Jan

31

A Needle Through Your Psyche

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I saw it with my own eyes. A group of men-they looked like typical peasants from the countryside- parade through the open marketplace. What they were wearing shocked everybody. Or, they were high on something. This group of Peruvians-ranging from age 12 to about 70 years old all had large silver awls protruding through their tongues. I mean these needles were like 8 inches long and at least one quarter inch in diameter. When I saw them walking and trying to talk with no apparent pain, I was astonished. I stopped several of the men just to make sure it wasn’t some sort of trick. It wasn’t. They had indeed shoved these giant needles through their tongues. It made me flinch jus to think of it. But they had overcome any physical pain. Maybe I was so impressed because I am such a wimp when it comes to pain. Not physical pain so much as mental-like when I lose money when making a bad stock or stock option trade.
 
The unusual scene I saw in Huamachuco, Peru made me think that I needed to learn how to stick a needle through my trading psyche. When I got back home, I did a little research and the results have helped me a lot in my attempts to be become a better trader. You see, I’ve been trading long enough to understand that real success in stock or stock option trading is learning how to handle the pain of losing.
 
Psychologists have taken a recent interest in what makes a successful trader.
The following was taken from one of the latest studies done by the University of Minnesota concerning certain personality traits that seem to characterize successful traders.
 
1)   Many successful traders show a certain amount of open mindedness. What this means is that they are open to new ideas and don’t close their minds off to possibilities if they can be shown to be beneficial. They may have a system that works for them but they are open to new ideas and will experiment if an idea sounds promising.
 
2)   Conscientiousness is a quality most traders possess. They take the time to study their markets and will not trade if not adequately prepared. Moreover, when a trader establishes a system, they will follow it to the letter. Conscientious traders trade on a regular schedule and seldom vary their routine-both in trading and in life.
Conscientious traders like their trading logs to be a work of art and pride themselves in record keeping.
 
3)  Personality types can be separated into introverts, extroverts and ambiverts. As trading is usually a solitary activity, one would think that introverted people would do best but that is not the case. Many traders come from a collaborative back-ground and like to link with other traders and to form networks of association and cooperation for the purposes of exchange of ideas and information. Even introverts are teaming up with coaches realizing that isolation is a choice and not a circumstance.
 
4)  Helpfulness is a trait seen in most successful traders. They don’t mind sharing and helping others improve. They seem to sense that the odds are against them and survivors like to support one and another. Many successful traders turn to a teaching or coaching role to not only leverage their expertise but also to help others attain success. They know that trading is not for everyone and understand that a slew of successful traders are not going to be the result of their teachings. However, they do understand that for the proper students, they can make a very real difference.
 
5)  Neurotic tendencies might be acceptable in some professions (linebackers and postal workers) but not in trading. Keeping a positive and winning outlook is a key quality for winners in any field-particularly in trading. But this doesn’t mean people with certain tendencies should be excluded. It can mean that by wanting to become a successful trader, the motivation will help to develop the techniques to over-come tendencies. Personality characteristics are not set in concrete. Moreover, over-coming shortcomings is what usually marks a winner.  
 

Once I accepted that trading is as much a psychological challenge as it is intellectual, I have undertaken a study of myself and where I can improve to help forge a more successful trader. “Oh, how new age”, you might respond, but I spend most of my working time and a lot of my net worth trading and so why shouldn’t I look at all ways to improve? How about you?

Jan

30

Down the Rabbit Hole We Go

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If Ron Ianieri is correct, we are all victims of History’s greatest fraud. By a collective collusion of vested interests, we are purposefully lied to everyday….but most particularly during Fed policy announcements and company earnings reports. If an investor or stock option trader uses fundamental analysis in trade decision making, take heed.
 
Ron, one of the founders of Options University, recently wrote an article in the December issue of the OU newsletter (www.optionsuniversity.com) called “What’s in a Number.” In the article, he asks the question most of us are asking: “If inflation is under control, am I the only one to have almost all of my expenses rising much faster than the official inflation rate?” He goes on to cast aspersions at the institutionally massaged definition of inflation and how that twisted version of the critical factor in determining interest rates can affect the economy. However, Ron carries the concern from the Fed super spin to the devious denizens of Wall Street. Yes, once again those bastions of “rational analysis-the Wall Street Analysts-may be at it again.
 
Ron presents an example of how some of the recent earnings reports might have been “adjusted downward” just a few weeks before actual earnings came out. These adjustments were made in reaction to the estimated effects of the subprime credit problems. Low and behold, some companies came out with earnings that exceeded the “adjusted estimated earnings” and the stock prices of those companies in question actually moved up in reaction to the “good news.” Of course, the implication is that there might be a consorted effort to hoodwink the investing public. If analysts can be persuaded to make “adjustments” to fundamental information, what effect does that have on the veracity of the information and its resultant effect on stock prices? Ron’s answer to the problem was to exclude fundamental analysis from his analysis of a stock.
 
But of course, technical analysis of stocks, stock options, etc is based on price movement and volume; as a result, it could all be a case of gigo (garbage in, garbage out). If this is indeed the case, then we investors and option traders might be a lot further out there on the probability curve that we think. Or, even more possible, it doesn’t mean a damn if everybody else doesn’t see a naked emperor.
 
This brings me to an interesting possibility. Could it be that the value of money and the perception of that value are all about marketing? If you are told continually and believe there is no inflation, will that effect your consumption patterns accordingly? If it is all a hoax, what does this mean to the economy….and our jobs….and our standard of living….and our well being. You get the picture.
 
Maybe we are seeing the evolution of a “new system of economics” akin to floating currency rates. The value and comparative value of currencies are based on perceived value-nothing more. If there is a way to “guide” perceived value (i.e., information from “credible sources”), the main benefit of capitalism-resource allocation-could be maintained. Old school economics of the business cycle with its gain and pain may be eradicated.
 

Many of us have children who are nearing thirty years old and have yet to experience anything like a recession. As an investor, it’s much the same. Option traders make money when prices go where we have correctly anticipated. Regard-less of where the information came from or what the talking heads say, it all gets down to what the consensus of the “emperor watchers” think. So, as an investor or trader, is it really a matter of understanding what is the “perceived reality.”  

Jan

29

Day Trading the News

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FMOC meetings are like waiting for the ancient oracles to speak. Will the Gods bless us or curse us? Should they deal with our transgressions lightly or with a heavy hand? Because of the subprime crisis, the oracles are now center stage and what they have to say carries some impact for investors and traders and, indeed, can move markets all over the world. So, for the serious stock and stock option traders, bring on the oracles and let’s make some money!
 
 
Peter Stolcers of One Option (http://www.oneoption.com/) wrote a nifty little article on the day of the last FOMC meeting (Dec 11th) on how to play the news. Pete pointed out that most investors, traders, Wall Street analysts and the markets in general were of the opinion that the FOMC meeting would bring about a 25 basis point cut in the Fed Funds rate, which indeed happened. But it was reading between the lines of the FOMC rhetoric wherein lurked the opportunity for a successful day trade on the news.
 
Fed watchers-which we all are these days-learn to listen closely to what is said by the Fed. As Pete noted, if the Fed makes “dovish” statements, there is a chance that we will see a rally in the markets; conversely if the statements are “hawkish”, we are likely to see a decline.  If, on the other hand (does that make three hands?) the Fed makes balanced statements, we are likely to see choppy back and forth action. Under this scenario, the market will settle down before the close, posting a marginal gain/loss for the day. To follow on to Fed statements are the reports on retail sales, Producer Price Index (PPI) and Consumer Price Index (CPI), which usually support the Feds decisions. One way to check the veracity of the inflation numbers is the Libor rate. LIBOR is considered by most to be the true cost of capital (LIBOR is the London Interbank Offered Rate).
 
Pete goes on to elaborate on a day trading strategy using the SPY Index as the benchmark. He suggests that a trader first pick the strongest and weakest stocks or options (make sure to check the bid/ask spread on the options). In the case of the recent December 11th Fed rate adjustment, he used an SPY at or above 152.50 as a trigger point to go long on strong stocks and 150.80 to go short on weak stocks.
Well, Pete was right in that the SPY plunged to a low of around 148 at close after the Fed announcement. It would have been a nice day trade on the short side; however, traders had to be very light on their feet to get out before close. On the following day, December 12th, the SPY gapped up and opened at 151.6. You can see Pete really meant a day trade.
 
The day trade was made strictly by playing on the words. What were the words that set the traders scurrying to the short side? By most accounts, the Fed left the impression that there might be no more rate cuts for some time because the Fed’s statements indicated that they expected moderate growth in the economy with no implied further cuts. As most investors and option traders seem to be of the opinion that more cuts will be needed to help control the contraction in assets being forced by the subprime problem, they went short for a couple of hours to demonstrate their collective disagreement with the Fed before covering. But the next day, it was business as usual.
 

From Pete’s article, we might say that FOMC meeting day is a day to listen carefully and be ready to jump into action at any verbal skew to either buy options on the strong or sell on the weak. And, oh yes, be ready to close out the position before close. Perhaps investors who digest the news overnight and will wake up the next morning with a completely different insight into what they thought they heard the day before. Always keep in mind that what the Fed seems to say might not be what it really means to say and vice versa. Say what?

Jan

28

Tracking the Elephants

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Remember the joke: “How do you know when an elephant has been in your fridge? Answer: By the footprints in the Jell-O.”
 
Well, how do you know when the elephants are interested in a company? Answer: by the footprints in the stock option contracts activity. When the “smart money” (elephants) smells something happening in a company, they will normally position themselves to take advantage of the play by buying stock options-either calls or puts. Some option traders like to keep it simple and have formed a strategy by “following the money”. The underlying philosophy is that smart money is usually in possession of privileged information and that regardless of what the current technicals and fundamentals might show, a notable increase in option contract volume trumps the generally accepted picture and is a harbinger of some impending action in the price. But even though this strategy sounds simple, it is a bit more complex in that to determine whether or not real option contract volume has really increased or decreased.
 
Trading volume is a relative thing and needs to be compared to the average daily volume of the stock in question. A large percentage change in price accompanied by larger than normal volume is a solid indication of market strength in the direction of the change. On the other hand, a large percentage increases in a stock price accompanied by small trading volume is less likely to indicate a market direction. In fact, this scenario may indicate that a reversal is possible.
 
Open Interest
Open interest is a concept all option traders need to understand. As a matter of fact, most option traders ignore open interest. You see, unlike stocks, where there is a fixed number of shares to be traded, option trading normally involves the creation of a new option contract whenever a trade is placed. The Open Interest category depicted in the financial pages will tell an option trader the total number of option contracts that are currently open – in other words, “contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.” Therefore, when looking at the total open interest of a particular option, there is no way of really knowing whether the options were bought or sold. So what good is this information, you might ask? Be assured that the open interest figure does provide important information when understood.

One way to use the information provided in the open interest figure is to look at it relative to the volume of contracts traded figure. When the volume of contracts exceeds the existing open interest on a given day, this usually suggests that trading in that option was high that day. In other words, open interest in comparison to contract volume can help an option trader determine whether there is unusually high or low volume for any particular option

 
When stock options have large open interest, it means that the particular option has a large number of buyers and sellers and an active secondary market; this will increase the odds of getting option orders filled at good prices. In other words, the market for the option is liquid. As a result, the larger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.
 

Elephants do leave visible tracks but an option trader needs to know how to read those tracks. Being able to do so may be a simple and affective way to gauge where the next option trading opportunity might appear. It’s simple and leverages the power that privileged knowledge might have. As always, paper trade first before you follow the herd. Otherwise, you might get trampled or covered in you know what.

Jan

27

Looking for Road Kill

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It’s a different strategy, but very interesting. It takes advantage of the fact that stocks taking a hit make much stronger moves downward than when on the rise. But for some reason, most traders shy away from taking advantage of these potential quick and sure (?) profit makers. In today’s markets, using a trading strategy on weakness is usually see as going against the market and produces a logical concern about getting caught being short in a rapid upward correction back toward the predominant trend.
 
Most traders are always on the lookout for breakouts-upward movements that break through upward resistance levels. These may signal a more sustained move to the upside. Similarly, a breakdown is when prices break down through support levels. As most option traders look for volatility, plunging prices can be really attractive because they can become really volatile.
 
Of course, going against the general trend can set up a short position for an abrupt snap-back reversion to the mean and make for quick loses. However, there is a way to protect against that possibility: purchasing call options. For example, suppose an option trader knows that a stock will be coming out with some unexpected bad news that hasn’t been factored into the price yet; the trader might want to consider shorting the stock and at the same time purchasing an out-of- the-money call.
 
Let’s say that the stock shows all the technical signs of breaking down through a resistance level and is currently at $26 per share. An option trader could sell a quantity of the shares and at the same time buy the out of the money call at let’s say .50 cents premium for each share. Therefore, each call option contract of 100 shares would cost $50. Most call option premiums will provide inexpensive insurance for a weak stock that might have the remote chance of reversing direction. Option traders call this strategy using a “protective call.”  
 
By selling a stock short, the trader makes a profit on the declining stock by buying it back at a lower price than at the price you sold the stock and selling it back to your broker at the higher sell price. It’s still buying low and selling high but in reverse order. If for some reason the stock turns on the trader, the call option increase will offset much of the unexpected losses depending on how close to being -the-money  the trader purchased the call option strike price.
 
So, why not feed off of the carrion of weak stocks? Instead of hunting for good news and exciting prospects, become a “grinch trader” and look for potential road kill just before it runs across the road.
 

It just depends on a trader’s perspective. Maybe after a time, grinch traders can start dressing in all black and do all trading after midnight. All it will take is for traders to see the results before they abandon the world of daylight.

Jan

26

Dancing with Time

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Don’t be a butt head. You know you’re going to lose trades. Not just a few but a bunch. Does that bruise your ego? Consider how trading works. It’s all about the probability of being more correct than not and not about being right.  I know it’s mincing words but an option trader must accept the fact that trading is an “educated guessing game.” For traders, all the analysis in the world will rarely reveal the big chaos factor—time. As an options trader, time is the wild card.
 
So, traders try to use sentiment to gauge the amount of emotional momentum is out there urging the stock to move. But emotion is a fickle beast and good traders can only fathom its intent about 70% of the time. But if those 30% losing trades can be cut short and capital preserved as best it can, the other 70% of successful trades should make more than enough repetitive profits to far outweigh the losses.  Option traders can make money even if they are losing 50% of the time. Flip a coin? No, the most influential factor is time and changing sentiment to usually unforeseen events. There is no way to accurately forecast the time an event will happen because it’s in the future and no amount of facts and figures can pin it down exactly-only probably. But, option traders can estimate a high probability of an event happening within a certain period of time. But- at best- it’s just an estimate.
 
Most investors who try to become option traders don’t make it. And the thing that discourages them the most is the fact that they are wrong too often. Long-term investors cope with time by mostly ignoring it. Stock option traders dance closely with its capriciousness. It’s a different game altogether. That’s why it’s important to learn to accept the losses. A trader deals with probabilities-not certainties.
 
A trader must develop a system that will produce at least a 65% win-loss ratio. Through paper trading, a system can be tested without the emotional pressure of losing money. After enough trials, a trader will see if the system is capable of recognizing and capturing a high probability trade. Not home runs, mind you, but steady singles and doubles.
 
To develop a system that will allow a trader to transfer his/her ego to the system takes time. Once a trader knows the fact that over a certain sample of trades that their system can provide a consistent win-loss ratio-at least in the 65% range- the trader will know how to mechanically deploy the system. The trader will know from experience that once a high probability trade is encountered, there is better than chance odds that the system will be correct. What the trader must be aware of is inconsistencies in the implementation of the system. The trader should “plug and chug” and implement the system the same way each time. It should become mechanical and there is nothing artistic or creative about it. Some traders leave the whole process for their computers and special programs to deal with. That would be the ultimate in mechanical trading and maybe someday we will all have a “little blue” on our desks. But by that time, there will be little risk and even smaller reward. But even with super computers, the time factor will probably never be pinned down to an exact function. 
 

In summary, if you want to be a successful options trader, pay your dues: study options and all they can do. Develop a good system that will yield an acceptable win-loss ratio. And most importantly, leave your ego at the door. Keep in mind that there is an extremely high probability you will lose many trades and it’s in the nature of the game.

Jan

25

VIX Options as Portfolio Insurance

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Things are getting dicey out there. Cascading subprime crisis, falling dollar, oil near $100 a barrel, no wonder the markets are as nervous as Brittany Spears in a library. I have about $10, 000 in unrealized gains in IBM stock I purchased several years ago and I thought maybe it’s time to buy a little portfolio insurance. I’ve never done it before so I sat down to take a look and this is what I found. Maybe you can tell me what’s wrong with this picture.
 
Normally, portfolio managers and other sophisticated investors consider buying put options to help protect unrealized portfolio gains. For instance, my portfolio has 1000 shares of IBM, to protect the position I looked at buying 10 IBM out-of-the-money puts. Currently, IBM stock is at $105 per share. To protect the position, I looked at buying 10 IBMPT.X puts with a Strike at $100 with a premium of $4.80 per share. As the protective put position will cost $4,800 (not including commissions), I really wouldn’t be protecting the unrealized gains because first the stock must drop 5 points before going into the money where the puts should then offset further declines- thus, a loss of $5,000 to go into-the-money and then the cost of the 10 puts for $4,800 for a total cost of $9,800. So, I would have hedged about $200. BFD! It must be because I’m not a professional portfolio manager. But could it be as more and more people learn about options that there will be more demand for hedging puts and this, in turn, will drive up premiums until the strategy falls apart? Or is this, once again, the dichotomy between theory and the real world.
 
I had read somewhere that the Volatility Index (VIX) is another way to hedge a position, so I decided to take a look.
 
The "VIX" is the Chicago Board Options Exchange (CBOE) Volatility Index,which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. The Vix is commonly called the “fear index” because the index is negatively correlated with the S&P. When the S&P goes up, the VIX goes down and vice versa. There are also volatility indices for the NASDAQ (VXN) and the Dow Jones (VXD).

VIX Table

As a matter of fact, the VIX is more volatile than the SPX-particularly when the S&P is making a downward move. Thus, a move down in the SPX will normally provoke a greater offsetting up move in the VIX.
 
Using puts is a good way to hedge specific positions but one can also use what is called a “macro hedge.” One way to hedge against macro moves is to purchase VIX call options. As a VIX call is negatively correlated with the market direction, if the market experiences a macro drop, VIX call options should rise. Several studies suggest that VIX options are a more effective hedge than buying SPX puts to protect against a macro downside move because they provide more dynamic protection.

For example, if a trader buys an SPX Dec 1400 put with the S&P 500 near 1520, the put is approximately 8% out of the money. If for some reason the index moves up, the put is even further out or the money. Because of the way VIX options trade, if the index moves up, the VIX call option reacts more to fear-the options will not be as sensitive in up markets. But when fear strikes, the VIX becomes highly sensitized and will magnify downward moves in the market index and be reflected in a rapidly increasing VIX. In other words, the VIX provides much more than a delta of 1 when the market is reacting to fear. This means that fewer calls need to be purchased to offset losses. As a matter of fact, a recent study showed that VIX protection is only needed for about 20% if the portfolio to provide an adequate offset to a down market.

Jan

24

Don’t fall off the See-Saw

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When they’re up….you’re down. When they’re down,… you’re up. It’s the “contrarian see-saw”. Most everybody agrees that market sentiment can be a very important component to doing the almost impossible-timing the market.  The Japanese rice traders knew that over 400 years ago when they developed the popular candlestick system for identifying changes in sentiment. Some of the modern day versions used for gauging sentiment are: Relative Strength Index (RSI), Volatility Index (VIX), and Put/Call Ratio. The basic concept is that fear (oversold) and greed (overbought) help the trader pick trades, strategies, and entry and exit points. When there is an excess of fear, the trader may want to be buying. When there is an excess of greed, it’s probably time to sell.  But like all indicators, they must be considered in context.
 
If a stock is imploding, no doubt the prices will drop and show an obvious negative sentiment.  But does this mean we should buy when an index shows an oversold condition?  Also, a stock on the rise might show an overbought condition but does that mean it will come screaming down when the index reaches new highs?  Being a contrarian can be hazardous if sentiment indicators are taken on their own.  Trying to read order out of chaos is too complicated for just one, two, or more indicators.
 
However, there is little doubt that sentiment is a valuable factor.  Considering market sentiment equivocates with trying to time the market; usually considered a taboo.  But stock traders of all ilks take timing the market as key to making money (buy low and sell high…but when is low really low or high really high?)  Stock options and futures traders are notorious time bandits.  To them, timing and direction are the two prime mandates: which direction will the price move and when will the movement take place?  If a trader is good at divining these factors, they can make a very good living.  It’s like a nut-shell game; it looks so easy but when the expected outcome doesn’t happen, the world temporarily comes apart.  Reality defiled.  That’s why being a trader can become an emotional roller coaster.  But if you were standing on a street corner with thousands of others there to give you advice, would you listen to them?  If the majority told you not to choose the center shell, would you heed their advice?  My point being is that sentiment is consensus and normally consensus is better than individual opinion. Why is it that sentiment indicators are set up for traders to choose an opinion contrary to the consensus?
 
A recent study presented by Market Harmonics (http://www.market-harmonics.com) demonstrated an interesting fact.  The article “Put/Call Ratio vs. Volatility Indices” showed that the Put/Call ratio is a much more sensitive indicator of “real-time” sentiment and that The VIX (S&P Volatility index) and VXN (Nasdaq Volatility index) are more indicative of sentiment trends.  The logic is that Stock option traders are more deliberate when choosing the price they will pay to buy future per-formance, whereas Put/Call ratio is more a reflection of a reaction to the market.  The implication of the article is it is best to use both indicators to see if sentiment is just a short-term emotional reaction as indicated by the put/call ratio or a more sustained trend as indicated by the VIX and VXN.
 
Another way to moderate a tendency to jump at overbought or oversold situations is to wait for a retracement to test the sentiment.  Many times-particularly when using the RSI-an indicator will make a correction just out of exhaustion and then retrace back to the oversold or overbought condition.
 

Bottom-line, when attempting to time the market, always have multiple supporting indicators and realize that taking a contrary position can be risky if there isn’t a very high probability of reversing direction.

Jan

23

A Naked Kamikaze

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Don’t go naked. It’s not that you’ll catch a cold but you might have to buy stock you don’t want to buy. To a stock option trader, going naked is buying or selling (writing) an option contract without owning the underlying stock. But you already knew that. And chances are you also know that most stock option traders will tell you to never sell naked puts. I say most because I have used selling naked puts successfully for years. I don’t recommend it because for many traders it would indeed be the wrong thing to do. But for some, it could work out well. It did for me.
 
Here’s my story. I used to own a medium sized company which had the advantage of having a large line of credit which we rarely used. At the time, we paid about 8% interest. As I was in charge of managing our money, I was always looking for ways to optimize our assets. One day it hit me. I have this line of credit, which I fortunately don’t need, but I wondered if there was a way I could use it in a productive manner for the company. As a desk bound executive, I had the capability to trade stocks and options because a computer was always an arms length away.
 
I had this mysterious friend who somehow made a good living for him and his family by no obvious means. Once I broached the subject and he muttered something about stock options. I prodded him and he explained a strategy that provided him with a steady stream of income. It got my interest and I offered to pay him if he would show me how to do it. He obliged and in ten minutes, I was out the door shaking my head. He was nuts because he was defying a common taboo of selling naked puts. Soon, I became focused on the unused LOC because the bank had informed us that they wanted to close out our credit line because we weren’t using it. So, I started to do some paper naked put option selling just to see if my nutty friend was right. Within a short period of time, I was pleasantly surprised. I just needed to focus on stocks that I wouldn’t mind owning if I were somehow forced to cover. Then it hit me. This line of credit was like having a huge margin account. It cost me 8% per year on any balances and yet I figured that I could fairly regularly make 5%-7% on out-of-the-money naked put options on stocks I wouldn’t mind owning if I had to.
 
The way I do it is the following: I look for out-of-the-money put options that have a time value that if divided by the stock price would yield at least 5%. For example, let’s say a stock has a current price of $40 and has an out-of-the-money put option with a strike price of $38 for a premium of $2. The time premium is $2 so if we divide the time premium by the strike price, we get a return of 5.6% exclusive of the costs of the round trip commission. All that is needed is for the stock to stay neutral or move up until the option month expires. If you do that repeatedly, you can have some nice annualized returns. The key is to have the cash to cover the purchase of the stock if required to do so.
 
So, I decided to tap my company’s credit line for about 20% for trading activities. “Getting naked” became part of my everyday routine and low and behold after the first year I had managed to capture a total return of over 35% net all transaction costs. I was forced to cover only three times in the year. Within several months, I was able to recoup the LOC cost by liquidating the stocks once they reached breakeven.  Over the past six years, I have accumulated almost as much money by going naked in my office as we make from one of our smaller divisions.
 
It might not be a good thing to do, but I, for one, don’t hold to selling naked puts as something bad. Just be sure you have a big wardrobe in the closet if you need it.

Jan

20

The Bell Curve May Have Been Rung

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Lies, lies and more lies! Now the venerable Bell Curve (also known as the Normal Distribution Curve) may be found out as just another false god-at least in the field of investing. You see, a normal distribution defines probabilities among a set of random numbers. But investing returns and volatility aren’t random. If this is so, then the validity of using normal distribution may very well nullify many important statistics used in the technical analysis of investments. For example, the measure of risk in a stock or option is measured by its variance from the mean of its prices. If a stock has a 15% variance from its mean, that means that price will vary-plus or minus- 15% from its average price. If you have a stock with an average price of $40 and a variance of 15% the price will normally move between $36-$46 about 68% of the time using one standard deviation. But there exists the probability that at least 2.1% of the time, the price could move out of that range (two standard deviations) and .1% that it would move even further away from the mean ( Three standard deviations). That’s if the data is random. But are stock prices random? We hope not. If that’s true, then IBM could range between 0 and infinity. If that’s the case, it’s a total crap shoot. But management, analysts and investors would beg to differ.
 

Distributation Chart

There are some economists and statisticians who believe that stocks move more like what is encountered in electrical power distribution. The real market experience over the recent years demonstrates that stocks move out of the three standard deviation range quite frequently. According to normal distribution, that should only happen in one out of billions of events. The online bubble and other highly volatile stock implosion episodes have pointed out that many stocks have strayed out of normal distribution expectations.
 
According to the power distribution curve, its not that uncommon for data to move out beyond a six standard deviation point. What this means is that risks can be much greater than those depicted by the normal distribution curve.
 
I guess you could liken it to how society and Wall Street seem to accept the bogus statistic we call inflation. Everybody pays attention to this most important number and accept it as fact. Incredible! Do you really think that housing prices, energy costs, insurance costs, medical costs should be ignored or given a “place holder number” way out of sync with reality? Its preposterous. Yet, the emperor still has new clothes. There are statistics and damn statistics. Maybe the seeming randomness of unexpected price movements is much greater and more frequent than we expect because we are using the wrong tool.
 

Power Law Chart

Jan

19

It’s All In The Head

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To a contrarian, bad news is good news. To my contrarian ears, good news is breaking out. Take the new book The Panic of 1907: Lessons Learned From the Market’s Perfect Storm by Robert Bruner and Sean D. Carr. It talks about the strong parallels between the disastrous economic panic that brought about the birth of the Federal Reserve Act in 1913. The book draws attention to the many similarities of then and now. I love it. Not because it is going to give me any new, insights but that fear might be lurking around the corner. There’s only one problem: too many people are talking about it. I say it’s a problem because when fear enters the picture, real opportunity can’t be far behind. But usually, when there’s a lot of talk, nothing happens. But as an option trader, I like that, too. You see. being an option trader is so exciting because there are so many ways to play the game.
 
During this time of dark clouds appearing on many traders’ horizons, it’s wise to take some extra precautions but not to panic. For instance, if you have accumulated gains in your stock investments, you can benefit by using the stock option strategy called the“collar.” In this strategy, you can protect your gains, ride out any temporary downturn caused by panic selling, and still make some money. Moreover, you can stay in the game and ride out the storm and be in position for a rapid rebound.
 
Case in point. During the 1987 market crash, most of the experts were out of the market, leaving us little suckers to take the big hit. But low and behold, the eggheads were left with egg on their faces as stocks quickly rebounded and left the experts on the outside as huge gains were reaped by the little guys.
 
Getting back to the collar. It’s a strategy where a simultaneous entry is made into a covered call and a long put. A covered call is when an investor uses the underlying stock to sell (“write”) an out of the money call and buy a put. If the market goes down, by properly hedging the long position with put options, profits from a declining market will offset losses suffered by the decrease in stock value. But why sell the covered call option?
 
When you write (sell) a covered call, you get paid a premium for each stock. If the call doesn’t go into the money, then the call option will expire and the premium earned helps to offset the cost of purchasing the put position. This strategy is good to use in a climate like in today’s markets. There is a lot of uncertainty and the hype may be laying the groundwork for a correction and maybe even a recession. As a contrarian, bring it on. But first, collar your gains or at least buy some downside protection.
 
One thing is starting to really influence my macro thinking. Most everyone-particularly the experts- don’t seem to understand that money is not money anymore; its all about perception. We can indeed psychologically materialize a recession or a boom. If we think things are good, they will be. If we turn negative, things will reflect that. The “relative truth” might be that the numbers look bad, but the “absolute truth” might just be that if few are listening or believing, the facts may mean nothing. This may be particularly true when dealing with the miserable science of economics. So bless the option trader, for he has many ways to hedge, collar, straddle, spread, and otherwise tweak to the sentiment of the day. I say, intrepid stock option trader don’t run scared, cover, collar, hedge and spread and wait for the storm to blow over….if there is a storm at all.

Jan

18

Option Advisory Newsletters

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It’s very seductive. But is it too good to be true? Can you really make triple digit returns on your horizontal investment money just by following directions? Yeah, right. Are the returns claimed by newsletter advisory services for real? Is there any third party entity watching over the hawkers of “easy money” newsletters? Generally, Investment newsletters cater to the do-it-yourself investor who thinks they are knowledgeable and confident enough to invest without a professional investment adviser and usually too busy to track all of the potential investments. Are they just another example of P.T. Barnum’s famous statement (“a sucker is born every minute”)?
 
Most investment newsletter subscriptions appear to cost between $100 and $300 for a yearly subscription. But trading stock options are not as simple as trading stocks. Stock options have so many uses and strategies that to be a good “do-it-yourselfer” probably means that you are well trained or have too much free time. But there are many stock option traders who think they know what they are doing but are really in over their heads.  If you don’t believe me, just try reading some of the stock option trading blogs. Quickly, one can see that trading options is rarely about trading plain old option calls and puts. It’s much more about spreads, front and back months, analyzing deltas, and understanding the differences between eagles, butterflies and other esoteric strategies. Not only is trading stock options understanding about the underlying stocks but also about the derivatives of derivatives and what makes them tick… Let’s face it, it’s not for everybody. The complexities of trading options belay the beauty of stock options for those who understand them.
 
Maybe the guys and gals who write the advisory newsletters understand options and how to trade them and maybe they don’t. It should be easy to find out by having the authors of stock option advisory newsletters provide an audited trade journal with all suggested trade results to substantiate their claims. The closest thing I could find for some third party evaluations was the Hulburt Financial Digest.
 
Since 1980, Mark Hulbert (www.marketwatch.com) has been monitoring the performance of advisory investment newsletters and publishing the information in the Hulbert Financial Digest which is considered to be the preeminent source for advice on investment newsletters.  Each year, Hulbert publishes a list of his top ten newsletters, ranked by performance. But before you start hunting for inexpensive ways to make “big bucks,” you need to ask yourself some fundamental questions:
 
  1. Do you want to learn about trading or are you more concerned about building wealth? If you’re not interested about learning the complexities of trading stock options, then you should be seeking third party confirmation of newsletter returns. Also, you need to make sure that you understand enough about trading options to enter and exit trades properly.
  2. If you are interested in learning about options, you need a newsletter that is going to discuss the strategy and methodology of each trade and provide support if you have any questions.
Maybe a newsletter isn’t the best way to go. It might be better if you hired a trading mentor or contracted a service such as the Options University Strategist program which is a real time investment advisory service with trading analysis presented on a trade-by-trade basis. You learn and you earn. It costs more, but if the returns on capital and knowledge gained is worth it-the price is just the cost of doing business.

Jan

16

Think About It

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I don’t have time for this! Looking at stock and option screeners, making a short list, doing the fundamental and technical analysis, and using an option calculator to figure out the Greeks can be exhausting. Bust my butt and then after all that work, get kicked in the teeth.
 
I love option trading but-to be honest-there just isn’t enough time for me to do all the due diligence and I’m not so sure that I will ever acquire the level of knowledge that other traders have. Just when I think I understand it, I find out I’m just scratching the surface. I think I’ve bought into the illusion of my own abilities. So, the question is: do I want to be trading options because of my ego or do I want to make money? Do I want to complicate my life even more than it is or do I need to start doing an analysis of the cost benefit of how I use my time? Seems obvious, doesn’t it.
 
Options University just came out with a new program; it’s something that makes a lot of sense. They will use their professional trading expertise to not only trade their own accounts but will let a subscriber to their service look over their shoulders and make the same option trades they do. Not only that, they will send emails or text messages when things need to be attended to. This new program appeals to me because it does three things: 1) Makes me more passive income; 2) Allows me to focus on other aspects of my life; 3) if I want, I can learn the real nitty-gritty of options trading from the pros. No more wasted time trying to keep up with something that requires full time commitment and, yes, maybe a better intellect than I possess. So be it. My end game is to optimize passive income and if the cost benefit is there-only ego would stand in the way.
 
I look at it this way, if the Options University Strategist program can show me just a net return of over 15% per year, it’s a no brainer. That’s my criteria. Moreover, I won’t have to use my free time reading about things I really don’t like. My quality of life should improve greatly as a result of the added free time. FOUR!!! MATCH POINT!!! Good bye, Black-Scholes. Hello better returns on my investment capital.
 
I have an IRA that has been languishing and loaded down with low yielding but “safe” investments; just what you don’t need in a tax advantaged investment vehicle. How stupid! That’s where the higher risk-reward money should be to juke by the capital gains taxation. But high reward investments need high level knowledge to reduce the risk.
 
I know enough about stock options to know that they are fantastically flexible and can be used effectively in any market condition. But to realize that potential by myself just isn’t going to happen. All you have to do is go to some of the stock option trading blogs and read. It takes about two seconds to see that what the small investor knows about stock options is rudimentary at best. Besides, if a pro can’t get me at least 15% returns a year, I think I’ll start investing in laddered bonds and forget about the markets altogether.

Jan

15

Kiss My RSI

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Say, what? Yep, keep it simple stupid, and use the relative strength indicator.
 
Could it be so simple? Remember the KISS method-another form of the “razor of Ocam (usually the simplest explanation is the best)? Pete Stolcers of 1option.com hit me in the sweet spot when he talked about using comparative RSIs to make stock option trades. I like his strategy and have used it successfully many times. I guess I don’t use it all the time because I don’t seem to be able to convince myself that it should be that easy. I guess it just makes too much sense and being a contrarian, you know what that means.
 
As you recall, the relative strength indicator (RSI) measures sentiment by looking at the relationship between gains and losses. The principle is that when there’s a high proportion of daily movement in one direction-either up or down- it can suggest an extreme condition and prices are likely to reverse. If RSI is above 80%, this normally indicates an overbought situation and stock prices are likely to reverse as the volume reduces and traders take profits. The reverse is true if RSI is below 20% as this normally indicates an oversold condition and buyers may soon take advantage of low prices and move into a long position.
 
What Mr. Stolcers proselytizes is that RSI can be used to determine strong and weak stocks in comparison to the RSI of the market in general.
 
Stolers first framed this strategy within the context of a sideways moving market as indicated by looking at the SPY (S&P500 Index ETF) RSI. He then contrasted this to a stock with an increasing RSI and one with an RSI decreasing relative to the SPY. He used this as an indication of weak and strong stocks relative to the general market. He then purchased a call option on the strong stock and a put option on the weaker stock. If the SPY RSI moved to a more oversold condition, he had a high probability of making money on the put option and if SPY moved up, the probability switched to the call option. Let’s call it an “RSI option spread.” A very simple strategy, indeed. KISS. Of course choosing the right strike price and expiration month can complicate things a bit, but you get the picture.
 
That brings up a little talked about factor….looking for delta. You remember delta, one of the famous stock option Greeks. Delta, as you may recall, measures the correlation between the movement of the particular option expiration month and strike price and the movement of the underlying stock. A high stock option delta means a close relationship. For instance, a delta of .60 means that if the underlying stock goes up one dollar, the option premium goes up sixty cents. As delta is a derivative of the Black-Scholes formula and there are many option value calculators and stock option software programs available. It’s a plug and chug sort of thing, so don’t be intimidated. There are even some stock option trading websites that provide current data and charts on the subject.
 
I like the RSI strategy system because sentiment drives prices. Sentiment in terms of markets and stocks is a cocktail of logic, statistics, and special knowledge of the industry or company. All these things can influence sentiment strong enough to forge a financial commitment, also known as pulling the trigger.
 
As always, before you try out a new system, do at least 50 or more paper trades.

Jan

14

R.I.P. 80% of Option Traders?

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Another B.S. statistic! I put off trading options for years because I read someplace that over 80% of all options expire worthless. Expire worthless… something we’re all afraid of. You don’t want your tombstone to say: “Here lays so and so….he expired worthless.” But seriously, many a potential stock option trader may have been scared away from the wonders of trading stock options by the 80% statistic by not fully understanding what that dismal statistic (some say it’s as high as 90%!) really means. As the old saying goes, “there are statistics and then there are damn statistics”. In the case, the famous 80% is a damn statistics. Here’s why.
 
Option contract and open interest
 
An option contract is where one person buys (long) and another sells (writes); this transaction constitutes one contract. If the buyer and seller close out their positions, there is one less contract. If one original buyer sells their original position to another person, then the original contract would still be open; thus the name “open interest”.
The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or a negative number. Most traders interpret that if open interest is increasing, more money is coming into the market for that instrument and usually means or verifies increasing prices. Conversely, if open interest is decreasing, it means that money is exiting the investment vehicle and usually means decreasing prices. Open interest and price is one way to confirm a trend. The following table is a well known description of the relationship of price, open interest and trend.
 
Price
Open Interest
Interpretation
Rising
Rising
Market is Strong
Rising
Falling
Market is Weakening
Falling
Rising
Market is Weak
Falling
Falling
Market is Strengthening
 
But how does that tie into the mysterious 80% worthlessness of stock options?
 
The myth
 
It has to do with two things: First, it has a lot to do with how options are pur-
chased. Most stock option traders seem to prefer buying out of the money calls if they think a stock is going to make an impending upward move in price. Out-of- the-money calls are cheaper than in-the-money calls. However, not all stock option traders trade that way. As in-the-money options have intrinsic value, they are normally closed out and not left to expire as they will have intrinsic value. However, as most options are purchased out-of-the-money they are normally left to expire because as they approach expiration, they quickly lose premium value which has only time value and no intrinsic value.
 
Secondly, many sophisticated stock option traders and portfolio managers use stock option puts for hedging purposes. They purchase out-of -the-money puts and if not exercised, they expire worthless. It’s not uncommon that thousands of put options are used for hedged positions. Thus, given the open interest of out of the money calls and hedged puts, 80% of stock options expiring in a state or worthlessness might be accurate but it doesn’t mean that 80% of stock option traders lose money.

Jan

13

The VIX Canary

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There’s gas in the mine, run for your lives! If you were a miner in olden times, that’s what you’d yell if you saw the canary fluttering like a fish out of water on the bottom of its cage. Its imminent death told everybody in the mine to get out.
 
In 1993, a new measurement for the index of volatility for the S&P 500 stock index (SPX) came out. It was to become like the canary to the miner for stock option traders. If the volatility index went up, traders should start looking for the exits. You see, there is an inverse relationship between the volatility index (called the VIX) and the movement of stocks. Usually, if the stock market starts to go down, activity in stock options increases. If stocks are going up, there is less interest in stock options (hedging against losses) and the index is subdued or goes down. In other words, the correlation between the VIX and stocks is a negative one. Moreover, the sensitivity of the VIX magnifies the movement of the stock movements. For example if the S&P 500 goes down 10%, the VIX may go up 35%. Conversely, if the S&P goes up 10%, the VIX may go down 15%. But what does this mean for investors other than the VIX as a “Chicken little”(the sky is falling in) fear indicator?
 
VIX as portfolio insurance
 
Normally, when stock option traders hear the word hedge, they think of a put or spread. If an investor has a portfolio of investments and wants to protect gains, they may purchase puts to help offset any losses; the long put options become portfolio insurance. But using VIX options can be better and cheaper protection. Because of this fact, VIX options are becoming popular as portfolio insurance. Consider the following example:
 
Suppose you have a portfolio and you want to protect the unrealized gains against loss. Let’s say that you purchase out of the money S&P puts to protect against the down side. But as luck would have it, your portfolio grows and leaves a large gap between your out of the money puts strike price and the portfolio. Now the portfolio has more gains to lose before hitting strike price. You could close out the put position and roll up to a new strike price, but this will cost money. On the other hand, owning VIX option protection is different. There is no strike price to hit. If the S&P moves down, the VIX moves up-usually in a much larger proportion. Additionally, there is no gap to cover before going into the money. Moreover, because of the volatility of the VIX, it takes less money to “insure” against loss. It only takes about 10% VIX option coverage to portfolio value to provide enough protection.
 
Lawrence McMillan, President of McMillan, a registered investment advisory firm in Morristown, NJ. provides a good example: Suppose one buys SPX Dec 1400 puts with the S&P 500 near 1530; the puts are approximately 8% out of the money. If a strong summer rally develops, the S&P 500 might rise to 1700 in September, a time when protection is most needed, as stocks tend to perform relatively poorly in the fall. But the puts are now 300 points out of the money, and therefore almost useless as protection.
 
VIX as a sentiment indicator
 
VIX can also provide a good barometer of the sentiment of the market for the next 30 days. If the VIX is going up, anxiety is going up as the VIX measures  option prices and volume increase. Importantly, VIX doesn’t have a linear relationship with the market in general; it is much more volatile. As a result, a moderate downtrend in markets will trigger a large upward movement in the VIX.
 
As volatility is food for the short term trader, keeping an eye on VIX can also add valuable information in helping to get a feel for the general market and looking for times of high volatility. 
 
All in all, learning more about the VIX and VIX options may help not only in hedging situations but also in “catching bigger waves”.
 
The following are some VIX strategies:
 
Bullish on VIX, and Bearish on stocks
 
Might consider –
Long VIX Call Options
Long VIX Call Spreads
Short VIX Put Credit Spreads
Long VIX Futures
Investors who are –
 
Bearish on VIX, and Bullish on stocks
 
Might consider –
Long VIX Put Options
Long VIX Put Spreads
Short VIX Call Credit Spreads
Short VIX Futures

Jan

12

How to Trade High Priced Options

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“Spread the risk”
Sometimes, the best ideas are so simple. One of the great advantages of using options is their flexibility-that is if you know how to use them. Consider the well known and expensive stocks and their expensive options. Sometimes a trader passes on a good opportunity because the cost of the option premiums seem too expensive. But there is a way to reduce the costs of expensive stock options to allow the option trader to take advantage of opportunities- even with high priced options.
 
Suppose an option trader believes that Slumberger (SLB) is going to make a move up in the next few months. The trader would like to purchase the call option, but the premiums for the strike price and expiration months are expensive. The trader believes the trade to have a high probability of success but the capital required exceeds the option trader’s money management parameters. Most option traders would pass on the trade but there is an easy way to reduce the premium costs……take a bull spread position.
 
A bull spread position is when a call option is purchased and another call option is written for the same expiration month but at different strike prices. The purchased call is made for the option contract with the lower strike price and the written call for the higher strike price. Immediately, the premium for the written call offsets a portion of the total costs for the spread position.
 
Let’s look at an example: SLB is currently trading at $96.15. The option trader pulls up the option chain and sees that a call option at the desired strike price and time period is currently asking $ 27.30 per share for a total of $2730 for the call. To help offset the costs, the trader writes a naked call for a higher strike in the same expiry month for a price of 7.30 per share for a total premium of $730. Net total cost for the two options are: $2730-$730= $2000. Because the “real option strike price” we want is the lower one, we make sure that we are out of the written call (higher strike price) before it can go into-the-money. In affect by writing a covered call, our price for the purchased call (lower strike price) is reduced. The bad news is the upside is limited by the strike price for the written call. Maximum loss exposure on the spread is $2000 versus the original $2730 if the trader had purchased only the one call contract. In the real world, most spreads are closed out before expiration to ward off the effects of the time decay of the option as it approaches expiration.
 
As Karim Rahemtulla said in his columnat (smartprofitsreport.com), executing a spread is easy and profitable.

Jan

11

Trading Endurance

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“Stock option trading is hitting for average and not about hitting home runs”
 
You’ve got to pay to play. If you pay too much or too often, you‘re out. It’s that simple. This fact is in spades for stock option traders. One of the most important objectives in stock option trading is to be trading for the long haul. You do that by employing well defined and strict money management rules.
 
Trading stock options demands a strategy of cutting losses quickly and making sure that the trading system wins more than it loses. Some basic trading rules are:
  1. More winning trades than losers;
  2. Average profits are larger than average losses;
  3. Compounding profits yield high annual returns
  4. Trading account drawdown limits aren’t reached
% Drawdown
% gain required to recoup losses
10
11.11
20
25.00
30
42.85
40
66.66
50
100
60
             150            
70
233
80
400
90
900
100
busted

 

First of all, trading account funds should be non-essential funds. Even then, the trader needs to conserve the trading account to enable a steady volume of trades. Most traders limit each trade to no more than 10% of the total trading account. If you have a $ 20,000 trading account balance, no trade will be more than $2,000.
 
The concept of drawdown is extremely important in providing the trader with exposure to the option market. Consider the chart.  As you can see from the chart, when a trading account reaches about 35% drawdown, required gains just to get back to the original balance start to go logarithmic and it becomes a difficult chore just to get back even. As a result of this fact, many stock option traders will put a drawdown limit of around 25%. Sometimes it can just be “bad luck” but when the win-loss ratio isn’t where it should be, more often there needs to be some adjustment to the system or to the trader’s psychology. Hitting a drawdown limit forces the trader to step back before winning trades only help claw back to the initial balance.
 
Along with setting up a drawdown limit, it’s important for stock option traders to also set up some trading rules to help conserve trading capital. For instance, a trader may establish trading policies like: no more that one trade per day; no trading when not feeling well; no trading if in a bad state of mind; or once hitting monthly goals, to stop trading for a week. A stock option trader must know the eccentricities of their own trading style and how best to accommodate their trading success.
 
Stock option trading is hitting for average and not about hitting home runs. It a trader can have a win-loss ratio in the sixty percent range and have an average profit at least twice of the average loss, we have a happy camper. Because trading is a matter of finding trades with a high probability of success, there will always be the variance from the average-both positive and negative. So, having losing trades is part of the territory of the option trader. If you are too much of a perfectionist and hate to lose, options trading will be a “voyage of self-discovery.” Its all about discipline, constant analysis and keeping above the trading account drawdown limit.

Jan

10

Don’t Forget the Greeks

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You can’t consider yourself “stock option literate” if you don’t know the Greeks. Option traders analyze underlying stock and hope to leverage that knowledge through use of the surrogate stock option. But a stock option doesn’t necessarily mirror the movements of the underlying stock. The Greeks can help a stock option trader to understand the vital relationship between a stock and its derivative. To pursue that most popular of Greeks-Alpha (profit) – you need the other Greeks to help smoke it out.
 
  1. Beta: is a measure of correlation between the general market and an individual stock. For example if the stock market index moves up 1%, a stock which also moves up 1% would have a beta of 1.0. A stock which moves up .5% would have a beta of .50. A stock that moves in a direction opposite to the market would have a negative beta.
  2. Delta: is of particular interest to stock option traders. The Delta is a measure of the correlation between option premium price movement and that of its underlying stock price. For a call option, if an option premium goes up $.50 for a corresponding move of $1 for the underlying stock, the option would have a Delta of .50.  For a put option contract, the Delta is the relationship of a rise in put option premium as the underlying stock prices fall. An important fact to understand is that as an option approaches expiration, the time value of an option approaches zero and the Delta between option premium and underlying stock goes to 1.0.
  3. Gamma: measures the correlation of delta as it approaches an in-the- money status. For example, a Gamma change of 0.50 indicates the price of the option premium rate of movement will increase by  50% if the underlying price approaches the strike price. When an option is way out or the money, Gamma is very low and increases as it approaches the strike price.
  4. Lambda: measures the leverage an option has in relation to the underlying stock. For example, if the underlying stock price changes 1%, an option with a high Lambda would change more than 1%.
  5. Rohm: is a measure of correlation of option value to change in interest rates. Rohm indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rohm of .060 indicates the option’s theoretical value will increase by .060 if the interest rate is decreased by 1.0.
  6. Theta: is a measure of correlation of option value to time decay. Theta indicates a change in the option value for a ‘one unit’ ( 7day) reduction in time to expiration For example, a theta of -250 indicates the option’s theoretical value will change by -.250 if the days to expiration is reduced by 7.
  7. Vega: is a measure of correlation of option value to change in volatility. For example, a Vega of .010 indicates an absolute change in the option’s theoretical value will increase by .010 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. (Volatility is a measure of price variation from a mean price over a period of time. High volatility means large and frequent price swings.)

Jan

9

Staying Away from the Option Trader Blues

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“Traders can’t afford to get emotional in their trading”
 
“If it weren’t for bad luck, I’d have no luck at all”, go the famous blues lyrics about being a loser. Stock option traders define successor failure by the trading account balance. A trading account balance is a function of win-loss ratio and average gain over average loss. But there are times when probability turns its back on the trader. It’s going to happen and for perfectionists losing can be a difficult event and can make a trader feel like singing the blues.
 
From early childhood, we are taught that losing is a sign of personal weak-ness and failure. But to a trader, what is losing? Is it one trade; or more than 50%? Some traders actually have a win-loss ratio of over 70%, but most are below this ratio. Nobody-except a storyteller- has a ratio in the 90’s. Losing trades are a part of the territory-even for the best. The sooner a trader understands this, the better. Many high achievers take losing very personally, but in the option trading theatre of probability, losing is part of the process. Having the affliction of expecting perfection takes a heavy toll on the ego of option traders.
 
Traders can’t afford to get emotional in their trading. That’s why we develop a disciplined trading system. It’s mechanical and the less art, the better. When the system isn’t producing the way it reasonably should, (less than 55% win-loss over at least 100 trades), then the system needs to be modified. But to have a “system” means applying the rules of the system consistently. In this way the system is tested and not the trader’s “abilities”. If you want to hear “he’s a great trader” then your ego will kick your butt every time you lose and when that happens things can start to unravel. Beating yourself up is no fun and it usually only makes things worse.
 
Successful option traders cut losses immediately, review the reasons for the loss as part of a learning process, and move on. They understand that if they follow a strict regimen and the system is just average, they will come out winners-if they keep trading options mechanically and understand it’s a number’s game. Drawdown limits become the deciding factor not whether a limited number of trades are winners or losers.
 

If you find that trading is getting you down, first analyze if it’s your ego and requirement for being right. Are you trading to prove that you are better than others or to make money? This internal monologue needs to be squelched. Making money by trading options is a mechanical, analytical skill combined with the patience to stay the course. Effective traders are like anybody else with the exception that they learn to control their egos and care not if using a checklist and a set of pre-determined rules make them money. If over the long haul (trading year) traders see high double digit or triple digit returns for the year, traders understand that it was not due to their intelligence or “special abilities” but their ability to stay disciplined and keep the big picture always in mind: “it’s not about me but about my ability to consistently apply my trading system”.

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