How Much Money Can I Make Trading Options?


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.

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