Theta Trend – Proprietary Trading System Document

Table of Contents:

Introduction & Assumptions

Legal & Options Disclaimers

Chapter 1 Vertical Spread

Chapter 2 Trend Following Principles

Chapter 3 Risk Management

Chapter 4 Strategy Overview

Chapter 5 Entry Rules

Chapter 6 Exit Rules

Chapter 7 Sample Portfolios

Chapter 8 Adaptations - Tailoring Theta Trend

Chapter 9 Winning Habits

Appendix A Trade Entry Checklist

Introduction & Assumptions

Welcome and thanks for purchasing Theta Trend. Theta Trend is a

positive theta (we sell options), mechanical, trend following options
trading system. What that really means is that Theta Trend follows
price trends; however, instead of buying the underlying, Theta Trend
sells out of the money options. Selling out of the money options
increases the number of ways to make money with the system. Trades
will benefit if a strong trend develops, a weak trend develops, and
even, in some cases, when a trend fails to develop or reverses.
Additionally, the system benefits from the passage of time because the
short options decay.

Theta Trend assumes a basic understanding of options and ETF’s, but by

no means expects you to be an expert in volatility or technical
analysis. If you understand how options work and know how to
construct a vertical spread, you will understand Theta Trend. Theta
Trend is intended to be a practical, easy to implement system that
generates consistent profits with a higher winning percentage than a
typical trend following system.

Theta Trend does not require you to follow the markets all day and is
definitely not a day trading system. Most trades last from a couple
of weeks to a month and can me monitored and managed in a few minutes
a day. That being said, the need to manage risk and be consistent in
trading can’t be overemphasized.

The trading software I personally use and highly recommend Thinkorswim

by TD Ameritrade. The quality of their software is incredible and all
pictures in the Theta Trend system document are views from the
software.

Successful trading is more of a journey than a destination. My hope

is that this system will save you some of the years and frustrations I
spent developing it. If anything in the system seems unclear, feel
free to send an email to info@thetatrend.com, enjoy.

-Dan
info@thetatrend.com

Page 1
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 1 – Vertical Spreads

The Vertical Spread is the building block of all Theta Trend trades.
A vertical spread is named by the layout it takes on an options chain
and can be established for either a debit (you buy it) or a credit
(you sell it). All Theta Trend trades begin as out of the money
credit spreads, so we’re always selling premium. We sell out of the
money options to avoid concerns related to early exercise even though
the likelihood of early exercise, especially on out of the money
options, is fairly low.

Image 1.1 below shows the option chain and various expiration cycles
for IWM, the ETF for the Russell 2000. The option chain below
displays the open interest, delta, implied volatility, extrinsic
value, and theta. Vertical spreads are constructed in one expiration
cycle and involve selling an option closer to the money and buying
another option to hedge the risk further out. In the picture, options
that are more heavily shaded are in the money.

Image 1.1: Various expiration cycles and option pricing

information for IWM, the ETF for the Russell 2000.

Theta Trend uses a Bear Call spread to get short the market and a Bull
Put spread to get long. What the spreads mean is that if we want the
market to go up, we’ll sell puts below the market. If we want the
market to go down, we’ll sell calls above the current price.

Page 2
Copyright © 2013 Theta Trend
www.thetatrend.com
Image 1.2 below is an example of a vertical spread Theta Trend might
use to get long a market. In the image, the red line represents the
expiration risk profile of the position and the white line represents
the position risk today. While the expiration line is where the
position will end up, the position risk today is our main concern when
managing risk. The reason the current risk is used to manage
positions is that the current risk line is where the position is today
and it’s the risk you have in a position today. If you manage the
risk in a position today instead of hoping about the future, you can
help yourself avoid major losses.

Image 1.2: A Bull Put vertical spread in SPY, S&P 500 ETF,
showing a simulated long position.

The position shown in Image 1.3 is an example of a short out of the

money call vertical. The short Call vertical is the bearish version
of the trade in Image 1.2. The position pictured is the view of an
actual trade. In the picture, you can see that the current market
price of TLT, the long term treasury bond ETF, is around 118 and the
one contract position has an open profit of approximately $18. One of
the major principles of Theta Trend is to trade numerous small
positions in uncorrelated markets.

Page 3
Copyright © 2013 Theta Trend
www.thetatrend.com
 Image 1.3: An actual Bear Call vertical spread on TLT, the long
term bond ETF.

One of the first things to notice about a vertical spread is that it

has a poor risk/reward ratio on it’s own. The reward pictured above
is 1.60 risk / .40 reward or 4 to 1 risk/reward, however, the tradeoff
is that the probability of receiving the reward is fairly high. We
can roughly estimate the probability of an option being in the money
at expiration by looking at the Delta on the day of sale.

Theta Trend generally sells options with Delta of 15-40. A 15 Delta

option has a 15% chance of being in the money at expiration, which
means it has a 100%-15% = 85% chance of expiring worthless at
expiration. Everything in options involves a tradeoff and the
tradeoff for selling a further out of the money option is that you
receive a lower premium because the option is less likely to be worth
something. The lower premium results in a less favorable risk/reward
ratio and, in some cases, the position will not meet the Theta Trend
risk/reward criteria. The specific risk/reward characteristics Theta
Trend uses to enter trades is discussed in Chapter 6 – Entry Rules.

Page 4
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 2 - Trend Following Principles

Theta Trend is a Trend Following trading system. Trend Followers

generally make money by quickly exiting losing trades and riding
winning trades until the trend ends. Most Trend Followers adhere to
some type of mechanical trading system with strict risk management and
entry/exit rules. That being said, most traders attempt to follow
some type of trend. The trend can take place on any timeframe from a
few seconds to months or years. The success of most trend following
systems is based on the notion that securities prices are not normally
distributed. What that means is that returns tend to be much greater
or much worse than a normal distribution would suggest.

Many mechanical Trend Following systems have fewer winning trades than
losing trades, but still make money because the winning trades are so
much larger than the losing trades. A ratio of 40% winning trades to
60% losing trades is not uncommon and can be built into a profitable
system with proper risk management. Theta Trend is designed to
achieve a higher winning percentage, which makes it psychologically
easier to follow the system. Forward testing of Theta Trend has shown
that a ratio of 60%+ winning trades to 40% losing trades is
achievable.

While Theta Trend trades have a fixed profit potential, they are
constructed to lose less and potentially profit even if the system is
wrong on direction. Theta Trend is intended to be a mechanical system
meaning there is no discretion involved in the daily decision making.
Trades either meet the entry/exit criteria or they don’t. The trend
is cleared defined by the system indicator and trades are not taken
against the trend. Theta Trend is also intended to be in the market
at all times as long as a valid entry is made and there is no reason
to exit.

Although trading Theta Trend does not involve any sort of discretion
on a daily basis, it does require some discretion is setting up a
portfolio of instruments to trade. Trend Following systems trade
numerous uncorrelated markets because it increases and smoothes
returns. Theta Trend subscribes to the notion that trading
uncorrelated markets increases returns and trades a wide range of
markets including currencies, bonds, commodities, and stocks. Sample
portfolios are discussed in a later chapter. The general idea is to
trade several markets that are uncorrelated to each other. The hope
is that if you’re wrong and losing money in one market, you’re right
in another market (or markets) and that cancels out the negative
return.

Despite the wide range of markets traded, you do not need to

understand the fundamental information surrounding all of the markets.
Theta Trend is a mechanical system and assumes that all fundamental
information is reflected in price. The signals generated by Theta
Trend never involve analyzing or predicting employment numbers, crop

Page 5
Copyright © 2013 Theta Trend
www.thetatrend.com
yield, or interest rates. Additionally, Theta Trend reacts to price
trends, but does not predict price trends. Trades are executed with
the hope that prices will continue in our direction and managed based
on the assumption that they will not.

Risk management is an extremely important topic and discussed in more

detail in Chapter 3. Theta Trend works largely because it manages
risk in a way that avoids taking large losses. Many option trading
systems advocate “adjusting” losing positions and sitting through the
pain. Theta Trend trades will also bear pain at times, but have
clearly defined exit points. The system is completely clear about
when a trend has ended so there is no reason to try to fix a losing
trade. Theta Trend always trades with the trend and never against it.

The purpose of trading a mechanical system is to minimize trader input

and errors. Emotionally removing yourself from trading is very
difficult, but it is a necessary condition for good decision making.
There are numerous resources discussing trader psychology and getting
a grasp on your psychology is highly recommended.

Page 6
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 3 - Risk Management

Topics discussed:

Expectancy
Risk Equity and Risk per trade

Note: This is the most important chapter in the Theta Trend system.
None of the other chapters will create a positive outcome without
strict adherence to risk management rules. Reading and rereading this
chapter is highly recommended.

Theta Trend and all trading systems are profitable primarily due to
risk management. Forward testing through live trading suggests that
the system has a roughly 60% winning percentage. However, due to the
limited maximum win per position, strict risk management must be used
to create a positive expectancy. Positive expectancy is the goal of
all trading systems and basically means that a system is profitable
over a long period of time. See the examples below on expected payout
for a numerical illustration:

Expected payout = P(winning)-P(losing)

Expected payout = (winning %*payout)-(losing %*loss)
Where P(winning) means the probability of winning

Example 1: Trading system with 65% win rate, Win = 1, Loss = 2

EP = (.65*1)-(.35*2) = .65 - .7 = -.05

Example 2: Trading system with 45% win rate, Win = 2, Loss = 1

EP = (.45*2) – (.55*1) = .9 - .55 = +.35

Example 3, Theta Trend: Trading system with 60% win rate,

Win = 1, Loss = 1

EP = (.6*1)-(.4*1) = .60 - .40 = .20

In the examples above we can see that a high winning percentage is not
enough to create a profitable system.

Example 1 is similar to a losing trader who takes profits as soon as

they’re available and lets losing trades run with the “hope” that
they’ll be able to break even.

Example 2 is a typical Trend Following model. Despite a low winning

percentage, the system is still profitable over time because the
winning trades are much larger than the greater number of losing
trades.

Page 7
Copyright © 2013 Theta Trend
www.thetatrend.com
Example 3 is how Theta Trend is designed to work. Theta Trend is
designed to provide more winning trades than losing trades and be
profitable by strictly managing losses. Theta Trend is designed to
have a higher winning percentage because trading a system with more
winning trades is psychologically much easier to adhere to than
trading a system with long strings of losing trades.

Risk Equity: Risk equity is the starting point for all risk
management and is essentially the amount of money you are saying you
have in the game. For example, if you have a $10,00 and want to keep
a 10% reserve that you will never trade, you have risk equity of
$9,000. All positions are sized based on risk equity and drawdown
rules will take effect to reduce position size if risk equity falls
below a certain level.

Maximum Risk per Trade: Theta maximum risk assumed on any trade never
exceeds 1% of risk equity and is frequently less than 1%. Risk equity
is the account size set and revised on a monthly basis for the purpose
of measuring risk. Theta Trend provides a framework for managing
risk, but you may modify the parameters to suit your trading style and
risk tolerance. A more in depth discussion of adaptations can be
found in Chapter 9.

Maximum Profit and Target Profit per Trade: The maximum profit per
trade is equal to the initial credit received. The target for initial
trades with one vertical is equal to 80% of the maximum credit. The
maximum loss on any position is equal to the same amount. The caveat
here is that your potential loss and potential win must always factor
in commissions. Commission costs are a very real part of trading and
not taking them into account is similar to running a business without
worrying about the overhead.

Note: It is possible to aim for a lower profit percentage and achieve

a higher wining percentage, however, losing trades must be managed
much more closely.

Drawdown Rule: If the risk equity becomes drawn down 7%, the risk
equity size is automatically reduced 10% to minimize market exposure.
Because the loss per trade is a percentage of the account size,
reducing the trade size minimizes losses during losing periods. An
example is given below:

Initial Risk Equity = $10,000

Initial Risk per Trade = $10,000 * .01 = $100
10% Drawdown Threshold = $10,000 - ($10,000*.07) = $9,300

Suppose the system has a series of 7 losing trades that each take a 1%
loss and, as a result, the risk equity has fallen to $9,300.Once the
$9,300 threshold is reached, risk equity is reduced.

Page 8
Copyright © 2013 Theta Trend
www.thetatrend.com
 Post-threshold Risk Equity = $9,300 - ($9,300*.10) = $8,370
Post-threshold Risk per Trade = $8,370 * .01 = $83.70
Revised Drawdown Threshold = $8,370 – ($8,370*.07) = $7,533

The reduced risk equity has the effect of reducing the 1% risk per
trade from $100 to roughly $80.

Having a basic understanding of your expectancy is the first step in

making good trading decisions. Once you understand expectancy, it
makes sense to apply the principles to your own trading. Theta Trend
tracks all positions in a spreadsheet and updates expectancy after
every trade. The idea behind tracking your own expectancy is that it
helps you determine the amount you can lose on a trade. It is much
easier to control how much you lose on a trade than it is to control
how much you win.

Note: There are two important lessons to be learned from the risk
management discussion above. The first is to never bet too much on
any one trade. You can lose 1% of your account quite a few times
before running into problems. The second lesson is that the Theta
Trend risk management rules are designed to protect your risk equity.
If you begin losing, it makes much more sense to reduce your trading
size than to increase it. By reducing your trading size you
significantly decrease the likelihood of having a major drawdown in
risk equity.

Page 9
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 4 – Strategy Overview

Note: Specific entry/exit rules are given in Chapters 6 and 7, this

section is just intended to give a big picture view of Theta Trend.
If you get bogged down with the entry/exit rules or details rereading
this chapter should bring things back into perspective.

The system sells out of the money vertical spreads with a position
delta in the direction of the expected trend. The options sold range
from a 15-40 delta with 30-90 days to expiration. The goal is to
capture the majority of the premium from the spread with a target of
80% of the initial credit. All ETF verticals are sold with a two
strike wide spread to manage risk and delta exposure. A two strike
wide spread is never sold for a credit of less than .40, providing a
maximum worst case risk/reward of 4 to 1.

The system was designed to trade ETF’s with liquid options markets.
While the system could be applied to futures options and cash settled
index products, the small size of ETF options makes it easier to
manage risk. The system trades several uncorrelated markets at all
times and sample portfolios are listed in Chapter 8. Trading
uncorrelated markets by definition increases diversification and tends
to reduce portfolio volatility. That being said, during times of
extreme sentiment (either elation or panic), all markets tend to move
strongly in some direction and it makes sense to reduce your position
size.

Theta Trend trades options, as opposed to buying the ETF’s. The idea
behind using options is that if price fails to move significantly or
does not move, positions can be exited with a smaller loss (or even a
small gain) than the outright position would generate. As time goes
on, the vertical will lose value, even if price is not moving, and the
spread can often be bought back for less than the initial credit.

In order to trade in a trend following manner, Theta Trend uses a

simple indicator to define trend. An indicator is used to remove all
subjectivity from what constitutes an uptrend and what constitutes a
downtrend. Theta Trend does not attempt to predict the trend in the
future, rather it takes the stance that currently it makes sense to
trade from either a long or short standpoint.

Note: Theta Trend was initially developed in response to my

frustration with trading Iron Condors. Iron Condors benefit most when
prices remain in a confined range for the duration of the trade and
frequently require “adjustment” when the trade begins to move against
the Iron Condor. Theta Trend employs only one adjustment and that is
to close the trade when trend suggests that it has changed.

An Average True Range trailing stop reversal defines the expected

trend. The ATR TS is calculated based on a 5 day ATR and trails at
3.5 ATR below the most recent high in the case of an uptrend and is

Page 10
Copyright © 2013 Theta Trend
www.thetatrend.com
3.5 ATR above the most recent low in a down trend. A new entry is
signaled when the price of the underlying closes above/below the 3.5
ATR TS.

Image 4.1: Chart showing the ATR trailing stop on IWM. Notice
that the stop moves up and down with the market and clearly
signals reversal points.

Theta Trend will sell vertical spreads with a short option around the
ATR trailing stop as long as the trade risk parameters are met and the
trend continues. Once price signals a reversal based on the ATR
trailing stop, any open positions are exited and new positions in the
opposite direction are analyzed. As a result, Theta Trend is in the
market most of the time.

Losing trades are exited after a one day close above/below the TS
or when price closes below the 50 day SMA if the distance to the SMA
is greater than the expiration breakeven point of the trade. Losing
trades are also exited if a close meets or exceeds the maximum dollar
loss of the trade.

Page 11
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 5 – Entry Rules

Theta Trend initially looks to enter new positions when the ATR
trailing stop signals a reversal; however, not meeting the risk
parameters may sometimes force the system to wait for a new entry. A
brief review of the chapter on risk management may be helpful when
reading the entry rules. Additionally, a spreadsheet was provided
with the purchase of Theta Trend that will help analyze potential
trades to determine whether or not they meet the risk/reward criteria.

There are two rules of thumb for analyzing new vertical spreads:
• The short option will be near the ATR trailing stop
• The maximum risk if price reaches the ATR trailing stop level is
roughly the credit received

Image 5.1: The shaded rectangle around the 84 price level in IWM
is where the short vertical was initially located. The position
was initiated following the price gap up in the picture.

Theta Trend attempts to achieve a risk/reward ratio on all vertical

spreads of at least 4 to 1. What that means is that a 2 point wide
vertical should never be sold for less than a .40 credit. When
verticals are sold for less than .40, the cost of commissions and
limited profit make the risk/reward ratio unfavorable. Using Theta
Trend, most 2 point wide verticals on ETF’s seem to be sold for
credits between .40 and .50. Additionally, Theta Trend recommends
selling vertical spreads with 40-90 days to expiration. Spreads

Page 12
Copyright © 2013 Theta Trend
www.thetatrend.com
inside of 40 days tend to fail the risk/reward analysis and spreads
further out than 90 days tend to decay too slowly.

After the trend direction has been defined, we need to analyze some
potential vertical spreads. Placing a trade in a risk graph analyzer
makes the process much easier.

Image 5.2: The 84/82 vertical spread discussed in the Image 5.1
description. In this case, both time and trend have helped the
trade.

In the risk graph analyzer, choose a short strike at or around the ATR
trailing stop level. For example, if the market is in an uptrend with
the ETF price trading at 103 and the ATR trailing stop sitting around
100, analyze 40-90 day vertical spreads with the short option around
100. On the vertical being analyzed, determine the potential loss
TODAY if price was to go to the ATR trailing stop level. If the risk
today plus round trip commissions is less than or equal to the
vertical credit, the trade is a candidate. Theta Trend never loses
more on a trade that it can potentially make.

Page 13
Copyright © 2013 Theta Trend
www.thetatrend.com
If the discussion of trade entry seems confusing, you can use the
Trade Entry Checklist and the Excel Trade Entry tool to help you
analyze trades. The trade entry checklist appears below and is also
duplicated for quick access in the appendix.

Note: The checklist below should be used in conjunction with the

Theta Trend Trade Entry spreadsheet.

Theta Trend Trade Analysis Checklist:

1. Is price in an uptrend or a downtrend as defined by the ATR

trailing stop?

2. Does the options chain provide options with 40-90 days to

expiration?

3. What is the price level of the ATR trailing stop?

4. Analyze a few vertical spreads with the short option around the
ATR trailing stop. What is the expected loss today if price hits
the ATR trailing stop level?

5. Is the risk/reward ratio 4 to 1 or better and will the vertical

generate a credit of at least .40?

6. If the expected loss at the ATR trailing stop level is less than
or equal to the initial credit of the trade, the vertical meets
the risk/reward criteria.

7. If the trade meets the risk/reward criteria, does it meet your

risk percentage per trade. Specifically, if you have chosen to
risk 1% per trade, does the amount at risk in this trade exceed
that amount? If so, you should not take the trade.

8. If a trade is taken always, always, always, record it in a

trading log.

Page 14
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 6 – Exit Rules

Note: When you exit a trade is significantly more important than when
you enter a trade. Exiting a trade is a demonstration of your ability
to manage risk and if you are unable to manage risk, you won’t make
money. It’s unfortunate, but it’s true. Remember the lessons from
Chapter 3 on Risk Management.

Theta Trend has three potential rules to exit a trade:

1. The price of the underlying closes beyond the ATR trailing stop
and signals a reversal.

2. The loss on the position is equal to the credit received when the
vertical was sold. For example, if a vertical was sold for .40
and the open loss on the trade is equal to $40, it’s time to get
out.

3. The profit objective of the trade is hit . . . take the money and
risk off the table.

The first rule is when the price of the underlying signals a reversal.
If the price of the underlying closes beyond the ATR trailing stop, it
is an indication that the trend has reversed. When the rule is
triggered, exit any existing positions at the market open the
following day. If you have the luxury of watching the markets during
the day and know that the market will close beyond the trailing stop,
you can also chose to exit near the close on the day the rule will be
triggered.

Theta Trend never attempts to predict prices, we just follow what’s

happening and react to changes in the market. If the trend suggests
that it might reverse, we always listen to the signal. Occasionally
the signal will be wrong, but, as can be seen in Image 6.1 below,
sometimes the market takes off and never pulls back to let you out.
Image 6.1 below is SPY and the shaded oval shows an area where price
signaled a reversal. The reversal would have led to exiting all long
positions and also entering a new short position. Unfortunately, the
trend reversed shortly after the signal creating a whipsaw.

If you followed strict risk management rules you would have been out
of both trades quickly for a small loss and entered a new long trade.
Once that new long trade was entered it would have gone strongly in
your favor.

Page 15
Copyright © 2013 Theta Trend
www.thetatrend.com
 Image 6.1: A whipsaw reversal in SPY without a pullback in price.

The second rule, when the loss on the position is equal to the initial
credit, is generally not triggered if your entry is analyzed
appropriately. For example, if a vertical spread was sold for .45 and
the open loss on the position is $47 or so, it would be time to exit
the position without any questions and move on to another trade.

The third rule is the desired or “good” exit. Theta Trend shoots to
receive 80% of the initial credit on a trade and if that profit target
is hit, the trade is closed and it is time to start looking at the
next month in the option chain. The idea behind this rule is that
once you receive 80% of the initial credit, there is more risk in
holding the position than getting the last few cents out of the trade.
Basically, the meat of the trade is gone.

Theta Trend recommends calculating your profit target immediately upon

entering a new trade. Once you know the profit target, put a Good
Till Cancelled limit order in at your desired profit. When you have a
set price in the market waiting to get filled you will be much less
likely to second guess a winning trade and take the trade off too
early. Additionally, having a limit order in place eliminates any
need for you to check the markets and enter an order to exit.

Page 16
Copyright © 2013 Theta Trend
www.thetatrend.com
 Image 6.2: A trade that is close to achieving the profit
target. The live price is the vertical red line and the white
line is profit on that particular day. The open profit is
approximately $35 of a $48 initial credit.

Once any trade is closed, it is time to
spreadsheet and update your expectancy
the Risk Management chapter). Tracking
idea of how much you are able to lose on
come out ahead.
log the trade in the tracking
calculations (see the end of
your expectancy gives you an
an individual trade and still

Page 17
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 7 – Sample Portfolios

Theta Trend was designed as a Trend Following system and, as a result,

attempts to trade a diversified basket of uncorrelated markets. The
benefit of trading a diversified basket of markets is that it reduces
the correlation, decreases portfolio volatility, and reduces
drawdowns. The principles we subscribe to are very similar to a
systematic Futures Trend Following system that trades numerous Futures
markets. Following the news has no role in our decision making.

Theta Trend can be applied to any market or instrument that has a

liquid options market. The categories below are broad groups that
theoretically have a low correlation. It is advisable to choose one
or two ETF’s from each category, which will produce 6-12+ monthly
positions.

There are several broad categories of markets that Theta Trend

attempts to trade and always does so using ETF’s. Below is a list of
some markets and specific ETF examples. The starred ETF’s are markets
that I tend to trade.

Domestic Equities (US Stocks):

1. SPY – S&P 500
2. DIA – Dow
3. IWM* – Russell 2000

International Equities (Foreign Stocks):

1. EEM* – Emerging Markets
2. FXI* – China Stock Index
3. EWZ – Brazil Stock Index

Energy:
1. USO* – Oil
2. UNG* – Natural Gas

US Bonds:
1. IEF – 7-10 Year US Treasury Bond
2. TLT* – 20+ Year US Treasury Bond

Metals:
1. GLD* – Gold
2. SLV* – Silver

Currency:
1. FXE* – Euro
2. FXI – Japanese Yen
3. FXF – Swiss Franc

Page 18
Copyright © 2013 Theta Trend
www.thetatrend.com
My suggestion would be to select an ETF from each broad category and
then trade those ETF’s for 3-6 months until you feel comfortable with
the system. Initially you should paper trade or trade very small (1
contract). Trading should be overwhelmingly mechanical and borderline
boring. If you feel extremely elated or discouraged because of equity
swings, you are probably trading too large.

Additionally, it is essential that you choose ETF’s from a diversified

group of markets. If you trade only individual stocks and stock
market ETF’s, you may have diversified your risk slightly but you are
really only trading stocks. Theta Trend recommends trading a
portfolio of uncorrelated markets, not just one market, and it
recommends trading the same markets every month if the entry
parameters are met. If you’re set on trading only one market, see
Chapter 8 on adapting the system to your preferences.

A word of caution about correlation: Although Theta Trends trades a

diversified basket of markets it is possible for markets that are
normally uncorrelated to move together. For example, during times of
crisis all markets tend to go either sharply up or down. Even though
Theta Trend is designed to keep you on the right side of the market
during a crisis, it is good to notice whether or not all of your
positions seem to be going in the same direction and reduce size until
correlation decreases.

Page 19
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 8 – Adaptations

In order for you to be a profitable trader, you need to find a system

that suits your preferences and risk tolerances. Any number of
variables in Theta Trend can be modified to suit your risk tolerances.
A list of variables with a brief discussion is given below, but you
may find other ways to tweak the system.

1. Risk per trade – Theta Trend recommends a Maximum Risk per Trade
of 1% of Risk Equity, but you may feel comfortable taking more
risk. Note that more risk will increase equity swings. Please
revisit the Chapter on Risk Management.

2. Delta of short option – Theta Trend tends to sell options with a

Delta around 25. You may want to sell options closer to the
current market price or further away from the market price.
Selling further away increases the probability of success, but
also increases the risk if you’re wrong.

3. Days to expiration – Theta Trend sells options with 40-90 days to

expiration. We feel that inside of 40 days the risk exceeds the
potential reward, but you may want to tweak the system to sell
outside of the recommended window.

4. Use of additional indicators to filter trend – You can use an

additional indicator to determine whether or not to take trades.
For example, if you want to use the ATR trailing to stop define
trends, you might only take long trades if the price is also
above the 50 day moving average. Note that when markets reverse
the ATR trailing stop will get you in or out of trades faster
than if you wait for price to pass the 50 day moving average.

5. Target profit – Theta Trend recommends shooting for a target

profit of 80% of the initial credit, but you might want to shoot
for more or less. If you aim for a lower profit percentage, you
should theoretically hit it more often but you must me very
careful not to loose too much on any trade and wipe out the small
wins. Again, reread the Chapter on Risk Management.

There are two big takeaways from the choices given above. The first
is that everything in options is a tradeoff and that’s great because
it means you can adapt the system to suit your preferences. The
second takeaway is that all modifications require an understanding of
the Risk Management implications. If you want to be a successful
trader, you must know what your expectancy per trade is and trade
appropriately.

Page 20
Copyright © 2013 Theta Trend
www.thetatrend.com
Chapter 9 – Winning Habits

It is often noted that the Psychology of trading is equally or more

important than the skill involved in trading. The implications of
that theory are really empowering because it suggests that you can
become a successful trader by getting your mind right. At the end of
the day successful trading is just a numbers game. If you create a
positive expectancy, you will win over time. A list of some winning
habits is given below.

1. Keep a trading journal and track all of your trades. Theta Trend
provides you with a spreadsheet to track your positions and
recommends that you compute your expectancy. Knowing your
expectancy gives you an incredible amount of insight into your
trading and very few people know their expectancy.

2. Trade a diversified basket of markets. Trading one market gives

you one type of risk; Theta Trend recommends diversifying your
risk across uncorrelated asset classes.

3. Be consistent with the markets you trade and don’t try to predict
what market will do well. Any market can do whatever it wants at
any time. Again, we follow and react to market conditions . . .
we don’t try to predict markets.

4. Know in advance that you will have some losing trades and be ok
with that. Everyone wants to win on every trade, but that’s not
the way trading works. Acceptance of that fact will put your
mind at ease.

5. Follow a system and have a plan in advance for every trade

because that way when things go bad it’s not your fault. The
purpose of trading with a system is to remove your ego from the
trading process. The purpose of trading is to make money, not to
inflate your ego.

6. Realize that if your goal in trading is to win that it doesn’t

happen all at once or on one day. Winning in trading is a
process, not a destination, and it happens by making good
decisions on a daily basis.

7. Lastly, and definitely not least important, don’t focus on making

money when you’re trading. Focus on making good, positive
expectancy decisions and over time the money will come.

Some of the ideas above seem somewhat simplistic, but they are
definitely worth thinking about. I believe that trading is the most
interesting game you will ever play. Be inquisitive, rational, and,
above all else, trade profitably.

-Dan, Theta Trend

Page 21
Copyright © 2013 Theta Trend
www.thetatrend.com
 Appendix A – Trade Entry Checklist

Note: The checklist below should be used in conjunction with the

Theta Trend Trade Entry spreadsheet.

Theta Trend Trade Analysis Checklist:

1. Is price in an uptrend or a downtrend as defined by the ATR

trailing stop?

2. Does the options chain provide options with 40-90 days to

expiration?

3. What is the price level of the ATR trailing stop?

4. Analyze a few vertical spreads with the short option around the
ATR trailing stop. What is the expected loss today if price hits
the ATR trailing stop level?

5. Is the risk/reward ratio 4 to 1 or better and will the vertical

generate a credit of at least .40?

6. If the expected loss at the ATR trailing stop level is less than
or equal to the initial credit of the trade, the vertical meets
the risk/reward criteria.

7. If the trade meets the risk/reward criteria, does it meet your

risk percentage per trade. Specifically, if you have chosen to
risk 1% per trade, does the amount at risk in this trade exceed
that amount? If so, you should not take the trade.

8. If a trade is taken always, always, always, record it in a

trading log.

Page 22
Copyright © 2013 Theta Trend
www.thetatrend.com