and risk. The 1380-1390 call credit spread has higher probabilities of succeeding but also has a worse risk/reward than the 1340-1350 call credit spread.

In conclusion, you can see that some foundation has to be set before you can really delve into a meaningful discussion of yields. Hopefully this was a help to you. I n future blogs, I will explore this topic more deeply.

I hope you had a great Memorial Day holiday ! 

Dan Sheridan