Rules Are Meant To Be Broken

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

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

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

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

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

Rule3: Wall Street bankers know what they are doing.

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

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

Reality: Five words: Alan Greenspan and Ben Bernanke.

Rule5: International equities give you a lot of diversification.

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

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

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

Rule7: Financial markets are rational.

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

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

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

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

Reality: See above.

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

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

Implied And Statistical Volatility

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

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

Pattern Recognition And Tape Reading Skills

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

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

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

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

Wrangle

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

Reminiscences Of A Stock Operator

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

Double And Triple Prints

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

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

Haircut

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

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

Trend Is The King

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

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

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

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

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

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

You Get What You Pay For

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

Casinos And Options

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

Volatility

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

Put Call Parity

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

Investment Tips

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

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

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

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

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

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

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

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

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

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

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

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

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

Stops In Options

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

Hard Deltas v/s Soft Deltas

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

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

Wings

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

Too Wealthy Or Too Crazy

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

Speculative Trading Procedures

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

 

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

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

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

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

Progressive Betting

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

Keno And Iron Condors

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

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

Euphoria And Pessimism

1. Markets tend to return to the mean over time. When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.

2. Excesses in one direction will lead to an excess in the opposite direction. Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.

3. There are no new eras – excesses are never permanent. Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it – human nature – is never different.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction eventually.

5. The public buys the most at the top and the least at the bottom. That’s why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing. 

6. Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold. Gains make us exuberant; they enhance well-being and promote optimism. Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. This is why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop. Watch for when momentum channels into a small number of stocks.

8. Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree – something else is going to happen. “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?” Going against the herd can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest.

10. Bull markets are more fun than bear markets. Especially if you are long only or mandated to be fully invested.

Ratio Vertical Spreads

Ratio vertical spreads (Buy less Sell more) are the most infamous of all spreads because they are strategies that often ruin traders. Trading them is like playing hot potato with a time bomb. The object is to not be holding it when it explodes. Huge wealth has been created with these plays over the years, sometimes only to be donated back to the market all in one day, with bankruptcy proceedings to recoup any amount that exceeds the trader’s capital, his or her family’s capital, the investors’ capital, and the trader’s houses, computers, cars, yachts, airplanes, motorcycle, and children. Most traders like to trade them for a credit, so that if both options go worthless they can keep the credit. That modus operandi is penny-wise and pound-foolish.

There Is No Such Thing As A Hot Tip

1. An attempt at making a quick buck often leads to losing much of that buck. The people who suffer the worst losses are those who overreach. If the investment sounds too good to be true, it is. The best hot tip I’ve found is “there is no such thing as a hot tip.” 

2. Don’t let a small loss become large. Don’t keep losing money just to “prove you are right.” Never throw good money after bad (don’t buy more of a loser). When all you’re left with is hope, get out.

3. Cut your losers short; let your winners ride. Avoid limited-upside, unlimited-downside investments. Don’t fall in love with your investment; it won’t fall in love with you. 

4. A rising tide raises all ships, and vice versa. So assess the tide, not the ships. Fighting the prevailing “trend” is generally a recipe for disaster. Stocks will fall more than you think and rise higher than you can imagine. In the short run, values don’t matter. 

5. When a stock hits a new high, it’s not time to sell something that is going right. When a stock hits a new low, it’s not time to buy something that is going wrong. 

6. Buy and hold doesn’t ALWAYS work. If stocks don’t seem cheap, stand aside. 

7. Bear markets begin in good times. Bull markets begin in bad times.

8. If you don’t understand the investment, don’t buy it. Don’t be wooed. Either make an effort to understand it or say “no thanks.” You can’t know everything, so don’t stray far from what you know. 

9. Buy value, and sell hysteria. Paying less than the underlying asset’s value is a proven successful investing strategy. Buying overvalued stocks has proven to underperform the market. Neglected sectors often offer good values. The “popular” sectors are often overvalued. 

10. Investing in what’s popular never ends up making you any money. Avoid popular stocks, fad industries and new ventures. Buy an investment when it has few friends. 

11. When it’s time to act, don’t hesitate. Once you’re in, be patient and don’t be rattled by fluctuations. Stick with your plan… but when you make a mistake, don’t hesitate. Learn more from your bad moves than your good ones. 

12. Expert investors care about risk; novice investors shop for returns. If you focus on the risks, the returns will eventually come for you. If you focus on the returns, the risks will eventually come for you.

Trend Is Your Friend

The rule of the trend says that trend persists much longer than one can imagine and if you are on side of the trend - you will be right - 7/10. That’s the job of the trader. The trend of the market is down and that’s what counts. And when the trend of the market is down, do not waste time on predicting bottom because that will only stress your mind. There is no technical indicator that can predict the bottom. No one knows where all this will stop - here, 100 points down, 500 points down. You will know when the trend changes…How…your short trades will stop working. Concentrate on big picture and not on small individual data points or what some one is saying. All that matters is the trend. Never take your eye from what market has been doing recently.

Don’t Make Bets With No Upsides

At the end of the day, options can be as simple or complicated as you want to make them. But every complex spread is comprised of little single options and those little single options are all probability bets. You can combine them many different ways but they are still a total of all the other probability bets you are making. Over time, what determines your success in trading "volatility" is probability and having an edge. Legging out early on a trade is the same as opening a new a trade. Obviously buying back .05 or .10 options always makes sense, but if you are doing spreads for .30 to .50 credits then those nickel and dimes represent substantial costs to the position. Too many times option traders think they can overcome negative edge through adjusting a position a thousand times or they can simply "manage" the risk well. At the end of the day you are simply just making even more trades with negative edge. Over a long enough time horizon and enough trades, the negative edge will become realized through the erosion of your account. Many guys are afraid to trade the underlying and they often end up in the options arena because they are told or they believe that they can be successful without trading direction. Simply not possible. Either you are trading the direction of the underlying or the direction of volatility. Either way, you have to make a bet.

The best solution for a guy that tells he has no feel for direction is to take a very small position. Once you have money on the line, you get a feel for the market really fast. You can replicate the long term returns of an iron condor through the underlying by simply trading a mean reversion strategy with small size. Think about the p&l distribution of both and you will see they mimic each other with about 95% correlation. You trade very very small and you simply add shares on the way down and sell them on the way up. Now this might sound like gamma scalping except you are accumulating deltas as the market goes against you just as in an iron condor. In the end if your volatility assertions are correct, you should make money on both. All you have to do is replicate the deltas of the iron condor. Execution costs are not that great as you will not really be making that many trades and your p&l will be greater most of the time. You might even get lucky and catch a flyer. If you really want to trade volatility, you should be trading 6 to 9 months out. Even selling naked ATM straddles produces very little delta risk as there is no gamma out there with much greater reward. Much easier to remove the delta risk and trade pure volatility. Selling 5 delta spreads is not really trading volatility regardless, you are simply selling the tails that smart money is usually buying. Tails really don't have any useful greeks associated with them, they lie dormant until awakened. And when they awake, it's usually to remove equity from your account, lots of it.

At the end of the day, options are incredibly useful at manipulating your payoff structure. But there has to "be" a payoff. Earning small credits is not a payoff unless you are able to do that thousands of times a day via market making. The idea is to "manipulate" your payoff structure to actually "increase it" not decrease it. It's analogous to a futures trader who trades direction and moves his stop to break even once he is 10 ticks in the money and adds another contract. As the underlying moves higher he is able to geometrically expand his upside while keeping his risk fixed. There is a quote from the book "Ugly Americans". There is a section in there on the eight rules of Carney. Here is number 4: You walk into a room with a grenade, and your best-case scenario is walking back out still holding that grenade. Your worst-case scenario is that the grenade explodes, blowing you into little bloody pieces. The moral of the story: don’t make bets with no upside. Options in general are severely under priced. All of them! But there is more to this statement. Over short periods of time and data sets, option values will appear to be over priced. It's a function of the small data set. This is because of the fat tails. Over long periods of time, option prices resemble nothing even close to being fair. The reason for this is simple. The rare and isolated events that blow options up 100 to 1000 fold simply cannot be factored into the pricing equation. Otherwise there would be no buyers and no liquidity in the market.

The concept of fair value is similar to the concept of God. You are not going to know what it is until it's too late. But all options have realized volatility at the end of any period of time and that we know after that period concludes. Therefore we can look back and see if the implied volatility at that time matched what the actual volatility was. Again, you will find under most circumstances that the realized volatility matches the implied volatility pretty closely. Except on those rare occurrences where it's actually under priced by magnitude of orders. The error is always to the upside, not the downside. In other words, sure in some circumstances the implied volatility was 34 when it should have been 32. But on the upside you see examples where the implied volatility was 25 and it should have been 200. As you can see, if one is going to error, they are better off assuming volatility is priced too low rather than too high because the payoff for volatility being a little too high is minuscule vs volatility being too low.

Contrarian Investment Rules

1. Do not use market-timing or technical analysis. These techniques can only cost you money.

2. Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in­-depth profits. Having too much information and thinking that one has mastered the details causes the investor to become overconfident. 

3. Do not make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

4. Trade carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

5. There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble. Analysts cannot predict the future any better than you and me. 

6. Analysts’ forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimate.

7. Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

8. It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past accurately to estimate the future. The past gives some frame of reference but cannot be exact.

9. Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

10. Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

11. Positive and negative surprises affect “best” and “worst” stocks in a diametrically opposite manner. Interesting point is saying that beaten down stocks don’t go down as much because nobody expects much, but if it does better, everyone is surprised and up it goes. Vice versa for darlings. 

12. (A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites. (B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites. (C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks. (D) The effect of an earnings surprise continues for an extended period of time.

13. Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

14. Buy solid companies currently cut of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

15. Don’t speculate on highly priced concept stocks to make above-average returns. The blue chip stocks that people traditionally choose are equally valuable for the more aggressive businessman or woman.

16. Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.

17. Buy only contrarian stocks because of their superior performance characteristics.

18. Invest equally in 20 to 30 stocks, diversified among 15 or more industries (if your assets are of sufficient size).

19. Buy medium-or large-sized stocks listed on the New York Stock Exchange, or only larger companies on Nasdaq or the American Stock Exchange.

20. Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

21. Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

22. Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.

23. Don’t be influenced by the short-term (3 or five year) record of a money manager, broker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

24. Don’t rely solely on the “case rate.” Take into account the “base rate“– the prior probabilities of profit or loss.

25. Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

26. Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out. 

27. The push toward an average rate of return is a fundamental principle of competitive markets.

28. It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

29. Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell. 

30. In a crisis, carefully analyze the reasons put forward to support lower. Stock prices more often than not they will disintegrate under scrutiny

31. (A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker. (B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

32. Volatility is not risk. Avoid investment advice based on volatility.

33. Small-cap investing. Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm).

34. Small-cap investing. Buy companies with increasing and well-protected dividends that also provide an above-market yield.

35. Small-cap investing. Pick companies with above-average earnings growth rates.

36. Small-cap investing. Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one. 40-60 small caps in a portfolio?

37. Small-cap investing. Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

38. Small-company trading (e.g., Nasdaq). Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.

39. When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be. Many brokers usually charge more for sub $1 stocks. Commissions get out of control. 

40. Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

41. A given in markets is that perceptions change rapidly.

Develop Your Own Trading System

Computers are among the most common pieces of equipment that traders use. Unfortunately, the vast majority of traders are engaging their computer to enter into trades, without engaging their mind to think! There is a huge difference between buying a computer trading system and sitting down to do the research to develop your own computer-based trading system. Any computer-based trading system that you buy might be profitable (in sales or trading) to its author; however, to a trader that is not intimately familiar with the research behind it, and why the rules exist, the program is basically worthless. The vast majority of successful traders developed a methodology by building their own trading system from the ground up. As they devise their trading strategy, they very well could have used indicators, beliefs, and subsystem rules by purchasing them, studying them, or learning them from a more experienced trader. The distinction is that until the techniques have been verified, studied, and invariably modified, the trader will not use them. Only after constant experimentation with the new idea, and after verifying and internalizing, and then deciding that the idea is valid and valuable, does the trader add the new concept to his or her methodology.

Unfortunately, designing a computer trading system that accurately reflects your trading methodology demands a lot of time. It is not something that you can put together over a weekend. However, the huge advantage is that when you are done, you have accomplished something that 98 percent of all traders never do. Consequently you will see your trades produce consistent results. Once you are producing consistent results, either profitable or not, you can begin working on your ability to perceive the market better. As your perception increases, your ability to produce consistent profits will increase. It should be stressed that in order to have the internal beliefs required to do the research necessary to develop your methodology, you must make a decision to become responsible for all your beliefs. At some point all traders must confront how they will use the power of the computer to optimize their trading methodology. Optimization is achieved when you have written a mathematical formula or theory that describes the market action (in part or wholly) through variables. By programming the computer to literally perform all the mathematical permutations possible on the variables, and then correlating these permutations to the profitability, you can determine the variables that created the most profit. In other words, by determining the best combination of variables to maximize profitability, you can create a highly profitable methodology. The only problem is that it is good only for historical data; it is absolutely worthless in real time.

Say we have a simple moving-average crossover trading system. Our rules are very simple. First, if the short-period moving average goes above the longer-term moving average, go long. Second, if the shorter moving average goes under the longer moving average, go short. Consequently we are always long or short. By writing (or buying) a program, we can specify that we want to vary the shorter moving average from a period of 2 to 20, and the longer period from 21 to 60. Then by allowing the computer to test all the permutations that could occur by varying the periods of the shorter and the longer moving average, and by keeping track of the profitability, we can determine the most profitable short-term and long-term moving average. For example, the computer might indicate that a shorter moving average of 15 days and a longer-term moving average of 57 days generates the best profit. Typically the second most profitable combination of variables will generate less than half as much profits as the most profitable combination! At this point most beginning traders are very excited, convinced that they have just found the Holy Grail! There is a huge problem here. These traders have just wasted some very valuable time programming, because all they have accomplished is to curve-fit their variables to historical data. While it appears to be an outstanding combination of variables, it is an outstanding combination because it is only looking at the specific data used to perform the permutations. In other words, if they modified the data by changing either the dates used or the contracts, and re-performed the computer optimization study, they would come up with different short-term and long-term moving average values.

All traders use optimization studies to one degree or another. It is important to realize that by varying the length of the data used and by using different contracts, the value of your variables will vary. If you do in fact optimize your indicators and trading system, your goal is to find a group of variables that perform equally well on different contracts and different time periods. When you start analyzing the profitability of the various variables, you should automatically discard the variables that generated profits far in excess of any other profitable variables. Why? Suppose that a certain set of variables generated profits of $2000 and the second most profitable set of variables generated profits of $1000, and the third most profitable set of variables generated profits of $950. Then it would be safe to say that the variables that generated the profits of $2000 are so optimized that they are worthless. Your goal whenever you are doing optimization studies is to come up with a set of variables that perform equally well on different commodities, using a wide variety of different data lengths and, perhaps most important, using commodities that are clearly in bull and bear markets. Lately there have been some very good computer-based systems that have generated profits. Typically, however, the system is geared only toward a bull market. When the market goes sideways or actually drops, the system loses a lot of money. It is important as you devise your system to look at the widest possible variety of markets, trends, and time frames. When you are developing your methodology, keep in mind that you will be trading in markets dominated by bulls, markets dominated by bears, and markets where everyone is snoozing. You want your trading methodology to reflect this fact. An outstanding methodology will be profitable in all markets, in all time frames, and across all trends.

How To Build A Position?

One thing you need to understand about options is that most professional options traders don't just put on a position. They build them. They spend weeks building their positions. They look at each of their positions as a whole position, not the individual trades that compose that position. Each trade on its own has negative expectancy, but as a combined position, it can be morphed into a positive expectancy trade. At the end of the month you should care about your position as a whole and your p&l. Let's look at an example of a trader. He is selling the ATM combo on a stock and looking to offset with the purchase of the wings 7 to 10 days down the road. His goal is to try to capture as close to a full 5 pt credit as possible. So let's say he sells the Sep ATM combo in XYZ for 3.70. Now the 42.5/47.5 wings are trading around 1.95. He is going to wait on the purchase of the wings to try to get them cheaper. Maybe he thinks volty will continue to drop and perhaps 10 days from now he can purchase the wing combo for 1.20. He now has a net credit of 2.50 in the trade. What is his risk? He has none! His risk is the difference between the 2 strikes minus the credit. So 2.50 minus 2.50 is 0! He now has a risk free trade. And his expectancy is certainly positive. If he ran a simulation on his trade going forward from that date to exp 1000 times and summed the results and divided by the number of trial runs, he would get a positive expected return. This trade certainly has a positive expectancy.

Now you might be saying that he took risk when he sold the first ATM combo. Of course he did. All option traders take risk when they are building the positions. There is no way around that. The idea is to be able to offset as much of that risk over the course of that trade as possible and create a positive expectancy trade. Neither the sale of the ATM combo nor the purchase of the wings carried a positive expectancy on their own. But combined, in this example, they turned into a risk free trade with the upside of 2 1/2 pts! Not a bad trade. All successful option traders try to build their positions towards a positive expectancy. This is why in order to be successful; you need to be a good trader. You can't just slap on a fly or a condor and sit back and watch. At some point, a trader has to trade. There is no escaping this. But the beauty of options is you can create all sorts of combinations and permutations that offset risk with each additional trade and increase your upside! That is why we trade options. Not to blindly sell juice and count our theta! It just doesn't work that way.

Every trade begins with a negative expectancy. Nothing you can do about this. However, many traders make most of their money on adjustments. In other words, when you put on trades, they are just a shell. You don't expect anything out of this shell. But somewhere down the road, you expect to have opportunities to morph this trade into something with positive expectancy. Options traders do not make binary bets. The nature of their speculation is neither so apparent nor as black and white as outright directional traders. They put their pieces on the table and play a game. They arrange their pieces in such a way so that they can make favorable moves down the road. Then they are patient and wait. By adding to your initial position 'after' the favorable move you don't change the expectancy of the trade. The expectancy 'after' the favorable move is already positive. What you change is your payoff distribution. You are making the small payoff more certain by sacrificing some of the upside potential.

Trend Following

In trend following, the trader attempts to capitalize on large price movements over the course of several months. Trend followers enter trades when markets are at historical highs or lows and exit when a market reverses and sustains that movement for a few weeks. Traders spend a lot of time developing methods to determine exactly when a trend has begun and when it has ended; however, all the approaches that are effective have very similar performance characteristics. Trend following generates excellent returns and has done so consistently for as long as anyone has traded futures contracts, but it is not an easy strategy for most people to follow for several reasons. First, large trends occur fairly infrequently; this means that trend following strategies generally have a much higher percentage of losing trades than winning trades. It may be typical for a trend following system to have 65 or 70 percent losing trades. Second, in addition to losing money when there are no trends, trend-following systems lose when trends reverse. A common expression that the trend followers use is “The trend is your friend until the end when it bends.” The bends at the end can be brutal both on your account and on your psyche.

Traders refer to these losing periods as draw downs. Draw downs usually begin after a trendy period ends, but they can continue for months when markets are choppy, and the trend-following strategies continue to generate losing trades. Draw downs generally are measured in terms of both their length (in days or months) and their extent (usually in percentage terms). As a general rule, one can expect draw downs for trend-following systems to approach the level of the returns. Thus, if a trend following system is expected to generate a 30 percent annual return, you can expect a losing period in which the account may drop 30 percent from its highs. Third, trend following requires a relatively large amount of money to trade using reasonable risk limits because of the large distance between the entry price and the stop loss price at which one would exit if the trade did not work out. Trading with a trend-following strategy with too little money greatly increases the odds of going bust.

9 Trading Mistakes

Mistake 1: Fishing for Bottoms: Bottom fishing — trying to catch a stock as it bottoms out — is a great way to get soaked and lose a bucketful of money. In a bear market, stocks get much cheaper than most of us ever expect or want. They won't stop falling until they've run out of gas.

Mistake 2: Timing the Top: Tops and bottoms share something in common. They rarely arrive when they're supposed to. When traders and investors are exuberant, they keep buying even after doing so no longer makes fundamental sense. That's why shorting a stock that's trending higher makes no sense, even if its price is far beyond reasonable.

Mistake 3: Trading Against the Dominant Trend: Trading against the dominant trend in the market leads to costly mistakes. Unfortunately, misidentifying the trend by focusing on the chart in front of you and forgetting to look at the next higher level chart is an easy thing to do.

Mistake 4: Taking Trading Personally: A losing trade is bad for your trading account, but you can't let it get to you. Sure, it makes you feel bad, but a losing trade doesn't impugn your honor or disparage your heritage. A bad trade may reduce your net worth, but it shouldn't damage your self-esteem.

Mistake 5: Falling In Love: When you fall in love with your stock, you risk large losses. It's easy to fall in love. After doing hours of research and analysis, you want to be right. You want your trades and your trading plans to generate profits, but hoping doesn't make it so. Be smart. Don't fall in love. Dow Jones doesn't have feelings and your stock won't love you back.

Mistake 6: Chasing Runaway Trend: If you miss the breakout entry point for a stock that you want, waiting is better than entering a position as a trend accelerates. Often, stocks will pull back and test the breakout point. Wait for that point, or wait for the stock to take a short breather after its first leg up. If you're still interested, that's a better entry point than chasing a stock as it accelerates into the trend. Like a fine wine, you sometimes need to let a stock breathe.

Mistake 7: Fishing for Bottoms: Averaging down is a below-average idea. You sometimes hear advisors suggesting it as a way of reducing your cost basis, but it's really merely a technique to throw good money after bad. The logic of averaging down is completely contrary to the logic of trading. Traders sell losers. They don't reward them with infusions of trading capital.

Mistake 8: Ignoring Your Stops: Talking yourself out of honoring your stops is an easy thing to do. You'll be tempted when a trade goes against you. You'll look at your indicators and the support levels on your charts, and you'll be certain that the stock soon will stop falling. When you start thinking you want to give a position a little room to work its way out of losing territory, you're on your way toward a trading debacle. Its wishful thinking, it's hoping against hope, and it's a good way to lose a lot of money. Unless you're omniscient, close the position when the price hits your stop. Take your loss.

Mistake 9: Enduring Large Loss: To trade is to lose. No matter how good your trading system is, no matter how experienced you are, no matter which stocks you pick, you're going to have losing trades. Your success as a trader depends on how you handle those losing trades. If you dispose of the losers quickly, you can become a very successful trader. But if you hold onto those losing positions, you can lose so much money that it may knock you right out of the trading business

Bulls, Bears And Pigs

1. Bulls, Bears Make Money, Pigs Get Slaughtered. It's essential for all traders to know when to take some off the table. 

2. Its OK to Pay the Taxes. Stop fearing the tax man and start fearing the loss man because gains can be fleeting. 

3. Don't Buy All at Once. To maximize your profits, stage your buys, work your orders and try to get the best price over time. 

4. Buy Damaged Stocks, Not Damaged Companies. There are no refunds on Wall Street, so do your research and focus your trades on damaged stocks rather than companies. 

5. Diversify to Control Risk. If you control the downside and diversify your holdings, the upside will take care of itself. 

6. Do Your Stock Homework. Before you buy any stock, it's important to research all aspects of the company. 

7. No One Made a Dime by Panicking. There will always be a better time to leave the table, so it is best to avoid the fleeing masses. 

8. Buy Best-of-Breed Companies. Investing in the more expensive stock is invariably worth it because you get piece of mind. 

9. Defend Some Stocks, Not All. When trading gets tough, pick your favorite stocks and defend only those. 

10. Bad Buys Won't Become Takeovers. Bad companies never get bids, so it's the good fundamentals you need to focus on. 

11. Don't Own Too Many Names. It can be constraining, but it's better to have a few positions you know well and like. 

12. Cash Is for Winners. If you don't like the market or have anything compelling to buy, it's never wrong to go with cash. 

13. No Woulda, Shoulda, Couldas. This damaging emotion is destructive to the positive mindset needed to make investment decisions. 

14. Expect, Don't Fear Corrections. It is not always clear when a correction will strike, so expect and be prepared for one at all times. 

15. Don't Forget Bonds. It's important to watch more than stocks, and bonds are stocks' direct competition. 

16. Never Subsidize Losers With Winners. Any trader stuck in this position would do well to sell sinking stocks and wait a day. 

17. Check Hope at the Door. Hope is emotion, pure and simple, and trading is not a game of emotion. 

18. Be Flexible. Recognize and be open to the unexpected shifts in the market because business, by nature, is dynamic, not static. 

19. When the Chiefs Retreat, So Should You. High-level executives don't quit a company for personal reasons, so that is a sign something is wrong. 

20. Giving Up on Value Is a Sin. If you don't have patience, think about letting someone who does run your money.

21. Be a TV Critic. Accept that what you hear on television is probably right, but no more than that. 

22. Wait 30 Days After Preannouncements. Preannouncements signal ongoing weakness, wait 30 days to see if anything has gotten better before you pull the trigger to buy. 

23. Beware of Wall Street Hype. Never underestimate the promotion machine because analysts get behind stocks and can keep them propelled in an up direction well beyond reason. 

24. Explain Your Picks. Buying stocks is a solitary event, too solitary in fact, so always make sure you can articulate your reasoning to someone else. 

25. There's Always a Bull Market. It's OK if you have to work hard to find it, just don't default to what's in bear mode because you are time-constrained or intellectually lazy.

Smart Money Ratio (SMR)

While rollovers paint a pretty bullish picture, there are quite a few indicators that suggest it’s about time the bears reinforced their presence. Though the volatility index (VIX) is commonly known as the fear index and is considered to be one the best indicators of fear and recklessness, it can often be misleading for a trader. While an extremely low VIX may push a trader into going short with the expectation that recklessness will give way to panic (because of a meltdown in prices), if the former exists along with a bearish mood in the market (or an adequately hedged market), the expected panic may not materialize. This was exactly the case right through this series, as traders were quite often fooled into going short in the market looking at the low VIX levels. The expected meltdown never materialized, as the market was almost always adequately hedged. So, as a derivatives trader, one should ideally see it in conjunction with another indicator that reflects the bullishness/bearishness in the market. An ideal indicator for such a thing can be the put-call ratio (PCR). If we divide the daily VIX with the daily near month put-call ratio, the resulting ratio probably takes care of this inefficiency of the VIX. More importantly, it’s probably a better tool for someone trying to make a trading decision. This is called as SMR.

Making Sense Of VIX Index

You would have heard of VIX (Volatility index) before. It is a term often used to gauge volatility in the financial markets. But what is VIX (Volatility Index)? VIX provides a benchmark for the pricing of options. Options are like insurance products in financial markets. The insurance premiums shoot up when insurance provider becomes extremely uncertain about future or have high risk perceptions. In the same way, in uncertain and fearful times, the option writers (insurance provider) jack up the premium prices on insurance products when they are extremely fearful and uncertain about future. This gets reflected in VIX. The VIX is derived from a real-time calculation that averages the weighted prices of out-of-the-money puts and calls on the index. The resulting measure provides a benchmark for anticipated volatility in the index as a whole over the next 30 calendar days. VIX is also called Fear index. VIX is not a reflection only on equity markets but tells us the state of complete financial market landscape.

Why Leverage of 30 times was completely acceptable in 2004-2007? Large Financial Institutions across the world are collapsing and everyone is blaming that management of these companies took too much risk, much more than they could have handled. Is that so? Fact: The management of these companies knew that they were taking excessive risk but they also knew that they can handle it. Remember, in markets risk perse is not bad...what matters is risk management. Most of the companies assumed that their risk management practices were sound. This was not just the management's belief but also the belief of analyst community. That's why no one raised any red flag on business model of investment banking business till things started falling apart. Where management of the companies went wrong - is in their assumption: World will be like this forever. Stability leads to Complacency. "Perception is Reality". 2004-2007 was an era of low volatility. (Low VIX). Low Volatility = Low Risk = More Leverage. It was much easier to manage risk in a stable market environment. And that's why everyone was ok with the excessive leverage. What changed in 2008? - were not the leverage levels but the Volatility. The sudden spike in Volatility changed the risk perception and suddenly the entire business model started collapsing. It became just too difficult to manage risk and price assets in an unstable market environment. The "mark to market" accounting became too difficult to manage and companies suddenly found themselves going under water in no time.

2008-2011: Welcome to Period of High Volatility. Now times have changed and with it the thinking. Leverage now is a bad word because it is just impossible to manage now-a-days, and hence people are getting rid of it. The level of 40 on VIX is now considered as level of low volatility, which in 2004-2007 - was an extreme level. The stable market environment of 2004-2007 created a sense of complacency in financial market system and every financial engineering innovation that happened during that period is now collapsing. This will no doubt create excessive pain for everyone. Periods of High Volatility signifies risk perception and uncertainty market participants have about future. As long as VIX remains at elevated levels, the market will remain a traders market; and gains will be difficult to stick. As per psychological studies, human beings become extremely short term in their thinking in stressed conditions. Hence, in periods of high VIX, gains will be smaller and short lived. The normal old fashioned market will not return till we see a substantial cool down in VIX. Hence, keep an eye on VIX to formulate your strategy. May be Instability is the new world order, and we need to learn to live in times like these.

Money Management (Risk Management)

We look at a trade; it’s a good trade.... a beautiful clean sideways pattern just itching to breakout. Our plan is to buy the breakout and ride the trend, trail stopping upwards at every pivot low. Cool. So far so good. We now need to ascertain how many shares we plan to buy. For example, the stop is 20 away from our entry point. Right, do we buy 10 shares (which means we lose 200 if stopped), or do we buy a 100 shares (which means we lose 2000 if stopped), or a 1000 shares (which means we lose 20000 if stopped)? The amount of money lost if stopped is the risk on this trade. Don't let it get past 2% of your equity. Which means, first calculation is: How much capital do I have in my trading account? (trading account only, not the worth of your house and car and jewellery all put together).

Let us say that I have 10 million in my trading account, that means the maximum risk that I can take on any single trade is: 2% of 10 million=20,000. Which is to say that if I enter into a trade, and the trade goes against me, I will lose 20000? So whether you paid 2.5 million for that stock or not, you are not risking 2.5 million, but 20000, as that is where your stop is. Now must it definitely be 2% of the capital.... not necessarily. Can be anywhere between 0.5-2%, but no more than that. So, therefore, first I look at my trading capital at the end of the month. I then assess how much my risk would be the next month. For example, let us say I have 10 million at the end of July. Let us say I take 1% loss in each trade. Therefore for the month of August, I would be risking 10,000 per trade (to reiterate, that means the amount lost if stopped out).

Now I have my ups and downs in August, and landed up in August with an equity of 10.5 million, now my risk in the month of September would be 1% of 10.5 million=10,500 per trade.

So too, if my equity had dropped that month to 9.5 million, then my risk of 1% for the following month would be 9,500 per trade... so on so forth!!

Right, I now know my trading capital, the amount of percentage risk that I am willing to take, and the amount of money risked for the following month at the end of each month..... now how do I calculate share size: Share Size= (% risk * trading capital) divided by (entry-predetermined stop loss). So, therefore, we look at our charts, we get our entry point let us say 200, and our stop loss is at 175. Now presuming our capital is 10million, and our percentage risk per trade is 1%. Therefore, Share Size= (1% of 10 million) divided by (200-175)

= 10,000 divided by 25 = 400. Therefore in the above example we would buy 400 shares with an entry at 200 with a predetermined stop loss at 175. The max we should lose in this trade if stopped would be 10,000. The 2% rule for assessing position sizing is vital, but there is more to be done. Another major part of money management that must be looked into..... just as how crucial having a predetermined stop is and proper share sizing, this part is vital for the survival of our trading account and therefore our survival as traders.

If we were to risk 2% per trade and we get into 20 stocks, a move down would trigger all the 20 stops.... we have put proper stops, great... we have taken small losses, great... and yet, our account is down 40%. If our trading capital was 10 million, well 4 million has vanished into thin air!! This is unacceptable.... and unpardonable as far as the trader is concerned. We therefore have another set of percentages in place so that we are protected from market movements.... now what that percentage is basically comes back to the individual trader and his comfort levels. There are many absolute truths in the world of trading, but no absolute methods, all relative to what our psyche allows us. For example, I believe that a 2% risk is just too much to bear; I am on the other hand comfortable with a risk of 0.5-0.75%.... so there are as many methods as there are traders. Basically tweak to your individual comfort levels. Now what are these percentage rules of max risk?

1. In an intraday position, take no more total risk than 4% in that day. Which means that I would take no more than 4 trades at the same time? Why? Because I am risking 1% per trade, and if I take more than 4 trades, I would be risking more than 4% in that day. Therefore, I enter into a stock with my stop loss at the previous pivot low at a risk of 1%. Then I see a great setup in another stock, same thing as above. Now I see a great trade in yet another stock, I grabbed that as well. Then yet another stock. Now I have 4 trades running simultaneously, and I risking 4% as of now. I then see a great play in one more... But my rules prevent me from taking that 5th trade, however juicy that set up. Now I get a great move in 2 stocks, and that gives me the opportunity to raise my stops in the two to breakeven. Now I can take that fifth stock if it still looks great… if it has already run off, well, nothing can be done about it. Missed money better than lost money!!  Also make sure you have your max percent loss in a week after which you wouldn't trade any more, and your max percent loss in a month after which you are no more than a bystander. If I lose 10%, that’s it....I am out for the month. Many put that figure to 6% or 8%.........once again, your comfort levels.

2. In a swing position that may last up to 4-5 days, once again similar rules come into play. I basically take a max risk of 6%.......now why these figures, well, basically no real reason except years of toying around and tweaking it to comfort levels. As said before you will have to do the same. So, here again, a risk of 1% per trade allows me to take 6 swings that week. Every time I am able to raise my stop to break even, I am allowed another trade. Else that's that...

3. In a position trade, that can take up to weeks to months, I tend to take a max risk of 12%, meaning that if you are taking a 1% risk per trade, max number of stocks that can be got into is 12. And then, once you get to breakeven stop in a trade, you are allowed to get into a new position, or add to the previous position. If you are the type that can take on a bigger amount of risk, fine... but total portfolio risk no greater than 20%.Greater than that, think you would be fishing for trouble. So careful on that one.

It is very important that these rules are in place.... very, very important!! The percentages you as the trader will have to work out. But you MUST have a stop, you MUST adhere to them, you MUST have a risk per trade and share size accordingly, and you MUST have a max risk that you are willing to take, after which you are going to pull the plugs. And you MUST have a point where a bad day or month is accepted as it is..... and all trading comes to an end. If you are out on the 15th day of the month, that does not mean that you sleep and watch TV for the rest of the month.... You come to work as in every other day, you paper trade, and you do it till the end of the month. Your first trade would be the first day of next month. Discipline is discipline, and rules are rules..... These are like commandments in the Holy Scriptures of the Trader. Not observing them is sacrilege, a blasphemy. They, once drawn up, MUST be followed at all cost.