How much cash reserve should I keep for 10PercentPerMonth?

On their FAQ page, 10 Percent Per Month (10ppm) recommends keeping 50% in cash reserve. Assuming that an account only trades this service, and trades all 4 autotraded condors (SPY, DIA, QQQQ, IWM), then that means 1/8 of the cash in the account should be allocated to each condor.

Iron Condors and Margin Requirements

The positions recommended by 10ppm are known as iron condors. Each iron condor can be treated as two vertical spreads (a put spread and a call spread). An investor receives money for selling these vertical spreads. This is similar in concept to selling short a stock. And, just like when selling short a stock, the investor needs to keep a certain amount of cash in the account to be able to buy back the position. The broker enforces that need with the use of margin requirements. A vertical spread's margin requirement is the difference in strike prices (for example, the margin requirement for being short a SPY 112-114 spread is 114 - 112 = $2). As an aside, iron condors are an interesting beast in that the broker only uses one side (either the put spread or the call spread) for the entire condor's margin requirement. As another aside, options are different from stocks in that they can be assigned (but this is something we want to avoid, when selling iron condors) and they can expire (which is what we're hoping for, when selling iron condors). If the options expire then we're happy because we keep the money we received when we sold short the spreads, our margin is freed, and we don't have to pay any commission fees. Poof! The investor lived happily ever after.

The margin money that the broker requires the investor to keep in the account is used to cover the premium for buying back a spread, or the premium for rolling a spread.

What is the cash reserve used for?

The cash reserve that should be kept in the account (but is not enforced by the broker) is used to cover the margin requirement for rolling a spread, and to be able to open another position after executing one or more debit transactions. Sometime, instead of buying back a spread, 10ppm will recommend 'rolling' the spread to a different strike price or a different expiry date. Rolling is a single transaction that involves buying back the existing spread, and selling short another spread. Rolling a spread is usually a debit transaction (meaning the investor pays the premium instead of receiving it), but the premium to be paid will be covered by the margin requirement. In addition to paying the premium, rolling also requires the same amount of margin as the existing spread. This is because the margin that will be freed when the existing spread is closed won’t be available until after the roll (and some of that to-be-freed margin will be used for paying the premium, too). After the roll is completed, the margin of the old spread becomes available again, and can be used to perform additional rolls or what not. If part of that margin was used to pay for the premium, then the margin left over has to be topped up.

So, how much cash reserve is actually needed?

Let's consider some worst-case scenarios, and then look at some previous 10ppm months when adjustments have been required. In all these examples, we will ignore commission fees (which of course have to be taken into account in real life), and we will assume we are dealing with a single contract for each spread (just multiply by your typical position size to adapt to your portfolio).

First, let's assume that 4 spreads (not full iron condors, just one side of a condor) are opened, and that all 4 spreads need to be closed (not rolled, just closed) at the same time. The premium to pay for that will never be more than the difference in strike prices, which is almost always $2 for autotraded positions (the RUT position, which has a difference of $10, is not autotraded). Also, some premium will have been collected when selling these spreads.Nevertheless, just as an extreme worst-case scenario, let's just assume that 4 x $2 x 100 = $800 is needed to pay the premium for closing the spreads (Options have a multiplier of 100). This is the same amount as the margin requirement to open & maintain the positions. Thus, in this scenario, as long as there no further transaction following the buy back, no cash reserve is needed (we're ignoring commission fees and such, but some cash needs to be kept aside for that too).

What if after closing these 4 spreads, we wanted to open 4 more spreads? Then the account would have needed enough cash reserve to cover the premium paid for closing the spreads, so that we still have $200 of available margin per new spread we want to open.

Or what if 4 full condors were opened first, before closing 4 spreads? Then $200 of cash reserve per spread closed would have been needed, since the margin would not have been freed when closing each spread (the margin was still needed for the other side of the condor). This ignores the fact that some premium would have been collected for opening the 2nd side of the condor.

Second, let's assume that 4 spreads need to be rolled simultaneously (and again, assume that only spreads were opened, not full condors). Once again, the premium to pay for that will never be more than the difference in strike prices, but it will typically be less, as that is the reason for performing a roll in the first place: to lower the premium that has to be paid. Nevertheless, just to continue with the desire to setup a worst-case scenario, let's ignore any premium received when selling the spreads, and assume that the premium to be paid is $200 per spread (which will come out of the margin freed after the roll, since we are not dealing with full condors). Since rolling a spread also needs $200 of margin just to perform the roll, that means that 4 x $200 would be needed to perform 4 simultaneous rolls. That means investing 50% of available equity, and keeping 50% in cash. If we relax the need to perform the rolls simultaneously and do them sequentially (one after another), then there is $200 of margin in total required for all 4 rolls. That means investing 80%, and keeping 20% in cash. And don't forget commission fees!

Finally, 4 full condors were opened in the previous example, then cash reserve would have been needed to cover the premium to be paid, since margin would not have been freed when rolling the spreads. In that case, 67% of cash reserve would have been needed for performing 4 rolls in parallel (cash reserve of $1600, and invested capital of $800), or 56% for performing rolls sequentially (cash reserve of $1000, and invested capital of $800).

Actual Cash Reserve Requirements From The Recent Past

Now, let's take a look at what cash reserves have been needed in the past. These are listed in reverse chronological order (latest first). The first table explains what the column headings are. The three rows at the bottom of each table are the summary for that month. The cash reserve needed is the sum of all cash reserve additions performed throughout the month; the total capial is the sum of the cash reserve and the capital invested (assuming that the plan was to open one condor per underlying); and the third row shows the minimum percentage cash reserve that would have been needed to execute the month's trades.

Please note that in the tables below, the premium received for opening the first spread in the condor is not taken into account. This is because when calculating the number of spreads to open when opening the first spread of each condor, the premium received should be subtracted from the margin requirement, to make maximum use of funds available. For example, if an account has $190 available, then it would be able to open exactly one spread (with a 2$ difference in strike prices) with a $0.10 premium ($190 / ( 100 x ($2 - $0.10)). There would be no excess liquidity after the transaction. When opening the second spread of a condor, the number of spreads to open should match the number of spreads for the first spread. That premium received is added to liquidity. If your autotrader doesn't do this for you, then they are not making best use of your funds -- switch to Global AutoTrading!

Columns Explained

March 2010

Several adjustments were needed, but because no QQQQ positions were open after March 9, only a small cash reserve was actually needed this month.