Why I Chose Trading and My Grind to Profitability

I haven't written an article in a little while, so I decided to write something different. So why did a choose trading?

I have always been very entrepreneurial. The first thing I started with was an allowance. I had a choice I could receive all the change in my dads pocket everyday or I could receive an allowance. This brought me to thinking about risk versus reward. Do I want a steady income or something less reliable with more upside. I took the upside. Why you ask? I was FIVE what risk did I really have. If I wanted something I could just ask my mom to buy it, and I wouldn't have to spend a dime to buy it. Now to be fair, I don't think I was necessarily thinking through all of this at that age, but I think I grasped the idea.

3 years later after I got out of the being "King of the World" stages I became interested in business and finance. I was fascinated about how you could make money. Therefore, I started my own business. Now at age 8 I was a little shy and had limited resources, so I was kind of stuck with illiquid and unfair markets....my parents (they could charge any price the wanted). However, I decided to start with dish washing. I was making a $1 a day from this at dinner time. Okay great that is $365 a year which went into my savings. Then I decided to have a lawn watering business. Okay great no cost and plain revenue takes 20 minutes. That brought in $282 (140 days a year of watering * $2 per job). Then, being the evil child that I am, I sold "information" to my mom of the daily happenings at school, which I probably made $.50 a reports, and I sold about 3 reports a week (begining, middle, and end of the week) which ends up at $78 a year. So we are at a minimum of $726 a year + the income I was making from my dads change (which if you think about is a lot like options income investing, if the insurance doesn't pay I don't get my premium). So, I was making pretty decent for a 8 year old at this point. I decided to package this into a "giant" conglomerate, so I could use cash from one company to fund another company. Then the question came up. What do I do with the extra cash?

This shot me right into the trading world. Within a few weeks, I had decided I needed a brokerage account, and I had to invest. I spent a 1/2 year learning and not doing as single trade until January 2009. In January 2009, with a $500 trading account, I bought shares of 5 shares of INTU at $ 52. I ended up scratching the trade, but it was a great experience. So, at the end of 2009 I ended up going through some decent pain, and I scratched the year. I also decided from just that volatility that I couldn't make big returns from such a small account, but I could prove that I could consistently the outperform the market, and I did making 20 % + with relatively small draw downs in 2010 and the same in 2011 of less than 10% unfortunately it was to difficult to leverage in such small accounts. Today, I have learned to simply use more leverage for a higher return

Now by the end of 2011 I had decided that I am going to learn options trading. I also began trading longer term and mostly macro markets in 2012 with a $2500 trading account. By the summer of 2012 I was almost solely trading macro directional options buying ITM options, and a pretty non strategic approach. I was basically managing winners and playing the trend, in my dads IRA account, and my own account. After the summer of 2012, I began taking on a strategic approach, and I was also doing pretty well with that, and I ended the year in my dad's IRA in + 15% with a max drawdown of 3% (My dad has a limited risk tolerance so I cut down on leverage big time), and I made just a little in my small account ending with $4500, but I put in contributions. I think I had the best year ever here from a risk to reward standpoint. To put it in perspective, in a higher risk trading account I would use 3x leverage of a low risk IRA with a return of 45% and a draw down of 9%.

Now I am going to fast forward into summer of 2013. At this time I was up 4% on the year in a higher risk margin account that I was willing to take more risk in. Then I got whipsawed on deltas, volatility sucked, and I got overly short deltas. It ended up being the first year the market tested me into losing money, but I learned 100x what I did before all the previous year because nothing teaches you more than being tested.

Now in 2014, I have been doing much better. My portfolio volatility has decreased and returns have been much more consistent. My goal is to beat my 5/1 risk to reward in 2012.

When is There Not An Edge to Sell Premuim?

In the financial industry, the likelihood of outlier moves has been a constantly argued subject. This is especially true when it comes to derivatives products, specifically options. How often do the 3 std deviation, 2 std deviation, or even 25 std deviation events occur? Now I do not want to turn this into a mathematical article at all. In fact the way I will look at this just might make a mathematician cringe. However, lets take a look into some of the facts.

1. When volatility is above its mean to is a time to sell volatility.
2. The seller of the options wants implied volatility to forecast greater moves than realized volatility will be.
3. Not all stocks are good products for premium sellers because implied volatility is consistently wrong in predicting the actual moves/volatility.

Therefore, lets take a look at the opportunity this presents us. As we all know, many individual stocks are much more volatile than the stock market indices. This means historically indices have performed well for the short premium side not including some large outliers (i.e 2008-2009 crisis). Despite this, historical volatility tends to stay above implied volatility most of the time. This means volatility is low and continues to contract. The large opportunities in indices come only when there are large discrepancies in the volatility. However, this is looking at it on a long-term level.

However, if we were to expand our range to more range bound volatile indices like emerging and global markets we have more risk, but we have much more decent opportunity of implied volatility outweighing realized volatility.

If we were to sell premium in global indices we would overall have the edge. Even statistically index short premium works (You would especially know if you have ever watched the Karen the Super trader interviews). However, in individual stocks, commodities, currencies, and extremely volatile markets these rules do not always hold true. In fact, we will often see outliers where long premium makes sense. These are often the high flying stocks like TSLA or NFLX. Sometimes they are even commodities such as Natural Gas. However, overall short premium still wins, but the premium sellers (usually me) can get burned severely in these underlyings that have such large moves.

What we also must understand is that stocks/markets that behave this way take a long time to mean revert. For example, TSLA has consistently had a discrepancy of realized volatility being much higher than implied for months (you are looking at weekly charts BTW). It is also the same with NFLX. These stocks are premium buying stocks, and these are stocks that I try to avoid selling volatility in. However, when the discrepancy goes the other way their is opportunity.

This is also how I like to use historical volatility in conjunction with IV Rank. I try to look at both before I make a decision. This is especially true when I try and enter a core position where I plan to be short for a while because their is a large discrepancy. My point in all of this is simply "make sure you being paid for the risk you are taking." I always prefer short premuim and even with "undefined risk", but I don't want to be caught in those scary outliers.

Also, I suggest you read this article from Al Sherbin. It is some very interesting views on AAPL historical distributions.
 
Al's Calls of the Day

Patience in the Options Markets

Trading options is quite a bit different than any other trading instruments. In most trading instruments you are looking for more of a instantaneous profit or loss, or in other words instant satisfaction (instant being more quickly). However, the options markets are much more about the likelihood of the move (volatility) and time.

Options decay with time going by, but that is just it. Time takes time. Traders have to wait for time to go by. This is the opposite for the premium buyer, but this person simply wants to bet on direction, and therefore is not a strategic trader (not necessarily a bad thing if it makes money). However, strategic options traders need either volatility to kick in their way, or time to go by. Both of these takes time has volatility grinds down and theta takes time. With undefined risk these factors tend to come in very quickly because you are taking more risk. However, with spreads you have to be very patient. Most spreads that have defined risk will take much longer for both volatility and time to come in because the trader of the spread is taking much less risk, so they give up the risks that come with being naked(Quiet strange minds!). Therefore, you have to be patient when trading options simply because of the factors involved.

 The general rule when it comes to spreads is MANAGE YOUR WINNERS, and be very patient. However, if you trade with spreads being core positions I would say BE SLOW TO ADJUST TRADES. The trader has to give time to let an options spread work for them, and follow their exact rules. If you take the trade off at 50% of max profit then do that. If you repair the trade be slow to do so; therefore, time can work in your favor while you are waiting.

MA and C Trade

I talked about a volatility pairs trade in my last post, and I got a great response on it. Therefore, I am going to take a look at another one. MA (Mastercard) and C (Citigroup) are two stocks that are both in the banking/Financial industry. Both of their earnings reports have also been released, so there volatility is not pumped because of the binary event risk. However, both their volatilities are at extremes, and these stocks have a correlation of (.63).

As you can see, C has a very high IV Rank, and MA has a very low IV Rank; therefore, they are both at volatility extremes. However, if you look up top there is another indicator that shows both at very different extremes. This is a model I have built that looks into volatility extremes. When the blue line is equal to green the model is telling me that it is more advantageous to buy volatility, and red means it is more advantageous to sell volatility. In this case, the model is looking more medium term extremes, and as shown above MA is a great long volatility play, and C is a great short volatility play. This indicator is what interests me instead of IV Rank when it comes to volatility pairs trades.

Now there were a couple of trades I was looking at to put this on. The first one was selling a Citigroup iron condor (.61 credit) 3x MA, and buying a MA iron condor (1.44 debit). However, I do not like that trade because also like to play these directionally. Instead, I was looking to sell a put spread in C and buying a put spread in MA.

Position I will try to take:
C Strikes: Short 47/Long 45 MAR 14 .75 credit (2x MA)
MA Strikes: Long 77.5/Short 75.5 MAR 14 1.08 Debit (1x)

This overall position is then short volatility and long delta in C. It is also short delta in MA and long volatility. However, I did sell more C put spreads than I bought MA put spreads. The reason for this is I prefer to be overall short volatility when I do this, due to my general short volatility bias. However, I wish to know what the overall position risk looks like, so I understand I am setting up the trade properly. I do this by beta weighting the positions against the SPX, and then looking at what those overall trades look like against an index.

Below is the SPX beta weighted position of C and MA:

I will be looking to put this trade on monday morning. The mechanics for me is to let the trade sit, and find a time to manage the winner, as you can not hedge an already hedged position (it is hedged because it is a pair). However, if you do this trade you have to STAY SMALL! You need to give this strategy time to work for you. GOOD LUCK TRADING!

Index Volatility Pairs Trade

If you have been watching the markets you know the VIX has shot up very fast very quickly in the past few days. The Vix has worked its way up to 18 from a low of around 11. This means many  indices have a high IV_Percentile. I am aware that IV_Percentile is not perfect; however, it is a good indicator of where volatility is compared to its own range. The SPY/SPX vol percentile has reached about 78%. This means volatility is over extended. However, we have had a decent down move in the past few days making a new low for the year. This puts a lot of risk in the water of where volatility might go or where the stock market might go.

This risk on the table allows for a very interesting opportunity. I do not pretend to know where the market will go, and I do not know where volatility will go. However, I do like to trade relationships. Now we have SPX/SPY volatility trading in the the 78th percentile, but we have IWM and QQQ trading in the mid-60's considering percentile. What this is telling me is that small caps and tech stocks are saying that there is much more room for vol expansion than the larger stocks are. In other words, the high volatility stocks that often make the first move are saying that there is room for volatility expansion. The larger markets are not saying this, and the vol percentile is telling me that there is room for volatility is mean revert. These conflicting signals give me an interesting volatility relationship that I could trade. So, I have interest in selling the higher volatility (SPY) and buying the lower volatility (IWM/QQQ).

Chart of RVX (Russell Volatility (IWM)) - VIX (SPX Volatility (IWM)):

 So what I am doing is buying this pair. Now this chart doesn't show all the opportunity because it is not illustrating the high IV_Percentile. If we were to trade this pair there are a couple ways have doing this. The first was is selling an SPY iron condor and buying a IWM double Diagonal. This is a pure volatility trade. I prefer to trade this pair factoring in direction because the markets have fallen very quickly. Considering direction, I am going to want to be long delta in the index I want to sell volatility (vol goes down into up moves), and I want to be short delta in the index I want to be long vol in. Below are some possibilities to do this trade.

1. SPY: Sell a put and IWM: Buy a put
2. SPY: Sell a wide put spread and IWM: Buy a wide put spread (same width of strikes)
3. SPY: Sell a skewed iron condor and IWM: Buy a skewed double diagonal
4. SPY: Sell a put spread and IWM: Buy a short duration directional Diagonal (Long ITM back month and short OTM front month (Puts))

(You will want to skew these trades considering your directional or how strong your volatility bias is.)

More Vol Coming? Probably?

We just had a 25 point down move in the /ES. Implied volatility jumped up to 13 (a level still below the mean), and the markets started looking slightly bearish. A lot of options traders have been caught short the market, due to the low volatility. Therefore, large up moves are not always easy to stand for many professional options traders. I only have one warning. Do not get over excited. The markets are not showing signs of crashing down. However, volatility is slowly rising. As I said before, the markets will go down with everyone least expects it. I only say do not get over excited, but as earnings season is back, there is volatility back on the board. My own personal hope is the VIX slowly creeps up, and causes some panic. We then will see much more interest in the markets. I will leave you with a few interesting stocks. DOW, FB, and TWTR. I have been playing these stocks like crazy with all this high volatility. I have also amassed some pretty large positions. I continue to sell weekly directional premium in these while being short iron condors in the back month (FEB 38 days to expiration). However, it is easy to get too big. The most promising of three right now is TWTR. I would give it until earnings for  great opportunity, and after then the volatility most likely get crushed. I would still like to be able to play TWTR for a while, if possible.

Hints for More Oppurtunity

2013 was a really tough year for traders, specifically strategic traders. The markets did almost nothing but go up, and we had no volatility. We only had a few days where the VIX went above it annual mean in the last year. An environment like that gives us very little opportunity as traders. It was very difficult to take advantage of volatility because it rarely became overextended and direction is hard to deal with all by itself. However, I am starting to see some more opportunity on the board. I have scrolled through many stocks on my platform, and slowly the volatility ticks up more and more. I think we are going to see some volatility expansion very soon, and we will likely see a sell off in the ES. My position has become short delta, but I am still making money almost every day this year. That is weird. However, that might be a reflection on some of the opportunity out their. I am been seeing some very interesting premium crushes. The main stock I am watching is TWTR. It is a relatively new stock so the volatility is pumped. My general game plan is to be short volatility while getting slightly short or long delta considering the move. If TWTR falls a bit I am long some delta (At the current time selling some weekly put spreads), or if TWTR goes up a bit I will be selling call spreads. At the moment, I am short weekly put spreads, short call spreads in the front month, and short an iron condor. This stock will only have such pumped vol for a few more week, so take advantage of the opportunity available. Otherwise, I am short delta, short premium, and long index volatility (Vix is an example). The only really interesting stocks/markets right now are CMCSA, MSFT, and DOW. Sell some premium in these, stay small, but remember there is some new volatility opportunities starting to come in; therefore, be watching and be careful with earnings.