The 5-10-20 Rule: The Easy Way to Passive Trading

Here I am about to describe in detail my most important rule for one of the most basic option strategies that anyone can do with a peace of mind.  It is called the 5-10-20 Rule and it applies to vertical credit spreads.  Every month, I allocate about 40% of my portfolio to this strategy.  


I think we are going into an economic cycle for several months where the market just cannot continue to grind higher or break down to new lows in a fast blistering speed.  We will remain range bound which at this point for S&P seems to be 1050 and 1150.  Until a better picture emerges, going forward most of my trading ideas will be based on how to make the most out of your money while the market doesn't do anything.  And that's where 5-10-20 Rule can make a difference.  Note that this is not meant to hit home runs, but rather take a passive approach and let Theta decay work for you.  


Most of my readers are familiar with credit spreads.  They are done when you buy a lower OTM strike puts and sell a higher OTM strike puts to bet that the stock will remain above certain strike by expiration.  We sold put credit spreads in AAPL and GS in Feb and they expired worthless (see the archives).  A similar bet to the downside can be made when you buy an OTM higher strike call and sell an OTM lower strike call.  When you combine both calls and puts, it becomes an iron condor.  


Here is the breakdown of the strategy:


5% - When trading options, never ever in your life time allocate more than 5% of your portfolio in a single trade.  It doesn't matter you have $10,000 or $1 million in your account, stick with the rule and it will serve you good in the long run.  


10% - When doing a credit spread, the OTM strike you're selling or shorting, the difference between that and where the stock is currently trading at must be at least 10%.  This is important because if the stock runs against you, it gives you 10% cushion before your shorted option can get in the money.  


20% - The total return or profit by selling the spread must be at least 20% each month.  So, if it is $5 spread, it should be done for no less than $1 credit; $1 spread should be done for no less than $0.20 credit.  


To give you an example.  Look at DNDN right now.  There is no event in the horizon before March expiration that can move the stock significantly.  The stock is currently trading at $31.  First rule, no more than 5% of your money should be allocated to this trade.  Second rule, if you decide to do a credit spread by buying March $27 puts and selling March $28 puts, the difference between current stock price of $31 and the strike you're selling $28 is in fact just about 10%.  So, that meets our test.  Third rule, this 27/28 credit spread is $1 spread, so it should be done for no less than $0.20 credit.  If done correctly, you will make 20% on your money as long as the stock stays above $28 by March expiration, and you have 10% cushion in case the stock falls.   


The idea here is to sell credit spreads each month and take in 20% on each trade when stocks are trading sideways or in a range.  You must also combine technical elements to do the trade and the ideal would be to sell a put spread that is below support line, or sell a call spread that is above resistance line.  


The best time to do this is at the beginning of each option cycle.  I normally start out by printing out the entire list of S&P 500 stocks.  I break it down by sectors and review the best of breed stocks in each sector.  I eliminate those that have earnings risk before the option expiration.  I look at technicals, fundamentals and latest reports by Tier 1 analysts.  When all things line up and the stock meets the 5-10-20 rule, I put on a trade and expect the spread to expire worthless on expiration.  


With 5% rule in place, you can do 20 such trades if you wanted to allocate 100% of your portfolio.  If done right, take a calculator out and punch in 20% compounded monthly and see what the results will be after one year.  This is how I had a fantastic year in 2009.  


Exit Strategy:  There will be times when despite all your research and check ups, the stock moves enough by expiration that the shorted call gets in the money.  A word of caution and I'll use Cramer's rule here.  Do your homework every day.  Try to allocate at least 1 hour every week per trade to make sure your trade is doing fine.  Watch the technicals, the analyst commentary and general sentiment from the option activity.  Try to identify scenarios early on when there is such a danger.  And when you find one, cut your losses and move on.  There will always be another day to make money, but if the principal capital is lost, there will not be many days to get back in the game.  


Over next several days, I will be presenting many ideas for March expiration based on this 5-10-20 Rule.  Stay tuned and feel free to ask questions.  


Good luck!