Greetings! I am writing this to fill everyone in on what has happened since we launched the Option Masters Group in June, including the announcement of an incredible new Option Strategy called Credit Magic.
As you might imagine, this new Strategy trades Credit Spreads. I will discuss Credit Spreads in a few pages, but let’s get down to business on how this little gem performs.
Credit Magic uses % of Equity for its allocation method. The equity curve to the right is from a run set at just 1% allocation per trade.
Using this setting, we see an Average ROI of 37.9% with an Average Max Drawdown of just 6.8%, using just 11.6% of the capital in the account on average.
We can also see from the Equity Curve that Credit Magic made a great return in 2015 – a challenging period for the U.S. Stock Market.
The performance of this Strategy is very good at 1% allocation. But what happens if we increase allocation to 2% or 3%? The next page shows a table with the results at these levels.
Dial-In Your Profit or Risk Level
To the right is a simulation where we set allocation per trade at 2%.* The curve is the same shape, but we see an Average Ann ROI of 88.9% with Average Drawdowns of just 13.3%.
At 1% allocation, we see a very respectable 37.9% historical return, with an Avg. Max Drawdown of just 6.8%. As we increase allocation per trade, the Return to Drawdown ratio goes up from 5:1 at 1% to 8:1 at 3%.
So, “How has it done so far this year?” Our 2018 simulation at 2% allocation per trade shows Returns of 51.9% with a Max Drawdown of 11.1%. The market has returned just 8.2% in the same period with a 10% Max Drawdown in February.
Increasing allocation per trade above 3% increases ROI, with an expected increase in Max Drawdown.
What is a Credit Spread?
A Credit Spread is created by selling a
Near-the-Money Put and buying an Out-of-the-Money Put, creating a “credit” in our account. The hope is that the security will end up above the strike of the Put we sold so we can pocket the credit received.
Credit Spreads have the advantage of time decay. In the example to the right on EBAY, we SELL the Nov 34 Put and BUY the Nov 33 Put for a net $0.39 credit. We just need EBAY to be above $34 at expiration to keep the credit as a profit.
With the current price at $34.56, this means the chart can go sideways to down and still yield a profit. With a Debit Spread, the chart MUST go up to make money. For this reason, Credit Spreads are more accurate (make money more often) then Debit Spreads.
It must be pointed out here that Debit Spreads do make more than Credit Spreads, when they are directionally correct. But higher accuracy means the equity curve for trading Credit Spreads will be more consistent and therefore more desirable on the basis of Risk.
The Credit Spread we use in Credit Magic is defined with contracts that expire several months in the future. This makes the Strategy less sensitive to downside movement, which in turn translates to lower draw downs.
Page 2 shows an example with allocation per trade set to 1%. I think most investors would be comfortable trading an account at 1% allocation per trade if the average percent invested stays at around 11%.
The Robustness of CreditMagic
I evaluated this strategy this morning. It’s a 4.0! Easily the best and the most consistent strategy that I’ve ever tested (option or equity).
I define tradeable as a Profit Factor of around 2.0 and enough trade samples to believe the results – ie, around 50.
I checked to see how the results change based on IVR (Implied Volatility Rank). Every IVR quintile had a Profit Factor of between 1.9 and 2.1 - extremely consistent.
I also checked the results on the Liquid 450 Focus List - passed with very limited degradation. Then I checked the Liquid stocks 450 to 900. Once again, very limited degradation. In fact, the Average Profit/trade was actually improved.
You might want to raise the price on this one to $10,000 if it holds up in live trading. The only issue that I see is the potential fills.*
In fact, the strategy is robust enough to use essentially any optionable stock with good volume. I use AVG(V,21) >- 650k and C >=5.
Too bad Most IRA’s don’t allow credit spreads!
* Thanks LD for your inspiring letter! On fills, I wanted to say you can use the new Fair Market Value Limit to ensure that fills ARE in the range of the current market. Thanks again for diving in and providing this feedback!
Why does CreditMagic Perform so well?
Excellent Signals, Optimal Exits
The Signal Generator in the Credit Magic Strategy is very unique. It applies multiple Systems with different Momentum calculations. But the Exits are also key in this Strategy. Notice in these pictures how the Profit Target is very close to the optimal value for each trade.
In fact, many trades exit precisely at the Profit Target. This behavior is very consistent. The Signals, Exits and option definitions in the Credit Spread combine to create “Magic.” Make sure you read “Trade in Real Time” on page 9.