Trading Journal

This is a piece from my trading journal, excuse the typo's.

Trading Journal

6/19/15

The market is being very choppy which makes it a decent environment to structure Iron condors. However, the rise in the /VX future and the change in the futures curve away from contango is making me nervous. However, because any particular direction is unclear to me, I butterflied off short SPX puts for a credit that I was holding on to allowing me a risk free bearish trade with a “sweet spot” area of 1975-2030. This trade will benefit from any downside move. As for other positions, I am holding my pairs trade in EWZ and EWW which I am waiting on, and I have a small position in TWTR looking for upside. I could imagine the stock could easily have a quick upside move on a piece of news considering the depressed price, and the options are cheap because of low volatility.

I do have a few investments primarily in oil. I do not have any current thoughts on this besides the fact I am simply allowing the calls to decay.  

Trading With Edge (Being the House)

Trading is all a game of math and statistics, but most people don't think about it properly. Most traders only think about either the reward/risk ratio or their probability of profit, but in reality it is somewhere in between. Options trading is quite a bit like being a casino. You hope for many small occurences with a small edge and overtime it will add up to be big amounts of dollars, and you look for trades than can have a big edge and pile because they rarley occur. What many people do not realize is that a Casino only has   1-2% edge over the players. However, in the markets you will find small edges and very large edges, so your betting size makes a difference. Casinos understand this concept well.

Kelly % = W – [(1 – W) / R] 

W  = Probability of Profit
R = Win/Loss

The Kelly Criterion illustrates this concept very well. It shows you what ones risk as a % of their capital should be. For example, if a trader has a W of .85 and a .5 R (.5/1) then they have a Kelly Criterion of .55 or 55% of their capital can be used to make this trade. However, lets say they have a W .6 and an R of .5 (.5/1) they will have a Kelly of -.2 or -20% of your capital. This is because there is no edge in the long run considering this certain trade. I could run several tests and find this almost never works; therefore, the returns are sharply negative. Options sellers need to keep this in mind because it  means letting your losses run is not an acceptable strategy, and since your risk is greater than your reward on a single trade the optimal loss point is something that need to be considered.

However, the premuim buyer also needs to keep the Kelly Criterion in mind . If they are long an option with a .25 W and a 3 (.75/.25) R then that trader can only break even (Kelly Criterion is 0), and after commisions and slippage they would be a small loser. The premuim buyer has to have an understanding of their probability of profit compared to their risk reward because the trader might make money over 10 or even 100 trades, but over 10,000 trades it is extremley unlikley.

If one want to trade like a Casino or the house one has to have a very good understanding of edge compared to ones sizing. If we assume returns are distributed randomly even with a large edge returns can be very volatile. Sizing is key because the bigger the edge the larger the optimal position size is; the smaller the edge optimal postion size also becomes smaller, but considering returns are randomly distributed the trader needs to have many occurences, but always have edge working in ones favor. If the trader has proper sizing the volatility in returns is much less because little trades can work for the trader overtime while trades with much larger edge can provide the meat of ones returns while the small trades are paying little bit of money every month or every year.

The reason this concept is so important is even with edge a trader can have periods of time where they peform poorly. This is due to the random element in distribution of returns. This does not mean the markets are a "random walk", but it does mean we can not predict the future, and we can only play the numbers we see now.

For example, the chart below illustrates a simulation of an options trade with a 55% probability of sucsess and a reward to risk of 1 and 2% of the portfolio is used. As shown, the returns over 1000 occurences is muted. There is a low chance of this with this edge, but there are times when your "edge" does not work.

In the chart below, I am using the same 55% probability of profit and a Reward/Risk ratio of 1. The returns are ridicoulously huge for such a low risk strategy; this also is unlikley.

However, As we get to several different tests the results are closer to each other.

The data seems to illustrate the  returns reaped from trading like a casino does business o. However, the casino understands size well also. That is why they put table limits in place, and this is why us traders need to always need to stick to our risk guidlines. There can be wild girations in returns even over 1000 occurences or more. The biggest mistake many traders make besides improper size is changing strategies when something doesn't work. If you have found positive EV in a certain strategy stick to it because you can have large volatility in returns during certain periods of time, but over many years and occurences you are going to find yourself with a large positive return. This, for example, is why buy and hold works or selling index premuim works so well. They both have edge, and it is only a matter of the risk you are willing to take and proper sizing.

Covered Strangle (Across Multiple Indices)

Here are the two major US equity index ETF's the SPY (S&P 500) or the IWM (Russel 2000). Now I have been considering the actualy value of say historical volatility, and I have come to a conclusion that I would rather use ATR than historical volatility which is a topic I should get into with a different post. However, my bullish for the next 5 days or so is slightly bullish to neutral. I am much more bullish IWM than I am bullish SPY (Completley Neutral), but I am witnessing the SPY seems to be a more suitable premuim sell in this case since the Implied Volatility is above the ATR (what I am using for historical volatility, but to reduce capital anything I sell will have wings on it.

 On the case of buying IWM stock, considering the 3 days down and 2 closes above the low of the day we have an extremley bullish upside historical criteria.

Below is a performance chart of the pattern described above. Bought on the first day the signal was intiated and sold 5 trading days later (1 week). The historical stock trade that included leverage in IWM had a 69% win rate.

A trade that I like is a covered strangle trade across indices for  a short duration of time possibly 2 weeks on the strangle (I will Iron Conderize it by buying some wings as protetion) so I can get a decent premuim at the 1 std dev move, and then I will either buy IWM stock or do a synthetic stock trade using options (Short ATM put, Long ATM Call) to reduce capital once again.

Besides this trade I have very few positions all based of statistical criteria in stocks I follow closely. There a few short premuim trades available at the moment, so I am playing directional and long premuim directional. Long stock seems suitable in TSLA, AMZN, and LNKD.


Thanks,
Alex

NQ Makes for a Different Story than Usual

NQ (NQ Mobile) not to be confused with the /NQ futures (Nasdaq futures) has been a interesting trading vehicle to watch latley. They have over and over again moved there earnings back and back. I have been watching the ATM strangle. I bought iton 7/2/14 before the expected earnings report that didn't come out. I had to pick it up beause it was extremley cheap trading for around .35 -.40 in front of earnings. The reason for this is nobody knew/knows when the actual earnings are/were going to come out. I had a chance intraday to actually sell the strangle for a decent profit, but most of my readers know what my deal with time decay is. Anyway, I have been watching it the day after the expected earnings report which hasn't come yet and the straddle/ATM strangle seems to price approximately the same thing everytime and rally from that level.

The next question is why would I be selling NQ volatility at a 97% IV Percentile. The reason for this is I really don't care. The first line in the sand is that look at the price movement. Implied Volatility hasn't been correct on this stock except for that short period of time in novemeber and back in July and August of 2013. But even that isn't the real reason. The reason is we have the market underpricing options around an even because of the uncertainty of timing of this event. However, we continue to make large unpredictable moves in the underlying paying for most of the decay.

Lets pretend we do but the atm straddle or strangle on 7/9 and the earnings come out. The market does not know if they really will come out or not, so it will be a cheap trade. This stock is either going to go bankrupt (near 0) or it might announce something really good and the stock will rocket. The stock rocketing is the potentially most profitable trade, but it is the least probable. Therefore, the shortside trade is the most probable to be sucsessfull, but it has the least profit potential. This makes the straddle or ATM strangle make a lot of sense.

However, if there is some announcement or piece of news that will end up making sure earnings are on a certain date the options will be over priced again. I prefer the selling put trade because it is the safest if you want to do it. The stock could rocket or go to 0 and your risk is defined with the put. In the case of the call side. The stock could just 100,200, or 300 % at any given moment for any give reason. In stocks like these the downside is always much slower often and the upmoves that are news drive can be huge.

I do warn people who go out and do this trade. Do not do it with large size. I do this in the context of my overal portfolio. The main risk in the trade is time decay, and that is the most important element of my portfolio. How much time decay over my directional risk I have. In a trade like this I will risk no more than 1% of my portfolio and probably about .4-.5% of my overall portfolio.

Email me with questions at alex.optionstrading@gmail.com

Interesting Markets

These make for some very interesting markets at all time highs and low volatility. However, the general feel of the market has been very much different than last year which is good. First of all small caps (TF/RUT/IWM) and Nasdaq (NQ/QQQ/NDX) have been very weak lately. The NQ just rallied with the ES, but it has been a great scalping vehicle, and it also has been a very good vehicle for strangles while the ES/SPX has not been nearly as good. The cyclical action has been okay in the ES but we still are having the grind higher tendency which is something I do not care for. However, we have seen quite a bit of volatility in major names (TSLA, NFLX, AAPL, GOOG, TWTR, etc). Those names have been pretty good, and macro markets have been good. Even if I have not had a focus on some of these bonds, currencies, and commodities have all had decent trading volatility.

As for the US indices, I think we are going to need a catalyst to get some volatility going. I have been long a few Vix calls, but I am going to dump those positions if we do not catch something within the next week. However, I will be selling calendar spreads in the VIX. Vix options are based of the futures so when volatility goes up front month vol will go up much more than back month vol, and these calendars can trade at huge credits when we get vol expansion. I will sell these as cheap protection, but I am remaining long theta and long some vega. My net portfolio Prob of Profit has been lowered by the long vix but the analzye tab/models do not take some of these things into account. The premium sale for a while is going to be IWM. I have a relatively large position in IWM, but it is skewed to the downside for the purpose of protection. This continues to be of interest as volatility percentile in IWM is consistently above the vol in SPY/SPX lately, so the options are relatively expensive, so I am selling them. However, do keep in mind that ATM premiums as a % of the SPX price are at 5 year lows.

 I also see some interesting trading in bonds and currencies. Trading the fear in the euro for example is acceptable and even if the ECB meetings on Thursday take a bad I am still trading euro from the long side via calls in FXE or the 6E futures options. I am buying options in this case because considering what kind of move could happen the longer term options (108 days to expiry) seem cheap. Bonds will also have some interesting movement because I see slowly these assets creeping up as market participants lose interest in equities and move into less risky safer assets such as bonds. I will be buying the dip and playing options is going to depend on vol and binary events that can occur in these markets.

Lastly, commodities are also of interest. Agriculture could also be in play in the coming months and into the harvest season and summer. I am thinking about a direction, but go with the weather trend. I think Corn could be a buy as we are heading into the summer months, and if we have a hot summer then it will get interesting. I prefer directional trades in this case because all the options seem to be fairly priced. I am also going to be selling premium in oil when I can. It is more cyclical than people give it credit for and right now it is out of the picture of news.

Interesting Markets

Interesting markets, still down some money because of crap I had to carry over from 2013, but the horizons are set for good returns. We are back in a traders market. Range bound and cyclical. I have a feeling the next few months are going to be like this, but this is the market forming a long term top.

The chart above is a weekly chart, and as you can see it takes months for tops to form. However, be careful because even before the collapse we see extreme volatility, and this is why we tend to maintain a slightly short delta bias. Long VIX calls are always decent hedges considering the tail risk. Sometimes pairs trades work; selling QQQ volatility and buying SPY volatility which was a great trade last week if you skewed the pair to the short side enough is a good example. I personally though have been keeping the large positions in the indices. If you have followed my trades on dough.com you will see many trades being QQQ trades, and that is just me maintaining basic short strangles. If we see the VIX fall anymore you will likely see me begin buying QQQ volatility including puts, straddles, and long bearish diagonals. The reason for this is when we get a bad downside explosion the Nasdaq tends to explode to the downside at a faster rate. If we see the 12/11 print in the VIX,  I will begin initiating parts of the trade

As for my personal stuff it has been indices and lots of weekly or shorter term trades. They have been working for me much better. I have put out several weekly ratio trades along with a few other custom orders. These have been extremely profitable. My large positions have generally been in the QQQ and a few in the SPY. Strangles have been doing well lately, but I also have to do wide iron condors because of the capital requirements with strangles. The weekly trades have been undefined risk because that is what works for me. In larger stocks I will buy a strike wide out to define the risk, but undefined is my wheelhouse.

I will go into a specific article later about what my weekly trades look like. A few other guys that have really good weekly trades are the Shadow Traders. I do not get anything at all for promoting them, but they do have some interesting stuff. You can find them at shadowtrader.net or Shadow Trader uncovered on tastytrade.com

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.