Starting to Trade with a Smaller Account
As the new year begins and more individuals enter the market, it's crucial to understand how to effectively trade with limited capital. Many new traders seek guidance on getting started, and this article addresses this topic with research-backed insights.
The Growing Market and Capital Constraints
With the markets trading at all-time highs, the significant growth of the stock market over the past few years is evident. Over the last five years, the S&P has almost doubled, the NASDAQ has more than doubled, and the Russell has increased significantly. This growth presents a challenge for new traders, as asset prices rise, leading to increased capital requirements for trading options, which are often based on a percentage of notional value. Therefore, it's essential to find underlyings and strategies that keep capital requirements low while maintaining a high probability of profit.
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Market Growth Examples:
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In December 2019, QQQ was at $211; now it's at $531.
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Meta (Facebook) was at $200; now it's at $600.
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Netflix was at $300+; now it's at $900.
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McDonald's was at $200; now it's at $300 (showing that even stable stocks have seen growth).
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The Impact on Iron Condors and Probability of Profit
Simply adding long wings to short strangles may not be the only solution. A fixed-width spread or an iron condor in an underlying asset that has significantly increased in price experiences a considerable reduction in its probability of profit (POP). For example, to achieve the same POP as in 2019, an IWM iron condor's wings on a 20 Delta might need to be $20 wide, making it less feasible for smaller accounts.
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POP Comparison:
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December 2019 IWM iron condor: 69% POP.
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Same iron condor five years later: 61% POP (a 15% reduction).
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Leveraging Product Indifference and Liquidity
The key to overcoming these challenges lies in embracing product indifference. The specific name of the company is not as important as the risk/reward profile of the trade. Instead, focus on finding liquid assets with tight bid-ask spreads, high implied volatility, and high IV Rank. Iron condors or even strangles on these assets can be viable for traders with smaller accounts.
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Examples of Potential Assets:
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FXI (Chinese ETF)
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EWZ (Brazilian ETF)
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GDX (Gold Mining ETF)
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SLV
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Capital required for strangles on these assets can be relatively low (e.g., $300-$500).
Defined vs. Undefined Risk Strategies and Implied Volatility
Small accounts are often constrained from using undefined risk trades. However, defined risk strategies typically cost between 20% and 40% of the credit received, depending on implied volatility.
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Impact of Implied Volatility:
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In low implied volatility stocks, using undefined risk trades leads to a significant increase in buying power required.
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In high implied volatility stocks, the percentage increase in buying power is much less, allowing for more undefined risk trades.
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Consider Delta Airlines (high IV) and CMG (low IV) as examples. Although priced similarly, the credit received on a one standard deviation strangle is much higher with Delta due to its higher implied volatility.
Strangle vs. Iron Condor: Buying Power Considerations
When comparing a strangle to an iron condor using Delta and CMG, the iron condor will require roughly the same amount of buying power. However, the strangle in CMG requires more money because the credit received is less.
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Buying Power Reduction: These are buying power reductions and not credit received.
- The strangle in CMG requires more money, due to the lower credit received. The percent change in buying power for CMG is 58%, compared to 36% in Delta.
Key Takeaways and Recommendations
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The significant increase in asset prices makes it more challenging for new traders with limited capital.
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Defined risk strategies cost 25-40% of the credit received.
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Undefined risk strategies in high IV stocks offer a better credit/buying power reduction ratio, making them more feasible for smaller accounts.
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New traders should prioritize product indifference, focusing on high liquidity, moderate to high implied volatility, high POP, and low capital requirements over specific asset names.