This Option Strategy Turned $10k Into $1 Million In One Year

Summary

In this video, the presenter shares a powerful options strategy that has turned $10,000 into $1 million in just one year. The strategy focuses on selling earnings volatility, exploiting inefficiencies created by implied volatility crush and stock moves that fall short of expectations. Backed by data and research from over 72,000 earnings events, the strategy is tested using short straddles and long calendar spreads. Key metrics and Monte Carlo simulations highlight the importance of risk management and position sizing. The presenter personally prefers the calendar spread for its balance of risk and reward.

Takeaways

• 😀 The Kelly Criterion is used to optimize position sizing, reducing variance by adjusting the bet size, balancing risk and return.
• 😀 A 30% Kelly bet in the calendar strategy lowers the maximum drawdown significantly, while still maintaining solid returns and a good Sharpe ratio.
• 😀 Reducing the Kelly bet to 10% helps bring drawdowns in line with a more sustainable risk profile, improving long-term viability.
• 😀 The calendar strategy offers a better balance of risk and reward compared to the straddle, which may offer higher returns but comes with extreme drawdowns.
• 😀 The long-term performance of a 10% Kelly calendar strategy over 10 years shows a 90% compound annual growth rate and an average drawdown of 20%.
• 😀 A higher Sharpe ratio (around 3) for the calendar strategy indicates superior risk-adjusted returns compared to the straddle strategy.
• 😀 Risk management and position sizing are key to longevity in trading; overly aggressive sizing can lead to significant losses.
• 😀 A Python script is available to scan for upcoming earnings events that fit the criteria for high-probability trades, with recommendations based on key metrics.
• 😀 The script flags trades as 'recommended' when all conditions are met and 'considered' when only two of three conditions are met, ensuring more selective trades.
• 😀 The example with Amazon earnings demonstrates the success of the calendar strategy with a profit of $9,300, while the straddle made more but with much higher risk.
• 😀 Despite the straddle having higher returns potential, the calendar strategy is preferred for its more manageable risk profile and better overall trade management.

Q & A

What is the Kelly Criterion and how is it used in the context of the calendar strategy?

The Kelly Criterion is a mathematical formula used to determine the optimal position size in order to maximize the growth of a portfolio while minimizing the risk of significant losses. In the context of the calendar strategy, it helps determine how much capital to allocate to each trade based on expected returns and variance. Adjusting the Kelly bet (e.g., 50%, 30%, or 10%) affects both potential returns and risk, with higher bets offering higher returns but also increasing risk, and lower bets reducing risk at the cost of some returns.

What is the impact of reducing the Kelly bet on returns and drawdowns?

Reducing the Kelly bet results in smaller position sizes, which reduces the potential returns but also helps lower the drawdowns (the magnitude of losses during unfavorable market conditions). For example, reducing the Kelly bet to 30% or 10% results in more manageable drawdowns, making the strategy more sustainable over the long term, even though the returns may be lower than with a higher Kelly bet.

Why does the speaker prefer the calendar strategy over the straddle strategy?

The speaker prefers the calendar strategy because it offers a better balance of risk and reward. While the straddle has the potential for higher returns, it also comes with a much higher risk, especially in unpredictable markets. The calendar strategy is less likely to result in massive losses, making it more suitable for the speaker's risk tolerance and long-term sustainability.

How does the speaker adjust position sizing for different risk levels?

The speaker adjusts position sizing based on the Kelly Criterion to manage risk. They start with a 50% Kelly bet, but due to the high drawdowns, they scale it back to 30%, and eventually to 10% for better risk management. This gradual reduction in position size helps balance potential returns with acceptable levels of risk, ensuring the strategy remains sustainable even during periods of large losses.

What is the significance of the Sharpe ratio in evaluating the performance of the strategies?

The Sharpe ratio is a measure of risk-adjusted return, calculated by dividing the excess return of an investment by its volatility (standard deviation). A higher Sharpe ratio indicates a better risk-adjusted return. In the context of the strategies discussed, the Sharpe ratio helps assess the efficiency of each strategy in delivering returns relative to the risk taken. The speaker highlights that even with a lower Kelly bet (e.g., 10%), the Sharpe ratio can still be favorable, showing that the strategy is effective in managing risk while providing reasonable returns.

How does the long-term performance (over 10 years) look for the calendar strategy?

Over a 10-year period, starting with $10,000, the calendar strategy at a 10% Kelly bet resulted in an ending portfolio value of around $6 million. This equates to a compound annual growth rate (CAGR) of approximately 90%. Despite the impressive returns, the strategy had a mean maximum drawdown of around 20%, making it a sustainable approach for long-term capital growth.

What is the role of the Python script shared by the speaker?

The Python script is designed to help traders scan for earnings events that meet the criteria discussed in the video. It calculates key metrics based on the model and provides recommendations for trades. If all conditions are met, the trade is marked as 'recommended'; if only two conditions are met (excluding the term structure slope), it is marked as 'consider'; and if the term structure slope is not met, it is labeled as 'avoid'. This allows traders to quickly evaluate potential opportunities for the calendar strategy.

What factors are used to determine whether a trade is recommended or avoided?

The decision to recommend, consider, or avoid a trade is based on three conditions: the term structure slope, the expected move, and other key metrics such as the stock’s volatility and historical performance. If the term structure slope aligns with the expected move and other conditions, the trade is recommended. If it does not align with the term structure slope, the trade is avoided. The script helps automate this evaluation to identify high-probability trades.

Can you explain how the straddle trade compared to the calendar trade in the example with Amazon?

In the Amazon example, the calendar strategy resulted in a $9,300 profit, while the straddle trade, though it traded fewer contracts, ultimately made more money. The straddle trade had fewer contracts (20 contracts vs. 100 contracts for the calendar), but it benefitted from larger price movements. However, the straddle also had a much higher risk, as it could have led to significant losses if the market moved against it, whereas the calendar trade offered a more balanced risk-to-reward ratio.

What does the speaker mean when they say 'risk management is key to longevity'?

When the speaker says 'risk management is key to longevity,' they are emphasizing that no matter how strong a trading edge may be, if position sizing and risk management are not properly handled, a trader is at risk of significant losses that can wipe out capital. Effective risk management ensures that a trader can withstand adverse market conditions, preserve capital, and remain in the game long enough to profit from their edge over time.