We've heard the phrases so many times..."Exits are more important than entries"..."Money Management is the Holy Grail of Trading"..."Failing to plan is planning to fail"...blah, blah, blah. What more could possibly be said about it. Well, I would like to add my 2 cents to the discussion and hope it assists in making you a lot more.

Let's say you actually decided to do what the experts say and write down a trading plan. Based on the current information out there, what would it look like?

**Capital Allocation by Strategy Model**

In the world of options education, the Capital Allocation by Strategy Model is quite popular. Many prospective mentoring students come to us having learned this model from other options education sources. This approach says that you should allocate your options trading capital by strategy, possibly using an equal amount of capital for each of several approaches. Figure 1 shows an example.

Figure 1: Capital Allocation by Strategy Model Example

In the example above, a trader would allocate and equal amount of capital to the Calendar Spread approach, the Condor Approach, and the Butterfly Spread Approach with a small amount of cash left over for reserves. Other strategies could be substituted, of course. Various directional strategies could certainly make their way into this model.

Now, what if you were to actually execute the Capital Allocation by Strategy Model? What would it look like day-by-day and how would it pan out?

**Risk Evaluation**

To answer, we'll employ an imaginary options trading portfolio of $20,000 and then go through a three step process to better understand.

1) Define each strategy within the example model

2) Determine the amount risked for each strategy

3) Summarize the risk impact of each approach to our total portfolio

Using the example in Figure 1 and with $20,000 in our options trading portfolio, we would allocate $6,000 to each strategy and keep $2,000 in cash. When looking at each strategy, we'll have to do some rounding to keep things simple.

**Condor Spreads**

This involves selling an out-of-the-money (OTM) credit spread in both the calls and the puts simultaneously. Exit and adjustment strategies for this approach vary as much as my waistline (on Atkins and then off Atkins). For our example, however, we'll keep things simple and adopt the following rules when evaluating the risk.

1) Sell an OTM call credit spread and an OTM put credit spread with the short strike located just outside the first standard deviation.

2) Sell both spreads in the first month with over 30 days remaining until expiration.

3) Exit the position when a yield of 8% can be achieved, OR

4) Exit the position if or when the underlying index hits a short strike.

These rules are in no way intended to be the final say in Condor-trading wisdom, but rather are designed to serve as an approach that gives us a risk level for purposes of evaluating the Capital Allocation by Strategy Model. There are many ways of trading Condor Spreads, and any one of them could have served this same purpose.

Figure 2: An OptionVue Matrix with the Condor Position Entered.

Notice that the 8-lot Condor position results in a Net Requirement of $6,200. Now, what is the possible return and what is the possible risk to this trade? On the return side, 8% of $6,200 is $496 which represents our yield target. On the risk side, well...this is a bit more complex because we need future theoretical option values to accurately predict our risk. So, we will use OptionVue 6 to model the position in the Graphic Analysis screen.

Figure 3: Condor Risk Graph with Selected Line Halfway to Expiration

The Selected Blue (dashed) line shows the condor position as it will look at a date halfway between today and the Expiration Date. So when the position still has 22 days to go before expiration, we see clearly that theoretical risk on an upside move to the short strike amounts to $2,160 and the risk on a downside move to the short strike amounts to $1,750. This information will help us later analyze our Trading Plan.

**Butterfly Spreads**

The Butterfly spread involves selling two or more at-the-money (ATM) call options...and then buying half that number of contracts one standard deviation OTM...and then buying half that number of contracts the same distance in-the-money (ITM). This approach takes advantage of the fact that the fat ATM time premium that is sold erodes quickly compared to the scant time premium available in the long options.

The following Butterfly Spread trading rules are typical of an approach used by option premium sellers.

1) Sell 2 ATM calls in the first month with over 30 days remaining until expiration.

2) In the same month, simultaneously purchase 1 call located one standard deviation OTM.

3) Also in the same month, simultaneously another call option located the same distance ITM.

4) Remove the full position when a 10% yield is be achieved, OR

5) Remove the position if or when the underlying index touches one of the long strikes.

The stops are quite wide in the above rules, and some traders might feel uncomfortable watching the index drift all the way to a long strike. Our research shows, however, that wider stops in a Butterfly Spread approach typically result in greater winning percentages and profitability. However, when a loss does occur, the pain to the trader's psyche might too high. This becomes a preferential area, and will vary from trader to trader.

Figure 4: A 2-lot Butterfly spread with 4 ATM short options and 2 each OTM and ITM.

This position requires $6,180 to initiate and our yield grab target is thus $618. On the risk side, we once again will need to use OptionVue 6 to model our theoretical risk if the index reaches a long strike in either direction.

Figure 5: Risk Graph of Butterfly Spread modeled 22 days before expiration

The selected blue (dashed) line shows what the position will look like when it still has 22 days to go until expiration day. Under the exit rules we chose, the risk to the upside is quite substantial with a maximum potential loss at 22 days of $3,160. This is a large figure that will play a role in demonstrating why the Capital Allocation by Strategy Model is deficient.

**Calendar Spreads**

The calendar, or time, spread takes advantage of the fact that time premium in near month options decays faster than time premium in more distant options of the same strike price. The trader will simultaneously sell a nearer month strike and then purchase an option of the same type and strike price but in a more distant month. Managing the position usually amounts to either exiting altogether with a predetermined profit or loss, or else the trader might add another calendar spread to the existing position under certain circumstances. The possibilities and combinations are endless.

For purposes of deriving a reasonable risk level, we'll employ the following creative Calendar Spread campaign rules.

1) Purchase an ATM Calendar Spread with the front month having at least 21 days.

2) Should the index move to the modeled intersection of the Expiration Risk line and the breakeven point (see Figure 7), then add another ATM Calendar Spread.

3) Exit the full position when a yield of 10% is achieved (using the full allocated capital as the basis), OR

4) Exit the position when the loss is 15% of the total allocated capital.

Figure 6: Matrix with an at-the-Money (ATM) Calendar Spread

Figure 6 shows an OptionVue Matrix with a 4-lot Calendar Spread position proposed. Note that this requires just $3,650 in capital. The rest of the allocated $6,000 is reserved for placing the additional position should the market move fast enough.

The trigger for adding another position occurs when the underlying index moves to a price that matches the intersection of the Expiration Risk Line and the 0% Breakeven Line. The trigger points are illustrated in Figure 7.

Figure 7: Trigger points for adding another Calendar Spread

What is the risk of this Calendar Spread approach? Look carefully at the trading rules above and you'll see that we will exit at a 15% loss. With $6,000 allocated to this strategy, we will exit the position if we reach a loss of $900.

**Risk to the Portfolio**

The following table displays each strategy along with the capital required, the dollars risked and then the percentage of the portfolio this represents.

Look carefully, and you'll see that the Calendar Spread approach is risking less than one-third the amount as the Butterfly Approach. This is a big difference and squarely illustrates the pitfall of the Capital Allocation by Strategy Model. The conclusion is that allocating equal capital amounts to different strategies will result in at least one of those strategies exposing the portfolio to too much risk.

**Alternative Trading Plans**

At DiscoverOptions, we mentor students to employ a customized Trading Plan that limits the percentage of capital risked to no more than 5%. Anything beyond this is dangerous to the trader's confidence in the face of losses. Yes....you read that right....“losses"! Losses will occur even with the most well researched and highest probability strategies.

To alter the risked amounts to 5%, simply adjust the contract size until the modeled risk is appropriate. Yes, this means using OptionVue 6 (or whatever analysis method you use) over and over again until you get it right. For some approaches, you will have to model proposed positions and then alter the contract size and then model them again until you “back into" the appropriate contact size. This could take some time, but you will get faster with practice.

For more information on Trading Plans used by DiscoverOptions mentors, please email us at info@discoveroptions.com or give us a call. We'd love to hear from you.