Rules Are Meant To Be Broken

Think of all the rules and beliefs that worked reliably for decades, and which have been trashed in 2008

Rule1: You can safely trust the stock market to outperform over a decade.

Reality: Anyone who invested in Wall Street in the summer of 1998 and held on has earned just 9%. That's the total return on the Standard & Poor's 500 index, and includes reinvested dividends. And that's before inflation. Bonds, and savings accounts, did far better. If you held your cash in an account earning an average of just 3%, for example, today you'd be up 34%.

Rule2: Don't try to "time" the market.

Reality: OK, you may not be able to "time" the market perfectly, but you can often value it – especially when it goes to extremes. Last year it should have been obvious to everyone that European stock markets had become overheated – while those in Asia, especially China, were in a huge bubble. Yet too many investors kept on buying (in the name of diversification, of course).

Rule3: Wall Street bankers know what they are doing.

Reality: Almost none of them saw this coming. The people running Bear Stearns didn't even know how much their own bank was worth at the end, let alone their loan book. The head of Citigroup was still betting on subprime loans last July, months after the industry had hit the iceberg. How many Harvard MBAs and Chartered Financial Analysts does it take to lose a trillion dollars on subprime mortgages? You will know when this is all over.

Rule4: The Fed, and the world's other central bankers, are steering the ship.

Reality: Five words: Alan Greenspan and Ben Bernanke.

Rule5: International equities give you a lot of diversification.

Reality: In a global market, no one is spared. The U.S. subprime crisis has hit many European markets much worse than Wall Street. And those booming Asian markets? They've done worse than the U.S. China's economy is still growing quickly, but the stock market is still down 50% from its peak.

Rule6: Value and equity income funds will protect you in a downturn.

Reality: Many of these funds have done very badly. That's because a lot of "value" stocks started out overpriced. And many of these funds were loaded up to the gunwales with high-yielding banking stocks.

Rule7: Financial markets are rational.

Reality: Throughout this crisis they've been all over the place – once again. Among the many examples: Banks were refusing to lend to perfectly sound municipalities last winter, and buying inflation-protected government bonds instead - at a zero percent real yield.

Rule8: The U.S. housing market never goes down.

Reality: The U.S. housing market didn't go down between 1945 and 2005. But so what? Investment strategies based entirely on history are useless without a time machine.

Rule9: Mortgage debt doesn't matter because the value of your house will keep going up.

Reality: See above.

Rule10: Real estate and mortgage brokers can successfully advise you about economic trends and the direction of interest rates.

Reality: This is how so many people ended up in adjustable rate mortgages. After all, how bad could the resets be?

Implied And Statistical Volatility

One of the biggest fallacies is the relationship between implied and statistical volatility. If you trade with the idea that if implied is over stat and you sell the options because of that and vice versa buy options when the implied is less than the stat, you will have a financial lesson that will be devastating. Not saying this is the case 100% of the time, but implied leads stat about 90% of the time. Example, say the stat volatility on XYZ is 45 and the implied volatility is 55. Well, these options are overpriced right? Wrong! The implied is telling you that the marketplace believes that the stat volatility is actually going to increase that is why everyone is buying paper. Now say that stat volatility is 55 on XYZ and the implied volatility is 45, well options are too cheap right? Wrong! Paper is getting sold and they are selling it because they believe that the stock is going to settle down and not move as much. Do not trade options by comparing the stat volatility to the implied volatility except to buy the options when they are over their stat and sell them when they are under their stat. 

As far as being short gamma, there are many ways to earn the premium on options without trying to steal the theta. Why not sell the vega? You will profit from eroding premiums without exposing yourself to a stock halt pre-open that could put you out of business. Best thing is long gamma because those gaps can make your entire year, and when a stock breaks out and runs, you can have a money printing machine on your hands. And if you’re still not happy, add a ratio spread on Friday to hold over the weekend on your front month premium. Then take it off on Monday. At least you reduce your gamma exposure 4 out of 5 days a week and can collect the weekend premium. Most floor guys if they want to earn the theta will put on back spreads. This way, they can capture that front month premium around the strike and if the market takes off or the stock gaps, their position will become a long gamma position and they won't get hurt. So they essentially are short gamma short premium around the ATM strike and if the stock runs or gaps, the position becomes a long gamma long premium position. This is how guys avoid blowing up on the floor. This stuff is absolutely critical to understanding options. There really is not much room for error.

Pattern Recognition And Tape Reading Skills

When there is a real institutional buyer or seller in a stock, they never show their hand until they are almost done. Think about it, a real buyer is not going to say to the world, look at me, I have so much stock to buy, please lift all the offers so I have to pay up to get my stock. No, he is showing that bid because he has been buying the stock all day with no bids and now, that is all the stock he has left and wants to get hit. And he will get hit. When you see these bids, you sell into them hard all day long provided the stock is weak and you know there are sellers in the stock. Trying to buy stocks with large bids and sell stocks with large offers is a sign of a dumb trader that jumps in front of size only to see that size hit and then quickly is sitting on a losing trade. Most of the time, especially with small and mid cap stocks, you would see 100 shares on the bid or maybe 300 shares on the bid, and it would be stepping up all day long. You never see the bid get hit, or if you did, you would see 300 shares bid, then 2k shares would go off at the bid and he would still be there with 300 bid. Very classic. This guy has a lot of stock to buy. And he would never show his hand.

When a large offer would show up, the dumb traders would quickly run to sell. The buyer would be there or the specialist buying all the cheap shares from the dumb traders. When the dumb traders were done selling, the 300 share bid would step to the size offer and suddenly the offer would get lifted in one print, bamm, gone. Now those 300 shares are stepping up again and the dumb traders are all bitching about how the stock is manipulated. This would go on all day every day. The dumb traders would never learn. If the stock is strong and near the high of the day, you would be looking to buy the stock. But in general, even if the stock is strong, if he is showing size, it means that is probably all he has left and he will be done and the stock will trade lower the rest of the day. Remember, the reason the buyer is showing his hand is because he has already bought all his stock. He will never show his hand if he still has stock to buy. Would you? When there is a buyer in the stock he usually has a level where he wants to buy the stock. As the day goes on and other buyers come into the stock, this level goes higher and higher, hence the bid stepping up. The key is to find these levels. They usually are not at round numbers and they are not at key support levels. It could be something like 100.57. You will notice there is a bid at .55 for 200 shares and you will see large prints going off at .57. You will never see the stock trade at the bid. This is your buyer. You would want to be buying the stock around this area. And since you know the buyer is resting at .57, as soon as the price trades, you know to get out.

Pattern recognition skills are very important. You need to find the pattern. Every specialist is different. One of the things you will notice with very strong or a very weak stock is the charts are very smooth. If you are seeing a lot of volatility, there probably isn't a real buyer there, but rather a lot of momentum traders. You may be fooled by the size. You might mistake them for large institutions. The difference is, traders may trade size, but there is nothing behind it that is why the stocks drop so fast and go back and forth. If it were a real fund with hundreds of thousands of shares to buy or millions, they would be bid for that stock. You wouldn't see sharp drops. Being able to know the difference is paramount. Specialist knows that the buyer has size to buy and he is going to help him work the order. The specialist knows who the size players are. He knows who the buyers and sellers are and how much stock they have to buy and sell. That is his job. The specialist is also interesting in making money and if he has a big buyer at his post, he is going to want to buy as much stock as he can. Now how he is going to accomplish that if he is showing the full size of the buyer? The specialist cannot get long on an uptick and cannot get short on a downtick. He needs to buy on downticks. He needs you to sell your stock to him. He will never show you the size of the buyer. He will do everything he can to make the stock look weak. He will step up on 100 or 200 shares.

Tape reading has not changed in a 100 years. The bottom line is, real institutional buyers and sellers never show their size until they are done. It's all patterns. When a buyer is accumulating stock, he will usually bid in even amounts; you will see 500 or 300 on the bid. Keep in mind, this is a trick, he has far more than 300 shares to buy. But what you will see are the prints, 5k goes off, 10k goes off, 25k goes off, so on. When he is done, he will show you his bid. And this bid will usually be an odd number. When you see a size bid show up for 13,600 shares. Hit that bid as fast as you can. He's done! Now if you see him come back for 300 shares because he has been bidding 300 all day. You might want to get back in. Also, other things to look for are uptick bids. If you are still seeing uptick bids, he is still there. The key here is pattern recognition. You have to identify the patterns. It's very much like a game of chess. He will telegraph his moves. You just have to catch them.

Wrangle

Typically a wrangle involves selling the ATM call/put and buying the wings. So the profit range will be a lot narrower but will produce a larger credit. The condor will have a larger profit range but the profit will be smaller. Anytime you put on a spread where you are trying to earn premium, it hardly ever pays to exit early since the most gamma exists as you near expiration. The opposite is true when you are long premium, it's more beneficial to exit early and not wait till you near expiration. Remember the relationship that delta, gamma, theta and vega have to time and to price. This makes things so much easier. Your gamma, theta and vega are centered at the strike. The more ITM or OTM you go, the less gamma, theta and vega you will have. The further you go out in time, the more vega, the less gamma and theta. Deltas become very sensitive to time as your near expiration. Increases in volatility add deltas and decreases in volatility subtract deltas. Options that are ITM will have deltas moving toward 100 as time passes and options OTM will have deltas move toward 0 as time passes. If you study this over and over you will have a very complete understanding of every spread.

Reminiscences Of A Stock Operator

Jesse Livermore actually goes into pretty good detail of what he did. Keep in mind this was during a different era and trading was much different then. The guy would have a ticker tape machine in his office and he would simply watch the prints. He could tell if someone on the floor was accumulating or distributing stock. He would stay in the stock for hours, days or weeks as long as he saw buyers accumulating stock. As soon as he saw distribution, he would get out. Now this was much easier to do then this way because there was very little volume compared to today so these single prints would stand out a lot more. Plus when a large buyer or seller came in, they were much more easily spotted. But the same principles apply today. It's just today we have futures and options and options on futures and ETF's and day traders and everything else that create noise around what's really going on. It means you have to focus that much harder then you needed to then. Between one of his favorite tricks was he would send out market orders for small amounts to see the exact price he got filled out to spot the real buyer or seller. Amazing, over 100 years and that technique still works wonders.

Double And Triple Prints

Double prints are exactly what you want to see in strong and weak stocks. A double print means you have two buyers in the stock. You have to watch very carefully though. Even if you are watching, they are sometimes hard to see, you will simply see size flash twice very quickly. And don't always assume its big size. Sometime you'll see 200 shares flash twice. What is happening here is two buyers have left stock for the specialist to work. So any sales that come into the market, the specialist will split the order and give half to buyer A and the other half to buyer B. The reason brokers leave these orders with the specialist is because they don't have time to stand at the post all day and they also don't want to let another buyer push the stock up without them getting any.

This leads to another variation of this called the go along buyer. It means when a broker knows there is a big buyer in the stock who is carefully buying at good prices. Instead of standing there all day and trying to work the stock, he will leave instructions with the specialist to tag along with the other buyer. In other words, whenever buyer A buys stock, I want to buy stock there too, same shares, same price. This is the go along buyer. If you are long a stock and it's strong and you notice the double prints this is a sign that you should stay with the stock. This means there is a lot of stock left to buy and you should not get shaken out of the stock. Again, so many times, traders would miss these prints and would dump their stock because it would just go sideways for hours not realizing there are still two buyers left in the stock! Then at the end of the day, the stock would take off and close at the highs and they would be kicking themselves. It's so important to pay attention to every print. And if for some odd reason you should see triple prints, they are rare but do happen, you better hold on to every share you've got, because that stock is going much higher!

Haircut

A haircut is what is offered to market makers, a risk based haircut. A haircut is where you are not putting up the notional value of your position but rather the risk capital. Using the word leverage to describe it is rather tricky. Because it can be anywhere from 10 to 1 to 100 to 1. Haircuts usually consist of using the max loss your position would incur today with a 15% up move and 15% down move in a stock. With indexes it's 10%. This is all you put up. Everyday your haircut changes as the underlying moves. The biggest advantage to haircuts is not the initial leverage, but rather the fact that when you make adjustments to your position, rather than having to put up more capital, you put up less capital. This allows you to trade the underlying at will, trade synthetics, and lay out premium at no cost. When one is long gamma, since there usually is no risk outside of daily decay, the exchange makes you put up a minimum of $25 per contract on equities and 1$ per contract for indexes.

It’s difficult to trade options for a living in a retail account. Not that it's easy doing it in a professional account either. You need haircut margins unless you’re managing OPM in large amounts. Even then, it's beneficial to have a haircut account. The real value of a haircut is not in the additional leverage it provides; leverage is a doubled edge sword, but rather in its ability to help you remove risk. In other words, the very opposite of what leverage creates. If you cannot manage risk, you cannot make money trading options. It's just that risk is what kills every trader. Guys don't go broke because they have a bad strategy, or they have no edge, or their commissions are too high. They go broke because they can't manage risk or don't have the ability to. A haircut allows you to manage risk without the outlay of additional capital. If market makers couldn't have haircuts on the floor, they could not make markets, end of story.

Trend Is The King

1. Buying low and selling high- it is the most basic thing that every investor must know. A layman could also tell you the secret of making profit by buying at low and selling high. Despite this fact the majority of investors and traders do the opposite. A basic problem of most of the investors is that they are emotional and, hence forget the basic rule of trading in some conditions. Success of every stock trader is determined by the fact how smartly he sells for higher and purchases for low.

2. Trend or flow of the market- trend in the share market and stock price are the only reality of trading and rest are myths. Do not get fooled with other techniques that disapprove the stock markets. Share market is always right. If you want to play safe and make money by trading then, you need to do your trading in accordance with the flow of market. Some people, trade opposite to the direction of market and have sometime made money as well, but such method is extremely risky. If the market is down and you are long, then you are wrong while market is right and vice-versa also holds true. The simple reason behind is that the stock market is driven with a lot of simultaneous factors while a trader going opposite is just an exception. If you stay in flow with market then, chances for you to stay in trade are long and of course chances for making money are also bright.

3. Trend is the king- share markets are volatile and trading works with momentum. If the market or particular stock goes up with a certain pace then, there are equal chances that market or stock will go down with the equivalent pace, as the trend changes. Therefore, trend is the king of trading that change rules according to its motion.

4. Don’t try to find market’s movement reasons- a lot of investors and traders try out finding reasons for movement of the market. They use different techniques, constantly watch markets, etc, but never find a certain reason. It is true that, no one could actually tell a particular reason for movement of market. So do not waste your time. Trading is done in accordance with perception of market and not reality. So, concentrate in trading rather than reality of market. If you want to stay in the game and make money in trading then, concentrate on direction and duration of market’s movement not on its reasons.

5. Work on your profits and minimize loses- every investor must try to run his profits and eliminate all loses quickly. This is the only way out to become successful in share trading. If you want to achieve this target then, you have to trade with pure discipline. Discipline is a necessary condition to trade successfully. Share trading done with discipline helps investors and traders to stay long in market and enjoy making huge profits.

6. Experience and knowledge- there is no age bar for gaining knowledge. Therefore, you must try to acquire maximum knowledge as you can, but make sure you get it from trusted and reliable sources. Experience is what makes every investor a professional trader. So, keep practicing and become successful trader.

You Get What You Pay For

Since the statistically expected expiring value of an option is priced-in as the time-premium, there is no advantage in buying options vs. selling them. In the end they both end up empty handed. Any combination of option positions, like verticals, butterflies, even time spreads, and of course straddles and strangles have all a long-term expectancy of zero. E.g. a fly that costs 0.50 that could expand to 5 has a probability of 1 in 10 to do so. Buying or selling 1000's of these flies over the years will statistically mean no profit (and thus a loss due to commissions). Randomly selling or buying any speculative contract, be it stocks, futures, and also options or any combinations thereof will in itself not make you any money in the long run. So, also in options trading you can only make money by predicting the future (of either actual or implied volatility) and choosing a strategy which fits this prediction. Even choosing an optimal Risk/Reward amongst the different possible combinations is almost moot, since determining the actual Risk (or Reward) is in the end the same as determining the expectancy of the combination, which is zero. This means that if you can't predict the future you won't make money, whatever strategy you use. Also, reversely, if you can predict the future, any strategy is ok; you get what you pay for.

Casinos And Options

Casinos are not a good analogy. The edge a casino has is defined. The edge in options is perceived. In a casino, when you play roulette there are 38 numbers on the table and if you win, they don't pay you 38 to 1 but rather 36 to 1 (due to the 0 and 00 on the wheel). This edge is real and defined. If you are trading deltas, you cannot have edge per se. Unless you feel you have a directional trading system that provides you with "perceived" edge. Adding deltas is not creating an edge. That is akin to me saying I think GOOG is a buy here at $500 a share. Instead of buying 100 shares, I'll buy 200 shares and have twice the edge!!! No, it doesn't work that way. The delta of your option has nothing to do with edge. If the delta you are selling is a 30 delta option and it should be a 25 delta option that does not equate to more edge or any edge at all. Delta is "loosely" regarded as the probability of an option finishing in the money or not but again, this has been proven mathematically to be incorrect. It's just a way of helping people understand delta better. If we know for a fact how many shares need to be bought or sold dynamically to replicate a risk free position, there would be no risk! If you are selling an option that you think has a 25% probability of being ITM and you are getting paid as if it were a 30% bet, one of you is wrong!

Volatility

In options trading, the only way to capture volatility is if you both buy and sell a volatility mispricing. If you just sell an overpriced option, all you have is a delta bet, not a volatility bet. It's a common misnomer that if you just buy options that are cheap or sell options that are expensive, then you are capturing some sort of edge in volatility. Only if the position is continually hedged, are you actually capturing that volatility. Let’s say you are a market maker and a customer sells you 10 Dec 105 calls for .80 with the stock at 100. Let's say these calls have a 40 delta and you are buying them at a 30 volatility which you believe is too cheap. So now you are long 400 deltas. In order to lock in a 30 volatility on those calls, you need to sell stock at exactly 100.00. Because the options are only at that volatility at that price. If you go to sell stock and you don't get that price, say you sell stock at 99.50 instead. Well, at 99.50, you did not lock in a 30 volatility but a 33 volatility. Well, that's no longer underpriced. You wanted to buy a 30 volatility but now you have them at a 33 volatility. What happens if you don't sell any stock? You didn't lock in any volatility, you simply took a 400 delta bet. The delta is a function of the volatility. What MM's typically do is if they buy those Dec 105 calls for .80 at a 30 volatility, they will look to sell some options they think are overpriced to hedge the deltas and capture the volatility. So maybe they ended up selling Dec 110 calls for .35 which are trading at a 33 volatility. So they sell enough to be delta neutral. So they bought a 30 volatility and sold a 33 volatility. They captured some edge in volatility. You simply cannot just buy underpriced options or sell over priced options for edge. They teach you this day one of being a MM.

Put Call Parity

Put/call parity states that calls and puts at the same strike have to trade at the same volatility otherwise an arbitrage can be had. The only time this will not be the case is with either a pending dividend or if a stock is hard to borrow. Put/call parity only refers to a trade at its inception and at expiration. Many things can happen between inception and expiration in the interim that can throw this relationship out of balance. That is not a violation of put/call parity. Again, put/call parity is only used at the inception of a trade where one has the opportunity to trade its synthetic counterpart for a risk free arbitrage. If one then holds the trade all the way through to expiration, the relationship will hold. Dynamic hedging refers to one being able to maintain delta neutrality through the life of the position. Selling call spreads as a stock is dropping has nothing to do with dynamic hedging.

Investment Tips

1. Choose a sound financial lifestyle. This is the first thing you should do before investing. There are three steps you need to take: Graduate from the paycheck mentality to the net worth mentality. People with paycheck mentality spend to the max based on their net incomes. Their financial lifestyle is all about earning to spend. On the other hand, people with net worth mentality focus on building net worth over the long term. Pay off credit card and high-interest debts Paying your high-interest debts is the highest, risk-free, tax-free return on your money that you can possibly earn. Establish an emergency fund. For most people, six months living expenses is adequate. 

2. Start early and invest regularly. Saving is the key to wealth, so there is no substitute for frugality. And, due to the power of compounding, starting early makes a huge difference.

3. Know what you are buying. Know more about the various investment choices available to you, such as stocks, bonds, and mutual funds. Don’t invest in things you don’t understand.

4. Keep it simple. Simple investing strategy almost always beats the complicated ones. Index investing takes very little investment knowledge, practically no time or effort – and outperforms about 80 percent of all investors. Instead of hiring an expert, or spending a lot of time trying to decide which stocks or actively managed funds are likely to be top performers, just invest in index funds and forget about it. However, not all index funds are created equal. Many of them will also charge you high sales commission and high yearly management fee. Do not buy those. Only consider investing in no-load funds with annual expense ratios of 0.5 percent or less, the cheaper the better.

5. Diversify your portfolio. When it comes to investing, the old saying, “Don’t put all your eggs in one basket,” definitely applies. In order to diversify your portfolio, you should try to find investments that don’t always move in the same direction at the same time. A good mix for this is stocks and bonds.

6. Decide your asset allocation. You should decide what a suitable stock/bond/cash allocation for your personal long-term asset allocation plan is. This is the most important portfolio decision you will make. Investments in stocks, bonds, and cash have proven to be a successful combination of securities for portfolio construction. At times, you will read about other more exotic securities (such as hedge funds, unit trusts, option, and commodity futures). It is advised to simply forget about them. 

7. Minimize your investment costs. The shortest route to top quartile performance is to be in the bottom quartile of expenses. Costs matter, so it’s critical that you keep your investment costs as low as possible. It is recommended to avoid all load funds and favor low-cost index funds.

8. Invest in the most tax-efficient way possible. For all long-term investors, there is only one objective – maximum total return after taxes. Tax can be your biggest expense, so it’s important to be tax-efficient. One of the easiest and most effective ways to cut mutual fund taxes significantly is to hold mutual funds for more than 12 months.

9. Avoid performance chasing and market timing. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two. Using past performance to pick tomorrow’s winning mutual funds is such a bad idea that the government requires a statement similar to this: “Past performance is no guarantee of future performance.” And market timing (a strategy based on predicting short-term price changes in securities) is something which is virtually impossible to do. The logical alternative to performance chasing and market timing is structuring a long-term asset allocation plan and then staying the course.

10. Track your progress and rebalance when necessary. Rebalancing is the simple act of bringing your portfolio back to your target asset allocation. Rebalancing controls risk and may reward you with higher returns. Rebalancing forces us to sell high and buy low. We’re selling the outperforming asset class or segment and buying the underperforming asset class or segment. That’s exactly what smart investors want to do.

11. Tune out the “noise”. Most sales and advertising pitches from brokerage houses and money managers are variations of one single message: “Invest with us because we know how to beat the market.” Far more often than not, this promise is fictitious at best and financially disastrous at worst. Here is a simple guideline: all forecasting is noise. Believing that “It’s different this time” can cause severe financial damage to your portfolio.

12. Master your emotions. When it’s time to make investing decisions, check your emotions at the door. Things such as blindly following the crowd, trying too hard, or acting on a hot tip will almost always leave you poorer. Forget the popular but misguided notion that investing is supposed to be fun and exciting. If you seek excitement in investing, you’re going to lose money. Get excited about earning and saving money, but be very dispassionate when it comes to investing.

13. Protect your assets by being well-insured. To be a successful investor requires being a good risk manager. Managing risk means having a plan to cover the downside. That’s what insurance is all about – damage control to prevent the unforeseen from smashing your nest egg. You need to consider the following type of insurance: life insurance, health care, disability, property, auto, liability, and long-term care. Three key rules for being properly insured: Only insure against the big catastrophes and disasters that you can’t afford to pay for out of pocket. Carry the largest possible deductibles you can afford. Only buy coverage from the best-rated insurance companies.

Stops In Options

The idea that you can take off a short option position when you reach a certain loss point is laughable. When markets roll over, spreads explode. There is no such thing as being able to just take off a spread at a given price. Your 10 delta vertical that you are short for .30 will go to 4.00 on one print. So if you think you can just get out when the spread goes to .60 in order to preserve the credits you have earned in past months, that’s not possible. Unfortunately in the options world, stops don't work the same way as they do for futures or even stocks. Even if you put a stop order at .60 to get out, it becomes a market order when touched and your fill will likely be 3.00 to 5.00. If you decide to hold it and wait and see, you could possibly blow out your entire account. This is not a viable risk management strategy. The only way to protect against losses in options trading is to ALREADY be long enough strikes to offset the move when that move occurs. You can't repair the position after the fact. Options simply don't work that way. In options trading is if you are going to sell juice, you better make sure you get as much juice as possible. A .40 credit ain't going to cut it. There is nothing wrong with selling premium, just make sure you are long enough options.

Hard Deltas v/s Soft Deltas

Futures create too many hard deltas. When you trade options for a living, you need to make a decision day one. Do you want to trade hard deltas, or soft deltas? These two beasts are not the same. Hard deltas are real, soft deltas are not. Hard deltas are ATM or ITM options. Soft deltas are always OTM and have nothing but time premium. When you are trading hard deltas, it is said that you have a real position. You are trading the underlying. If it moves against you, you need it to move back. This is not true with soft deltas. Some guys like to trade hard deltas. Some guys prefer to always trade softs. Some do both but try their best to roll their positions anytime their short options get ATM. You should never leave .05 and .10 options on your sheets. Buy them back and sell if you can re-sell them for 1.00 to 2.00. Buying back your short options is not gamma scalping. You usually have a flat delta position when you are buying back your short calls. The reason you are buying them back is because they are worthless, not because you are trading your deltas. 

Anytime you are short options you should always scalp them. If you have a spread on and you are short a put for 3.00 and can buy it back for .40, why wouldn't you? You can resell that put for 2.00 and possibly leg into back spread for a credit and possibly scalp the short put again. As your short options approach zero, the risk/reward inverts. Meaning you are risking more and more to make less and less. But by scalping it, you are actually reversing that and increasing your reward and reducing your risk. Close to money back spreads are easy to scalp because they have enough deltas and gamma. Back spreads are the most versatile option strategy. Because you can trade direction, trade delta neutral, sell juice, play for a big move, gamma scalp, all while having very limited risk. A good trader will be able to leg into his back spreads for credits and trade direction for free while having unlimited upside and zero risk of taking large hits. The goal is to make 5% to 10% a month.

Wings

How do you think professional market makers/takers, who are well capitalized consistently make money? Why are they well capitalized? In other words, why do banks back these guys? Remember, bank directors have a fiduciary responsibility, mandates and have to answer to management, shareholders, the SEC the NASD, yada, yada, yada. One hint is they don’t make money the new fashioned way. The answer is that Pros are, by and large, premium sellers. They can be, because they are well diversified through the products allowing for the occasional bloody beating when a stock does a tap dance on their wind pipe. But what happens when the whole market goes…you know…goes really big, in one direction, fast and far, across the board, in all the products? Meaning: you can throw the idea of diversification out the window. Insight: Wings. By owning, that is being long cheap wing premium, one is given permission to short closer to the money, beefier premium. The proof is in the implied volatility (IV) skew, the smile. To the public and speculators high implied volatility represents an over-priced opportunity motivating them to sell OTM options. The smile is caused by options inventory guys, that is, market makers, hoarding the wings. Did you ever notice the price, in terms of dollars and cents, of those high implied volatility options? They are the cheapest options available in those underlying instruments and this is the reason that market makers can sell premium across all sectors, and the reason that the banks can back them and remain comfortable with the firm’s exposure. They may lose money here and there, but when the nightmare hits, these institutions with extra-long wings score big. They avoid getting destroyed like victims of derivatives debacles. Why? Their wings kick in and it rains money.

Too Wealthy Or Too Crazy

There are, of course, safe ways and dangerous ways to be short premium and still manage it successfully. Bottom Line: Limited-Risk-Short-Premium is the only way to go. Shorting premium is a way that many derivatives traders consistently make money. On average they win more often than they lose. However, when they lose, it is usually by a much greater amount than their average gain, owing to the high-risk nature of selling naked premium. Selling naked premium should only be for the too wealthy or the too crazy. Too wealthy could be defined by taking a severe beating in the market and it still makes no material difference to the wealth of the individual. The only other reason to sell naked premium is if the person is too crazy. There will be times when there is no chance to manage it, for example the huge gapping market situations. The ideal situation for a premium seller is to go to sleep after initiating the trade and to wake up at expiration with the price of the underlying at the short strike price. It is of course not that easy because the market stretches out the trader’s wallet from time to time, causing him to react for protection. Be careful when selling premium. If at the end of a trading day, the trader has a naked short premium, he or she is in the hands of fate. It is often too late to turn back especially when earnings warnings are announced, unusual surprise events or other great or horrible news.

Speculative Trading Procedures

Many of the trading opportunities are speculative in nature. If you are using option volume, option premiums, or the put–call ratio as a predictive indicator, you are most likely going to take an outright position, as opposed to a hedged strategy. In a broad sense, outright speculative positions are the easiest to manage—you are generally long a security (stock, futures, calls, or puts), and all you have to do for follow-up action is to adhere to some sort of a stop loss. In reality, though, an outright trading position needs more management than that—from initial selection to final sale. In some cases, there is no underlying—sector index options, for example—so options are then the only choice. However, when there is a choice, the only way to logically make it is to evaluate the options with a mathematical model. You must know the relative price of an option before you trade it. If the options are too expensive, you may then decide to trade the underlying instead. In order to decide if the options are “too expensive,” you must have some gauge against which to measure the current option price. That gauge, of course, is volatility. You should compare the current implied volatility of the options to the recent historical volatility of the underlying. In addition, you should also compare the current implied volatility with recent implied volatilities.

 

Another decision that must then be made is which option to buy. Buying the short-term in the- money option is usually the best choice. The trader obtains leverage because he owns an option, but he does not spend a lot for time value premium. The number-one reason that option buyers lose money is that they buy options that are too far out-of-the money. These options also may have too little time remaining. This mistake can cause the trader to lose money even though the underlying may move in his favor. Whereas with the in-the-money option, he will almost assuredly make money if the underlying has a favorable move. As for actually buying the position, be careful about using market orders in options unless (1) you are trading a very liquid option, or (2) you are placing a small order. Otherwise, limit orders would serve you better in the long run. You may find that you can often “split” a market (i.e., buy between the bid and the offer), especially in a moderately active option. Don’t be stubborn about using limits, though. If you are attempting to buy a very thin (illiquid) option, the market makers may just raise their offer when they see your bid, for they don’t really want to take a position.

Risk management, through stops, of an existing position is another important factor, especially in speculative trading. Not only must you adhere to a stop loss of some sort, but you should also have a plan for taking partial profits at times along the way. Set the stops based on technical support and resistance levels in the chart of the underlying security. Some traders who buy options set stops based on the option price; this can mean that time will stop them out or that they sell their options when the underlying is sitting right on a support level—not a good idea. However, when they are trading in-the-money options, they don’t have to worry about time decay so much, so they can use the underlying’s technical levels to place their stops. If you are trading options, use a mental stop; if you are trading stock or futures, you can use an actual stop. A mental stop means that you don’t actually have a stop-loss order on the floor of an exchange; but when the underlying hits your mental stop price; you can evaluate the situation at that time. If it seems that the position should be sold, then you can decide on a market or limit order. In general, if your mental stop has been violated and if the stock or futures contract seems to be headed in the wrong direction, a market order is best. However, if the stock or futures seem stable, you might try to use a limit order to exit the position.

Perhaps even more important than limiting losses is managing profits. Everyone wants to follow the conventional wisdom to “limit your losses and let your profits run.” Actually doing this is easier than it might appear, despite conventional wisdom to the contrary. Most traders know the anguish of seeing a position move in their favor, thereby generating an unrealized gain, only to have it fall back and stop them out. To me, this is far more devastating than taking a profit too early, although we can attempt to get the best of both worlds. There are two ways to do this: (1) take partial profits and (2) use a trailing stop. Some traders take partial profits on a strict basis. For example, if they own options, they may sell a part of the position if they get a 25 percent profit. Then they would sell a similar portion if they get a 50 percent profit. Then they would attempt to hold the remainder with a mental stop. Other traders prefer to take profits based on the underlying’s action—if it hits resistance or spurts ahead too fast, they take partial profits on their position. In either case, this is the correct approach, for it allows them to take some realized gains but still lets their profits run. The other technique that protects profits is the trailing stop. Once a position begins to move in your favor, raise your stop price, whether it is a mental or an actual stop. Initially, you use a fairly tight stop in a trading position. But, if you are taking partial profits along the way, you might not want to keep the trailing stop as tight when you raise it. That is, when things are going your way, leave some extra room for a small correction to take place without stopping you out.

To limit your losses, set a reasonable stop to begin with and have the discipline to adhere to it. Then use the trailing stop to let profits run. Don’t be lured by targets, and don’t fall prey to your emotions when profits are building up. Targets don’t do anything except get you out of a position that is about to make a long run. Staying with one or two super-trending trades a year can make all the difference in the world. Closing stops are also easier for traders who might be employed in another profession. All you have to do is check where your stock is trading with about 10 minutes to go in the trading day. If it has violated your stop, then exit your position. Or if you miss the close on any given day, then see where the stock closed and exit on the opening the next morning if the stop was violated. There are variations on the type of stop that could be used. Chandelier stops and parabolic stops are designed to “hug” the current price more closely if a very strong, parabolic-style move develops, and they incorporate the recent volatility of the underlying. But the real point is use a trailing closing stop. In summary, some axioms are difficult to accomplish—such as “buy low, sell high”. But cutting your losses and letting your profits run is something that everyone can accomplish without much difficulty, merely by setting an initial stop to cut losses if necessary. Then, if profits develop, using a trailing stop to let them run.

Progressive Betting

In progressive betting, you increase your bets each time you win; but if you lose, you return to your original bet size. The common technique is to increase your bet by 60 percent every time, pocketing 40 percent of the winnings for yourself. If you are lucky enough to be involved in a streak of even eight or nine straight wins, you’ll be very happy. At the end of eight wins, for example, your next bet would be 1.68 times your initial bet. If you think it would be hard to remember how much to bet after each win, especially if the streak gets long, just bet the Fibonacci numbers: 3, 5, 8, 13, 21, and so on. Each one is about 1.61 the previous one; but even easier, each one is the sum of the previous two. So all you have to do, in order to calculate the next one, is remember the last two. That’s pretty easy to do, even in the heat of battle.

Keno And Iron Condors

It does not matter when you close your position. In fact, it’s the same problem when you close your position as when you open it. At the end of the day, you are either buying or selling your options above and below fair value or you are not. No amount of trickery can get around this. There is no edge in putting on iron condors every month if you are not modeling volatility. There is nothing you can argue about this. Getting out early is not an edge! Selling 5 delta vertical spreads is not an edge. Even if you go way way way out of the money....that is not an edge! Your ability to close a position early. This is a zero sum game and you are trading against professionals. Do you really think having a pulse and an internet connection is the path to financial freedom?

There is no problem with legging positions but once you do that you become a directional trader. No issues with that either but then one's long term success will be a function of their directional trading skills. And if you are so good at legging, whether it be legging in or legging out, then why not trade the underlying? There are a million ways to trade options; iron condors simply have the most negative edge of all of them. It's analogous to Keno in a casino. Keno has the highest negative edge of any casino game but it's the most fun to play, especially for older people. Iron condors are the same way. At the end of the day, when you trade options, you are either trading volatility or direction or some combination of both. You are not trading time or theta. If you even have the slightest bit of success legging your positions, you will have a far better risk to reward structure just scalping a few pennies in the SPY a couple times of month or trading pure gamma.