Hey everyone, this is Kirk here again at OptionAlpha.com

and in this video, we’re going to talk about targeting your portfolio returns and basically

figuring out how much money you can make trading options. Now, at this point, if you’re new to our program

or are just watching this video, you should understand or have a solid understanding of

where our edge is as options traders in selling options. The concept that implied volatility is always

overstated and therefore option selling is always more profitable than option buying. Before we start talking in depth about finding

and entering trades, first we need to have a target to shoot at, or something to aim

for. So whether you’re new to options trading or

not, one of the major questions that people have are the following: “How much money can

I make?” Or, “What kind of return can I expect?” So I want to introduce you to the concept

of using targeted returns or targeted probabilities as your guidepost for how you should be placing

the majority of your trades in the futures. Before we even get to that, I think it’s insanely

important that we first talk about market trade offs, because markets are extremely

efficient. And what I mean by that is that if you have

a trade where you are taking on less risk, then you will have a lower overall profit. And likewise, in markets where you’re taking

on more risk, you’re going to have a higher overall profit. It’s just how markets work. Risk and profit work in the same directions,

meaning lower risk, lower profit, higher risk, higher profit. Okay? That also means that, with regard to options

trading, you’re probability of winning and your profit potential work in different directions,

or in the opposite direction. And what I mean by this is that when you increase

the probability of winning on a trade … so instead of having a 70 percent chance of success,

you increase that chance of success to 80 percent, your profit potential goes down accordingly. Again, the markets are efficient here, so

when you’re going to win more often, your profit potential goes down, okay? And this works in reverse too. So if your probability of winning goes down,

meaning you reduce your probability of winning from say, 80 percent to 50 percent, then your

potential profit on those trades that are maybe 50 percent of the time going to win

or not are going to be higher when you do win. So your profit potential might be a little

bit higher. This is like a lottery ticket I use as an

analogy all the time. Your probability of winning a lottery ticket

is insanely low, I mean piratically non-existent, right? But your profit potential is really really

high because it’s in direct correlation and relationship with the probability that you’re

going to win, so it’s all efficient and in fair. Okay? Now, the reality is … and this is one nobody

tells you in this business, but I want to go through here with you today … is that

you can target whatever return you want annually in your portfolio. You want a 10 percent return, a 20 percent

return, a 50 percent return. But just ask yourself the following: “How

much risk will I need to take to make a 50 percent return?” Again, because there’s no free lunch, it’s

not that you can make a return without taking some risk. So how much risk will you need to take to

make a 50 percent return? Or, more importantly, can you handle the volatility

in your account trying to get there. And I think that’s the more important question

that people need to ask. See a lot of people shoot for the really high

percentage annual return on capital, but they can’t handle the volatility. They don’t have the persistence and confidence

to get there. Okay. Now, I want to use this graph as a quick visual

aid because I think it’s going to represent the point that I’m trying to make here with

your targeted returns, is that, again, you can target anything you want, it’s just can

you handle the volatility and the risk that comes with that, trying to get to that target. Wherever you want to be at. So if your target, let’s say is 10 percent

annually, which is very good, and in all cases, beats the market averages across the board. So 10 percent annual return on your trading,

which I think is very very doable. Right? Your account and portfolio might start here

at zero on some timeline. Now this timeline doesn’t matter, whether

it’s days, weeks, years, it’s just the concept that we’re trying to prove here. But your account balance might start with

a zero percent return as you just start funding it. And then the first month that you start trading,

maybe you make five percent. And the next month, maybe you make three percent. And the next month, you make four, and then

you make seven, and then maybe one month, you lose maybe eight percent. Or whatever the case is. You can see that there’s definitely some volatility

as you’re working towards your 10 percent target. And you can get there over time, but you’re

going to have a certain amount of volatility in your account. A 10 percent return is not taking on a substantial

amount of risk. You’re not taking on an insane amount of risk

to get to a 10 percent return. And actually we’re going to prove that here

later on in the video with some actual real number and calculations. But you’re not taking on an insane amount

of risk to get to 10 percent. And that means that, yes, you’re going to

have some losing months, but most of the time, the vast majority of your trades and your

potential winning months are going to be above zero. Meaning that they’re going to be profitable

on some level. Now, let’s take the opposite example here,

and let’s say that we’re shooting for a 50 percent return per year. Now think about this, at 50 percent return

per year, means you’re taking on at least five times more risk, right? Probably more because it’s going to be exponential

risk to actually earn 50 percent per year. You’re going to try to basically make a ton

of money, but you’re going to have to increase the amount of risk that you’re making per

trade. So again, you start off with that same account

balance at zero with not making any money. The first month, maybe you make 10 percent. The next month, maybe you lose 10. And the next month, you lose 20. And then the next month you make 10, right? So now you can start to see that your account

balance, although you may get to 50 percent eventually, the fluctuations and the volatility

in your account trying to hit that 50 percent target is going to be much greater. And the problem that I have with shooting

for a target that’s too high, even though I think you can do a 50 percent return, is

that, when the times when you lose money, are you going to be the type of person that’s

willing to hold through those really tough times where you could potentially lose 30,

40, 50 percent of your account over the course of a month or two months or a year, and then

try to trade back from that time period? And I don’t think that many people would do

it. I don’t even think that many people want to

do that. Because honestly, think about it, if you invested,

say 10,000 dollars, and over the next six months, you could lose half of that, would

you really be willing to continue to stay on track trying to hit that 50 percent target? And I doubt many of you actually would, even

though some of you might right now during this video say, “sure, I’ll definitely stay

on track to hit that 50 percent target.” But I doubt that’s the case. In my personal opinion, I shoot for around

15-20 percent. That’s where we’ve historically landed. We’ve actually landed around 18 percent, but

we shoot for anywhere between 15 and 20 percent return, and again, I’ll show you how we come

up with those numbers here in a second. Because for me, I feel like that’s a good

amount of volatility in my account, it definitely moves, and yeah I have the occasional month

where I lose a little bit of money, but most of my months are higher. Meaning most of my months are profitable,

and I’d much rather see a consistent, conservative income stream. So, the question from her naturally becomes,

well we know that we can sell options at any probability level that we want. So we can sell options at a 60 percent level,

an 80 percent level, 50, what is the optimal level for return and risk or margin use? What we’ve done before, is just go back and

look at one IWM naked put. Now we did this a little while ago, and this

is not the “one size fits all” example here, but it does prove the point that we’re trying

to make with regard to the optimal, or what we believe to be the optimal, probability

level for selling options. What you can see here on this chart is that

there’s different probability levels that we’ve looked at for some naked IWM trades. So 60, 70, 80, and 90 percent chance of success. So the likelihood that you win on the trade. Now, naturally, with a 60 percent chance of

success, you make the most amount of money if you’re right. Because, again, the market’s fair. So lower probability of success, higher potential

profit or credit. Same this starts to happen as you go further

out in probability. The amount of credit that you make as you

go further out declines because as you increase your chance of success, you decrease the total

potential profit that you make, okay? So now it becomes, where do we find that optimal

difference? Well, the difference in credit between 60

and 70 in this case was almost a 30 percent difference in credit. The difference between 60 here … I’m sorry,

the difference between 166 here and 112 here was, again, another 32 percent difference. And now the difference between 112 and 47

was a 58 percent difference. Okay, so you can start to see that your credit

starts going down exponentially. First it goes down 29 percent, then the next

10 percent jump-up goes down 32. And then the next 10 percent jump-up, it goes

down almost 60 percent. Okay? So you do have a point at which it doesn’t

make sense to increase your potential profit, or your probability of profit, because your

money that you could make is going down exponentially. Now the margin that’s required is here. And you can see the margin that is required

on each trade goes down as well because the brokers know that as you sell further out

options, as you’re increasing your chance of success, you don’t have to cover as much

margin because there’s not as much risk in the trade. Now if we look at just the return on capital,

which is basically the credit divided by the margin, you can see that the return on capital

as well goes down. So it’s all making sense. The increased probability of success, lower

total credit, lower margin, lower return on capital. But what’s interesting here is that the difference

between return on capital for the first two, so jumping from 60 percent to 70 percent,

was a 17 percent difference in return on capital. Meaning the difference between 11 and 968

here. The next 10 percent jump level, so from 70

to 80 percent, was a 19 percent drop in return on capital. And then you can see, again, just like what

happened with the difference in credit, once we jump from 80 percent winners to 90 percent

winners, the return on capital dropped a dramatic 41 percent. Okay? So what’s really important here to understand

is that there is a point at which having 90 percent winning trades is actually taking

on potentially too much risk and not getting in enough credit, or taking in enough credit

to compensate you for that risk. And you can see that break-even point starts

somewhere around 80 and starts to head out towards 90. So, for the sake of what we do here at Option

Alpha, we basically base most of our pricing on a one standard deviation probability move. And we think that gives us the most optimal

use of capital. Okay, that’s around a 70 percent chance of

success when you start building out trades. So whether you’re doing a one-sided trade

or whether you’re doing an iron condor, or a butterfly, you want to try to build those

trades to have about a 70 percent chance of success. And again, that’s what we’ve found looking

at multiple pricing scenarios over the last eight years that gives you the best use of

capital, the best return, and doesn’t sacrifice your win-rate too much. And definitely not anything under 60 percent. That’s at least where we stand. Now, as we start to transition to figure out

how much money we need to be making on a yearly basis, what we do is we break that down into

basically two components. So we basically break down how much allocation

your overall portfolio is invested in options. Now we have here different allocations just

to kind of prove the point. But let’s say, for example, that of all of

the money that you have available to trade, five percent over the course of the year is

invested just in options trading. So if you have 100,000 dollars, that would

be 5,000 dollars of your 100,000 dollars is invested in options trading. Okay? If you have a 10 percent allocation, that’d

be 10,000 dollars of your 100,000 dollars, etc. etc. etc. Now the reason that we cap that at 50 is because

we never suggest really that you go over 50 or 60 percent of your total account balance. That means that if you’ve got 100,000 dollars,

we never suggest that you invest more than say 50 or 60 thousand dollars in options trading. You just don’t need to invest the full 100,000

dollars to make a return that’s extremely great on the full portfolio. Okay? We feel like you can use options really wisely,

use the leverage that options give you on that 50 to 60 thousand dollars and still make

a great return on the overall 100,000 dollar portfolio, okay? Now the other thing that we look at, is we

look at return on capital per day. So again, we’ll go through a bunch of example

here, but there’s different return on capital levels per day. And so this is really what you want to start

thinking about is where do you want to target your return on capital. Again, the more risk that you take on, or

the higher the return on capital that you shoot for, you just have to understand that

you may not win as often, and you may be taking on more risk, which means more volatility

in your account, like we talked about before. But for example, let’s say that we want to

generate 10 percent, or around 10 percent return on our overall portfolio. So this is that whole hundred thousand dollar

portfolio. Well we would need to earn about 0.3 percent

return on capital per day for the entire year on just 10 percent of our account. So again, if we just invested 10,000 dollars

of our 100,000 dollar portfolio, just that 10,000 dollars and that 10,000 dollars was

earning 0.3 percent per day for the entire year, then at the end of the year, our overall

portfolio would make 10.9 percent. Okay? So that means we still left 90,000 dollars

in cash. And now you probably can start to see why

options, in my opinion, are extremely profitable and less risky than trying to invest 100,000

dollars in stock and hoping you make 10 percent. Investing the entire amount of money in the

market. So this gives you a really good basis for

where you want to start trading and basically targeting your probabilities and your returns. Again, we’re going to go through an example

here in a second. And in my opinion, I usually like to focus

on things that earn less than 0.25 percent per day because I want to be at a higher probability

of profit level, meaning that I want to have a higher chance of success on the trades that

I make. So I keep my win rate high. So I don’t really focus on something that

has a insanely high return on capital per day, but I’m also allocating a lot of my money

to the market every since month and every single week. So usually, we’ve got about 30 to 25 percent

of our portfolio allocated at any given time. And so obviously that gives us kind of the

numbers that we’re shooting for. So somewhere around 15 to 18, 20 percent per

year is what we’re targeting. So in this example today, I want to go through

a bunch of different pricing scenarios for IWN. Now it’s really important as we go through

this that you really take the time to understand this because this is going to be an integral

part in how successful you become trading options. If you don’t understand the math behind how

we get to whatever percentage return we’re targeting, then you really won’t know, or

won’t have the confidence to continue to make trades over and over again even if you have

a bad month or two bad trades or three bad trades. The numbers always work out to be profitable,

it’s just a matter of making small trades and making them often enough so that these

number work out. Okay? So in this example here, we just took a screen

shot just the other day of IWM. This is the Russel ETF, so insanely liquid,

great options, very tight markets. And at the time that we took this screen shot,

the IWM was trading at 106.92. So basically 107. The May contracts at the time, which were

57 days away, that’s that 57 right there, 57 days away, basically have these options

pricings across the board. So these are the puts on the right side, and

then we have the calls on the left side. Now what we did is we basically said okay,

let’s start with just naked selling a 102 strike put option down below the market. Okay, so again stock was trading at about

107 and we’re going to naked sell a 102 put option down below the market. Those put options were trading for about 173

each. And you can see that the probability of those

options being in the money, where the probability of those options losing based on that strike

price was about 31.47. Okay, so the likelihood that you actually

made money on this trade was about 70 percent. And the reason that I say about 70 percent

is because actually the break-even point, since we collected a dollar 73, was actually

closer to around 100. But just for the sake of argument, making

our numbers simple and the math simple for us, we are going to say that there’s about

a 30 percent chance that you lost money, about a 70 percent chance that you made money. And again, that’s based on probabilities,

historical pricing, everything that we know about IWM moves, any move it’s made in the

past, the magnitude, the timeline, for the next 57 days, there’s only a 30 percent chance

that it closes below 102. So that’s a high probability trade that we

can make. So when we bring up this order dialog box

that basically confirms everything for the order, we can see here that the max profit

on this trade is the 172 credit that we could take in. Again, this is selling the May 102 puts at

172 dollars each. Now the margin required for just one of these

contracts is 16.45. So that’s the margin right there that’s required

to get into one of those contacts, or basically the risk that you have to put up. So if we take 172 and we divide it by 16.45,

we basically get an initial 10.45 percent return on our investment. So if this trade works out, then we basically

make 10.45 percent. But we know that this trade is not going to

work out 100 percent of the time. So we have to take our 10.45 percent ROI and

times it by the probability of success that this trade has, which is basically 70 percent. So only 70 percent of the time are we actually

going to look at making somewhere around 10.45. So our effective return after we factor in

the probability of success is 7.31 percent, again after we factor in that 70 percent chance

of success. Okay? So now we have our return on capital after

we have calculated the return, or the probability of success. We now divide that number by 57, that’s the

number of days left in the contract expiration period. So again, if we go up here, you can see that

57 is right here, that’s the number of days left. And that gives us basically our return on

capital per day. So we’re basically going to expect to make

about 0.12 percent return on capital per day for the 57 days that we’re in this trade. Now if we assume, again, this is the assumption

that we make trades like this all the time, all year, which is very easy to do, so it’s

not hard to do a lot of trades like these … if we assume that we make this type of

trade every single day, all year, or have a trade on like this that makes 0.12 percent

return on capital per day, all year long, and we only invest 25 percent of our accounts

… okay so again, this is where we get back to what we talked about earlier. We’re leaving 75 percent of our account just

in cash in this example. So you can increase your investment, you can

decrease it, whatever you want to do. But in this case, we’re just assuming 25 percent

of our account is invested in something like this. Okay, so we’ll scale up the number of contracts,

or whatever we need to do to get to 25 percent of our account invested in a trade like this. So we take the 0.12 percent return on capital

per day times 365 days a year, but we’re only making that on 25 percent of our account that’s

invested, and that gives us an 11.71 percent annual return, okay? Hopefully I didn’t lose you. If I did, go back, rewind this video, go through

it again, we’ll go through another example here, okay? And again, the reality is that is a pretty

powerful return when you think about the fact that you’re only investing 25 percent of your

account. So if you’ve got a 100,000 dollar account,

75,000 dollars of your money is sitting in cash, not at risk at all, probably earning

a little bit of interest from your broker. And the other 25,000 dollars is actually earning

a much higher return on capital that compensates for the other 75 percent that’s sitting in

cash. So again, this is why I love options trading. Because, although we don’t want to ever invest

that 100,000 dollars, we still want to be smart and conservative with our money, we

can still have a lot of money left over. We don’t have to risk way too much money investing

in stocks and trying to earn a 10 percent return investing that 100,000 dollars. Okay? So now, let’s look at a different example. So, in this case, let’s actually go down and

look at a trade that has an even higher chance of success. And just to show you how these numbers work

out again, like we had talked about before, risk and reward is definitely efficient in

the market. So you can’t get something for free without

giving up something. So let’s actually look at selling just the

96 strike put options. Now obviously, these are much lower than the

102 options. And you can see the likelihood of these options

going in the money is about 15 percent. So 15.81, I’m just rounding down just so that

we can use simple numbers and simple math here. So about 15 percent chance that this thing

goes in the money. So about a 85 percent chance that it never

hits the 96 strike. And again, that’s logical, that makes sense. Because there’s about a 30 percent chance

it hits the 102, about a 15 percent chance that it hits the 96. Okay, because that’s a much lower strike. So if we were to sell those 96 strike put

options, we could basically collect a profit of about 77 dollars. Now you’ll notice our margin is lower as well

because this is a less risky trade. The brokers recognize that. They realize that you have aa higher probability

of success so they carry less margin to keep this trade. Where you’re buying power effect is dramatically

less. Now we have a return on capital on the raw

basis, or kind of the front basis, of 7.39 percent. Now this is different that our 10.45 percent

that we had for the initial or original trade. So now, again, we do the same type of calculations

that we did before. We take that 7.39 percent return on capital,

we times it by the likelihood that we’re actually going to win and make that money of 85 percent. And that gets us kind of an after return and

probability of 6.28 percent. And again, we take this number, divide it

by the number of days that we’re going to be invested in this, which is 57 days. So we’re basically looking at a 0.11 percent

return on capital per day for a trade like this. Now again, we take that return on capital,

assume, and yes this is an assumption, that we make the same type of trade over and over

again all year long. We have the same amount of money invested

in the same type of trade all year long. And again, it’s very easy to find these types

of trades, they’re not hard to find. So we assume that we have an 11 percent return

… a 0.11 percent return on capital per day times 365 days a year. But we’re only making that money on 25 percent

of our account that’s invested. Again, we’ve got 75 percent sitting in cash. That gives us a 10.06 percent return annually. Okay? So very easy to see how you can just make

a couple simple trades with minimal risk, without investing 100,000 dollars of your

money and still generate a very decent return trading options. And again, obviously we’re looking at a 10

to 12 percent return. So what you should have noticed is that obviously

the market is efficient. When your probability of success went up from

70 to 85 percent, your annual return went down accordingly. Went from 12.71 down to … I’m sorry, 11.71

down to 10.06. Now let’s look at something a little bit different. So instead of looking at just a naked trade,

which is just selling the 102’s or selling the 96, let’s actually look at something different,

and that is a credit put spread. So let’s look at selling the 102’s and then

buying the 100 strike puts and creating a put spread. Now, again this is going to have about the

same probability of success as the selling of the 102’s because it’s still … you would

still lose if the market goes down below 102. That’s no different. But now you have limited risk by doing this

credit put spread. So again, in this example, we’re selling the

102’s, we’re buying the 100 strike puts to create a vertical credit put spread. We basically cap our potential profit at this

point to just 40 dollars. But notice that our risk is dramatically reduced

from thousands of dollars, potentially, to 162 dollars per spread that we’re trading. Now on the outside, this is a higher return

on capital. So 40 divided by 162, we’re making 24.5 percent

return on capital. Now if we continue on with this example, again,

taking that 24.5 percent ROI times the likelihood that we actually win, which is 70 percent,

that gives us kind of that after probability being factored in return of 17.15 percent,

divided by the number of days that we’re in the trade, about 57, and so we’re looking

at basically a 0.3 percent return on capital per day that we’re investing in this particular

security. Now again, we take this and we say assume

that we make this type of credit spread trade time and time and time again over the entire

year. we’re looking at a 30 percent return … a

0.3 percent return on capital per day, times 365 days in the year. But we’re only making that money on 25 percent

invested. That leaves us with a 27.5 percent annual

return. Okay? And again, if we go back up to our chart that

we had before, if you look at basically a 0.3 percent return on capital per day with

that 25 percent return … or 25 percent of your account actually invested, you come up

with virtually the same 27 percent return annually on the entire amount of money that

you have invested. So again, you can see how this actually works

out really well doing the credit spread versus doing the short put. But don’t mistake this credit spread automatically

as being a better trade necessarily. Yes, you did increase your ROI and your annual

return, but you gave up 76 percent of your total dollar profit. Now remember, higher ROI, you had less risk

in the trade, but you gave up something. And in this case, you made only 40 dollars

versus making 172 dollars. Now It’s funny, because I’ll often ask people

if they want the highest ROI or the highest dollar profit. And there is a difference. Now there’s no right answer here, but it is

important to understand the trade offs. So you can absolutely go after more of the

credit spreads, scale up, sell more of the credit spreads, or you can do more of the

naked positions, right? And do less contracts. You do more credit spreads, you have a lower

dollar profit per trade, higher commission costs, because you’ll probably have to do

10 or 20 of those to make up for some of the sure premium naked positions. Again, it’s a trade off that you have to make

and have to decide on. But I’m just showing you that it is entirely

possible to make a very decent return trading options with a small amount of your money

invested, even if you’re doing naked positions or if you’re doing a credit spread trade,

which anybody can do. I mean, the reality is, I could go back to

this example, anybody that’s out there that’s starting out can take a trade that has 162

dollars of risk. That is a very very low risk threshold. You can take this trade if you’ve got an account

of 5,000 dollars or 3,000 dollars. That’s a trade that you can take. And the same thing is, you can just scale

up that trade or do some other trades, widen out the strikes. There’s a million different things that you

can do to increase your profit. You can take on a little bit more risk, sell

less contracts, okay. So there’s no right answer here as to what

is necessarily better, you just have to understand that the market is fair and efficient. So if you take on more risk, you could potentially

make more money, but you sacrifice probability of profit, etc. etc. etc. So I always say, you will hit what you’re

aiming for. We highly suggest you pick one probability

target, say 70 percent, and place all of your sure premium trades at that same probability

level over and over again. Okay? As a guidepost, if you target trades around

70 percent, you should hit anywhere between 15 and 20 percent per year, depending on the

types of trades you’re doing, how much money you’re investing in the market, etc. etc. Okay? We target around the 70 percent chance of

success for every single trade that we do on the sure premium side. That’s just where we hang out. That’s our target that we’re always going

after so that we’re consistently shooting at the same probability level. And again, that helps build confidence, it

helps build consistency, and persistence in your trading. I think it’s really important that you take

the time now to really think hard about where you want to be in your trading. I would highly suggest that you avoid trying

to go after the 92 percent, the even 50 percent return per year type trades until you get

really really comfortable with an options trading system. Start small. You can always scale up. You can always increase your risk. But if you go for the big home run shot in

the beginning, there is a good chance that you have a really bad trade because you took

on too much risk and you can’t ever recover from that. Or it takes you a long time to recover from

that. Okay? So I’m not saying that you can’t do that,

I’m not saying that guys out there can’t make a lot of money trading options, I’m just saying

know what type of risk you’re going to be taking on to get to that level. So, as always, hope you guys enjoyed this

video. This was a really fun one for me to do. Hopefully it was something different that

you’ve never seen before. I’d love to know your comments, your feedback. If you love this video, please share it online. Send it to a friend, a coworker, or a family

member, help us spread the word about what we’re trying to do here at Option Alpha. Until next time, happy trading.