How to Trade the Alpha Rotation Model Using Options
The Alpha Rotation model generates trades in two symbols, the primary Index ETF (SPY, or QQQ and IWM) and U.S. treasures ETF (TLT). While the Alpha Rotation models trade the ETFs, the model entries and exits make great setups for trading the underlying options as well.
When an alert goes out for a new Alpha Rotation model trade, normally you would do some calculations and buy the appropriate number of ETF shares for your account’s capital and risk levels. However, with some guidelines and a few simple steps, you can figure out the appropriate option to buy. We have outlined a few different ways to trade and manage the options:
The table above shows some basic performance stats for the different models and variants for trading Alpha Rotation ETFs or options. The options data is shown for different portfolio allocation percentages. These variations are explained below.
Options Portfolio Allocation
This is a key decision that will have large implications on the performance of your options portfolio. Since options provide natural leverage, you will need to keep part of your portfolio in cash or available as a buffer.
The historical range of options performance for individual trades in the Alpha Rotation strategy is -74% on the worst performing trade and +654% on the best performing trade. Even some trades in the Alpha Rotation where the ETF is only up or down marginally can result in a sizable negative options move, especially if a lot of time has elapsed over the course of the trade.
If you were trading your entire portfolio in options, it would only take a couple bad trades in a row to significantly impact your ability to keep trading the strategy. For this reason, we recommend only trading options equal to a fraction of your total portfolio (5%, 10%, 20%, etc…).
Let’s walk through an example of a 10% portfolio allocation. If you had a $10,000 portfolio, a 10% allocation to options would be $1,000. If the option’s price was $200 ($2.00 per share), you could buy 5 options contracts for $1,000.
If those options doubled in price when you sold them, your $1,000 in options increased to $,2,000 and your total portfolio went from $10,000 to $11,000. You would then find 10% of the $11,000 portfolio to find how much available capital you have for the next trade. In this case, your next options trade would be $1,100.
If those options lost 50% of their value, your $1,000 in options would only be worth $500 when you sell out of them. So, your total portfolio would go from the starting $10,000 to $9,500. You would then find 10% of the $9,500 portfolio to find how much available capital you have for the next trade. In this case, your next options trade would be around $950.
You would use the same basic calculation method if you are allocating 5% or 25% of your portfolio to options, only changing the allocation percentage to match your desired allocation.
Increasing your portfolio options allocation percentage increases your total risk and your total reward potential. Looking at historical performance, here is how changes in allocation percentage can change your average annual return:
An increase from 5% (low risk) to 20% (significantly higher risk) will increase your average annual return based on historical trades. However, it can also significantly increase drawdown potential if there are multiple losing trades in a row.
Here an increase from 5% (low risk) to 20% (significantly higher risk) more than tripled the historical maximum drawdown. These numbers are based on historical performance, but future drawdowns could be more or less than what is shown here. Some degree of caution is always recommended, especially when trading leveraged instruments.
For any trading strategy to be successful, you have to stick with it. It is very important for you to accurately and realistically determine your own comfort level with trading options and the volatility that comes with it so that you can stick with the Alpha Rotation trading signals.
Which Delta to Choose?
Delta measures the sensitivity of an option to price changes in the underlying symbol and is related to the odds that the option will end “in the money.”
The performance of different options is dependent on several factors (underlying price action, time until expiration, volatility, etc…). Higher delta options require more upfront capital to trade. We recommend trading the 0.50 delta options. Lower delta options will tend to underperform on marginal trades and outperform on the largest trades.
Which Target to Use?
Most ETF trades exit on a rotation prior to hitting a target and few go much beyond the first target. Additionally, trade management and time decay in the options become bigger issues on extended trades. We recommend taking off all of your options contracts if the model hits a first target.
Example Trade Entry:
Here is a typical example of an Alpha Rotation trade alert:
“Alpha Rotation Trade Alert: Enter full “SPY” position at the market on the open Monday 10/14/2019”
If you received the above alert, here are the steps to finding the correct option to trade:
- The first thing you would do is find the options contract that is about 120 days out (or greater) from the current date. In this case, the February 21st, 2020 expiration date is just over 120 days out from 10/14/2019.
- The second thing to do is find the call option strike that is closest to the 0.50 Delta. This will often be a strike that is close to where the market is currently trading.
Most trading platforms allow you to look up options strike data that includes the option’s delta value.
Position Sizing
You can determine how many contracts to buy based on your trading capital and your options portfolio allocation percentage. Once you have determined how much capital to allocate to this trade, you can calculate how many contracts to buy. In the example above, the options contract costs $998 ($9.98 per share). If you had a $1,000 allocation, you would only be able to buy one contract. A $10,000 allocation could buy 10 contracts.
The option price for the 0.50 delta will vary based on a number of factors. Sometimes if might be $10 and other times it could be half that. If the strike price exceeds your total allocation, you can consider rolling down to a slightly lower delta strike or your overall options allocation might be too low to effectively trade this strategy.
Trade Management
Once you are in an alpha rotation trade, you manage all future stops, targets, or exits according to the Alpha Rotation underlying ETF’s stops, targets and rotations with the exception that we recommend taking off the full position if the model reaches any profit targets. There are four potential reasons to exit or partially exit a trade:
- Stop Loss Exit
- Profit Target Exit
- Rotation Exit
- Time-based exit (Options Only)
Stop Loss Exit
The stop loss exit happens when the Alpha Rotation model hits a stop and fully exits the position. In this case, the options should be exited at the market when or after the underlying SPY or TLT ETF hits its pre-determined stop.
Profit Target Exit
The profit target exit happens when the Alpha Rotation hits a profit target. We recommend fully exiting the options position if the underlying Alpha Rotation model hits its first profit target.
Rotation Exit
The rotation exit happens when the Alpha Rotation issues an alert and fully exits the ETF position based on deteriorating market internals and ratio scores. In this case, you would exit your entire options positions at the market around the open alongside the Alpha Rotation ETF position exit.
Time Based Exit (Options Only)
If the option you bought has less than 30 days remaining before expiration, we consider it out of time, and it should be sold at the market even if it has not reached any targets. Sometimes this will yield a gain, but there will also be times that this will result in a loss. Based on average trade lengths, if you go out 120 days from entry for the options expiration, this should be an extremely rare event. If you use a time-based exit, we recommend remaining in cash until a fresh Alpha Rotation entry signal is generated.