Deleveraging Put Verticals (Part 3)

Last time I discussed the possibility of rolling out the put vertical if the market moves against me. Keeping with the theme of longer trades, I will now discuss trading less frequently as a way to deleverage.

Rather than deleveraging by holding a multiple of the margin requirement on the sidelines, I could be more selective in time and trade less often. I mentioned how 30% (or less) would be sufficient to meet my income goals rather than the lofty 120% annual returns promised by the vertical spread. I could, therefore, stay out of the market until the underlying prints a relative low. Alternatively I could use a momentum indicator like RSI and trade only when a critical value (e.g. 5, 10, 20) were crossed. By holding out for “higher-probability entries,” this is another way to deleverage since being out of the market represents lower risk exposure.

Backtesting can give me a historical sense of how often my trade criteria are triggered. How many times has the underlying printed an x-day low? How often has the RSI crossed above/below critical value y? If the number of occurrences is too low for my revenue requirements then I can lower x or raise y. I can lengthen/shorten the RSI period as another way to vary trade frequency.

More importantly, backtesting can help me understand whether my “high-probability signals” are actually higher probability. I have been suggesting placement of bullish trades after the market sells off but I have data suggesting the market may be most volatile in both directions when it is oversold. From a risk perspective, these may be precisely the times to stay out of the market altogether.

One final perspective on deleveraging regards staying ahead of the losses. For a $2.15 credit, 12 trades would generate $28.80 in profit. I then have no net risk until I hit a max loss because the profit I have generated is enough to cover that loss. Once I hit 24 trades then I have earned money to offset two max losses. This could be done in less than 10 months.

If I feel confident after enough “max loss units” of profit have accrued then I can increase contract size accordingly. At the larger position size, one max loss can wipe out significant gains but profits will also accumulate more quickly.

Profit hereby represents deleveraging because the net income is banked and able to offset future losses when they occur.