Direction v/s Volatility

There are two ways of making money in this business. You either need to be a damn good directional trader, or a damn good volatility trader. You'll often hear guys say things like "I don't care what the market does, I'm safe". That is not a volatility trader. People work very hard in this business forecasting future volatility and future price action. It's comical that some think you can just slap on a spread and make an adjustment here and there and make money. Yet, many of the late night infomercial groups tell you it's just that easy. You hear all the coin phrases: "I can always adjust", "I can leg into a fly", "my spreads are safe because they are DOTM", "I can only lose my debit so I'm not worried", "I have edge from my theta", etc....... And it goes on and on. You will never hear a professional trader utter these phrases. They are usually the mark of an amateur. This is a very tough business. If you are going to make it, it's because you develop into a great trader. Not because you can slap on spreads at good prices. Look at it this way. Most "professionals" in this business do not make money. The amateurs almost don't have a chance. Not saying it's impossible, some will. But the ones that do is mostly attributable to random luck. 

When you talk to people who do this part time or on the side to a full time job they usually point out a lucky stock they caught or they walked into an index before a huge move quite by accident. Very seldom do you find part timers that earn consistent income month after month without adjusting for risk. In other words, are they outperforming a benchmark with the same or less risk? If they are not, they should just invest in that benchmark. If they are, then they are doing something right. But you find those people few and far between. Sooner or later, traders revert to a long term mean which is usually the benchmark. Very few can actively beat that benchmark over long periods of time. Not saying you can't make money on the side by trading part time. That's a separate issue. We are talking about outperforming a benchmark here, not just making money. There are outliers out there, but we have to discount those as in any study. Benchmark meaning something that you could invest in that produces similar returns. Many people by default use the SP 500 by default. You could use the CBOE buywrite index if you like to sell premium. There are many ETF's out there that use particular trading styles that might be similar to yours. The bottom line is, if I can invest my money in an ETF and make 10% a year without putting any labor into it, why would I want to bust my ass working long hours on top of my regular job just to make 12% a year? 

Every vol trader is making a de facto directional bet whether he knows it or not. And every directional trader is making a vol bet whether he knows it or not. This is where many trader shortcomings are. This is why at the end of the day; you need to be a decent directional trader. Anyone that sells vol is making a defacto bullish bet on the market all things constant. Unless he is running a discrete dispersion strategy. If I sell front month gamma, the last thing I want is for the market to roll over hard. If I sell back month vol, the last thing I want is a hard selloff causing vols to spike. This is what it means by vol traders being an indirect directional trader. When I sell vol, it's usually because I think the markets are going higher. If I buy vol, it's usually because I think we are going to sell off. Why would I ever buy vol with a bullish market outlook? So at the end of the day, whether you are trading direction or trading vol, you are really trading direction regardless. One cannot make the argument that simply because of the wide placement of strikes that they don't care about direction.

Interview With Nassim Taleb

In the eight years since his first book, Dynamic Hedging: Managing Vanilla and Exotic Options, crowned him a celebrity in the derivatives world, Nassim Taleb has been expanding the focus of his work beyond the confines of finance while delivering his ideas to ever-larger audiences. The 45-year-old has been cited in testimony before Congress, participated in Pentagon think tanks and lectured at the respected Courant Institute of Mathematics. He has seen his most recent book, Fooled by Randomness, becomes a bestseller, with editions in 17 languages. Taleb is the first to boast that everything he learned about risk, he learned on the trading desk. Born in Lebanon but forced to flee amid the onset of civil war in 1975, he flourished as a student, ultimately obtaining his MBA from the University of Pennsylvania's Wharton School and his Ph.D. in applied mathematics from the University of Paris. Throughout the '80s and '90s, he held senior positions at a slew of Wall Street's biggest derivatives desks, including UBS, Bankers Trust and CSFB. In the early '90s, he walked away from the Street to trade as a local for 18 months on the CME. He's currently the head of Empirica LLC, the investment company he established in 1999. For the most part, he has forsaken the day-to-day grind of trading to focus on research via an endowed professorship at the University of Massachusetts. He's also working on his next book, about randomness in society at large. It's called The Black Swan, named for a worldview he developed around the idea that most people tend to ignore, or live in denial of, the reality that large, random and unexpected events -- black swans -- can and likely will happen eventually.

Would you describe yourself more as a writer or an academic? 

I refer to myself as an epistemologist of randomness. 

Do you miss trading? 

I've been a trader for 20 years, and I still hate trading as much as I did the first day. I have some form of addiction [laughs]. It's love-hate. 

Although you now have people who trade for you, can you share with us a little of your methodology? 

I specialize in way-out-of-the-money [fat] tails, but I don't like to buy volatility. A lot of people think I just buy volatility, but that's not true, and I laugh when I hear that said about me. I like to sell volatility and buy tails, which is the opposite of what a lot of people think I do. 

Please elaborate. 

Some of the products we used to offer customers were strategies that were viewed as protection strategies -- buying puts, buying strangles or buying butterflies, for example -- but one thing about fat tails is that the farther you're out on them, the less you have to be right from a probability standpoint. I specialize in options that are between 10 and 20 sigma out of the money. Let me explain better: Let's say I consistently buy a one-month option that is 20 so-called sigma out of the money. How long can I bleed the cost of purchasing those options and still be made whole when a sigma-20 event finally occurs? Years, we suppose. You want to know how many years? (Laughs loudly) More than 5,000 years!

You've been portrayed as a critic of Modern Portfolio Theory. 

It's a scam, all of it -- Markowitz, Sharpe, it's just like astrology. Take pension funds, for example. They want to show that they perform proper due diligence, so they say, "We use MPT developed by Nobel Prize winners" and hire consultants who generate fees by supplying them with variations on these models. That way, when they have a problem, they can always say, "Hey, look -- I'm using the industry's standard method of investing." They've made a science out of nothing. Everyone knows it's a joke. The practitioners know it's a joke, but it's a self-feeding mechanism, and nobody wants to abandon it now. This brings us to another big problem we have in finance -- fund managers whose objective function is not necessarily to deliver value. Let's say you make a dollar every day and lose a hundred once every hundred years. People are not going to wait 20 years to evaluate your strategy; they're going to review it every single year and then promote you or demote you based on that year's performance. 

So all you have to do is manufacture pseudo alpha and deliver it, and you can show consistent returns and a Sharpe ratio that's very high over a small time frame. Then you're going to be well-compensated. Its perception arbitrage: showing someone statistics that are meaningless. 

That sounds to us like something you wrote in your book Dynamic Hedging concerning how a lot of traders get compensated. You called it "accounting arbitrage," yes? 

Selling an option that's worth a dollar 100 times is not as attractive as selling a 50-cent option 500 times, because you care only about how many bonuses you get before it blows up on you. 

Does this mean you think that the compensation structure for hedge-fund managers is flawed? 

People think I'm cynical about hedge funds when, in fact, I'm extremely positive. I think they're a great mechanism. A hedge fund can be so much smarter than a bank or other financial institution in allocating its resources. The problem is I'm very cynical about these big hedge funds, or funds of funds, which are gaming the system. 

What was it like working with the Pentagon? 

People in the military understand very well that you cannot take things at face value. That you have to look at rare events. They understand hindsight bias very well, and they have a sense of mission. They pay attention to the process and not to results, which is exactly the opposite of Wall Street. I was very impressed; the thinkers I encountered in the Pentagon made me feel ashamed to be talking to them, because they are far more sophisticated than I will ever be. 

Were these military people receptive to your ideas? 

The people who like my message are those in the military, venture capitalists and pure traders -- people who are devoted to truth and less interested in appearances. 

Speaking of venture capital, what are your thoughts about hedge funds moving into more non-public investments? 

I'm glad that hedge funds are smart enough to invest in private-equity deals that have not yet reached that mature point. (Venture capitalists) look like idiots locally, but cumulatively it's a phenomenal business, a virtuous business. 

A virtuous business? We've never heard venture capital described that way. 

Any business that can "make big and lose small" -- that is, long the tail -- is a virtuous business. Economic loss always seems to come from "make small, lose big" (strategies) -- i.e., short options. 

So who is it, exactly, who doesn't get your message? 

Finance Ph.D.s. I don't really understand why anyone would want to pursue a finance doctorate. If you're interested in finance as such, just become a practitioner. If you have intellectual curiosity, you can study philosophy, biology or history, or something interesting.

Catch 22 Situation

There is a catch 22 with selling premium. You either sell very little and earn a miniscule return, or you sell more and risk blowing out your account. There is no way around this mathematically. No matter how hard you try. Let’s say you are selling bounded gamma (iron condors) in which you are risking 250k to earn a pittance of 6k credit. Let's say you have a 500k account. You realistically can make let’s say 60k over 10 profitable months (6k times 10). And let's say on the bad months you lose an amount equal to your credit (6k). So, after 12 months you have made 48k (60k minus 12k). Or roughly a 9% return. However, you are willing to risk a 50% drawdown to get this 9% return. Folks, you can make a 6.5% a year in a CD with zero drawdown! Why would you risk half your account for an extra 300 basis pts. This is the point. Now if we remove the wings and go naked on those options, your risk is probably 5 times that with only a slightly higher return. This is the rub guys!!!! You can't get around this. This is one of the reasons, people move on to diagonals and other trading ideas.

Corrections

There are two types of corrections. Price corrections and time corrections. People seem to forget about the time corrections but they both serve the same purpose.

10 Sigma Events

Over the short term, there is no edge to the buyer or seller. Over the long term, there is an edge to the buyer as options cannot price in catastrophic moves (10 sigma events).

Cost Of Being Wrong

What is the cost of being wrong? Everything you do in your life, trading or otherwise centers around this central tenet. You are wrong quite often in life, but usually the things you are wrong about do not carry dire consequences. For example, if you forget what time a movie was suppose to start. Or if you are wrong about the score of last night's football game. Or perhaps wrong about some trivial piece of information such as how high did the fed funds rate get in 2000. These things are of little importance in the big picture. Other things you do not want to be wrong about. For example, the babysitter you hire to watch over your children, having unprotected sex with the wrong person, underpaying your taxes, or perhaps even, the amount of inebriation while getting behind the wheel of a car. In these situations, being wrong carries substantially more risk. Well, in trading, you should always ask yourself, what is the cost of being wrong? Not what is the likelihood of being wrong. These are two different things. Let's say you have a trade on that says there is a 99% probability you will make a little bit of money every month. But a 1% probability that you lose everything to your name. Even though that 1% is very unlikely, the cost of being wrong is just too great.

Think of this. Would you put a gun to your head that had 99 empty chambers and one chamber with a bullet in it and pull the trigger? Of course not. Even though there is a 99% chance everything will be fine, that 1% will result in immediate death, therefore you don't do it. But for some psychological reason, we don't fear losing all our money to be the same as death, even though to some people the events are analogous. Do not trade in such a way that if the worst of luck happened to you. If Murphy's law went into effect. If the grim reaper should knock on my door, or the kiss of death should sit down beside you, you will not have the possibility of financial ruin. That doesn't mean you won't lose money, it's just that you won't have a strategy that offers you that possibility. Many people espouse their track records and their experience and how many years of profitability they have had only because their dark day is still ahead of them. Because they have not seen it yet, they believe it doesn't exist. 

To use a funny example, take life. A 32 year old man has lived 11,680 successful days without dying. He must be immortal as he had not died once yet during those 11,680 days therefore I doubt he will ever die. This is a common fallacy of course. Our mind is built to use past experience, not true probability when it comes to making decisions. In the 1980's it was the disbelief that AIDS existed. Hey, if you never got it, why would you believe you ever would?

The thing is, the only way to get around this barrier in our mind is to force ourselves not to look at past experience, but rather future possibilities. If you had to make the same trade 1000 times under 1000 different lives, how many times would that decision produce a positive outcome or a negative outcome. Under many situations, what happened to LTCM in 1998 would not have happened under some of their alternative lives, a few of them would have lead LTCM to be the most successful fund ever. Same thing about naked options selling. One has to ask themselves is it really worth the risk to take in such small amounts of money to have the goddess of risk pay you a visit? Do you really want to tempt fate that much? There are always two paths in every forest. There is always an easier path that everyone would be inclined to choose. It carried a lot of hidden risks, but most people would get through OK. The rewards were often less than satisfactory on this path. Then there is the other path. The other path was always darker, harder, more challenging and many did not make it through. But the rewards were substantial, not always from a monetary standpoint, but from a personal standpoint of taking the road less travelled. Selling naked puts might be easy and produce years of gains, but anyone can do it. The risks to some are huge and quite devastating. Everything in life has risk. Flying, driving, eating bad fish. The difference is, those are things we have to do. We don't have to sell naked premium. Why go through the motions of putting a loaded gun to your head when you don't have to?

True Or False

Q) 95% of all traders and all strategies lose money.

A) True.

 

Q) A good premium collecting trader can make consistent money. 

A) This is of no importance. That's like saying a savvy drug dealer can make consistent money. At what cost though?

Q) Any short gamma trader (good or bad) can be wiped out by a 3+ sigma event. So if I can be a good short gamma trader and my only fear is a rare catastrophe, I'm already way ahead of the other 95%. Is that so bad? 

A) No, a short gamma trader can be wiped out by a 1/2 sigma event. Short gamma traders wipe out on 5% moves. They happen on a daily basis. Your only fear is not a rare catastrophe, that's your broker's fear as all your money will be gone at this point.

 

Q) If I'm a bad short gamma trader, I will join the other 95% regardless. 

A) No, there is a big difference here. Who said that 95% of traders lose everything? No, 95% of traders are not profitable. There is a big difference between being not profitable and losing everything.

Angel

There is no true best strategy. There are only good traders, not good strategies. ATM options are generally the easiest to price. They are the most liquid and there is a generally a consensus agreement on vol. As you go further out, you have less activity and a much wider discrepancy on what vol should be, hence the vol skew. You will also notice the variance of the actual vol on the strips (wings) is much larger than the ATM vols. In other words, the ATM vols stay relatively constant while the deeper strikes move around much more. So here is the deal, the ATM vols are pretty efficient for the most part (think of having a large data sample to analyze). The OTM options are very inefficient (very small data sample). The ATM options are not really underpriced or overpriced per se. You are really just dealing with the vig that goes to the MM. OTM options though are drastically underpriced. Not over any one single strike or option, but over a large range of strikes and options. You simply cannot price an unknown event into an option (because it's unknown). Now as to the reason why everyone doesn't just buy these options, this is very simple. For the most part, the hedge fund industry lives in an instant gratification society. From the hedge funds stand point; they don't have the luxury of having a bad month, or bad quarter in hopes of making the big score down the road. Many hedge funds can lose investors after just a few bad quarters (bad meaning underperformance relative to their peers). No one wants to hang around for the "grand finale" so to speak.

This is the primary reason this edge cannot be exploited. Think of it this way. Suppose an angel came down from Heaven and told you to stand in the middle of a frozen field outside the city of Chicago in the dead of winter every day for 3 hours. And one day in the future, this angel would return and give you a suitcase with 100 million dollars. So every day you stand in that cold, frozen field waiting for that angel to return. Surely you are ambitious and hopeful and believe the wait will be worth it. But after awhile, you will question your sanity. You will grow tired, you will begin to doubt and at some point, you will stop going to the field. Even if you later learned that the Angel eventually showed up, you wouldn't care anymore. Your desire is gone. That is the rub. Now many will say how one can possibly profit from such a strategy. Surely no one will want wait forever in the hopes of a 10 sigma event. And to that end, you would probably be right. But the moral of the story here is not to profit from such an event per se, but rather to make sure this event doesn't profit from YOU! The idea to understand here is we are all vulnerable to this "angel" coming, only not so much in an angelic form, but rather in the form of disaster. All it takes is one event (that no one saw coming) to wipe out a lifetime of earnings and hard work. The idea is to find ways to profit from the markets while at the same time, not blowing up from the "rare event".

The Lottery Paradox - Nassim Taleb

This is one example of scholars not understanding the high-impact rare event. There is a well-known philosophical conundrum called the "lottery paradox," originally posed by the logician Henry Kyburg, which goes as follows: "I do not believe that any ticket will win the lottery, but I do believe that all tickets will win the lottery." To me (and a regular person) this statement does not seem to have anything strange in it. Yet for an academic philosopher trained in classical logic, this is a paradox. But it is only so if one tries to squeeze probability statements into commonly used logic that dates from Aristotle and is all or nothing. An all or nothing acceptance and rejection ("I believe" or "I do not believe") is inadequate with the highly improbable. We need shades of belief, degrees of faith you have in a statement other than 100% or 0%. One final philosophical consideration. Life is convex and to be seen as a series of derivatives. Simply put, when you cut the negative exposure, you limit your vulnerability to unknowledge.

Asymmetry

The asymmetry between bad and good random events shows that the negative domain is convex while the positive domain is concave, meaning that a loss of 100 is less painful than 100 losses of 1 but that a gain of 100 is also far less pleasurable than 100 times a gain of 1.

Unknown Unknowns

You can't claim that an event is predictable to the person doing the event. So if you blow up the world, it cannot be a black swan because you had knowledge of the event beforehand? Take any event that you think someone was genius enough to predict and let's see if they can do it again. You will find that they can't. The reason is because they got lucky the first time. There were a lot of guys who were short the market going into the 87 crash that never made a single dime trading ever again. It's the proverbial "even a broken clock is right twice a day". Take the guy that buys a winning lottery ticket. That's an event that was predicted by the ticket buyer. The guy got lucky and if he bought another million tickets, it's highly unlikely he would win again because of his ability to pick winning tickets. Of course, he could get "lucky" again. Similarly you cannot say that 9/11 was predictable. There were a million things that had to go exactly perfectly that day in order for those 13 hijackers to do what they did. Had the weather not been absolutely perfect that day, had there been limited visibility, those planes would not have made it anywhere near the WTC. The fact that people warned it was a likely event, does not make it so. The fact of the matter is if that event were tried again, without the exact conditions that allowed it to happen the first time; it would not be successfully pulled off.

There is something called the unknown unknowns. Things we don't know that we don't know. And there really is no way for anyone to "accurately" predict what we don't know we don't know. That most of what happens in life is very random. People who are charlatans try to sell their "skills" when in fact, they are simply lucky. The true test of skill is repeatability. Can that "skilled" person do it again? For example, Tiger Woods sinks a 45 foot put. Someone says he got lucky. Tiger Woods then goes on to sink that exact same put 100 more times in his career. That is called "skill". If you happen to sink that put once in your life, should you then try to go around the country and sell yourself as a professional golf instructor who can put just as good as Tiger Woods?

Lifestyle

Think of a trader who starts trading today. What would you tell him? You would tell him to prepare to spend the better part of the next 5 years going through various cycles both up and down. Improvement in trading and in health happen very slowly over time even though we all want to get rich now and get fit now! The problem with rapid weight loss or even rapid muscle gain is it throws your body out of whack. It's not natural and it won't last because your body has a tendency to fight any rapid change in your body whether it's good or bad. The guys who are in the best shape, the guys that make it look easy, took years and years to get fit. They focused on very minimal gains. This allowed their body to slowly transform without the evolutionary restraints that will try to hold you back. This is why many talk about a lifestyle change vs. the concept of a "diet". A diet is something that has a beginning and an end. A lifestyle is permanent. A lifestyle will allow for the slow gradual change that will be the new "permanent" you. Not the temporary you that is the result of some radical routine to force a result to happen quickly. If you eat well and exercise well over time your body will change slowly. Watching the scale every day is like a new trader that watches every up tick and down tick in their p&l. It's a waste of time.

Capital, Edge & Time

An edge with no equity will get you nowhere. An edge is worthless until you build the skill necessary to use it. It's like a high performance sports car. You just hand the keys to a 16 year old kid and expect him to be able to handle it even though the car itself is amazing. It takes skill to drive a high performance car. And it takes skill to refine and execute your edge. Edge itself is meaningless. The guys that worked on the floor of the CBOE when options had .50 spreads on the bid and offer. It was easy money for them if they knew how to calculate synthetics. Yet guys still blew out their accounts taking unnecessary risk. There is nothing about this business that's easy. Getting an edge is not enough. Capital buys you time. And every trader needs time, lots of it. It's the most valuable currency to any trader. And no, just because you have capital does not mean you have a prayer to make it as a trader. The two things are mutually exclusive. In fact even with unlimited amount of capital your odds are still pretty small. It doesn't matter how we define what edge is, it still has to be acquired. You can't just buy edge. It takes time to get that edge. Guys that are just starting out need TIME. And time is not free. It cost money. Without it you can never acquire, develop or create your edge.

Many hedge funds blew up in 2008 not because they did not have an edge, but because they ran out of capital. You have to understand that an edge is not a license to print money or even make money. Capital gets you through the draw downs. Also when one edge runs out, another must be acquired. All that takes capital. You can give a new trader all the edges in the world, but if they don't have the capital behind them to buy the time to learn how to actually trade, it really doesn't matter. Once you are already a profitable trader there are a whole new set of variables you have to contend with. There is no such thing as good or bad. The industry changes. Every business runs on capital. It's about risk vs. reward. A slow choppy market may be bad for a momentum trader but great for a counter trend trader. Markets themselves are never good or bad.

The Floor

There (on the exchange floor), 50 or 60 grown men stood leaning in each other's faces shouting as loudly as they could in primordial tones of voice that I had never heard before, except may be one time I tried to take a shrimp away from my cat. Veins bulged in the men's necks. Their eyes seemed ready to leap from their sockets at any moment. They waved their arms threateningly at one another in some incomprehensible code. It was like a cockfight without the cocks. A crowd this angry couldn't help but come to blows at any moment... My heart was in my throat. What was going on here? The men were trading cotton.

Prudent Rational Trader

A prudently rational trader knows that any option strategy that is exposed to unlimited risk, no matter how small the probability, will eventually suffer catastrophe under the law of large numbers. As a Wall Street maxim notes, "There are bold traders and old traders but no bold, old traders." There is no way in the long run to beat the odds consistently if they are against you. The improbable should never be assumed to be the impossible.

Personal Monetary Value System

The greatest danger that one faces after being exposed to the markets is the loss of their personal monetary value system. It is not uncommon for the traders to make or lose 5000 to 10000 in a matter of seconds. Now suppose at the end of the day you are shopping for a shirt. You find one priced at 299 and another one priced at 399. Subconsciously, regardless how grounded or disciplined your background is, in the back of your mind you will eventually ask yourself, “What’s 100? I just saw some lunatic trader lose 5000 in about five seconds”. This exhibits the biggest drawback of entering a trading career. No matter how well grounded or disciplined you are, your value system will suffer.

Technicals & Fundamentals

Whenever traders start commenting on fundamentals when they are in a losing position the next step is usually a blowout. It's just a bad omen. There many quantitative funds that look at macro stuff but a technical system does not trade on fundamentals. When a trader starts commenting frequently on fundamentals "while they are in a losing trade" it's usually because the system has failed them and now they are turning to religion (fundamentals) so to speak. Many traders will comment on fundamentals when they are in a "winning" trade. Usually this is done to keep them in the trade and extend their winners because we all have a tendency to cut our winners short.  Large funds that commit to technicals do not "suddenly" start introducing fundamentals while they are in a trade. This is usually decided upon from the beginning. When guys get desperate they start yelling at the rain. There is no shortage of guys trying to defend their short positions in this bull market with fundamental commentary. 

Fundamental traders stay in trades as long as the fundamentals justify their trades. A technical trader trades a model and that model has inputs that create values for you to trade on. At some point those values are invalidated and action must be taken. You can't create a model that trades on data and suddenly use fundamentals to justify losses. There has to be a consistency there. One of the worst markets you can have is one that is technically strong and fundamentally weak. And vice versa one that is technically weak but fundamentally strong. Because the technicals will blow out the trader before the fundamentals can save them. To quote two of the best traders in the world, Bruce Kovner and George Soros, they only trade their fundamental views when the technicals agree with the fundamentals. If there is a dichotomy then they will not make the trade.

Hedging & Speculation

A guy was trading convertible arbitrage and also setting up option strategies. The head of the department was a well-known arbitrageur who didn’t blink at positions of several hundred thousand shares in a risk arbitrage position. However, he didn’t really understand options too well. So one day he asked this guy to explain his position in XYZ options. Apparently the position had been marking to market at a small loss, and the head of the department wanted to know why. The reason was that XYZ had been rallying in October and November, coming out of its oversold bottom of the 1973–1974 bear market. The position was a one-by-two ratio call spread. It was on the order of being long 100 calls and short 200 calls. The spread had an upside break-even point of about 300. Thus, it was net naked short about 100 calls. So the trader explained that the position was good for another 80 points on the upside over the next three months, and that it could make about $300,000 at expiration. However, the head of the department wanted to know what the result would be if XYZ went higher. When told that this would be a loss of $500,000, he said “What if the Arabs take over XYZ? We’re screwed. Take off the position.”

Now that’s paranoia. What were the odds of the Arabs even wanting a computer company? Probably something way less than 0.1 percent. Still, it was too much risk for this otherwise heavy-risk taker. At the least, the department head, an experienced trader, knew what made him uncomfortable, and he didn’t want to pursue that strategy any longer. Your comfort level extends beyond just deciding whether to trade options strictly from the long side or the short side. It goes deeper— more toward your approach to the overall market. Some people prefer hedging, some prefer speculating. Hedgers generally limit their overall profit, but they also have less risk than speculators do. If hedged positions drive you crazy because you know you’ll have a losing side as well as a winning side, then perhaps you should trade options more as a speculator, forming opinions and acting on them accordingly. The important thing to realize is that it is much easier to make money if you are “in tune” with your strategies, whatever they may be. No one strategy is right for all traders, due to their individual risk and reward characteristics and accompanying psychological demands. Many traders don’t like speculating, preferring a more conservative tack. If that is your philosophy, that’s fine. You should look for hedged positions with a statistical edge and not attempt to day trade or engage in other forms of short-term speculation.

Beat The Crowd

1. Forget the news, remember the chart. You're not smart enough to know how news will affect price. The chart already knows the news is coming. 

2. Buy the first pullback from a new high. Sell the first pullback from a new low. There's always a crowd that missed the first boat. 

3. Buy at support, sell at resistance. Everyone sees the same thing and they're all just waiting to jump in the pool. 

4. Short rallies not selloffs. When markets drop, shorts finally turn a profit and get ready to cover. 

5. Don't buy up into a major moving average or sell down into one.

6. Don't chase momentum if you can't find the exit. Assume the market will reverse the minute you get in. If it's a long way to the door, you're in big trouble. 

7. Exhaustion gaps get filled. Breakaway and continuation gaps don't. The old traders' wisdom is a lie. Trade in the direction of gap support whenever you can. 

8. Trends test the point of last support/resistance. Enter here even if it hurts. 

9. Trade with the TICK not against it. Don't be a hero. Go with the money flow. 

10. If you have to look, it isn't there. Forget your college degree and trust your instincts. 

11. Sell the second high, buy the second low. After sharp pullbacks, the first test of any high or low always runs into resistance. Look for the break on the third or fourth try.

12. The trend is your friend in the last hour. As volume cranks up at 3:00pm don't expect anyone to change the channel. 

13. Avoid the open. They see YOU coming sucker 

14. 1-2-3-Drop-Up. Look for downtrends to reverse after a top, two lower highs and a double bottom. 

15. Bulls live above the 200 day, bears live below. Sellers eat up rallies below this key moving average line and buyers come to the rescue above it. 

16. Price has memory. What did price do the last time it hit a certain level? Chances are it will do it again. 

17. Big volume kills moves. Climax blow-offs take both buyers and sellers out of the market and lead to sideways action. 

18. Trends never turn on a dime. Reversals build slowly. The first sharp dip always finds buyers and the first sharp rise always finds sellers. 

19. Bottoms take longer to form than tops. Fear acts more quickly than greed and causes stocks to drop from their own weight. 

20. Beat the crowd in and out the door. You have to take their money before they take yours, period.

It’s All About Survival

It's all about survival. No platitudes here, speculating is very dangerous business. It is not about winning or losing, it is about surviving the lows and the highs. If you don't survive, you can't win. The first requirement of survival is that you must have a premise to speculate upon. Rumors, tips, full moons and feelings are not a premise. A premise suggests there is an underlying truth to what you are taking action upon. A short-term trader's premise may be different from a long-term player's but they both need to have proven logic and tools. Most investors and traders spend more time figuring out which laptop to buy than they do before plunking down tens of thousands of dollars on a snap decision, or one based upon totally fallacious reasoning. There is some rhyme and reason to how, why and when markets move - not enough - but it is there. The problem is that there are more techniques that don't work, than there are techniques that do. You should spend an immense and inordinate amount of time and effort learning these critical elements before entering the foray of financial frolics. So, you have money management under control, have a valid system, approach or premise to act upon - you still need control of yourself.

Ultimately this is an emotional game - always has been, always will be. Anytime money is involved - your money - blood boils, sweaty hands prevail, and mental processes are short circuited by illogical emotions. Just when most traders buy, they should have sold! Or, fear, a major emotion, scares them away from a great trade/investment. Or, their bet is way too big. The money management decision becomes an emotional one, not one of logic. Money management is the creation of wealth. Sure, you can make money as a trader or investor, have a good time, and get some great stories to tell. But, the extrapolation of profits will not come as much from your trading and investing skills as how you manage your money. What creates the gargantuan gain is not great trading ability nearly as much as the very aggressive form of money management. The approach is to buy more contracts when you have more equity in your account, cut back when you have less. That's what makes the cool million smackers - not some great trading skill. 

Greed prevails - proving you are more motivated by greed than fear and understanding the difference. The mere fact you are a speculator means you have less fear than a 'normal' person does. You are more motivated by making money. Other people are more motivated by not losing. Greed is the trader's Achilles' heel. Greed will keep hopes alive, encourage you to hold on to losing trades and nail down winners too soon. Hope is your worst enemy because it causes you to dream of great profits, to enter an unreal world. Trust me, the world of speculating is very real, people lose all they have, marriages are broken up, families tossed asunder by either enormous gains or losses. Good approach to this is to not take any of it very seriously; the winnings may be fleeting, always pursued by the taxman, lawyers and nefarious investment schemes. How you handle greed is different than someone else does, but you must get it in control or you will not survive.

Fear inhibits risk taking - just when you should take risk. Fear causes you to not do what you should do. You frighten yourself out of trades that are winners in deference to trades that lose or go nowhere. Succinctly stated, greed causes you to do what we should not do, fear causes us to not do what we should do. Fear, psychologists say, causes you to freeze up. Speculators act like a deer caught in the headlights of a car. They can see the car - a losing trade, coming at them - at 120 miles per hour - but they fail to take the action they should. Worse yet, they take a pass on the winning trades. But the reality is, more frightened you are of taking a trade the greater the probabilities are it will be a winning trade. Most investors scare themselves out of greatness.

Big money does not make big bets. You have probably read the stories of Jesse Livermore, John 'bet a millions' Gates, Niederhoffer, Frankie Joe and the like. They all ultimately made big bets and lost big time. Smart money never bets big. Why should it? You can win big on small bets, but eventually if you bet big you will lose - and you will lose big. It's like Russian Roulette. You may well spin the chamber holding the bullet many times and never lose. But spin it often enough and there can be only one result: death. If you make big bets you are destined to be a big loser. Plunging is a loser's game; it can only set you up for failure. There can be no survival without damage control.

God may delay but God does not deny. You never know when during a year you will make money. It may be on the first trade of the year, or the last. Victory is out there to be grasped, but you must be prepared to do battle for a long period of time. Additionally, the belief in a much higher power, God, is critical to success as a trader. It helps puts wins and losses into perspective, enables you to persevere through lots of pain and punishment when you know that ultimately all will be right or rewarded in some fashion. God and the markets is not a fashionable concept. Yet that connection is what keeps people going in times of strife, in fx holes and commodity pits.

You should believe the trade you are in right now will be a loser. This is the most powerful belief and asset as a trader. Most would be wannabes are certain they will make a killing on their next trade. These folks have been to some 'Pump 'em up, plastic coat their lives' motivational meeting where they were told to think positive thoughts. They took lessons in affirming their future would be great. They believe their next trade will be a winner. Who will have their stops in and take right action, you or the fellow pumped up on an irrational belief he's figured out the market? Who will plunge, the positive affirmer or you? If you have not figured that one out - I'll tell you; you will succeed simply because you are under no delusion that you will win. Accordingly, your action will be that of an impeccable warrior. You will protect yourself in all fashion, at all times - you will not become run away with hope and unreality.

Your fortune will come from your focus - focus on one market or one technique. A jack of all trades will never become a winning trader. Why? Because a trader must zero in on the markets, paying attention to the details of trading without allowing his emotions to intervene. A moment of distraction is costly in this business. Lack of attention may mean you don't take the trade you should, or neglect a trade that leads to great cost. Focus means not only focusing on the task at hand but also narrowing your scope of trading to either one or two markets or to the specific approach of a trading technique. Have you ever tried juggling? It's pretty hard to learn to keep three balls in the area at one time. Most people can learn to watch those 'details' after about 3 hours or practice. Add one more ball, one more detail to the mess, and few, very few, people can make it as a juggler. It's precisely that difficult to keep your eyes on just one more 'chunk' of data. Look at the great athletes - they focus on one sport. Artists work on one primary business, musicians don't sing country western and Opera and become stars. The better your focus, in whatever you do, the greater your success will become. When in doubt, or all else fails - go back to Rule One.

Trade The Price Action

If you want to do analytical work on the economy, go to school, get an economics degree and become an economist. At least that way you will get paid a decent salary to analyze all day and you will get paid either way, right or wrong. But if you want to trade, then trade. Trade the price action. Don't mix the fundamentals with trading. You are going to blow out if you trade like that. Could the housing market collapse? Of course it could. It could happen next year, it could happen 10 years from now. You need to get paid TODAY. That is what a trader does.

Undervalued Options

Options are empirically undervalued, especially the fat tails, which means the seller actually has a negative expectancy. Over a small series of data points, the expectancy is relatively flat. However, over a large series of data points, options become more and more undervalued. How is this possible? Because it's not possible to price a put on 9/11. It's not possible to price a put on Enron. It's not possible to price a put for the crash of 87. These puts are substantially undervalued. What this means is, if you sell enough puts over a long enough period of time, your expectancy will go from zero to more and more negative. There have been numerous amounts of academic papers written in the difficulties of pricing fat tail options. It's not that rare events happen more frequently then we think (they do) it's that rare events are seriously underpriced. Again, there are no "positive edge" options.

Knowledge Is Power

Here is one way to think about the markets. It's one big arbitrage trade. Not an arb in the sense of locking in a profit between a real and synthetic instrument, but rather an arb for yield. The market is trying to capture yield. Or put another way, the market is trying to capture relative yield. There is a constant relationship between interest bearing products with less risk, and non-interest bearing products (equities) with more risk. Traders are chasing alpha. They are chasing performance. And every market in the world from the dollar, to the yen, to the sp 500, to the 30 year bond produces some return relative to its own risk. Traders are looking for that optimal level where they get the most return for the least amount of risk. The top of the food chain is not the equity guys though; it's the fixed income guys. These guys are pretty smart, the Bill Gross's of the world, who control hundreds of billions of dollars by himself alone.

Do you realize how big the swap market is? We are talking greater than 124 trillion dollars worldwide. Do you guys realize how big that is? That's trillion! These guys are trading swaps and options on swaps in size that you cannot fathom. This is what is pushing the equity markets. People live in their own little world, perhaps trading ES futures and they are completely oblivious to the big picture. They live in their own little world of paranoia and fear. Every tick that goes against their short position, they have a conspiracy theory waiting in their back pocket. All they really need to do is actually accumulate some knowledge of how the market really works and everything will become a little bit clearer to them. Knowledge is power guys.

Risk Takers

In our society, and most others, those who take risks, add gamma to their earning potential. In other words, their income potential is squared over time and becomes exponential. Those who don't take risks, have a more linear income stream with a fairly flat slope. The truth of the matter is, while it often seems romantic to think of all us becoming rich and living the life of excess, most of us have no interest in taking the kinds of risks that provide that potential. The reason is it becomes somewhat of a binary bet, only without the binary outcome. To put it more succinctly, if we had the opportunity to place a bet by flipping a coin with heads being we become filthy rich and debt free or tails we go completely broke, lose every dollar to our name and incur a lifetime of debt and humiliation. And let's say the odds of getting heads is 1% and the odds of getting tails is 99%. What would you choose? Well, most normal, rational people would choose not to flip and play the game. We would continue to live out our meager existence to avoid the extreme negative outcome that is the result of taking large risks and losing.

Some people however say, I'm going to flip. Who are these people? They are famous actors, musicians, artists, CEO's, traders, gamblers, writers, etc. People who become fabulously wealthy when they make it (we only hear from the winners). The losers disappear or become cautionary tales. We warn our children about these people and tell them to become teachers, salesmen, join a union, anything boring and simple, just so they can avoid the possibility of failure of taking risks. The bottom line is, we would all love to be Brad Pitt, Tiger Woods, Michael Jordan, Donald Trump, Steve Cohen, Sam Zell, Tom Brokaw, Edward Murrow, etc. They are the winners. The risk takers. There were millions of people who tried to be them and lost. Let's take a look at one more example, traders. Is the income distribution fair in the trading world? Not even close. In fact, it makes the CEO to worker example pale in comparison. The best traders, the Steve Cohen's and the James Simmons make nearly 800 million a year. The worse traders make nothing, in fact, worse than nothing. The worst lose money, lose everything, and go into a lifetime of debt. How many traders really make it? Maybe 5% (10% tops). Definitely not fair and equitable. However, the profession is the epitome of risk taking. There is no way to even the distribution of returns to make it more fair. Doing so, would negatively impact the returns those at the top are getting for taking the risks that they do.

CEO's are usually not given their position at birth. Most of them start out at the bottom of company. Jack Welch started out in sales and engineering at GE and worked at the bottom for nearly 20 years before he actually made any kind of money. It was only after 40 years at GE do we see him as the wealthy and successful (ex-CEO) that he is today. He is one of the "winners". How many at GE tried to do that and failed? We will never know (survivorship bias). So you can't compare CEO's to common laborers because both parties are not taking the same risk. The common laborer gets a check every 2 weeks. He works 9 to 5. He has a job with minimal responsibility and virtually no risk. As long as he has a job, his dinner plate is full. The CEO does not enjoy the same safety. Every day he has to take risks, take chances. If he has one misstep and his stock drops, or he misses earnings one quarter, he could be removed. He could lose his job, resign in humiliation and perhaps not ever be wealthy again. Surely he will go out on his own, start his own company with whatever capital he managed to save over his life, only to get bitten by some random outcome that leads to failure and bankruptcy. Meanwhile the commoner is still making the widgets in the factory and putting food on his dinner plate. He is none the wiser.

Also, when comparing CEO salaries to that of their workers, it's not the actual salary of the CEO that is high, but rather the compensation. Most CEO's are given generous stock options and stock. If their company does well and the stock goes higher, they make billions (think MSFT). If it doesn’t, in many cases they worked for free (think of the dotcoms in 2000). The only way we can make an honest comparison to labor is if we took a wage earner from Radio Shack and compared them to a wage earner at Best Buy. Their mean income will be very similar (they are both not taking any risks). Now if the worker at best buy was making 300k compared to the worker at Radio Shack that is making 30k (both have the exact same job), then we would have a serious inequality present. However that is not the case. The reality is one person is trying to be the next Michael Jordan, the others is simply selling Air Jordan sneakers at the local shoe store. The income distribution cannot share the same slope. One has much more curvature in their income slope then the other. At the end of the day, you have to make a choice. Do you want to flip the lop-sided coin (1% heads, 99% tails). Or do you want to be entertained by those that do? Most of us would choose to live vicariously through the ones that do and complain about their success afterward.

Profit & Fun

It is no loss for you as either a person or trader if the depth of your fascination for and knowledge of various things puzzles the bored and directionless people, i.e., most people. If financial trading can prove both profitable and entertaining, fine, but if you must do without one, do without the latter. Too many traders and practically all gamblers have found the latter while doing without the former.

Leverage

The number one reason traders lose money is leverage. You know you hear all about leverage and how wonderful and great it is, but leverage only adds value to traders who are already consistently profitable and disciplined traders. The bottom line is, the FX market attracts the undercapitalized trader. You give leverage to a guy that can't trade and he has zero chance of making it. So really, it not only applies to FX traders but also to guys that trade Crude, Natural Gas and even GOOG. There is no way around this. Most traders don't have the emotional capacity to deal with the gearing involved in highly leveraged instruments. There is nothing inherent in the actual product itself. For example, you can trade the FXE, which is an ETF on the Euro against the dollar. It trades just like a stock. If most of the guys would trade that instead, they might actually make money, just not very much because it is highly de-leveraged. When one is learning how to trade, they should trade the least leveraged instrument they can find. The problem is FX attracts all the newbies either from late night infomercials or from the onslaught of new FX books hitting the bookstores. There is nothing intrinsically harder about FX to trade over say bonds or index futures. But with hyper leverage involved, 99% of the guys don't stand a chance. They will never admit, they will just slowly fade away with the money in their account.

It does not matter if you are trading direction, volatility, or a spread price, there is nothing easy about trading. Trading a spread is no easier then trading direction. In fact, it's harder. Usually when a spread goes against you, you have no reason why it's going against; you just know that it should trade within a certain band. You don't understand it except you believe it should. At least if you are long or short the stock at certain levels, you have an idea why you are wrong if you get stopped out. Also, when spreads go against you, they can explode against you. They can get very violent. In fact, the irony is they are actually much more volatile than the actual indices themselves. It's incredibly difficult because you are driving the car but you don't know what's underneath the hood and if the car breaks down, you don't know why. You are basically driving blind. It's not technical or fundamental. It's all stat correlation. Firms have 100 PHD's quants writing all sorts of very complex stat correlation models that they adjust every day. It's not as simple as saying, oh the spread is too narrow, I think I'll buy it. The hedge funds that trade this way spend millions on research and millions more on technology to create their stat correlation models. That's why it’s humorous when guys think, oh this looks easy. Just trade the spread, you don't care which way the market goes. Guys, it's not that easy. You better be very well versed in statistics and programming if you want to have a go at this. Because ma and pa kettle are not the ones taking the other side of these trades. It's the super traders that you are trading against.

Braggarts

The market has a way of exacting a toll on braggarts. Whenever you meet someone at a social function and he starts telling you about his winning trades, you know you are not talking to a professional trader. Professional traders, if they want to tell you about their trading at all, will more likely tell you about their losses (those are often better stories, anyway). Also, remember not to confuse brains with a bull market. That is, if you got lucky in a position because the market moved your way, don’t feel that you are of superior intellect; you might get stung the next time.

Pickpockets

In Great Britain of centuries past, pickpockets were routinely hanged at public executions. Meanwhile, pickpockets routinely operated in the crowds of spectators. Obviously, what was happening on that platform did not impress them much. They did not get the message or the lesson no matter how powerful the delivery. If you think of those "90 percent" futures and options loss statistics as financial public hangings, vast numbers of speculators are likewise unimpressed until they themselves go to the gallows.

Lone Hunter

The lone hunter is the man who bags the game. The big men are just as often wrong as the little fellow, but most of them are smart enough to change quickly when they find they are wrong and do not hold on and hope, as the public does.

Respect

Respect as trader? That you won't get until you finally figure out how to make money trading. So instead of showing off the intellect, why not figure out a way to harness that mental prowess by coming up with a plan that uses your full brainpower while blocking out your personality elements that are stopping you from being profitable? If what you're doing now isn't working, change it somehow so that your mental talents are applied, but your defects blocked. Then you'll get the monetary satisfaction that is worth a thousand times more than all the intellectual gratification in the world! You need to dumb yourself down just to be able to communicate with any of the normal non-genius people that surround you. Well, how about also trying to dumb yourself down when talking (trading) with the market? The market isn't as smart as you think, simply because 99.99% of the participants that make the prices move aren't as smart. So dumb it down a bit when thinking about price! The price movements of indices and other trading vehicles aren't as sophisticated. It's just people buying and selling stuff, and the prices changing due to varying supply and demand... that's all it is. It's not Einstein's Fifth Movement or any fancy intellectual thing like that; it's just a bunch of guys buying and selling stuff to each other!

Simplify your mission! All you need to do is figure out where the price of anything is most likely to be after any set amount of time you choose passes. That's it! Is the price of Stocks or Euros or Debt or Corn likely to be higher or lower than now in a month's time (or a week, or a day, etc.), and why should it move there? Will people want to pay more or less for SPX in two hours from now, and why? Data mining can tell you that, if you figure out what you're looking for. Mine more data, find repeating patterns, and only then will you be ready to program anything. Steaming forward on a hunch and your wild optimism alone isn't going to cut it. The market has no 'fair value'. Forget any notion of a 'fair value' that doesn't exist, dumb yourself down to the market's level, and figure out where future prices are most likely to be. That's all. Then you'll have what you're looking for.

Don’t give the market godlike quality in your search for the Holy Grail. Ironically the Holy Grail in literary terms being the cup Christ drank from at the Last Supper. What the market really is though is just people buying and selling stuff. That's all. And for all we know, the holy chalice may just be that, an ordinary cup. Your refusal to acknowledge this may well prove to be your doom. Because if the market is just ordinary people buying and selling stuff, then the further you go into this quant land, the further you remove yourself from these ordinary market participants. It's generally not wise for one to follow someone else's system unless they understand it forward and backwards. The reason for this is twofold. One, they will abandon it as soon as it falters. And two, they will never be able to trade with size and conviction with something they don't understand.

Successful Trader

Someone who sticks around for years is not necessarily successful. Someone who is trading part time is not necessarily successful. The truth of the matter is the success rates in this industry are pretty much the same across the board regardless of product traded or the firm where one is at. There are lots of traders who have been trading for more than 5 years who are not successful. Hell, there are guys that have been trading for 10 to 15 years who are not successful. You need to define what a successful trader is. The failure rate is about 80% to 90% across the board when accounting for survivorship bias in the data. But that number needs to be broken down more in terms of long term viability. Long term success is probably under 10% due to changing market conditions, volatility levels, liquidity, etc. The numbers have been pretty constant over the last 100 years. A successful trader is someone who earns all their income from trading and trades full time. No other jobs. And someone that can pay all their overhead and living expenses and still build equity in their account for 3 consecutive years. Trading can be broken down into 3 levels. The level 3 is what is defined as a successful trader.

Level 1: net negative trader

Level 2: scratch trader (someone who makes only enough money to cover commissions and maybe their expenses month to month.

Level 3: Someone who is both net profitable and earns enough money to not only cover all their expenses and monthly bills but also builds their account equity at the same time. 

Level 1 and 2 have a burn rate. They have a finite amount of time before they run out of money. Level 3 is a trader that has the ability to completely support himself and continue to build his account balance year after year.

Iron Condor

An iron condor is 4 options (two verticals). Every option in this spread is either priced above fair value, at fair value or below fair value. Over an infinite number of trades, the only way this strategy can produce a positive expectancy is for the trader to consistently sell each option above its fair value and to buy each option below its fair value. Anything else will produce a negative expectancy. There is no way around this. The argument is often given, Oh, I'll adjust it. But the adjustment is a whole other trade and that trade itself has to be executed at better than fair value prices or it too will have a negative expectancy. There is no mathematical way around this. Why it sells on the seminar circuit because it's easy to teach, it's great for lazy people who don't want to put any effort into trading and it's perfect for guys that are scared to take a directional view. The problem is it just doesn't work. 

Of course it works for awhile, until it doesn't. One can put on an iron condor in GOOG if they think the two component verticals are trading above fair value. Selling the verticals in this example should produce a positive expectancy if the trader is correct on their volatility assessment. But that is not how guys are taught to trade it. They routinely put it on an index usually every single month on the same day of the week even and then sit back and pray and hope the market doesn't go anywhere. Trading is 1000 times harder than that. Time does not matter (Comparing weekly iron condors to monthly). Negative edge is negative edge. You can't manipulate negative edge into positive edge through time or adjustments. You simply need to have a volatility edge to make the trade. Just slapping them on every week is not going to make you money and why should it? Markets don't just give money away because you have the ability to use a mouse.

Delta Neutral Hedging

If you are not a good directional trader, you have little to no chance making money trading options. The myth is that of the retail market neutral options trader. He doesn't exist. He may think he does, but he doesn't. There is a unique set of circumstances in options concerning "retail" traders that allows them to think they can make money trading volatility when in fact they are de-facto directional traders. True volatility trading dynamically hedges positions to have no delta exposure and isolates the volatility component. This is what market makers on the floor did for years. Lot of guys that trade iron condors think they are volatility traders or that they can have success slapping on a spread that will generate deltas (direction) and yet be impervious to the consequences of those deltas. Delta neutral trading though a retail broker will produce a horrific return on investment under retail margin. You are making pennies while tying up large amounts of capital. Also, delta hedging again comes down to trading direction well. If you sell stock on XYZ as its breaking out then you will bleed out all the gamma that is generating positive deltas so you will not have an opportunity to buy the stock back. Whether you buy or sell vol will be largely affected by the stock going higher or lower. It will be really hard to make money being long vol in a rising stocks and vice versa. And if the stock trends, you are done! So again, you need to be a competent directional trader. Not saying master stock trader, but competent. If this was such easy money, why are the 10,000 plus hedge funds out there spending a fortune on coding software and hiring 100 PhD's to come up with strategies.

Trading Cycle

The first step towards making a progress is admitting that there is something wrong in the way we invest/trade. Sometimes, its fun to know that we all start the same way
1 - Ah, the price is going up, let's watch the market - As a momentum trader, we love when stock starts moving up on great volumes.
2 - The trend is holding - I'll buy at the next consolidation - There is nothing wrong to buy a stock which consolidates after a strong move.
3 - Damn I missed the consolidation, but if I wait any longer, I won't profit from the trend, lets BUY - The problem starts here - when the feeling of left behind starts building up. It is at this point, we tend to make wrong choices. We should never buy a stock with a feeling of regret. Remember, the beauty of market is that "Opportunities are plenty" and its not a great idea to chase a single stock.
4 - Good thing I didn't wait - This is the time when bull market is confused with brains. Remember, it is the method/process that makes money and not the stock. Most of us do not have any trading strategy, and we are just responding to our emotions on daily basis. If stock is up, we feel great.
5 - I'll use this correction to increase my position - Was this a part of trading strategy?
6 - Brilliant! At this price, let's double it - This is what I call phase of denial. When stocks correct more than desired, its time to be cautious and not greedy.
7 - Ouch, as soon as it goes up, I'm selling out - Now, the trend has reversed. The pain starts building up.
8 - I don't believe, its down to this price. It has hit an absolute bottom - The pain is on rise, and one just consoles himself
9 - Ok, lets wait it to recover otherwise this has to be long term investment - This is the point when one just gives up. There is a recognition that this investment is a gone case, and lets forget about it.
10 - What regulators are doing? - This is the point where one is so frustrated that he looks for scapegoat. He considers everyone responsible for this mistake except himself.
11 - Enough, I am selling out - The pain becomes unbearable. Where do most investors sell? - They usually panic sell at the bottom.
12 - Good thing I sold everything - Consolation
13 - It's going to tank anyway - The market shows first real sign of recovery. There is no point watching a stock you have sold. It only adds to frustration.
14 - Told you so - The first recovery after a steep fall always gets sold into. But if market fails to decline below the low it made last time - its time to buy. But one tends to forget that. The pain just blurs the thinking process.
15 - You what - The strong recovery in the stock adds to the frustration.
16 - What the hell - The feeling that market is against me starts developing. Remember, market doesn't care who you are. But we make this a personal thing.
17 - More crazy stuff - who is buying this? - There is complete denial that stock is undergoing stock recovery.
18 - Time to give up
19 - Buy it again - Time to give up again
The problem happens because most of us don't have well defined trading strategy, and we keep on changing our stance while we are in trade. "A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them."

Trading Mistakes

It takes couple of years to understand what is required to become a good trader. Thanks to books, and personal experience. Those who do not learn from the past are condemned to repeat it"

Mistake 1 - I am a trader, so I should trade
This is one mistake I am most guilty of. The good news is that I am improving, but I am still not there where I should be. Let me share a story to explain my point - There was a fruit vendor who used to sell fruits from a small shop. He was happy selling 1 kg, 2 kg fruits to his customers. One day in the morning, a customer came to his shop, and said he wanted to buy all the fruits in his shop. The vendor refused. Customer was surprised and he asked the reason. Vendor replied - "if he sells all his fruits to him, then what will he do all day". This may sound funny, but that's exactly what we do when we take small profits and don't let our profits run. The reason we take small profits is so that we can trade again. I would have made fortune if I would have just followed this rule. We sometimes feel compelled to trade, and end up making losing trades. Winning is all about waiting for good trades to develop, and then riding those trades. As a trader, I am paid to wait for the best opportunities. Hence, I resolve to trade less - easier said than done.

Mistake 2 - Tendency to chase performance
As a trader, there is a tendency to chase the stock of the day. That's another big reason for my under performance. In order to succeed in trading - focus is very important. I have found that most of my winning trades have come in same set of stocks. The reasoning is simple - you can follow only few stocks well. I have also found that there are many stocks which are just not suitable for trading. They move one day, and then they become quiet, liquidity dries out. I call them sick stocks. We should never try to trade them. The best approach "Select few stocks that are expected to perform well and then follow them rigorously". Liquidity should be the number one criteria for selecting such stocks.

Mistake 3 - Trading on Opinion/news
I have completely stopped trading on news/opinion. So, I can say this is one mistake I have rectified completely. Lot of times, stocks behave in a weird fashion. Earlier, as a trader, I used to have a tendency to jump on to the stock on release of any good news expecting that stock will zoom - only to find to my disbelief that market thinks otherwise. I have lost some big time on sticking to my opinion this way. Lesson - Market reaction to news is what that matters, not your reaction to news. New based trades are best avoid.

Mistake 4 - Getting Influenced by so-called experts
Trading is a very lonely job; and its best done that way. Trading is management of emotions, and any activity that influences your emotions should be complete No No. Also remember, when your money is on line, its very easy to get influenced. One major influence comes from so-called experts on Television channels. This world is full of mediocre people; and I have seen lot of them giving advice on television channels. I am not painting everybody with the same brush. They may be successful, but lot of times, I have found them talking absolute non sense on TV. Sometimes, no lot of times, they can scare you out of good trades or compel you in bad trades. The exposure to news stations and chat rooms bring lot of subjectivity in the trading decisions. If you feel the need to get connected to TV for news, use the "mute feature" of your remote while trading. Chat rooms are also best avoid. Remember, in trading, opinions don't count, then why listen them. I only rely on what market tells me. Being a technical analyst, it means price on the screen.

Mistake 5 - Not Admitting losses early
One big bad trade can ruin all your good work in one shot. I have been guilty of this mistake lot of times, but I am satisfied on the progress I have made on this front. You must have all heard this famous rule - "Never Lose Money". Well, I cannot say this about trading. Losses in trading are reality, as they are the result of taking risks. If you are not making loss making trades, you are not trading or you are lying. The problem is not the loss making trades, but the magnitude of loss making trades. Stop Loss is more sacrosanct than target. Remember, you don't make money on winning trades. You make money by not losing it.

Summing Up: There is very thin line between gambling and trading. It all depend on us what we want to pursue, as the result depends on our pursuit. Trading is a business of probability and uncertainty - and hence discipline is the most important trait for success. Here, a small but highly probable profitable trade is more desirable than a big low probable profitable trade. So, here's my new trading resolution -
Trade Less (Be Patient)
Trade high probable profitable trade
Accept Losses early

Trading Capital

Trading is about the efficient use of capital. If it takes you 10,000 to make what someone else can make with 1k, one of you is doing something wrong. What is the difference between a hedge fund that earns 10% and 20%? One could argue that you could invest twice as much money in the 10% hedge fund and earn the same dollar return. True, but then why not invest that same amount of money in the 20% hedge fund? You can't simply discount capital usage as if it was a trivial variable. It is "THE" variable when it comes to trading. Risk can always be swapped around. Not to get rid of it, but rather to enhance the return on capital or lower the variance of your returns. That’s right; your risk based haircut can actually lower the volatility of your returns and achieves better performance. This is called a utility function or improving the utility of your capital.

Trading Losses = Tuition Fees

Even losing $100 a day over 6 months will cost you 12k. That is enough to blow out a 5k or 12k account. It's very easy to talk about what traders shouldn't do, the bottom line is, that's not reality. All new traders make the same mistakes, which is fine. It's just that 5k and 10k just isn't enough. It is also not true that guys that lose 300 to 500 a day are not cut out for this business. Some guys are down 50k to 100k before they get out. They turn out to be the best traders. The guys that are actually playing it safe never really make it. Sure they never go that deep in the hole but they don’t make anything either. Sooner or later you need to get aggressive and trade. Are there outlier guys out there on the far end of the bell curve that by chance made it through 6 months losing less then 5k who also became profitable traders and are very successful today? Sure, statistically speaking there must be. But it's disingenuous to use an outlier to make an argument. Nobody wants to lose 25k. Hell, nobody wants to lose 1k. But that is not how you look at it. You are not going to LOSE 25k. You are going to learn how to trade. I didn't go to college saying, wow, I'm going to lose 100k to get this degree. I PAID for that degree. With the idea that the degree would pay me dividends in the future. That is the same with trading. You are not going to LOSE 25k. You are going to LEARN how to trade. For some guys that education might only cost them 10k or 15k, for some guys it might cost 100k. Does the guy that went to Harvard and paid 100k for his education feel worse than the guy that paid 20k to go to Northern Illinois. Probably not. Different people need different things. 

Market Is Always Right

The value of any commodity is the price that one is willing to pay for it. A speculator must concern himself with making money out of the market and not with insisting that the tape must agree with him. Never argue with it or ask for reasons or explanations.

Experience

There isn't a way to mathematically explain what works and what doesn’t. If you could reduce it to a formula that if B is greater than A then C, we would all be billionaires. But the markets simply don't work that way. It comes from experience. You watch thousands of markets and you begin to see what a strong trend looks like. If there is a formula it's this. And this formula applies to trading, life, relationships, health, you name it.  Experience is the greatest edge. But to get experience, you need time. And to get time, you need discipline. Discipline affords you the time to gain the experience which will allow you to exploit the in-experience in everyone else. That is the only formula that seems to have any value. Everything else is academic.

Competition

Trading is all relative. You can continue to improve yourself and say you are getting closer and closer to where you want to be as a trader, but what about your competition. What are they doing? Are they getting better, faster, more capitalized? This falls back onto the basic tenets of Game Theory. Where we continue to make choices based on previous actions and our opponent’s previous actions but what is our opponent doing? The same thing! Hence the "prisoners dilemma". If you put 10 guys in a room with a million dollars to be had through trading and let them all trade till it's all in the hands of one guy. At some point, it does not matter how much self improvement you make. In fact, all traders could theoretically make improvements to themselves, but does this really matter. In the end, one guy ends up with all the money. As traders, we don't get paid for making self improvements. We get paid for transferring money from other traders to ourselves. So therefore in this equation, we cannot ignore what progress the other trader is making.

Can You Summon Your Talent At Will?

Trading is not about effortful study, or having mathematical abilities or even good hand eye coordination, but rather the number one deterrent for most people is they lack the emotional capacity to make decisions that have a monetary outcome. There have been countless academic studies particularly pertaining to gambling and simple investing. Most people, no matter how smart they are or how hard they work, simply are not cut out emotionally for this job. For example take Tiger Woods or former great Joe Montana. It's not just their ability or effort that made them good; it was how cool they were under pressure. How many guys could sink a put on the 18th hole with 5 million dollars riding on it? How many guys could hit a wide receiver in the end zone with an all out blitz in their face with 5 seconds on the clock and throwing the ball into double coverage? Well, none of us could. But Joe Montana did it, and he did it on a regular basis. Anyone can show you how to throw a tight spiral or how to hit an awesome cross court forehand in tennis. But under pressure, with the game or match on the line, at a professional level? Very few can.

Al Pacino had a great line in the movie "The Devil's Advocate". He was talking about pressure, how pressure changes everything. How anyone could be good at something, but how few people could really perform under pressure. His quote was "can you deliver on a deadline? Could you summon your talent at will?" That is what it boils down to. Can you perform under pressure? No amount of work will give you that. Very few people have that skill, very few. Hence the failure rate in trading. Emotional capacity is one's ability to handle pressure. One can always maximize the ability they have, but cannot increase that capability. One can put themselves under pressure a lot and get use to it and become more immune to it, but that is not the same as being able to excel under pressure. This is why there are very very few great sports stars yet there are millions of great athletes. Everyone can be trained, not everyone can excel.

Yes, Tiger was trained from a young age as was tennis great Andre Agassi who picked up a racquet at the age of 4. There is no doubt that most these professional athletes developed their "physical" skill at an early age as well as their hand eye co-ordination. Can we truly say this is what led to their greatness? You cannot attribute Tiger's greatness to playing at an early age. We are talking about real greatness here. There are many golfers on the PGA tour who have made it to the professional ranks. They hit the ball as well as Tiger, in fact some better. They put just as well; in fact, it's one of Tiger's weaker shots. They practice as much as Tiger. But you know what, when Tiger has to make a put, when he absolutely has to, the guy does, and that is called playing well under pressure. It's what separates all athletes.

Is Andy Roddick a great tennis player? You bet he is. Best serve in men's tennis by a mile. But what does it tell you when he played Rodger Federer at the final at the US open that not only did Federer outplay Andy, he out aced him 17-7. That's right, a guy that is not even known for having a decent serve, out aced the best server in men's tennis 2 to 1. Andy is a great athlete, but does not make the shots when it counts, he folds under pressure. You see very few people have that gift. Andy is out on the courts 10 hours a day. He is probably the hardest working guy on the men's tour. He picked up a racquet at age 5 as well. He is a great physical player. But when he plays Rodger Federer, he loses, and loses and loses. Andy has beaten Rodger once in 14 tries or so. The matches are usually pretty close. Rodger does not blow Andy off the court. He simply makes the shots he has to make under pressure, Andy does not. Same goes for Tiger. Most of the guys on the men's tour now lift weights and can drive a ball 320 yards. And most can put as well if not better then Tiger. Tiger just has this incredible ability to focus and concentrate, keep ice in his veins, and when he has to, "summon his talent at will".

Trading Is Not Gambling

1. Some traders consider trading as a sort of gambling. Without planning and calculations, they throw money at the market. They should distance themselves from gambling behavior. Why a scientific approach is applicable? Markets echo similar patterns over and over again. It allows identify reliable trends and select good trading vehicles.

2. Think in terms of probabilities and act upon them. There are no certainties in trading. You can keep yourself out of trouble by thinking in terms of probabilities. Get comfortable with approximate predictions and interpretations.

3. Hope, fear and greed are not strategies: they are emotions. Simple emotions are not an effective strategy. Positive emotions could cause us to fail to apply risk precautions. Negative emotion could cause us to hesitate. Trading is a psychological game. Most people think that they're playing against the market, but the market doesn't care. You're really playing against yourself.

4. Prices have memory. 

5. Bulls live above 200-day moving averages, bears live below and try to eat up all rally attempts.

6. Big volumes kill substantial price moves.

7. Reversals build slowly. The first sharp dip always finds buyers and the first sharp rise always finds sellers.

8. Bottoms take longer to shape than tops. Greed acts more quickly than fear and pushes stocks to drop from their own weight.

9. Losses are a simple cost of doing business. Don't try to justify a bad trade by convincing yourself that it will sooner or later turn into a good trade. Accept losses easily! Successful traders are able to ride through downturn periods. The confidence in their methods reassures them about their future success. The markets offer endless and plentiful possibilities. Missed opportunities exist only in your mind. Prices keep changing and generate other opportunities. The goal of trading is make a net profit after a sequence of trades. It is, therefore, necessary to accept some losses and to look forward without punishing oneself. 

10. Don't be a hero. Don't fight the trend. Follow the money flow.

11. Forget the news, remember the chart. The chart already knows the news is coming. 

12. Predetermine maximum losses in every potential trade. Do not risk more than 5% of your capital on any trade. Don't average your losses.

13. Do not buy a stock because it is low priced (or sell because the price is high). 

14. Buy on rumors; sell on news.

15. Trade active stocks, avoid thinly traded markets.

16. Prepare your action plan before the market hours and follow it. Do not formulate a new opinion during market hours.

17. Learn to monitor yourself and draw conclusions from your mistakes.

18. Take a part of the profit to reward yourself.

Normal Distribution Curve

Only 10% of all new traders ever make into their 2nd year as net profitable traders. These numbers do not change. The normal distribution curve over a large sample pool of traders has not deviated in 100 years and it will not deviate over the next 100 years. Anyone implying differently is trying to sell something. It does not matter what product or what strategy they trade. They could be trading Crude, stock pairs, or stat arbs, it does not matter. The normal distribution curve is the same.

Real Estate

Real estate is like investing in an index like the SP 500. There is no trading involved. You simply hold on to it for 30 years. You can't get stopped out. But when you factor in inflation, real estate prices have been steadily declining as a whole since the 1950's. When you factor in interest cost, property taxes, insurance, co-op fees when applicable and home repairs, you are locking in losses on your investment. The only possibility of high appreciation gains are in a bubble market. Without these bubbles, not only would real estate be a poor investment, it would be a catastrophic one. It takes these massive bubbles just to get the long term mean return equal to the rate of inflation before you factor in all the costs associated with owning a home. The only reason investment property is lucrative is because of the hyper leverage it affords the owner. Without the leverage, there is no money to be made there. Without the leverage you will not have any bubbles. And without the bubbles, you have no zero chance of outperforming inflation over the long run. Over the last 2000 years, the only variable that has moved land and real estate prices higher is real inflation. All real estate is one giant derivative with the underlying product being inflation. In order to value a derivative you must be able to break down its pricing components. When there is a rich volatility premium in real estate and if you get long, you run the risk of having the juice sucked out even if the underlying component stays unchanged. It's analogous to a stock whose option premiums rise dramatically going into an earnings announcement only to have those premiums crushed after the report.

Real Cash

One of the things you learn in this business after you have been in it awhile is it takes money to make money. Not leverage, MONEY! There is a difference. You need to be able to withstand the draw downs. Leverage does not allow you to do that. At some point you need to have real cash behind you. That is why guys start hedge funds. You want to be able to make real money with as little leverage as possible, not as much. Think about it, would you rather take home 50 million a year making 10% to 12% a year or take home 500k to a million but having to earn 300% returns to do that and exposing yourself to a catastrophic risk every day to do it.

Knowledge

You think it takes knowledge to make money. If that were the case, that "knowledge" could be packaged and sold to millions. What is required is an edge, knowledge is worthless. People are all so enamored by these buzz words "knowledge" and "effort" and "if you work hard". Those are bullet points.  But there is a very sad reality to this business. Trading is a business where the guy that can kick your ass and take your girlfriend and your wallet, will. And in the trading world, those guys have capital, technology, an edge, and they are taught to trade by some of the sharpest guys in the world. No boot camp, 3 day seminar, TA book, web site, or late night TV infomercial is going to give you what it takes to keep your money from the trader who is going to take it from you. There are ways to meet these traders and possibly learn from them but the odds of you trading next to them are less then it use to be. It was a lot easier when guys could clerk for a super star trader on the floor. And it was a lot easier when you could work at a huge prop firm that had 800 to 1000 traders under one room. Unfortunately, those days are gone.

First of all, knowledge is far too ambiguous a word to have any relevance. True, when one blows up, they do gain knowledge and wisdom. But this does not mean it will lead to profitability. 90% to 95% of all traders fail and they all gained this so called knowledge or wisdom by paying their tuition or blowing up. So this cannot be argued with a straight face that knowledge leads to profitability. When people talk about paying your tuition in terms of losses, this can only be said in hindsight after a trader has had such losses and has become profitable. You cannot prove with empirical data that teaching anyone this stuff has any correlation to profitability. It's analogous to saying that If Tiger Woods showed you his swing you could become a PGA golfer. Or If Michael Jordan showed you his jumpshot you too could play in the NBA. Or if you spent time with Robert Deniro and learned his acting techniques you could become a great actor. All of this is simply not true. Nobody really knows what makes Deniro, Deniro. Or Tiger Woods, Tiger Woods. Or Steve Cohen, Steve Cohen for that matter. Some guys just have the mental discipline and the emotional acumen to be able to do this, most people don't. 

Selling Naked Options

Do you have health insurance? Car insurance? Any form of insurance? Well, if you do, you would know that insurance rates have gone ballistic the last few years. For all practical purposes, you are probably grossly over paying on all your insurance. In other words, you are a long premium holder getting a bad deal. Or so it would seem. The insurance companies, the premium sellers, are raking it in selling you this premium, or so it would seem. What you don't see are the substantial increase in medical claims the last couple of years, or the large outlier events if you will. They are there. Most people don't see them because we are not looking for them. Everyday there are catastrophic moves in stocks, just about every day. Moves large enough, that if you sold enough size in naked straddles, you would be out of business. But chances are, if CNBC doesn't mention it, or if you don't have money on it, it will pass you by. In your mind, it doesn't exist. The proverbial if a tree falls in the forest and nobody hears it, did it really fall? If you sell enough of these, you will hit a pothole, a big pothole. The profits you earn on these will be tiny, but they will occur often. The losses will be catastrophic. Look at how many insurance companies go out of business every year, especially during hurricane season. This is despite the fact they are charging their customers with serious over charges. The bottom line is, you can't sell enough premiums at high enough prices to cover the debacles. All large unexpected price moves are seriously underpriced. Sometimes to the magnitude of 50 to 100 times. The irony is, by spreading out and doing a lot of these, you are actually increasing the probability of blowing out.

Think about it like this. Say you were going to have unprotected sex with another woman (assuming you are a male). Let's say there are 10k women to choose from in a certain subset. Let's say 100 of them have AIDS. Your best bet is to pick the hottest chic and have a go at it. Assuming there are no other men entered into the equation where we then enter a game theory situation where the most men will choose the hottest women. If it's only you and you know 100 of these women have AIDS, you certainly do not want to sleep with all of them! In fact, the greedier you get by sleeping with more and more women, the higher the probability you have of contracting AIDS. Your optimal situation would be to select one. Every additional one you select is not spreading your risk around, but increasing it. So no matter what you do, as long as you sell naked options, you are exposing yourself to catastrophe. It does not matter the duration in which you hold the short option. And it does not matter if you do 1,000 of them, sooner or later, the hurricane will come. There are a million ways to make money trading that do not carry the disaster tag with it. It's the same reason young people opt to go to medical school or law school instead of becoming a drug dealer even though it pays the same and in some cases more. No one wants the extra risk if they can avoid it.

Good Luck v/s Bad Luck

Sometimes people become fanatical about their ideas. Whether it is over politics, religion, or even trading. We latch on to something and then refuse to ever look at the other side of the coin because we want to believe it so bad. Let's try this for a minute. Let's remove the whole idea of the Greeks. Let's simply look at options as a bet on fair value. Let’s say you are going to play a game with one six sided die. You roll the die, whatever number comes up, you get that much money. So if you roll a 3, you get $3. If you roll a 6, you get $6. You are going to play the game over and over again. There are two players in this game. The roller and the house. The house is selling the bet, or selling premium if you will. The roller is buying the juice. The question is, as the roller, how much would you pay for the right to roll the die. Then, when you are the banker, how much would you sell the bet for? For most of you can figure out this is a very simple probability game that you probably played in your stats class in college. The fair value of the bet is 3.5. You get this number by summing the outcomes and dividing by the total. (6+5+4+3+2+1)/6=3.5. That means the fair value of this bet over a long series of throws is 3.5. So if you are the roller, you want to pay less than 3.5 for the bet, say 3.4. If you are the banker, you would want to sell this bet for more then 3.5, say 3.6. What you just did is you made a market. You are 3.40 bid at 3.60 offer. This in a nutshell is what options are all about. It does not matter if you are the roller or the banker. The person buying the premium or selling it. If you buy the option below fair value, you will make money. If you sell it for more than fair value, you will make money.

Market makers have been doing this since 1973 and nothing has changed since then except the technology. If you can grasp this very simple concept, trading options will become much simpler for you. But over the long run, the buyer of premium will generally outperform the premium seller for one reason and one reason only. Not because he/she is a better trader. But because of something called luck. That's right, luck. Luck, is very much like volatility in that it doesn't have a positive or negative bias. It simply is what it is. You will have both good and bad luck in your life. The difference here is that when you have good luck as the long premium trader, you might retire off of it. Bad luck to the option seller will bankrupt him/her. Good luck will do nothing for the option seller as there is very little upside in what they are doing. There is a famous quote from the movie "Rounders": "Amarillo Slim, the greatest proposition gambler of all time, held to his father's maxim: You can shear a sheep many times, but skin him only once.” Well, that is what an option seller is trying to do. Their only hope is that they can sheer a sheep 1000 times before they get burned. The inverse is then true for the option buyer; bad luck is really not going to hurt him/her. The net credit is meaningless as is the net debit. Just remember the dice game. Fair value, makes no difference if you are the banker or the roller. Everything else is just conversation.