Today there was a posting in my private group, which raised important questions that seem to be of general interest, and that I would like to address for the general audience.

OptionJedi: Hi Juan, in reading all of your posts, I know that you propose that you risk no more than 2% of your capital on a single trade.  As I have looked through many of the examples, this mostly has been the max amount the expiration day risk curve that dips below zero (usually this has been on the put/down side of the trade).
My question: is this realistic?
1) As you have said, IV usually goes up when the stock drops so that
curve will be "lifted" as the underlying price drops.

Juan: As with other IV-dependent trades, looking at the price/profit&loss charts is not reflective of what might happen with the value of the trade because it ignores the effect of volatility. Since this is a delta neutral trade with higher number of longs than shorts, and higher number of back moth than front month options (Calendar) it is exquisitely susceptible to variations in volatility. Therefore some may actually use variations of this trades are volatility plays, but they ignore the exposure to Theta and Delta. To answer your question, IV usually spikes as a stock goes down (but not always). So what you are saying is true, the risk curve will move toward the profit zone (higher in the ThinkorSwim analyze tab charts, or to the right in the modern risk graphs that I often post). The estimation of the risk may not be realistic, as you say, but you could still use it as long as you keep my rules of entry and this is why: I have been trading PCCRC’s for 4 years, and I have never encountered a situation in which I met the 2% max risk. In fact, very rarely did my losers meet the loss of 1% of my account. Remember, each trade may use 10% (I can have 10 trade at a time) of my account, and the risk of capital in the trade is 20%. In most other option trades, you risk the entire capital in the trade. So I view the PCCRC as a conservative form of trading.

OptionJedi: 2) Given that IV risk is the biggest risk of the PCCRC, I know you try
to mitigate by entering when IV is relatively low (<= 40%) and try to
get a skew edge between the front and back months.  However, just like
a stock can fall to zero in theory, IV could also, in theory, fall to
zero.  So maybe not zero, but certainly lower than when the trade was
entered.  Would it not make sense, from a defining risk more
convervatively perspective, to calcualte the max loss using an IV at
the lower bound of trading for some previous period of time?  For
example, you take the lowest IV from the past year and plug that
into the TOS analyzer to figure out what that risk curve under zero
looks like at expiration and use that to determine your 2% per trade
max loss computation.  I know that may be an uglier number, but it's a
number more probable in terms of defining risk.

Juan: First, I look for situations in which IV may rise such as in the case of 52 week highs, best performers over the last 90 days, breakouts, 52-week-highs and post-earnings jump of over 10%. The skew is a volatility play that you may or may not have in those situations. So long as the skew is positive (higher IV in the front month) or is negative by no more than 1%, I am comfortable trading the PCCRC. Finally, I have chosen arbitrarily the <40% cut off point because a decline in volatility after a takeover offer will not immediately go to 0%. Take the example of DNA, following the hostile takeover offer my Roche today, the IV went from the mid 40’s (IV back month) to the low 20’s. Along with that, the stock went up more than 10% in price. This should have been a good enough jump to increase the value of the trade due to Delta gains, while not causing much of a damage due to Vega, provided you’d have entered the trade before the announcement was made, and following my strict rules.




If you do go back in time and trade only stocks whose IVs are at the lowest point in their 1 year range as you propose, you probably would not find any candidates in the current environment. My recommendations have considered the fact that you may have a drop of 10-20% if the underlying company receives a takeover offer. However, I’d estimate that I won’t lose much since the takeover offers usually result in a good jump in stock price. Coincidentally, one of the trades that exceeded my 1% loss was DNA in Aug. last year when the company received the first offer from Roche. It is very good to know that even in such an extreme, I did not loss more than 2% of my account, which is very manageable by any standards. Imagine if you have a $100,000 account including 100 shares in $100 stock (a $10,000 investment). Would you exit the trade if the stock fell to $80,000? that would be a loss of 2% of your account. Keep that in mind when you define our own risk tolerance using the PCCRC. I reiterate that you can confidently expect to lose less than 2% in the worst case scenario. A scenario, btw, that I have not yet encounter.

Option Jedi: Why am I harping on this?  Because the whole notion of the PCCRC is to
put a trade on and "foreget about it" for the most part.  However, it
is not a defined risk trade.  Because the profit could be unlimited,
the risk is also not defined.  So an iron condor is defined.  Long or
short verticals are defined.  Butterflies are defined.  Meaning, when
the black swan hits, you know exactly what the worst case scenario is
and it will be no worse than that.

Juan: I most often heard from Options traders before I started trading the PCCRC that would recommend a maximum risk of 5% (of your account) in any individual trade. This to me is actually quite aggressive, because If I had a $100,000 account, I would not be willing to lose $5,000 in any individual trade. Compare this to a stock, and it would be equivalent to tolerating a decline of $50 in the price of a $100 stock for which you own 100 shares. In fact, when I enter butterflies, condors and vertical spreads I risk very little and only trade does strategies as curiosities, not trading even 1% of my account. Why? because I know I can rely on the PCCRC to produce profits consistently. I would suggest that you look at the statement of my paper trading account in which I have religiously kept my rules, and you will see the very large percentage of winners using the PCCRC strategy alone. So I rely on my experience to state that the risk, which is only “defined” by my experience, does not exceed 2% (at least not yet).

Option Jedi: However, for the PCCRC, that risk curve can "sink" if IV sinks.
Mentally and emotionally, I probably would "sink" along with the risk
curve.  However, if I use the TOS IV adjustment feature of the
analyzer, I can subtract 10% or 15% from current IV and then look at
that risk curve as a more probable scenario in the black swan scenario
so I can sleep better at night using that number as the actual amount
per trade that I am risking, and therefore what the total amount of my
portfolio is at risk at any given time.

Juan: I can only speak for myself when I say that I can sleep at night quite soundly. I can even leave the country and go to a remote area with no internet access for weeks, and only worry about doing my rollovers before leaving and be sure to be back 1 week before expiration. This is one of the very reasons I chose the PCCRC and further developed my rules. I can also relate to you that I have grown so weary of losing money while trading other strategies between 2000 and 2005, that I could not really sleep at night so long as I had a trade with “defined risk” or not. Today, I actually look forward to waking up hoping for some kind of a surprise such as a 10% jump or decline in an underlying for which I hold a PCCRC position.

I cannot persuade you not to worry about what may happen with your trades, but I can offer this: Paper-trade the PCCRC’s that I discuss in my Thursday webinars, follow the in detail for several months. I can assure you that whether you begin to trade 1 year or 3 years or 3 months from now, the results will be very similarly positive. You will soon stop worrying about any individual trades, and being focusing on the overall portfolio management.

Finally, If you start any form of trading with your own money and find that you cannot sleep well at night, reduce the risk on the trades. Do not do this by eliminating any candidate with higher then 30% volatility (I actually do not recommend IV’s below that). Instead, reduce the amount of capital per trade until you experience the consistency in profits that I have experience. Then you’ll graduate to a higher risk bracket.

Juan