The Option Trader’s Hedge Fund: A Business Framework for...
Transcript of The Option Trader’s Hedge Fund: A Business Framework for...
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TheOptionTrader’s
HedgeFundABusinessFrameworkforTradingEquityandIndex
Options
DennisA.Chen
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MarkSebastian
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VicePresident,Publisher:TimMooreAssociatePublisherandDirectorofMarketing:AmyNeidlingerExecutiveEditor:JimBoydEditorialAssistant:PamelaBolandOperationsManager:JodiKemperAssistantMarketingManager:MeganGraueCoverDesigner:ChutiPrasertsith
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ManagingEditor:KristyHartProjectEditor:BetsyHarrisCopyEditor:CheriClarkProofreader:DebbieWilliamsIndexer:LarrySweazySeniorCompositor:GloriaSchurickManufacturingBuyer:DanUhrig
©2012byDennisA.ChenandMarkSebastian
PublishedbyPearsonEducation,Inc.
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PublishingasFTPressUpperSaddleRiver,NewJersey07458
Thisbookissoldwiththeunderstandingthatneithertheauthornorthepublisherisengagedinrenderinglegal,accounting,orotherprofessionalservicesoradvicebypublishingthisbook.Eachindividualsituationisunique.Thus,iflegalor
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financialadviceorotherexpertassistanceisrequiredinaspecificsituation,theservicesofacompetentprofessionalshouldbesoughttoensurethatthesituationhasbeenevaluatedcarefullyandappropriately.Theauthorandthepublisherdisclaimanyliability,loss,orriskresultingdirectlyorindirectly,fromtheuseorapplicationofanyofthe
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contentsofthisbook.
FTPressoffersexcellentdiscountsonthisbookwhenorderedinquantityforbulkpurchasesorspecialsales.Formoreinformation,pleasecontactU.S.CorporateandGovernmentSales,1-800-382-3419,[email protected].,pleasecontactInternationalSalesat
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Companyandproductnamesmentionedhereinarethetrademarksorregisteredtrademarksoftheirrespectiveowners.
Allrightsreserved.Nopartofthisbookmaybereproduced,inanyformorbyanymeans,withoutpermissioninwritingfromthepublisher.
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PrintedintheUnitedStatesofAmerica
FirstPrintingMay2012
ISBN-10:0-13-282340-3ISBN-13:978-0-13-282340-1
PearsonEducationLTD.PearsonEducationAustraliaPTY,Limited.PearsonEducationSingapore,Pte.Ltd.PearsonEducationAsia,Ltd.PearsonEducationCanada,
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Ltd.PearsonEducacióndeMexico,S.A.deC.V.PearsonEducation—JapanPearsonEducationMalaysia,Pte.Ltd.
LibraryofCongressCataloging-in-PublicationData
Chen,DennisA.(DennisAnthony),1970-Theoptiontrader’shedgefund:abusinessframework
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fortradingequityandindexoptions/DennisA.Chen,MarkSebastian.p.cm.Includesindex.ISBN978-0-13-282340-1(hardcover:alk.paper)--ISBN0-13-282340-31.Options(Finance)2.Portfoliomanagement.3.Riskmanagement.I.Sebastian,Mark,1978-II.Title.HG6024.A3C48522012
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332.64’524--dc232012007222
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ForMelinda,Thankyoufor
encouragingmeandstandingbyme
inallofourendeavors.FormypartnersatSmartIncomePartners,Ltd.,
Thankyouforyourtrustandsupport.Thankyouforbelievingandinvestinginour
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business.—Dennis
ToLauren,thankyouforputtingupwithmethroughthickandthin;withoutyouallofthis
isnothing.Tomyparents,thankyouforpushingmetoconstantlytryto
exceedexpectationsandnever
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settle.Tomyson,maythe
roadthatliesaheadbeallyoucouldhopefor.Tomypartner,co-workers,andallofthoseassociatedwith
OptionPit,thankyouformakingwhatIdonotseemlike
work.—Mark
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ContentsIntroduction
Endnote
PartITheFramework
Chapter1TheInsuranceBusiness
HowInsuranceCompaniesMakeMoneyHowInsurance
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CompaniesLoseMoneySuccessDriversoftheInsuranceBusiness
Chapter2TradeSelection
MarketSelectionStrategySelectionTimeFrameVolatilityPricing
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Endnote
Chapter3RiskManagement
RiskManagementMoneyManagementPositionSizingPortfolioDiversificationAdjustingtheDifferentTradesAddressableRisks
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InsuringthePortfolioAgainstBlackSwanEvents
Chapter4TradeExecution
ConditionsoftheMarketEvaluatePotentialRealizedVolatilityEvaluateImpliedVolatilityEvaluatetheMonths
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EvaluatetheSkewEvaluateOtherProductsTradeOrderEntry
Chapter5TheTradingPlan
TheMind-SetTheImportanceofStickingtotheProcessQuestionsYour
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TradingPlanShouldAnswerEndnotes
Chapter6TradingInfrastructure
RiskCapitalTheTradingPlatform(Broker)PortfolioMarginInformationResourcesandOtherAnalyticalTools
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DedicatedSpaceBackupPlans
Chapter7LearningProcesses
TheTradingJournalSoundingBoardEndnote
PartIIImplementingtheBusiness
Chapter8UnderstandingVolatility
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WhatCausesVolatility?Three-DimensionalVolatilityandtheModel
Chapter9MostUsedStrategies
TheVerticalSpreadTheIronCondorTheATMIronButterflyTheCalendarSpread
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orTimeSpreadTheRatioBackandFrontSpreadEndnote
Chapter10OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ
TradingPlanExecutingtheTradingPlan
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PartIIILessonsfromtheTradingFloor
Chapter11LessonsfromtheTradingFlooronVolatility
UnderstandingWeightedVegasinSPXIndexOptionsTakingontheSkewFourTipsWhentheVIXCashIsDepressed
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HowtoFindandTrackVolatilitySkewSPXSkew:It’sAllRelativeUnderstandingImpliedVolatilityinIronCondorsTheStagesofSkew
Chapter12LessonsfromtheTradingFlooronRiskManagement
CashIsaPosition
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TheCardGameValueWhyAreOptionTradingHandsSoHardtoSitOn?HowOptionTimeValuePremiumDecaysovertheWeekendWhenIstheTimetoDe-riskYourPortfolio?HowtoTradeWhenYouGoonVacation
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Chapter13LessonsfromtheTradingFlooronTradingandExecution
WhatEverybodyShouldKnowAboutPaymentforOrderFlowWhenShouldYouWorryAboutAssignment?ASuccessfulShortSPXCalendarButterflyTrading
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ChecklistWhatIstheProperWidthforanIndexButterfly’sWings?TheImportanceofGoodExitsPreparingtoTradeforaLiving,HowMuchCapitalIsNeeded?TheImportanceofFocus
Chapter14Lessonsfrom
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theTradingFloorontheOtherGreeks
WhatHappenstotheGammaofITMorOTMOptionsWhenIVIncreases?WhyDoINeedtoWeightMyOptionPortfolio?GammaScalping
Chapter15TheBeginning
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AppendixARecommendedReading
Category1:TheStarterCategory2:GettingReadytoStartPaperTradingCategory3:ReadytoTradeCategory4:AdvancedandMathematicalOtherBooksThat
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MightBeUseful
AppendixBStrategyLearningSequence
AppendixCOptionPit.com
AppendixDKiteSpread
Index
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ForewordAsDirectorofResearchandCo-PortfolioManagerofJimCramer’sCharitableTrust,Icontinuouslylookformoreeffectivewaystooverseethefundandimprovereturns.Althoughitisalong-onlyequityfund,itisimperativetohaveaworkingknowledgeofallassetclassesandtheireffectsonthebroadermarket
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andtradingpsychology.Oneofthemostimpactfulmetricsofmanagingmoneyintoday’smarketis,withoutquestion,volatility.Volatilityasanassetclassisarapidlygrowingconceptinthemarketplace.Indexesandproductshavebeenintroducedtotrade,hedge,anduseasforecastingmechanisms.Financialmediacommonly
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portraystheVIX,orCBOEVolatilityIndex,asanindicationof“fear”inthemarket.Typically,whentheVIXistradinghigher,stocksaremovinglowerandtheinverseapplies.Yetitisfarmoreimportantthanthat,astheVIXandvolatility-basedproductshavebroughtthemarkettoitsnextstageofevolution.TheChicagoBoardOptions
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ExchangebeganitsacademicworkontheVIXintheearly1990s.Today’sindexhasevolvedintoaproductwithfuturesandoptionscontractsbasedontheS&P500,whichallowsforamoreaccurateviewofinvestors’expectationsonfuturemarketvolatility.Followingthefinancialmeltdowninthebackhalfof2008,impliedvolatilityexplodedasthemarketimploded,andthatis
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whenmarketparticipantsembracedvolatilityasadiversificationtool.Otherexchangeshavenowdevelopedtheirownfuturesandderivativesproductsacrossmultipleassetclassesandcommodities,includingcurrency,gold,andoil.MarkSebastianistrulyamasteroftradingoptionsandfuturesonvolatilityderivatives.Whenitcomesto
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thetechnicalsubtletiesofcomplicatedmarkets,hisanalysisandabilitytobreakdownthemathematicalandquantitativecomplexitiesinanintelligentandunderstandablestyleissecondtonone.Markforcesyoutothinkindifferentwaysabouttheoptionandfuturesmarkets,ofteninwaysthatareoutsidethecomfortzone.Forthisbook,Markjoined
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forceswithhisfriendDennisChenandconvincedhimtosharetheframeworkandprocessesusedwhenmanaginghishedgefund.Bydoingso,theyprovideyouwithareal-worldperspectivetothebusinessoftradingoptions.AlbertEinsteinsaid,“Anyintelligentfoolcanmakethingsbigger,morecomplex,andmoreviolent.Ittakesa
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touchofgenius—andalotofcourage—tomoveintheoppositedirection.”MarkandDennis’suncannywaytoconsistentlycomeupwithout-of-the-boxstrategiesencouragestraderstodigdeepandreallyunderstandtheworldofderivative-basedproducts.Frommyperspective,MarkandDennis’sideas,strategies,framework,andconceptsaresophisticatedyeteasyto
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understandandimplement,whichisinvaluablewhentryingtobeatthecompetitionandthebroaderaverages.TheOptionsTrader’sHedgeFundisauniquetoolthatcarefullyexplainshowtraderscaneffectivelyidentifyandmanagepositionslikethetopvolatilityexpertsdousingkeystrategiesintrend,time,andvolatility.Asuniqueasitsauthors,itencourages
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investorstoembracetheirindividualitywhendevelopingatradingplananddisciplinefortradingoptions.Acaptivatingandmasterfulread,TheOptionsTrader’sHedgeFundisamust-haveguidethateveryprofessionaltradershouldhaveinhisorherlibrary.Thebiggesttakeawayscenteronmethodology,riskcontrol,andeffectiveuseofcapital—
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thecornerstonesforsuccessfulmoneymanagementandtrading.Tradewell,StephanieLinkDirectorofResearch,Co-PortfolioManager,&VPofStrategyTheStreet
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AcknowledgmentsThisbookistheresultofasetofexperiencesthatwehavecollectedovertheyears.Whetherknowinglyorunknowingly,manypeopleandorganizationshavedirectlyandindirectlyhelpedshapethecontentofTheOptionTrader’sHedgeFund.Wewouldliketothankthefollowingpeopleand
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organizationsforsharingwithusexperiencesthathelpedcreatethisbook:
•AdamParis,CofounderoftheOptionPit.com
•AlexanderElder,TradingCoachandauthorofTradingforaLiving
•JimBoyd,ExecutiveEditor,FTPress
•CheriClark,CopyEditor,FTPress
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•BetsyHarris,ProjectEditor,FTPress
•HarryStrachan,PartneratBain&Co.andMesoamericaPartners
•JeremySiegel,FinanceProfessorattheWhartonSchoolandauthorofStocksfortheLongRun
•KerryLovvorn,TradingCoach
•Livevol
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•OptionVue•PaulHayward,MichaelShore,NinaYoo,andtheCMEGroup’sCorportateCommunicationsteam
•RobbieGarcia,Cofounder,SmartIncomePartners,Ltd.
•RobertWalberg,StephanieLink,JillMalandrino,andTheStreet
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•ShawnandShellyHowton,ProfessorsatVillanova
•TheChicagoMercantileExchange
•TheChicagoBoardOptionsExchange
•TheOptionsInstitute•TheteamatFTPresswhoassistedintheproductionofthisbook
•TDAmeritradeand
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ThinkorSwim
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AbouttheAuthorsDennisA.Chenisahedgefundmanager,investor,managementadvisor,andentrepreneur.HeisthefounderandChiefInvestmentOfficerofSmartIncomePartners,Ltd.,ahedgefundspecializingingeneratingincomeusingindexand
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equityoptions.Dennishasbeeninvestingandtradingequitiesandoptionsformanyyears.HehaspreviouslyservedasamanagementconsultantatBain&Companywherehefocusedonfinancialservices(bankingandinsurance).HewasaprincipalatDiamondTechnologyPartners,Inc.Asanentrepreneur,Dennishaspurchased,improved,andsoldseveralsmallbusinesses.
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Hehasexperienceinmultipleindustries,includingbanking,insurance,realestate,computertechnology,Internet,publishing,advertising,construction,commodities,quick-servicerestaurants,andautomotive.Hisbroadbusinessexperienceenableshimtomakebetterinvestmentdecisionsathishedgefund.DennisearnedhisMBAfromTheWhartonSchoolof
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Business.HealsoholdsaMaster’sinComputerSciencefromArizonaStateUniversityandaBachelor’sdegreeincomputersciencefromtheUniversityofTexas.MarkSebastianisaformermemberofboththeChicagoBoardOptionsExchangeandtheAmericanStockExchange.HeistheChiefOperatingOfficerofOptionPitMentoringand
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Consulting,aChicago-basedoptioneducationfirm.SebastianhasbeenpublishednationallyonYahoo!FinanceandhasbeenquotedinTheWallStreetJournal,Reuters,Bloomberg,andonJimCramer’sMadMoneyshowonCNBC.HehasappearedonCNBC,FoxBusiness,andBloomberg.Heisan“all-starcontributor”forTheStreet’sOptionProfitsTeam.MarkisalsotheManagingEditorfor
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ExpiringMonthly:TheOptionTradersJournaldigitalmagazinefocusedexclusivelyonoptionstrading.HehasspokenfortheCBOE,theISE,CME,andVOLX;isaco-hostonthepopularOptionBlockpodcast;andtheVolatilityViewspodcast.MarkhasaBachelor’sofScienceinfinancefromVillanovaUniversity.
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PrefaceTheideaofthisbookbeganinLasVegasin2010.MarkandIwereattendingaconferenceandwewereworkingongrowingourrespectivebusinesses.Markisthefounder,COO,andDirectorofEducationatOptionPit.com.HeisaformermarketmakerattheCBOEandAMEX.Hehas
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appearedonCNBC,FoxBusiness,andBloomberg.HehasalsobeenquotedinTheWallStreetJournalandisafeaturedcontributoratOptionProfitsofTheStreet.com.Heisanexpertinthefieldofoptionstrading.Ontheotherhand,Iammoreofabehind-the-scenesguy.IoperatemorelikeaKGBorCIAoperative.Uptonow,youwouldhaveknownwhatIhavebeendoingonlyifyou
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wereapartneratmyhedgefund.Itradeoptionsforaliving.Iamtheco-founderandChiefInvestmentOfficerofSmartIncomePartners,Ltd.,ahedgefundthattradesoptionstogenerateconsistentincomeforitspartners.IearnedanMBAfromTheWhartonSchool.Ihaveexperienceinmanydifferentbusinesses,includingfinancialservicesandinsurance,thatIgainedasa
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managementconsultantatBain&Co.andasanentrepreneur.MarkandIshareapassionfortradingoptionsprofitably.Wehavereadmanybooksonoptionsandoptionstrading.Mostofthemanswerthequestionof“what”optionsare.Theyareverydescriptiveandprovideusefulinformation.However,rarelydoyoufindabookthat
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answersthequestionof“how”tomakemoneyinanoptiontradingbusiness.Howdoyoudeveloptheframeworkforanoptiontradingbusiness?Howdoyouimplementasystem?Howdoyouactuallytrade?Howdoyoumakemoneyconsistently?Howdoyoubuildabusinessoutoftradingoptions?Giventhatvoid,wedecided
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towritethisbook.Webelievethatwebringadifferentperspectivetothebusinessoftradingoptions.Thisbookbringsyouourcombinedexperiencestohelpyoubuildasuccessfuloptiontradingbusiness.Wewillshowyouthe“how-to”andgiveyouaframeworkinwhichtooperate.ThebookisbasedonthewayImanageSmartIncomePartners,Ltd.SmartIncomePartnersisahedge
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fundthatspecializesintradingoptionstogenerateconsistentmonthlyincomeforitspartners.Thefundismanagedexactlylikeaninsurancecompany.Itusesthebusinessmodelofaninsurancecompany.InthisbookwewillsharewithyoutheconceptofTheOneManInsuranceCompany(TOMIC).TOMICisthebusinessframeworkthatisusedatSmartIncome
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Partners,Ltd.ThebookalsooffersinsightsdrawnfromthevastexperienceintradingoptionsthatMarkhashadasmarketmakerattheCBOEandNYSE.MarkalsodrawsfromallhisexperiencesfromcoachingstudentsatOptionPit.com.Imustsay,notbecauseheismyfriendandco-author,thatMarkprovidesoneofthebest
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optioncoachingprogramsavailabletoday.IhighlyrecommendOptionPit.com,whereIpersonallyamsubscribedasaprofessionalmember.Markisconsistentlythoughtprovoking,andhepushestheenvelopeonoptiontrading.YoumayrefertoAppendixC,“OptionPit.com,”foranoverviewofOptionPit.comservices.
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Imustwarnyou,thisbookshouldnotbeyourfirstbookindealingwiththeoptionsworld.Itisworthwhileifyouhaveaworkingknowledgeaboutoptionsorifyoucurrentlytradeoptions.Ifyouareanoviceintradingoptions,wesuggestyoureadsomeotherprimersonoptionsbeforereadingthisbook.Readerswillbenefitmostiftheyhavesomeknowledgeofoptions.
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Asmallbutnecessarydisclaimer:TheOptionTrader’sHedgeFundisintendedforeducationalpurposesonly.ThebookreflectsthephilosophyofhowSmartIncomePartnersismanaged.However,duetoregulatoryrestrictions,thisbookdoesnotshareanyperformanceinformationaboutSmartIncomePartners,Ltd.,andisnotintendedtosolicitanybusinessforthe
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hedgefund.Thefundisofferedonlytoqualifiedinvestorsonaone-on-onebasisthroughaprivateplacementmemorandum.IfyouwouldlikeinformationaboutSmartIncomePartners,Ltd.,youmaycontactmedirectlyatdchen@smart-advisors.com.MarkandIwanttothankyouinadvancefortakingthetimetoreadthisbook.Wehope
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thisbookwillhelpyoubuildaprofitableoptionportfolio.DennisA.ChenJanuary2012
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IntroductionTheworldofinvestmentsisverylarge.Youcaninvestinstocks,bonds,options,realestate,CDs,commodities,orfutures.Regardlessofwhereyouchoosetoinvestyourmoneyandtime,itwouldbeverywisetohaveaframeworkwithwhichtomanageyourinvestments.Thisbooksuggestsa
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frameworkfortradingoptionsprofitably;thisframeworkhasbeenusedbyanoptiontradinghedgefund.Thebookisaroadmapforanyonewantingtotradeoptions.Weprovideguidelinesonhowtorunanoptiontradingbusinesssuccessfully.Wealsoprovideyouwithourownexperiences,learnedalongthewayasaprofessionalhedgefundmanager(DennisChen)andaformermarket
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makerandtradingcoach(MarkSebastian).Ifyouarereadingthisbook,youalreadymayhaveexperiencedtradingoptions.Wewillnotteachyouhowtosetupahedgefundorhowtoinvestinhedgefunds.Thereareotherbookstohelpyousetupahedgefundifyousodesire.Thisbookgivesyouaglimpseofhowaparticularhedgefund,SmartIncome
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Partners,Ltd.,successfullytradesoptionsforitspartners.SmartIncomePartners,Ltd.,isanoptiontradinghedgefundmanagedbyDennisChen,aco-authorofthisbook.Athishedgefund,Dennisviewstradingoptionsinadifferentlight.Hethinksofhisbusinessnotasahedgefund,butasaninsurancecompany.Whenaskedthe
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question“Whatdoyoudoforaliving?”mosthedgefundmanagerswouldsay,“Imanageahedgefund,”or“I’mamoneymanager.”WhensomeoneasksDenniswhathedoesforaliving,heanswers,“Imanageriskforafinancialinsurancecompany.”Letusintroducetoyoutheconceptof“TheOneManInsuranceCompany,”orTOMIC.TOMICisthebusiness
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frameworkDennisusestooperateandguidehishedgefund.TOMICisaframeworkthatanyonecouldusetomanagetheiroptionportfolio.YoutoocouldrunTheOneManInsuranceCompany.Inthefollowingpagesweintroducetheconcept,explaintheframework,andshowyouhowtomanageyouroptiontradingbusinesslikeDennisdoesathishedgefund.Also,youwillfindthroughoutthe
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bookkeylessonstheyhavelearnedduringtheirtradingcareers.PartIofthebook,“TheFramework,”showsyoutheframeworkdetailsofTOMIC.Chapter1,“TheInsuranceBusiness,”providesanoverviewoftheinsurancebusinessandcomparesittothewaythehedgefundthinksaboutitsoptiontradingoperations.Youwillreview
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thevaluechainofatraditionalinsurancecompanyandcompareittothevaluechainofTheOneManInsuranceCompany.YouwilllearnwhatkeysuccessfactorsareneededtorunasuccessfulTOMIC.YouwillgainabetterunderstatingofthebusinessofTOMIC.Chapter2,“TradeSelection,”providesyouwithguidelinesoftradeschosenforTOMIC.
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Youwilllearnaboutmarketselection,direction,timing,volatility,andpricing.Eachofthesefivefactorsimpactyourtradeselection,whichistheunderwritingfunctionatTOMIC.Itisthekeytomakingmoneytradingoptions.Chapter3,“RiskManagement,”reviewstheriskstakenatTOMICandhowtomanagethoserisksto
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avoidaterminallossofthebusiness.Thischapterdiscussespositionsizing,moneymanagement,diversification,protectionagainst“blackswan”events,1andtradeexits.Chapter4,“TradeExecution,”explainshowtoimplementthetradesyouplace.Itshowshowtogetthemdoneefficiently.Thischaptergivesyouabetter
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understandingoftheconditionstolookforbeforeplacingthetradeandhowtoplacethetradeinordertogetbetterfills.Chapter5,“TheTradingPlan,”discussestheimportanceofhavingaplan,anditreviewstheprocessofcreatingyourtradeplan.Chapter6,“TradingInfrastructure,”reviewsallthetoolsandservicesyou
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needinordertobeabletorunasuccessfuloptiontradingbusiness.Chapter7,“LearningProcesses,”reviewstheimportanceofafeedbackloop.Weincludesuggestionsonsupportingfunctionsnecessarytomaintaintheedgeinthebusinessoftradingoptions.InPartIIofthebook,“ImplementingtheBusiness,”
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wegiveyouatasteofhowtoimplementthebusiness.ThispartofthebookshowsyouspecificexamplesofdifferenttradesthatareusedatthehedgefundthatyoucouldimplementinyourTOMIC.Youwillseehowtotradeaverticalspread,anironcondor,abutterfly,acalendarspread,andaratiospread.Chapter8,“UnderstandingVolatility,”showsyouwhat
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youneedtoknowaboutvolatilitytoimplementtheTOMIC.Chapter9,“MostUsedStrategies,”showsyouindetailthefivemostfrequentlyusedstrategiesatTOMIC.Itprovidesyouwiththekeycriteriaforusingeachstrategy.Chapter10,“OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ,”
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providesguidelinesforcreatingTOMIC1.0.ItprovidesyoutheanswertohowtocreateyourownTOMIC.PartIII,“LessonsfromtheTradingFloor,”isaselectionofblogswrittenbyMarkSebastianforOptionPit.com,withanoccasionalguestblogwrittenbyDennisChen.Thesectioncoverslessonslearnedattheoptionpitsondifferent
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topics.Youwillfindwordsofadviceonriskmanagement,volatility,tradingandexecution,andtheGreeks.Onceyouhavefinishedreadingthisbook,youwillhaveagoodunderstandingoftheinsurancecompanyframeworkusedtobuildaprofitableoptionportfolio.Asyoubuildyouroptiontradingbusiness,youmightdecidetoreadthebookagainbecause
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thereareadditionalinsightsyouwillgetafteryou’veexperiencedrealtradingconditions.Themarketsareconstantlychanging.Weencourageyoutocontinuouslylearnandseektoimproveyourtradingeveryday.Thisbookwaswrittentobeaguide,butyoumustwalkyourownpath.
Endnote
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1.Ablackswaneventisanunexpectedeventoflargemagnitudeandconsequence.TheblackswantheorywasdevelopedbyNassimN.Taleb.RefertohisbookTheBlackSwan.
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PartI:TheFramework
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1.TheInsuranceBusinessInthischapterweshowyouhowtocreateabusinessoftradingoptionssuccessfullybyusingtheframeworkofaninsurancecompany.ThisisthesameframeworkusedatahedgefundmanagedbyDennis(theco-authorofthisbook).So,forthisbook,we
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createtheconceptofTheOneManInsuranceCompany(TOMIC).Youwillneedtoknowhowtheinsurancebusinessworks.Whatisthegood,thebad,andtheuglyoftheinsurancebusiness?Howdoesaninsurancecompanymakemoney?Howdoesitlosemoney?Whatarethekeyprofitdriversofthebusiness,andwhatarethekeysuccessfactors?
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Insuranceistheequitabletransferofriskfromoneentitytoanotherinexchangeforcompensation,calledapremium.Theinsurancecompaniesmakemoneybytakingrisksfromothersinexchangeforapremium.Forexample,ifyouownavehicle,youprobablyhavecarinsurancethatprotectsyourassetagainstabiglossliketheftoraccident.Theinsurancecompanycollectsa
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premiumeachyeartoprotectyouagainstthebigloss.Theinsurancecompanypaysyoutomakeyouwhole.Foraninsurancecompanytofunction,itmustknowwhatrisksitiswillingtoinsure.Italsoneedstoknowhowmuchpremiumitneedstochargetobeabletobacktherisksandstillearnaprofit.Itwillneedtoknowthecar-theftstatisticsandaccidentstatisticsforyourcar’smodelandyear.
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Usingthatinformation,thecompanyisabletopricecoverageandchargeapremiumthatallowsthecompanytomakeaprofitonthelargepoolofcarinsuranceitwrites.Figure1.1illustratesagenericvaluechainofaninsurancecompany.
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Figure1.1.Insurancecompanyvaluechain.
Themainfunctionsinaninsurancecompanyarethese:
•Underwriting:Definingandselectingriskstoinsure
•Pricing:Identifyingtheinsurancepremiumfortherisktaken
•Reinsurance:Divestingorredistributing
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unwantedrisk•Claimsprocessing:Dealingwithcustomersandpayoutofinsurancelosses
•Customeracquisition:Sellinginsurancepolicies
•Investmentoperations:Earningadditionalincomeonreserves(float)
Theunderwritingfunction
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selectsriskstheinsurancecompanyiswillingtoinsure.Thisfunctiondefinescharacteristicsoftheriskandanalyzesthestatisticaloutcomesoftherisk.Forexample,theunderwritingfunctionofapropertyandcasualtyinsurancecompanywouldlookattheautoinsurancemarketanddecidewhichsegmentofthemarkettheywouldliketoinsure.Theunderwriters,throughtheir
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analysis,mayfindoutthatthesmall-SUVsegmentdrivenbymarriedwomenbetweentheagesof24and36haveonlya1%chanceofanaccidentversusthegeneralaverageSUVaccidentrateof5%.Theunderwritersmaydecidethatthisisasegmenttheywouldliketohaveintheirportfolioofinsurancepolicies.Thepricingfunction
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determinestheamountofpremiumtochargefortheriskbeinginsured.Continuingthisexample,theinsurancecompanypricesthesmallSUVdrivenbymarriedwomenbetweenages24and36atapricethatgeneratesapositiveexpectedreturn.Theypriceitatanexpectationofa20%returnonpremiumswrittenfortheyear.
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Thereinsuranceoperationdivestsorrelocatesunwantedrisk.Theinsurancecompanybuysinsurancefromotherinsurancecompaniesorreinsurancecompaniestospreadriskamongmany.Ineffect,ittransferstheunwantedrisktootherentities(reinsurancecompanies)thatarewillingtobeartheunwantedrisksinexchangeforcompensation.Anexampleofthisisa
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propertyandcasualtyinsurancecompany(AutoInsuranceCo.)withalargebaseofautoinsurancesubscribedintheSanFranciscoBayArea.Thecompanyisnotwillingtotaketheriskofanearthquakewipingoutalltheinsuredvehicles.AutoInsuranceCo.iscomfortableinsuringthevehiclesfornormalaccidentsandtheft,butiftheBigOne(earthquake)happensitwill
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causedamagetoallthecompany’sinsuredcars.Therefore,theinsurancecompanyreinsuresearthquakeriskbybuyingearthquakeinsurancefromareinsurancecompany(let’scallitReinsuranceCo.)thatspecializesincatastrophicinsuranceandiswillingtoassumetheearthquakerisk.So,iftheBigOnehits,AutoInsuranceCo.wouldnotlosebecauseReinsuranceCo.
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wouldpaytheAutoInsuranceCo.fortheearthquakeclaims,whichinturnusesthefundstopaytheindividualautoclaims.Hence,itsriskofanearthquakewasundertakenbythereinsurerandnottheautoinsurancecompany.Theclaimsprocessingfunctiondeterminesthecostofalossandpaysclaimstotheinsured.Goingbacktotheautoinsurancecompany
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example,theclaimsprocessingunitsendsoutadjusterstoanaccidenttoevaluatethelossandtostarttheclaimprocess.Thisinvolvescustomerserviceaswellascompensationsincetheadjusterdealswiththeinsuredandwantstoprovidegoodserviceinordertokeepthemasaclient.Thecustomeracquisitionfunctionisexecutedthrough
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agentsandbrokers.Theyareresponsibleforsellingtheinsurancepolicies.Theagentsmaybeexclusiveagentsoroutsideagents.Thechannelscouldbethroughphysicalagencies(offices),byphone,oronline(usingtheInternet).Thisfunctionisalsosupportedbymarketingandcustomerservicedepartments.Theinvestmentoperation
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functionisaprofitcenterofaninsurancecompany.Therearetwotypesofprofitsgeneratedininsurance:underwritingprofitsandinvestmentprofits.Theunderwritingprofitsaregenerateddirectlyfromwritinginsurancepolicies.Underwritingprofitsarewhatisleftafterthepremiumsarecollectedandclaimsarepaid.Theinvestmentprofitsaregeneratedfrominvestingthe
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premiumsandreservessetupwhenpoliciesarewritten.Somepeoplerefertoinvestmentprofitsasincomegeneratedfromthe“float”ontheinsurancecompanies.WarrenBuffettisamasteratinvesting.TheinsurancebusinessesinBerkshireHathaway(GEICOandGeneralRe,forexample)arerequiredtocreateasetamountofreserves.Thesereservesareinvestedby
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WarrenBuffetttogenerateincome.Thisistheincomederivedfromtheinvestmentoperations.
HowInsuranceCompaniesMakeMoneyInsurancecompaniesmakemoneyfromunderwritingandfromoperations.Underwritingprofitscome
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fromsellinginsuranceandtakingonrisks.Investmentprofitsareprofitsintheformofinvestmentreturns.TOMICmakesalmostallofitsmoneyfromunderwritingoperations.TOMICcouldmakemoneyfrominvestmentsalso,butthistopicisnotcoveredinthisbook.Hereisanexampleofhowaninsurancecompanymakes
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moneysellingautomobileinsurance.EachyearABCAutoInsuranceCo.insures10,000carswithaveragevalueof$20,000percar,anditchargesonaverage$1,000annualpremiumforeachcar.Eachyearithasonaverage1,000claimswheretheaveragecostofaclaimis$4,500.Lookingattheinsuranceoperations,ABCAutoInsuranceCo.earnsaprofitof$5,500,000.
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ThisishowagrossProfitandLosssummarylooks:
Ofcourse,therewillbeadministrativeoverheadbeyondthisgrossprofit.Also,whileABCiswaitingtopayoutclaims,itmakesmoreprofitfrominvestingthemoneyitcollectsaspremiumsandearns
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investmentincome.So,assumingABCcanearnabout3%onthepremiumsitcollectedanditmaintainedanaveragefloat(premiumcollectedandnotpaidoutasclaims)of$2,750,000($5,500,000/2),itwouldmakeanother$82,500ininvestmentincome.ABCAutoInsuranceCompanymakesmoneybychargingsufficientpremium
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tocovertheactuallossesincurredandleavingaprofitforthecompany.ThekeytomakingmoneyforABCistheexpertiseinunderwritingrisk.A20-year-oldsinglemaledrivingatwo-doorsportscarpaysahigherautoinsurancepremiumthana30-year-oldmarriedfemaledrivingaminivan.ThatdeterminationismadebytheunderwritersatABCusingstatisticalestimatesofthecustomerand
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typeofvehicle.So,bynowyouareprobablywonderinghowanoptionsellinghedgefundworkslikeaninsurancecompany.Howisoneoptiontraderabletodoeverythinganinsurancecompanydoestomakemoney?Keeponreading.Wewillshowyouhowtotradeoptionsexactlylikerunninganinsurancecompany.Aside-by-sidecomparisonof
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theautomobileinsurancetowriting(orselling)aputisshowninTable1.1.Table1.1.AutoInsuranceComparisonstoOption
Selling
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Table1.1showsaside-by-sidecomparisonofautoinsuranceandoptionselling.Rememberthatoptionsareaformoffinancialinsurance.Theytransferrisksfromthe
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optionbuyertotheoptionseller.Autoinsuranceisjustlikeoptions:
1.First,thereisanassetbeinginsured.Inthecaseofautoinsurance,theassetinsuredisthecar.Inoptionstheassetbeinginsuredisthestock,index,orfuture.
2.Everyinsurancecontractisineffectforaspecifictimeperiod.In
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autoinsurancethepolicyusuallyisfor12months.Inoptionstheperiodvariesdependingontheoptionsyoubuyorsell,anditcouldrangefromadurationofoneweekto30months.Inthisexampletheoptionexpiresin30days.
3.Forautoinsurancethereisanamountthatis
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insured,thevalueofthevehicle.Inthisexampleitisa$20,000car.Inoptionsthestrikepricedefinestheamountinsured.Inthiscaseit’s$90;thismeansthattheowneroftheputhastherighttosellXYZstockat$90beforetheoptionexpires.Thisislikeautoinsurance:Ifthevehicleisworth$20,000andgetsintoanaccident
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thatcauses$4,500indamages,thentheautoinsurancecompanyneedstomakethepolicyholderwholeandpayfortherepairsneededtobringbackthevalueofthevehicleto$20,000.
4.Topaylessforautoinsurance,somecarownersarewillingtotakesomeriskby
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agreeingtoadeductibleinthecarinsurancecontract.Inthisexample,thecarowneriswillingtopayforthefirst$2,000ofdamagesinaclaim.Hence,ifthecargetsinanaccidentandtherepairsare$4,500,theinsuredwillhavetopay$2,000andwillbereimbursed$2,500fromtheinsurancecompany.
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ThisisanalogoustosellingOTM(out-of-the-money)puts.Theoptionbuyer,topaylessfortheputthat’sprotectingXYZstock,iswillingtoassume10%ofthelossifXYZstockgoesdown.So,insteadofbuyingaputwitha$100strikeprice,hebuysaputwitha$90strikeprice.ThatmeansthatifXYZstock’s
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pricefallswithin$0to$10,orupto10%,thentheowneroftheputwillnotgetanythingbackfromtheputifheldtoexpiration.Heiswillingtoabsorbthefirst10%ofthefallinXYZ.
5.Apremiumispaidforinsurance,thesameasforoptions.Inbothautoinsuranceandoptions
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thefeepaidforthecontractiscalledapremium.Intheexample,thecarownerpaid$1,000toinsurethecarfor12months.Theoptionbuyerpaid$3toinsure100stocksofXYZatapriceof$90for30days.
6.FromtheABCAutoInsuranceCo.pointofview,thereisaloss
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ratiobasedonactuarialtablesexpectedfromsellingtheautoinsurance.InthisexampleABCexpectstohavea10%lossratio.Thismeansthatonaveragefromtheautoinsurancesegment,itexpectstohaveclaimson10%ofitspolicies.Fromtheoptionsellerperspectivewhenwritingtheput,
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accordingtotheanalyticalmodelused,theXYZputhasa90%probabilityofexpiringworthless.Theunderwritingisveryimportantwhenoneisrunninganinsurancebusiness.Thistopicisaddressedinalaterchapter.
7.Inautoinsuranceeitherthecompanypaysouta
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claimwhenthereisaloss,oritdoesnothavetopayoutanythingifthepolicyholderisclaimsfree.Inthelattercase,theinsurancecompanywouldhavemademoneysinceitkeepstheentirepremium.Itisthesamecasefortheoptionseller.Iftheputoptionsoldexpiresin-the-money(ITM),the
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optionsellerwillhavetobuyXYZstockfor$90fromtheputoptionowner.Iftheputexpiresout-of-the-money(OTM),meaningthatXYZwasabove$90atthetimeofexpiration,thentheputsellerkeepsthepremiumcollected.
8.Mostinsurancecompaniesreinsurepartoftheirrisk.For
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example,ABCInsuranceCompanymightbuyearthquakeandtsunamiinsurancefromareinsurancecompanytocoveralltheautomobilesforwhichABChaswritteninsurance.Thisisdonetoavoidacatastrophicevent.Iftherewereatsunami,mostlikelytherewouldbecloserto100%lossinsteadof
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10%expectedloss.Hence,reinsuranceagainstcatastrophiclossesisagoodidea.Theoptionsellercandothesametoprotectagainstacatastrophicevent(e.g.,9/11/2001,afinancialmeltdown,orapresidentialassassination)bybuyingaputatlowerstrikes(OTM)inXYZorbybuyinganOTMputat
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themarket(S&P500index).Bydoingthis,theoptionssellerreinsuresjustliketheinsurancecompaniestoavoidcatastrophiclosses.
Theexampleshowsthatsellingoptionsisverymuchlikerunninganinsurancecompany.Thebusinessofaone-maninsurancecompanyistocollectpremiumsfrom
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optionbuyersinexchangefortherisksoflossesintheunderlyingmarketsoftheoptionsandearnprofitsfromthetimedecayoftheoptions.
HowInsuranceCompaniesLoseMoneyUnderstandingthebusinessiscrucialtoyoursuccess.Nowthatyouknowhowinsurance
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companiesmakemoney,let’stalkabouthowtheylosemoney.Theinsurancebusinessisfabulous;justmakesureyouknowwhatyouaregettinginto.Makesureyouunderstandtherisks.Insurancecompaniescanlosemoneyintheirinvestmentsorontheinsurancecontractstheyhavewritten.Lossesfrominvestmentsarelossesthatthecompanyhadwiththe
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float(itsreserves).Thelossesfrominsurancecontracts,commonlyknownasunderwritinglosses,comefrominsurancecontractsonwhichthecompanyhadtopayclaims.Whentheclaimsaremorethanthepremiumsreceived,thereisanunderwritingloss.Theinsurancecompanylostmoneybecauseitmispricedtheinsurancebyunderestimatingtherisk.This
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iswhyknowingtheriskisextremelyimportantinordertonotlosemoneyinthisbusiness.Themostimportantfunctionintheinsurancecompanyisunderwriting.Underwritersselectandpricerisk.Theymakesurethatactuariallythepolicieswrittenareexpectedtohaveapositivereturn.Forexample,inalifeinsurancepolicy,theunderwritingunit
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istheonethatfiguresouthowlonga40-year-oldmale,nonsmoker,withacleanbillofhealthisexpectedtolive.Thenwiththisinformationtheyfigureouthowmuchtopricethepremiumforthelifeinsuranceforthissegmentofthepopulationinordertohaveapositiveexpectedreturn.Iftheunderwritingunitiswrong,thelossratiowillbe
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higherthanexpected,andthecompanywilllosemoney.Theywillpayoutmorethantheycollectinpremiums.Thissoundslikeasimplebusiness,butitisnot.Thecompanyestimatestheprobabilityoflossestoasegmentitwantstoinsure.Next,basedonthoseestimates,itpricesthepremiumneededtomakeaprofit.Then,itsellsthe
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insurancepolicies.Itcollectsthepremiumsandinveststhemwhileitwaitsforthepolicytoexpireortheeventtohappen.Finally,iftheeventhappensitpaysouttheclaim,oriftheeventdoesnothappenitpocketsthepremiumsasprofits.Whereistheugly,youask?Overall,insuranceisagoodbusiness.However,theuglycomeswhentherearerisks
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thatarehardtocalculate.Thefinancialcrisisof2008,whenAIGalmostwentunderandtheU.S.Governmentbaileditout,isanexampleoftheugly.AIGwassellingcreditinsurance,creditdefaultswaps(CDS),toinsuremortgage-backedsecurities.However,itdidnotcalculatetheriskscorrectly,andwhensubprimemortgagesstartedblowingup,AIGwasinbigtrouble.AIGsold$450
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billionofcreditinsurancewithoutaclearunderstandingofhowtherisksbehaved.Whenthesubprimemortgagesstartedtodefault,theunderlyingmortgage-backedbondsinsuredbyAIGstartedfailingandAIGwascaughtwithoutenoughliquiditytobackthesecuritiesithadsold.Itturneduglyveryfastandwasduetopoorunderwriting.AIGdidnotknowtherisksittookonand
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didnotcollectthenecessarypremiumstocovertherisks.Infact,itdidn’tmanageitsportfolioofriskscorrectlybecauseitwasoverexposedtosubprimemortgageriskswithoutknowingtheirmagnitude.Itwasadisasterthatalmostbroughtdowntheentirefinancialsystem.That’stheugly.Insurancecompaniessell“paper,”apromisetopayin
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thefutureinexchangeforcashnow.Inthefuturewhoknowswhetheritwillhavetopayornot,butmostlikelyitwillpayoutlessthanthecashitcollected.
SuccessDriversoftheInsuranceBusinessThekeyforaninsurancecompanytobesuccessful
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boilsdowntodoingfourthingsright:
1.RiskSelection:Identifyingtheriskitiswillingtotake,whichmeansbeinggoodatunderwritingandpricing.
2.RiskManagement:Managingrisk,reinsuringunwantedrisk,andmanagingclaimseffectively.
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3.RiskAcquisition:Subscribinginsurance,usingsaleschannels,andeffectivemarketingtoattractclientsandsellinsurancepolicies.
4.InvestmentOperations:Earninggoodreturnsonthereserves(orfloat).
Reviewingthevaluechain,Figure1.2,asyoucomparethetraditionalinsurancecompanyvaluechainto
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TOMIC’ssimplifiedvaluechain,youseethattheirfunctionsandtheirsuccessfactorsarethesame.TheinvestmentoperationsofTOMICareverysimple.TOMICkeepstherequiredreservesinmoneymarketfundsorincash.
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Figure1.2.ComparisonbetweenvaluechainsofatraditionalinsurancecompanyandTOMIC.
TOMIC’svaluechainhasthreeprimaryfunctions:
1.TradeSelection:Encompassesunderwritingandpricing.Selectsthemarketandstrategiestotrade.
2.RiskManagement:
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Encompassesmoneymanagement,tradesizing,hedging(reinsurance),tradeadjustment(claims),andtradedecisions.
3.TradeExecution:Istheequivalentofclientacquisitioninthetraditionalinsurancecompany.InthiscaseTOMICgoestotheoptionexchangestosell
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itsoptions(insurancepolicies).
Thesesuccessdriversneedtobemanagedinanyinsurancecompanythatwantsprofits.AtTheOneManInsuranceCompanyyouneedtoconstantlywatchandmanagethesedriverstoavoiduglyresults:
1.Tradeselection.Thisfunctionencompassesselectingmarkets,
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pricingtherisk,andselectingastrategyandatimeframe.AllstateandStateFarmselectgeographicregionswheretheysellhomeownersinsurance.ItisthesameprocessinTheOneManInsuranceCompany(TOMIC),butinsteadofhomesindifferentgeographies,TOMICselectswhichunderlyingindexesor
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equitiesmarketsitwillwriteoptionson.TOMICcouldwriteoptionsontheSPX,RUT,NDX,DIA,AAPL,IBM,PG,JNJ,orGOOG,tonameafew.Pricingoftheinsuranceisveryimportant.InaninsurancecompanylikeAllstatetheunderwritingdepartmentdefinesthe
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expectedlossesforaspecificgroupofinsured.Forexample,forautomobileinsurancetheywouldusevariablestopredictexpectedlossesfromasegmentofdrivers.Theyknowtoexpectfewercrashesfrommarriedwomenage32,drivingaminivan,thanforsinglemalesage18,drivingatwo-seat
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convertible.AtTOMICthepricingisverysimilar.Thedifferenceisthatyouaretheunderwriterandwillneedtoknowthevolatilityandpriceoftheunderlyingequityorindexyouaregoingtoinsure(writeoptionsagainst).Onceyouknowthemarketandtheriskyouwanttotake,youselecta
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strategy.Yourstrategyselectioncouldbeaverticalspread,calendarspread,condor,andsoon.Finally,youshoulddecideonatimeframeforthetrade—aweek,20days,30days,andsoon.Homesareusuallyinsuredonanannualbasis.
2.Riskmanagement.Thisfunctioncouldbemore
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accuratelycalledactiveriskmanagement.Thisfunctioncontinuouslymonitorstheriskportfolioanddivestsanyriskthatisnotwanted.AtAllstateifthelossratioonmarriedwomendrivingminivansstartsincreasingyearafteryear,theyhavetodeterminewhathaschanged.Maybeitis
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thatthewomenhavemorechildrenwhocausedistractionswhenthewomenaredriving.Giventhattheyareconstantlymonitoringtheirinsuranceportfolio,Allstateadjusts(raises)thepriceoftheinsuranceforthismarket,ortheymightnotinsuremarriedwomenwithkidsdrivingminivans.The
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sameshouldhappenatTOMIC.Forexample,ifTOMICinsuresdefensecontractorsandnewlegislationfromCongresscutsdefensespendingbyhalf,TOMICmightstopwritingoptionsondefensecontractorsoritmightreinsureitspositionbybuyingputs.TOMIChastoconstantlybeawareof
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changesinvolatilitiesandpricesoftheunderlyingmarket.RiskmanagementatTOMICinvolvespositionsizing,moneymanagement,tradeadjustments,portfolioinsurance,andportfoliodiversification.
3.TradeExecution.Thisfunctionisequivalenttothesalesofinsurancepoliciesbythe
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traditionalinsurancesalesforce.InsteadofhavingagentslikeAllstate,atTOMICwehavetheoptionexchanges.TOMICgoestoanoptionexchange,usingabroker,tobuyorselloptions.Thereisnoneedforasalesforcetosellinsurance,onlyacomputerconnectedtoanexchange.The
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efficiencyandeffectivenessinwhichTOMICcanexecuteatradewillhaveadirectimpactonprofitability.Therearedifferentwaystoexecuteacomplextrade,andtherearemanyfactorsthatimpacttheexecution.Thefactorscouldbethesizeofthemarket,sizeofthetrade,thetimeofday,theexchangesthe
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marketistradedon,andthemarketmakers.ThisfunctionisacruciallinktohavingasuccessfulTOMICornot,andyoumustknowhowtoexecuteyourtradeswell.
AllthekeysuccessfactorsofaninsurancebusinessneedtobeinplaceatTOMICinordertohaveanongoingsuccessfulbusiness.TOMIC
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operatingprofitablyandsuccessfullyis,intheory,achievable.Figure1.3showswhatTOMIClookslikewhenyouincludeallofitsfunctions:primaryandsupport.
Figure1.3.TOMICvaluechain.
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Everybusinesshassomekindof“infrastructure”beforeitbeginstooperate.Forexample,afast-foodfranchiseneedsrealestate,stoves,refrigerators,andtelephones.AtTOMIC,youneedhardware(computers,Internetconnections,andtelephones),software(tradingsoftwareandaplan),andworkingcapitalinordertooperate.ForTOMICtoexecuteitsfunctions(trade
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selection,riskmanagement,andtradeexecution),itneedstohaveasetofsupportingfunctionsinplace.ThesupportingfunctionsallowyoutooperateTOMICsuccessfully.Thesefunctionsaredividedintotradingplan,tradinginfrastructures,andlearningprocesses.Table1.2showsanoutlineofthesupportingfunctionsandtheirimportantprocesses.
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Table1.2.TOMICSupportingFunctions
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Thetradingplanistheoperationalplanofa
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traditionalinsurancecompany.Thetradingplanspecifiestradegoals,themarketstotrade,thestrategies,theriskmanagementparameters,andtheentriesandexits.ThetradingplanistheoperationalguidelineforthemanagerofTOMIC.ItdescribestheparametersinwhichTOMICshouldoperate.Thetradinginfrastructureis
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thecollectionofbrokers,executionsoftware,analysissoftware,informationresources,portfoliomargin,andriskcapital.ThelearningprocessesareasetofhabitsTOMICneedsinordertocontinuouslyimproveitsbusiness.Thisfunctioncontainsatradingjournal,atradinggroup,atradingcoach,andacontinuingeducationplan.
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Inthischapter,weprovidedyouwithanoverviewoftheinsurancebusiness,andweshowedyouhowTOMICisjustlikeatraditionalinsurancecompany.InthesubsequentchaptersofPartI,wediscussindetaileachoftheprimaryfunctionsandsupportfunctionsofTOMIC’svaluechain.
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2.TradeSelectionTradeselectionatahedgefundistheequivalentoftheunderwritingfunctioninaninsurancecompany.Ifunderwritingisexecutedcorrectlyandtheriskispricedfairly,thebusinessissound.Thebusinessshouldmakemoneybecause
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premiumscollectedareadequatecompensationfortherisktaken.Ifunderwritingisexecutedpoorlyandtheriskbeingtakenisnotwelldefined,thepremiumscollectedmightnotbeenoughtocovertherisks.Agoodexampleofthisisthecontrastoftwobigevents.OneeventislossesfromHurricaneKatrinain2005,andthesecondislosseson
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mortgage-backedsecuritiesthatledtotheimplosionofAIGin2008.Botheventswerebighitstotheinsuranceindustry.Thefirstevent,HurricaneKatrina,causedalotofdamagesandclaims.However,theinsurancecompanieswereabletosurviveandprofitevenwithclaimsresultingfromtheevent.InareporttoCongressin
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2008,RawleKinganalyzedtheinsurancelossesincurredduetoHurricaneKatrinaandconcludedthattheinsurerswereabletoabsorbthelosseswithoutanyproblem:
Catastrophe-insuredlossesin2005totaled$66.1billionfrom24disasters.EstimatedinsuredlossesfromKatrinaalonewere$43.6billionstemmingfrom1.75millionclaims.
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Despitetheseverityofstormdamages,HurricaneKatrinaandothercatastrophesin2005didnotthreatenthesolvencyandclaims-payingabilityoftheproperty/casualty(p/c)insuranceindustry.Insurersbenefitedfromfavorablemarketconditionsduringthelastthreeyearsandexperiencedsignificantgrowthinpolicyholder
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surplus.Insurers,infact,earnedrecordprofitsineachofthelastthreeyears—2004-2006.1
TheinsurancecompanieswereabletoprofitfromKatrinabecauseofsoundunderwriting.Theyhadpreviousexperiences(HurricaneAndrew,forexample)thathelpedthemdeterminetheirriskandenabledthemtocollectthe
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correctamountofpremiums.Thesecondevent,AIG’ssellingof$450billionofcoverageincreditdefaultswaps,wasnotwellunderwritten.AIGdidnothaveaclearunderstandingofhowtherisksbehaved.Pricinginsuranceforthebondswasnotlikepricingfireinsuranceforhouses.PricingCDS(creditdefaultswaps)isverydifferentfrom
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pricingfireinsurance.Ifahouseinaneighborhoodburnsdown,itdoesn’tincreasetheriskofahouseinanotherneighborhoodtenmilesawayburningdown.IntheCDSmarket,ifamortgage-backedsecurityfailedduetoweakeningeconomicconditions,forexampleanincreaseinunemployment,othermortgage-backedsecuritiescouldalsofail.AIGdidvery
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poorunderwritinganditpaiditsduesin2008whenthegovernmenthadtobailitout.Itdidnotunderstandtherisksitwastakingon,itdidn’tpriceitcorrectly,anditdidn’tmanageitsportfoliocorrectly.Italmostwentunder.Hence,tradeselection,likeinsuranceunderwriting,isthekeytothisbusiness.TOMICisbuiltbyhavingaportfolio
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ofriskstakeninexchangeforpremiumscollected.TOMICmustknowtherisksitistakingon.TOMICcannotinsurewhatitdoesn’tknow.Thisiswheretradeselectioncomesintoplay.ItisprobablythemostimportantfunctionatTOMIC,underwritingandthedecision-makingprocessontheriskstobeacquired.Thereareseveraldecisionstobemadewhenyou’re
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selectingatrade.First,youhavetoselectwhichmarketstotrade.Second,youneedtofindthebestavailablestrategytouseforthatmarket.Third,youhavetosetthedurationofthetrade.Fourth,youhavetoknowtheimpactofvolatilityinyourtrade.Finally,youwillhavetodecidethepriceatwhichyouarewillingtoenterthetrade.
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MarketSelectionTheselectionofmarkets(underwriting)isveryimportant.Eachmarketisunique;themarketsbehavedifferently.Forexample,GLD(SPDRGoldTrust)isaproxyforgoldanditbehavesmuchdifferentlythanSPY(SPDRS&P500ETF),theexchange-tradedfund(ETF)thatreplicatestheS&P500.Thedifficultyleveloftrading
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optionsonamarketdependsonyourfamiliaritywiththatmarket.Forexample,GEICOspecializesinautoinsurancewhileAFLACspecializesindisabilityandworkers’compensationinsurance.Bothareinsurancecompaniesbuttheyareindifferentmarkets.You,astheoperatorofTOMIC,willhavetodefinethemarketsyouwanttoplay.Youcouldbeaspecialistlike
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AFLACandinvestinoneortwomarkets,oryoucouldbelikeStateFarmorAllstateandmanagemultipleanddifferentmarkets.AtTOMICthemarketsarebrokendownintofourclasses:
1.Indexes:SPX,NDX,RUT,OEX.
2.Exchange-tradedfunds:SPY,QQQ,IWM,OIH,RTH,XLF,XLE.
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3.Equities:AAPL,IBM,MCD,WMT,GS,FCX.
4.Futures:Thesearenotcoveredinthisbook;however,theycanbetradedthroughdiversifiedcommoditiesindexesorETCs,exchange-tradedcommodities.
Indexes
Tradingoptionsofindexes
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providetaxadvantagestoU.S.citizens.Section1256oftheInternalRevenueCodeaddresseshowbroad-basedequityindexoptionsaretreated.Basically,anygainonthesaleoftheseindexoptionsistreatedas60%long-termcapitalgainincomeand40%short-termcapitalgainincome.Thisremainstrueregardlessofthelengthoftimeyouholdtheindexoption.Italsoapplies
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whetheryouare“long”or“short”theseindexoptions.IRCSection1256providesadiscountbecausethemaximumblendedtaxrateofanindexoptionis23%(assuming35%ordinarygainsand15%long-termcapitalgains).Thisrateof23%isasignificantdiscountagainstthe35%ofordinarygainsyoupayifyouareinthetopbracket.Beaware,
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though,thattheInternalRevenuecodeisconstantlychanging,soyouandyourtaxadvisorhavetomakesuretheserulesstillapply.TheindexeswesuggestusingareSPX,NDX,RUT,DJX,andOEX.Thefollowinglistshowsthetickersymbolsforthedifferentindexes.PrimaryTaxAdvantagedIndexOptions
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•DJX—DowJonesIndustrialAverage
•OEX—S&P100IndexOptions(Americanstyle)
•XEO—S&P100IndexOptions(Europeanstyle)
•SPX—S&P500IndexOptions
•XSP—Mini-S&P500IndexOptions
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•NDX—NASDAQ100IndexOptions
•MNX—CBOEMini-NDXIndexOptions
•RUT—Russell2000IndexOptions
ThefollowingarethebenefitsofIRCSection1256.Makesuretoconsultwithyourtaxadvisor.60-40TaxTreatment
•Appliestobroad-based,
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cash-settledindexoptions.
•IRSSection1256contracts.
•Regardlessofholdingperiod,profitsaretreatedas60%long-termand40%short-term.
•ReportedonForm6781andScheduleD.
•Positionsare“MarkedtoMarket”atyearend
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andtaxedasifclosed.Year-endpricesbecomecostbasisforthenexttaxyear.
Ifyoudecidetotradeoptionsonindexesyoushouldmakesurethattheoptionshaveenoughliquidity.Youcandothisbycheckingtheoptionopeninterest(seeFigure2.1).TheindexwiththemostoptioninterestistheSPX.Thismarketisveryliquidand
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shouldbeonthetopofyourlist.
Figure2.1.ChicagoBoardOptionsExchange(CBOE)
optionsopeninterest.(Source:
www.cboe.com/data/IntraDayVol.aspx
Exchange-TradedFunds
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(ETFs)
Exchange-tradedfundsareverysimilartoindexes.ETFsconsistofabasketofequitiesthattradelikeastockandmayalsomirroranindex.ItisbesttouseliquidETFswithoptionstrading.ForacurrentlistofETFswithoptions,refertotheChicagoBoardOptionsExchange(CBOE)Websitewww.cboe.com.The
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followingisasamplelistofETFoptionstradedontheCBOE.
DIA—OptionsonDIAMONDSDVY—iSharesDJSelectDividendEEM—iSharesMSCIEmergingMarketsIndexEWZ—iSharesMSCIBrazilIndexFundFXE—CurrencyShares
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EuroTrustFXI—iSharesFTSA/XinhuaChina25GLD—OptionsonSPDRGoldSharesIBB—iSharesNasdaqBiotechnologyILF—iSharesS&PLatinAmerica40IndexIWM—iSharesRussell2000IndexFundIYR—iSharesDJU.S.
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RealEstateIYT—iSharesDowJonesU.S.TransportationAverageIndexFundKRE—KBWRegionalBankingETFMDY—Standard&Poor’sMidCap400IndexMOO—MarketVectorsGlobalAgribusinessETFOIH—OilServicesHOLDRsTrust
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QQQ—PowerSharesQQQTrustRTH—RetailHOLDRsTrustSPY—SPDRS&P500ETFTrustSLV—iSharesSilverTrustTLT—iSharesLehman20+YearTreasuryBondFundUSO—UnitedStatesOil
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FundXBI—SPDRBiotechETFXES—SPDRSPDROil&GasEquipment&ServicesETFXHB—SPDRHomebuildersETFXLB—MaterialsSelectSectorSPDRXLE—EnergySelectSectorSPDRXLF—FinancialSelect
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SectorSPDRXLI—IndustrialSelectSectorSPDRXLK—TechnologySelectSectorSPDRXLP—ConsumerStaplesSelectSectorSPDRXLU—UtilitiesSelectSectorSPDRXLV—HealthCareSelectSectorSPDRXLY—Consumer
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DiscretionarySelectSectorSPDRXME—SPDRS&PMetals&MiningETFXOP—SPDRS&POil&GasExploration&ProductionETFXRT—SPDRSPDRS&PRetailETF
Youneedtoensurethatoptionsareliquid(withopeninterestgreaterthan500perstrikeprice);alsomakesure
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thatthereisadequatedailyvolumeintheETF.VolumedataisprovidedbyCBOEorotherexchanges.
OptionsonEquities
Usingoptionsonliquidequitiesisadvisable.Liquidequitiesarethosewithenoughtradingvolumeandwithoptionstradingallowed.ChecktheCBOEforaveragedailyvolume.Table2.1
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showsasampleofthemonthofApril2011.Thistableshowsthetop50(sortedbyaveragedailyvolume)underlyingequityoptionsinthatmonth.Table2.1.Top50OptionMarketsSortedbyAverage
OptionDailyVolume(Source:
www.cboe.com/data/AvgDailyVolArchive.aspx
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Ifanunderlyingequityhasoptionswithdailyvolume
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greaterthan50,000contracts,youcanconsiderthatmarketliquid.Selectafewequitiesandfollowthemcloselytolearntheirbehavior.Also,diversifyyourmarkets.Selectmultipleindustriesorsectors.Forexample,ifyouwantedtousefivedifferentmarkets,adiversifiedselectioncouldbeAAPL,JPM,FCX,LVS,andBP.
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StrategySelectionStrategyselectionandtradeconstructionarethecruxofthebusiness.YourabilitytoselectthestrategiesandsetuptradesgivingyouthebestchanceofprofitingisoneofthemainfactorsinasuccessfulTOMIC.Toselectyourstrategy,answerthefollowing:
1.Whichmarket(s)are
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yougoingtotrade?2.Whatisthedirection?3.Whatisthetimeframe?4.Whatisthevolatilityoftheunderlyinganditsoptions?
5.Whatistherisk/reward?
Themarketyouchooseimpactsyourstrategyselection.Thecurrentpriceoftheunderlyingandits
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liquidityinfluencesthenumberofstrikesavailabletotradeandthedistancebetweenstrikes.Stockpricedat$15doesnotpriceoutthesameasstockpricedat$300.Forexample,inthe$15stockitwouldbehardertotradeverticalspreadsthanitwouldbeina$300stock.Asforthedirectionoftheunderlying,therearethreepossibilities:up,down,or
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sideways.Havinganopinionofthedirectionthattheunderlyingwillmoveisimportantindeterminingthestrategyselectionyouwilluse.However,itispossibletostillmakemoneywithoutbeing100%correctinthedirection.Toobtainanopinionofdirectionoftheunderlying,sometradersusetechnicalanalysis,someusefundamentalanalysis,andsomeuseacombinationof
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both.Studybothandusewhatismostcomfortableforyou.
TimeFrame“Youwinbattlesbyknowingtheenemy’stiming,andusingatimingwhichtheenemydoesnotexpect.”—MiyamotoMusashi,17th-centuryJapanese
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swordsmanandr ninThetradingtimeframeisanotherfactorintradeselection.Forexample,whenyoubuyinsurance,doyougowithasix-monthpolicyoranannualpolicy?Thepricevariesdependingonthetimeframeyouinsure,soyoupaylessperdayifyoubuyanannualpolicy.AsaTOMICtrader,youwilldecidewhethertowriteasix-month
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orannualpolicy.Infact,thetimeframesusedatTOMICcouldbeweeks,months,quarters,semesters,oryears.Youcantradeweeklyoptionsinmanyindexesandstocks.Forexample,theCBOEoffersweeklyoptionsontheSPXandselectequitieslikeAAPL.YoumayalsowritemonthlyoptionsorLEAPSasfarawayas30months.Yourdecisionontimeframe
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isbasedonyourpredictionofbehavioroftheunderlyingandthevolatilityoftheoptionsinthedifferenttimeframes.Forexample,ifyouthinkSPXwillgosidewaysforthenextyearandvolatilityacrossthedifferentmonthsseemstohaveastablerelationship,thenacalendarspreadmightworkwellforyou.Anotherchoiceisashorterdurationtradesuchasamonthlyironcondoror
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butterfly,dependingonvolatility.
VolatilityThevolatilityoftheunderlyingandtheoptionsusedinthestrategycreatesanotherfactor.IfyouoperateaninsurancecompanysellinghurricaneinsuranceinFloridaandintheCaymanIslands,assumeyouhavedatarevealingthatforthepast150
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yearsFloridagetshitbyamajorhurricaneonaverageevery12years,andtheCaymanIslandsgetshitevery2years.WillyouchargethesamepriceforinsuringhomesofequalvalueinFloridaandintheCaymanIslands?Ofcoursenot.YouwouldexpectthattheCaymanIslandshurricaneinsurancewouldcostmore.Bythesamereasoning,volatilityimpactsthe
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selectionofmarketsandthepriceofinsurance.Mostpeopleignorethisfactorinstrategyselection.However,knowingvolatilitywillhelpyouinyourchoices.Tofigureoutwhichisbetterbetweenacalendarspreadandabutterfly,forexample,ifyoubelievethemarketisgoingsideways,thedecidingfactorwillbevolatility.Youusenotonlythevolatilityof
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theunderlying,butalsothevolatilitycurveoftheoptions(volatilityacrossdifferentstrikeprices),andthetermstructure(volatilityacrossdifferentexpirations).Therisk/rewardfactorsintoyourselection.Thisdefinesyouredge.Yourrewardgoeshandinhandwithrisk.However,sometimesyougetanasymmetricrisk/rewardfunctioninwhichyour
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rewardpaysbetterfortherisktaken.Inthesescenariosthetradehasanedge,whichisaverylargefactorinselectingyourtrade.ThistopiciscoveredinmoredetailinChapter8,“UnderstandingVolatility.”
PricingThepriceofatrade,whetherbuyingorselling,isthefinalfactorintradeselection.
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Volatilityandpricegohandinhand.Ifyoucompareanoptioninahigh-volatilityenvironmentagainstthesameoptioninalow-volatilityenvironment,theoptionpricesshouldbedirectlyproportionaltovolatility.ThisisthecaseoftheexampleofahouseinFloridaandthesamehouseintheCaymanIslands.Intheory,underidealconditions,assumingthatallhurricanes
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causethesameamountofdamage,theCaymanhurricaneinsuranceshouldbepricedatsixtimesthepriceoftheFloridainsurance.Pricesininsurancearenotfixed,justaspricesintheoptionsexchanges;itisamarket-basedsystem.SoifthepriceofCaymanhurricaneinsuranceisonlytwicethepriceofFlorida’sinsurance,somethingdoes
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notaddup.Oneortheotherispricedpoorly.Underthisscenario,whereisyouredge?ShouldyousellFloridainsuranceorshouldyousellCaymaninsurance?Thepriceimpactsyourdecision,right?ThecorrectthingtodoistosellCaymaninsuranceandbuyFloridainsurance.Thishurricane-insurancescenarioisthesame
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reasoningprocessforeverytradeinTOMIC.Pricingdetermineswhetheryoudoatrade.Andpricingisdrivenbythesefactors:underlying,strategy,timeframe,andvolatility.Puttingallthistogether,youselectatrade.Youunderwritetheriskanddecidewhattoinsureandatwhatpriceinordertomakeaprofit.
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Endnote1.RawleKing,1/31/2008,CRSReporttoCongress,“HurricaneKatrina:InsuranceLossesandNationalCapacitiesforFinancingDisasterRisks,”summary.
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3.RiskManagement
“Risk.Riskisourbusiness.That’swhat
thisstarshipisallabout.That’swhywe’reaboard
her.”—JamesT.Kirk,USSEnterprise,StarTrek,“ReturntoTomorrow,”Ep.
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51/4768.3Anyhedgefund,includingTOMIC,isinthebusinessofrisktaking.Itisnotinthebusinessofriskavoidance.AccordingtoWillRogers,“You’vegottogooutonalimbsometimesbecausethat’swherethefruitis.”ThebusinessofTOMICistosubscriberisk.TOMICmakesalivingfromtakingotherpeople’sriskinexchangefor
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apremium.TakingriskiswhatpaysthebillsatTOMIC.Infact,everythinginlifecarriesacertaindegreeofrisk.Ifpeopledidnotperceiverisk,theywouldnotbuyinsurance.Ifthestockmarketdidnothaverisk,noonewouldpaythepremiumsfortheoptions.Wecannotavoidrisk,butwecanmanageit.Whenyoucrossastreetyouaretakingarisk.Acarcouldhityou.Butyou
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managetheriskbylookingbothwaysbeforecrossing.Evenso,acrazysnipercouldshootyoufromthetopofabuildingwhenyouarecrossingthestreet.Ifyouareliving,youareconstantlytakingrisksandyouareconstantlymanagingthoserisks.ThetricktomakingmoneyatTOMICismanagingtheriskbybeingawareofexactlywhatriskyouarewillingtotakeand
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divestingorreinsuringtheriskyoudonotwanttotake.Intheprecedingchapterontradeselection,yousawhowTOMICidentifiestherisksitwantstotakeandatwhatprice.TOMIChastomakesureitreceivesenoughcompensationfortherisk.TOMIChastomanagetheportfoliorisktoavoidlossesduefromunexpectedrisks.Takinglossesfromidentified
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risksisacceptable,butgettingblindsidedfromunexpectedrisksisnot.
RiskManagementRiskmanagementisacontinuousprocessinvolvingeverythingfromunderwriting(selectingthetrade),sizingofpositions,andactivemoneymanagement.RiskmanagementshouldbeingrainedineveryTOMIC
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trader’sDNA.RiskmanagementshouldbepartoftheentireprocessofmanagingTOMIC.TomanagetheriskofTOMIC,youneedtobeabletoanswerallthefollowingquestions.Beforethetrade:
•Whatistherisk/rewardratioofthistrade?
•Whatistheprobabilityofsuccessofthistrade?
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•Whatisthemaximumlossacceptableforthistrade?
•Whatistheexpectedreturnandtargetprofitofthistrade?
•Doesthenewtrademaintainthebalanceordiversificationoftheportfolio?Isitoverexposedinanyonesector?
Duringthetrade:
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•Hasthetradereachedthemaximumallowedloss?
•Hasthetradereachedthetargetprofit?
•Istherewardofkeepingthetradeopenworththerisk?
Afterthetrade:•Didyoufollowtheriskmanagementrulesonthistrade?
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•Ifyoudidnot,whynot?YoumayhaveheardsuccessfulinvestorslikeWarrenBuffetsay,“Rulenumberoneisneverlosemoney.Rulenumbertwoisneverforgetrulenumberone.”ThesecrettoimplementingBuffet’srulenumberoneistohaveadisciplinedriskmanagementprocessinplace.Tomanageitsrisk,TOMIC
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needstodothefollowing:1.Createamoneymanagementpolicy.
2.Defineapositionsizingpolicy.
3.Maintainadiversifiedportfolio.
4.Adjustthetradesorexitwhenatradegoesbad.
5.Buyportfolioinsurancetoprotectagainstblackswanevents.
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MoneyManagementManytradershaveblownuptheiraccounts.Insomecasestheyhaveblownupseveralaccountsandhadtostoptradingforatime.Someofthemhavehadtogiveuptradingaltogether.Moneymanagementisaveryseriousissue.Mostpeople,whentheystarttrading,aresoexcitedthattheyarequicktoopenandfundtheaccount.
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Assoonastheaccountisopened,thefirstthingtheydoisplaceatrade.However,thefirstthingyoushoulddoismakesureyouhavemoneymanagementrulesinplace.Moneymanagementrulesareyoursafetynettohelpavoidblowinguptheaccount.Theworstthingthatcouldhappenislosingyourcapitalandbeingunabletotradeanymore.OneofDennis’s
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tradinginstructors,Dr.AlexanderElder,toldhimthattherearetwotypesofthreatseveryoneshouldwatchoutfor:sharksandpiranhas.Thesharkthreatisthatlosingtradethattakesoutabigchunkofyouraccount.Itisabigpainfulbitethatwillseverelydamageyouraccount.Italsodamagesyoupsychologically.Justimagine
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wipingout35%ofyourequityinonetrade.Thatisarealsharkbite.Thepiranhathreatiswhathappenswhenyouhaveasequenceofsmalllossesthatoverwhelmyou.HaveyouseenthevideosofhowpiranhaskillacowintheAmazons?Theytakealotofsmallbitesandendupeatingthecow.Samewithyourtradingaccount:Ifyouhavea
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lotofsmalllosses,youraccountwillshrinkanddie.Itisveryimportantthatyouraccountprevailagainstyourbadtrades,whetherpiranhasorsharks.Specificmoneymanagementrulesarewise.Forexample,youcansettwoprimaryrules.First,neverriskmorethan2%ofcapitalonanysingletrade.Second,ifinanysinglemonththeaccountlosesmorethan6%,
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stoptradingfortherestofthemonth.Thefirstrule,neverriskmorethan2%onanysingletrade,protectsagainstthesharkattack.Ifyoukeepyourriskto2%onanyonetrade,youraccountwillbeabletosurviveevenifyouhaveabigloss.Yes,losing2%isnotnice,butitwon’tkillyouraccount.Thesecondrule,stoptrading
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whenyouhavelost6%inasinglemonth,protectsagainstthepiranhaattack.Whenyouhavemultipletradesgobadinarowandthingsaregoingagainstyou,stopandreassessyourtradingstrategies.Maybeyoursetupsarewrong.Maybetheenvironmentchangedandyoudidn’tnotice.Maybeyouarenotmakinggooddecisions.Thepointisthatifyouaredown6%inamonth,stop
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tradingandstartfreshthefollowingmonth.Why6%?Thisisanarbitrarypercentage.Yourpercentagecouldbe5%,6%,7%,10%,oranypercentageyoucanlivewith.Thekeyistonotletthepiranhaskillyou.Youneedtobeabletotradeanotherday.Remember;don’tletbadtradeskillyouraccount.Makesureyouhavestrict
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moneymanagementrulesinplaceandabidebythem.Whenyoudothis,youwillbeastepclosertomakingmoney.
PositionSizingThesizeofthetradesshouldbestructuredbyfollowingsoundmoneymanagementrules:Noonetradecanriskmorethan2%ofthecapital,andinanymonththatyou
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lose6%thefundgoesflatandstopstradingforthatmonth.Assumethatafundhas$2millionundermanagement.Followingthe2%rulemeansthefundcouldriskupto$40,000ononetrade.IfyoutradeaRUTcondorwith10-pointwing-spreadswherecondoruses$1,000ofmargin(assumingReg-T),youwouldthinkyoucoulddo40RUT
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condors.Thatis40×$1,000=$40,000,whichis2%of$2million.Actually,thisiscorrectifyouassumeyouwillletthecondorlosethemaximumitcan.Inpractice,weusuallyuseasmallerallowedlossbeforewepullthetrade.Forexample,intheRUTcondorwemighthaveaprofittargetof15%ofmarginandanallowedlossof20%ofmargin.Soifonecondorlost$200(20%of$1,000),
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youwouldexitthetradeinsteadoflettingitlosethemaximum$1,000.Ifyouonlyallowthetradetorisk$200ifyoucanrisk$40,000(2%of$2million)pertrade,thenyoucouldtradeupto200RUTcondors.Aquestionthatcomesupalotisthatifthesecondruledoesn’tallowyoutolosemorethan6%inamonth,doyouhaveonlythreetradeson
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atanytimeduetothe2%rule?Theanswerisno.Youcanhavemultipletradesonwhenfollowingthe2%rule,becausenotallthetradesarelikelytogoagainstyouatthesametime.Iftheydo,youarechoosinghighlycorrelatedtrades,whichshouldnotbedone.Onaverage,ifyouhave15to20tradesonatatimeandassumean80%successrate,youwouldhavethreetofourtradesgoagainstyouin
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anygivenmonth.Sohittinga6%lossinamonthisunlikely.Ifyouhadfourbadtradesat2%,thelosswouldaddupto8%.However,youhavetocountthecontributionsfromthewinningtrades.Thesewouldhavetomakelessthan2%toyieldanet6%lossforthemonth.Ifyoudidlose6%,youshouldstopandreassessyourstrategies.
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Followstrictpositionsizingbasedonyourmoneymanagementparameters.Theseruleswillkeepyourfundssafeandkeeptheaccountfromblowingup.
PortfolioDiversificationInadditiontopositionsizing,TOMICneedstomaintainadiversifiedportfolioinorder
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toavoidgettinghitbyanyonesector.Eventhougheachpositionhasamaximumexposure,ifallthepositionsareincorrelatedmarketsthepositionsizingwillnotsafeguardtheportfolio.Forexample,let’ssayTOMICpositionsizingguidelinesprescribeamaximumportfolioexposureof2%perposition.However,ifallitspositionsareinintegratedoilcompanies,Exxon-Mobil,
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Chevron,BPAmoco,ConocoPhilips,andPetrobras,thepositionsizingwillnotsafeguardtheportfoliobecauseallpositionsareheavilycorrelated.Forpositionsizingtowork,TOMICmustbeawareofportfoliodiversification.TOMICshouldtrytoincludemultiplesectorsorindustriesintheportfolio.Thiswillhelpavoidhavingtoomuch
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investedinonesector.TodiversifyTOMIC’sportfolio,agoodideaistohaveatleastfivesectorsrepresented.Also,noonesectorshouldrepresentmorethan25%oftheportfolio.Forexample,TOMICcouldhaveoptionspositionsinfivemarkets,suchasSPX,AAPL,GS,FCX,andBP.Thismixwillcreategooddiversification.Inaddition,
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noonepositionshouldberiskingmorethan2%ofTOMIC’scapital.
AdjustingtheDifferentTradesWhileTOMIChasopentrades,ithastoactivelymanagerisks.IfatradeisgoingagainstTOMIC,itmustreducethelossescausedbyabadtrade.Therewillalways
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bebadtrades.Noonecanwin100%ofthetime.Youcanavoidlosingonlyifyoudon’ttrade.Adjustingyourtradesispartofriskmanagement.Afteryouhaveenteredintoatrade,makingadjustmentswillmakethedifferencebetweenlosingalotofmoneyandlosingalittle.TOMICmakesadjustmentstoprotectitscapitalandminimizelosses.
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Makingadjustmentsdoesnothelpyoumakemoremoney,butitdoeshelpyounotloseasmuch.Youmakeadjustmentstoatradewhenitisgoingagainstyou,notwhenitisdoingfine.Oneadjustmentthatshouldnotbeoverlookedisclosingthetradecompletely.Takingalossearlyissometimesbetterthanstayinginalosingtrade.Somepeoplebelievethatit
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doesnotmatterwhattradeyouarein—aslongasyouareanexpertatmakingadjustments,youwillmakemoney.Othersbelievethatselectingthetradeandthetradeentryismoreimportantthantheexit.AtTOMICwebelievethattradeselectionismoreimportantthantradeexits;however,makingadjustmentsisalsoveryimportant.Youneedtomasterentries,adjustments,
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andexitstobesuccessfulinthisbusiness.
AddressableRisksInthischapterdifferentsolutionstomanageriskhaveincludedthefollowing:
•Moneymanagement•Positionsizing•Diversification•Unitinsurance•Adjustments
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Everypositionisimpactedbydifferentforcesgoingfromamacroleveltothemicrolevel.Whenselectingriskmanagementstrategiesforaportfolio,youneedtobeawareofthefollowingrisks:
•Systemicrisk•Marketrisk•Sectorrisk•Companyrisk
Systemicriskistheriskofa
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financialsystemcollapsethatinturncanbringdownthelargereconomy.AnexampleofsystemicriskwastheeffectofthecollapseofLehmanBrothersin2008ontherestofthefinancialmarket.ThiscollapsestartedachainreactionthatfrozethecreditmarketsintheU.S.andallovertheworld,andalmostbroughtdowntheentirefinancialsystem.Afailureofonecompanyshouldnot
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bringdownanentiresystemorhavesuchagreatimpacttothelargereconomy.However,itdid.Theworldeconomycametoitsknees.Itisverydifficulttohedgeagainstsystemicrisk.Ifthefinancialsystemsfail,youmightnotknowwhetherthepaperhedgedwillhold.Forexample,theownersofcreditdefaultswapsbackedbyAIGmighthavelosttheirprotectionifAIGhadgone
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under.Thewaytoguardagainstasystemicfailureistoownrealassetssuchasphysicalgoldandsilver.Marketrisksaremacroeventsimpactingtheentiremarket,inwhichalmostallstockswillgethit.Examplesofmacroeventsincludethe9/11attacksontheWorldTradeCenterandthe2008financialcrisisintheU.S.Theseeventsmovedthemarkets,andit
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didn’tmatterwhichstocksyouhad.Marketriskscanbehedgedwithoptions.Buyportfolioinsurance,forexample.Unitputsprovidegoodprotectionforthesekindsofevents.Sectorrisksareeventsaffectingaspecificsector.Forexample,iftheU.S.iscuttingdefensespending,thedefensesectorcompanieswillallbehitnegatively.Another
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example:IftheU.S.weretoimposeanewtaxonfinancialinstitutions,theentirefinancialsectorwouldbeimpacted.Companyrisksareeventsspecifictotheindividualcompany.ExamplesoftheseeventsincludethetotalcollapseofEnronandtheBPspillintheGulfCoast.AnotherexampleisthedeathofakeyexecutivelikeSteve
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JobsatApple.Theseareeventsspecifictoindividualcompanies.Thecompanyriskscanbehedgedeasilywithoptions,andbykeepingadiversifiedportfolio.Risksrangefromthemacrotothemicroandtherearedifferentwaystomitigatethedifferentlevelsofrisks.Table3.1containsexamplesofriskmanagementsolutionsfordifferenttypesofrisk.
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Table3.1.RiskMitigationExamples
InsuringthePortfolioAgainstBlackSwanEventsInsuringorreinsuringunwantedriskisaveryimportantfunctionat
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TOMIC.TOMICisnotwillingtotakecatastrophicrisks.Anexampleofacatastrophicriskisa25%lossinthemarketinasingleday.TOMICshouldmanageitsrisklikeatraditionalinsurancecompany.Forexample,atraditionalautoinsurancecompanywouldreinsuretheriskitdoesnotwanttocarry.AssumethatABCInsurance
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Co.(afictitiousAmericanpropertyandcasualtyinsurancecompany)hasalotofcarsinsuredintheSanFranciscoBayArea.Thisregionispronetoseismicactivity.IfSanFranciscoweretosufferalargeearthquake,allthecarsthatABCInsuranceCo.insuredwouldsufferdamages.ABCwouldhavealotofclaims.ABCInsuranceCo.wantstoinsurecarsagainstnormal
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drivingscenarios,butnotabigearthquake.ABCwouldn’twanttotakethecatastrophicriskofhavingalltheirinsuredvehicleshavinglossesatthesametimeduetoanearthquake.Hence,ABCwouldreinsurethecatastrophicriskwithareinsurancecompanylikeGeneralRe(aBerkshireHathawaysubsidiary),thustakingonlytheriskofthenormaldailyroutines,and
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givingsomeoneelsetheearthquakerisk.ThedivestingofunwantedrisksisexactlythesamethingthattheriskmanagementfunctionsperformatTOMIC.TOMICiswillingtotaketheriskofnormalmovesinthemarket,suchasplusorminus5%pricemovement,butitreinsuresthecatastrophicriskbeyond.Toreinsurethisrisk,TOMICcouldbuyout-of-the-
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moneyputsontheS&P500toprotectagainstalarge(25%)downturninthemarket.Anotheralternativetoreinsurecouldbetobuyout-of-the-moneycallsontheVIX.ThisassumesthatalargedropintheS&P500wouldleadtoalargespikeintheVIX.DependingonthepricingoftheSPXputsandtheVIXcalls,TOMICcoulduseoneorbothoptionstooffloadthecatastrophicrisk.
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UnitsCanSaveYourPortfolio
Thefollowingisanexampleofhowtoprotectyourportfolioagainstablackswanevent.LookbacktotheflashcrashofMay2010.AfundhadenteredaMayOEXbutterflythathadbeendoingreasonablywell,untilthefirstweekofMay.Themarketbegantofallawayfromtheshortstrikes.Atonepointthe
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tradewasdownalmost10%onthebutterfly,evenafterallthehedgingandadjustinghadbeendone.ThenonMay6,theflashcrashhappened,andthepositionmadeakilling.Why?Becausethefundwaslongwhatmostmarketmakerscall“units.”Theseunitsenabledthebutterflyposition,whichbyitselfgotkilledbythecrash,tobeprotectedbytheoptions.
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AunitisaninexpensiveoptionwithunpredictableGreeks.Youcanbreakthemdownrelativetoproduct,sothatthemoreexpensivetheunderlying,themoreexpensivetheunit.Forinstance,inSPYanoptionbecomesaunitaround20cents;intheSPXanoptionisaunitcloserto2.00.Allunitswillhavedeltasbelow5andlittletonogammaorvega.Sohowdotheseunitswork?
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Oneofthemajorissueswithmostmodels,especiallythoseusedbytheretailworld,isthattheypredictuniformincreasesinvolatility.Thissimplyisnotthecase.Whenthemarketmakesaviolentmovedownward,twothingshappen:
1.Frontmonthoptionsincreaseinvaluefarmorethananyothermonth,inrelativeterms.
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2.Downsideputsgainfarmorevaluethanthemodelpredicts.
Thinkofthevolatilitycurveinastrongdownmovelikeathinpieceofwoodevenlybalancedoverafulcrum.Ifafatguyjumpsononesideofthewood,whatwillhappen?Aswithaseesaw,themoreyoumovedowntheboardawayfromthefulcrum,themoreindistancethewood
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willhavemoved.Thereisanotherfactorthough:Sincethefatguyjumpedonthepieceofwood,thewoodwillhavemovedviolently,causingthewoodfarthestfromthefulcrumtotemporarilybendupward.Thisisthewaycheapputsactinamajordownmove.Inthepanic,theworldisbuyingATMputs.Everytradersellingorshortingtheseputs
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racestobuysomethingtoprotectthepositionincasethemarkettanks.Theseshortsbuy“units”andallofthisbuyingcausestheunittogainalittleprice,whichincreasesvega,whichincreasesdelta,whichincreasesthevalueoftheunitasthemarkettanks.Thisinturncausestheunittogainmorevalueastradersracetobuythesetoprotectsales,
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whichraisesthevega...yougetthepoint—thereisasnowballeffect.HereisanexampleofexactlywhathappenedwiththefundintheOEXonApril20.ThefundboughttheOEXMay505putsasahedgeagainstashortironbutterfly.Theputswereboughtfor$1.20.WhenthemarketfellonMay6,theseoptionswereworthalmost$10,andonMay7,
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theyclosedat$14.50,areturnofover1,200%.Notbadforanoptionthatcost$1.20.Sohowcantheordinarytraderuseunitstoincreasethereturnsofhisportfolio?Buyunits,notahugeamount,butabout5%to10%ofallocatedtradingmoney(notthetotalaccountvalue),shouldgointoputs,againstastandardsetofspreadtrades(condors,butterflies,andtime
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spreads).Thisamountshouldbeenoughsothat,adjustedforanyincreaseinvolatilityifthemarketdrops10%,yourpositionnolongerlosesmoneyandpossiblygains.Ifthemarketdrops20%,youshouldbemakingmoney.Themathisnotthatsimple.Understandinghowunitsworkcomeswithunderstandingvolatility.Byproperlyimplementingunits,
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youarewillingtobetthatyouwillneverhavetosellyourhousebecausethemarketdropped25%.
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4.TradeExecutionPlanningneedstobedoneinsports,inconstruction,andintrading.Insportsorconstruction,oncethegamehasbegunthoseplanscangooutthewindow.Conditionsonthefieldcanchangeorrealestateconditionscanaffectthedevelopmentofa
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skyscraper.ThesamecanholdtrueinimplementingaTOMICtradingplan.However,unlikewithsportsandconstructionprojects,theTOMICtraderhasamuchgreaterabilitytocontroloutcomes.Thekey,asitisinmanybusinesses,isexecutingaplaninawaythatisdisciplinedbutadaptive,aformofhavingguidelinesandanapproachwithouthaving“tradingrules.”Justasina
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JamesDeanmovie,rulesaremadetobebroken,sotradersneedtobeflexible.InthissectionyouwillwalkthroughtheprocessofimplementingaTOMICplanfromstarttofinish.Todoso,youwillfollowachecklistthatdemandsathoughtprocess,guidingyouinyourtradingdecisions.Thenyouwillwalkthroughgettinganorderfilledeffectively.
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ConditionsoftheMarketThefirststepistoevaluatethemarket.Atanygiventimethemarketcanbeeithervolatileorcalm.Itcanhaveinflatedorundervaluedimpliedvolatility.Differentcontractmonthscanbeunderpricedoroverpriced.Withinacontractmonthdifferentstrikescanbe
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overpricedorunderpriced.Withallofthesemovingpartsgoingbackandforthatanygiventime,themarketisgoingtobemoreorlessfavorabletospecifictrades.Manybooksandcoursesteachtradingbasedonenteringthesametradeeverymonthregardlessofconditions;thisisanextremelyflawedapproach.Instead,takethesameapproachaninsurance
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companywouldtake:Seewhatconditionthemarketisin,andsellaninsurancepolicythatisleastlikelytobeexercisedbythebuyer.Todoso,youneedtofirstunderstandhowtoevaluatethesituations.
EvaluatePotentialRealizedVolatilityWhenMarkwasatraderon
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thefloor,oneofthethingshequicklyrealizedwasthathedidnotneedtohaveanopiniononacompany’searningsoranFDAdecision,buthedidneedtoknowthattheeventwascomingup.TOMICtradersneedtohavethesameapproach,especiallyfornondirectionalpolicyselling.Doesthecompanyhaveearnings,isthefederalgovernmentreleasingimportantdatathisweek,is
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thefederalreservehavingapolicymeeting,oristherepotentialtroubleinafar-offplacethatcouldpotentiallyaffectfinancialmarkets?Theseareallquestionsyouneedtobeabletoanswerbeforemovingon.Itissomewhatdifficulttoevaluatethepremiuminaparticularinsurancepolicywithoutknowingwhatfactorscouldcausethatpolicytobeenacted.
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Alltheresearchintheworldwillnotpredictearthquakes,terroristbombings,andothercatastrophicevents.ReasonnumberoneisthatlookingatHV(historicalvolatility)canequateto“pissinginthewind.”Thisiswhyyouneedtoevaluateandhaveyourworst-casescenariointhebackofyourheadatanygiventime.Lookingintothepastgivesyouinsightintohowthemarketmightreact.
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Ifyouassumevolatilityismeanreverting(anassumptiontheentireoptionuniverserelieson),astockorindexmovingatanextremelyhighrateofspeedislikelytoslowdown.Astockmovingmuchmoreslowlythannormalislikelytoincreaseinvelocity.Takingthisintoconsiderationhelpsyouevaluatehowexpensiveorcheapaninsurancepolicymightbe.
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EvaluateImpliedVolatilityThepriceofaninsurancepolicyisconstantlyinflux.Atanygiventimetheinsurancepolicymightbeexpensiveorinexpensive.IfyouassumethatHVismeanrevertingandthisisthebasisofIV(impliedvolatility),youcanalmostbecertainthatimpliedvolatilitymeanwill
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revertaswell.Thisisanimportantassumptionforanytradersellinginsurance.ButisthereawaytoprovethatIVreverts?Ratherthanrunabunchofnumbers,amoreinterestingwaytoseeproofofexpectationofimpliedvolatilitymeanreversioncanbeaccomplishedbylookingatVIXoptions.TheVIXoptionsarecashsettledandEuropean-style.
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Becausethereisnoriskofearlyassignment,ifIVgetstoolowortoohigh,theVIXoptionsshouldnotpricetothecashmarket,buttowardsomeexpectationoftheVIXrevertingtoitsmean.Thus,onanIVspike,in-the-moneycallsshouldappearunderpriced,andwhentheVIXisoversold,callsshouldappearoverpriced.Duringtheflashcrash,at
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3:30ESTtherewasstillalotofconfusion.TheVIXwastradingatjustunder40%.TakealookatthepricedifferentialbetweentheVIX30callsandtheVIX47.5calls,asshowninFigure4.1.
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Figure4.1.Noticetherelativepriceofthe47.5
callstothe30calls.(Source:OptionVue6)
Despiteonebeingin-the-moneyandoneout-of-the-money,thetwowerenotthatfarapartinprice.ThisisbecausetheVIXfuturewasactuallytrading29.20,sobothweretechnicallyout-of-the-moneyifyoulookatthefutures(althoughyouwould
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considerthe30stheATMoption).Evenwiththemarketexploding,theexpectationsofcalmingdownstoppedVIXfutures(andthusVIXoptions)fromhittingthe40%thattheVIXcashwastradingatthetime.Oneinterestingthingtonoteisthatthe30swereout-of-the-moneyinrelationtothefutures.Therelativevalueofthisfuturecomparedtothe47.5callswasquiteclear.Oneofthe
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worsttradesintheworldistobuyVIXOTMcallsinthemiddleofacrash.ThemeanreversionofVIXwillkillmostofthesetrades.Youwillfindmarketexpectationsofmeanreversion,andyoucanseehowtousethisassumptioninsellinginsurance.Ingeneral,whenimpliedvolatilityistradingatapremiumtoitsmean,itislikelytobea
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bettersellthanabuy.Thetraderissellingapolicythathistoricallyisoverpriced.However,thisequationisnotthatsimple.TherecanbegoodreasonsthatIViselevated.Thisiswhyyouneedtowalkthroughsteponebeforeevaluatingimpliedvolatility.IfthereisagoodreasonforIVtobehigher,thesalemaynotbenearlyasgoodasitappears.Forapolicytobesold,youneedto
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haveaclearpictureoftherisksofthepolicywhentrading.Onlythencanyoudecidethatapolicyisoverpriced.
EvaluatetheMonthsOnceyouhaveanoverviewofvolatility,itistimetogetyourhandsdirtyanddigintothenitty-gritty.Evaluatingoverallvolatilityisnotenough.Foraneffective
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TOMIC,youneedtoevaluatetheoverallsurface,startingwithtermstructure.Thisishowthedifferentmonthswithinaproductarepricedagainstoneanother.Contractmonthsaretightlycorrelatedtoeachother;however,thatdoesnotmeantheyaretiedatthehip.Atanygiventime,paperflow,thedirectionandsizeofcustomersbuyingorsellingoptions,cancauseonemonthtobemoreorless
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expensivethananother.Byevaluatinghowthedifferentcontractmonthsarepriced,youcanspotthebestmonthtobuyorsellatanygiventime.Itcanalsopresentdifferentchancestospreadonemonthagainstanother.Remember,yourgoalistosellthemostexpensivepolicyrelativetotherisk.Findingthemostexpensivecontractmonthgreatlyimproves
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collectedpremiums.Therecanbedifferentdriversindifferentmonths.Ifyouaresellingaspecificmonth,orspreadingonemonthagainstanother,doingalittlebitofdiggingtoseewhythemonthsarepricedmightrevealatradethatisnotnearlyasgoodasitfirstappears.However,sometimesalargetraderwithanaxtogrind(amajorpositiontoputonortakeoff)canpullthe
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contractmonthsoutofwhack.Whenthishappens,youshouldusethisinformationtoyouradvantage.
EvaluatetheSkewOneofthemostunderusedandcommonlymispricedpartsofoptionsistheskewcurve.SkewisatermforhowcheaporexpensivecallsandputsarerelativetoATM
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optionsinreactiontohedgingactivities.Forinstance,inequities,IRAs,401(k)’s,andpensionfunds,everyonewantstoprotectagainsttheunderlyingfalling.Todothis,mostfundsemployingoptionscollartheirpositions.Thismeanstheybuyputswithstrikesbelowcurrentmarketpriceandsellcallswithstrikesabove,tohelpfinancetheput.Thiscreatesputsthataremoreexpensive
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thanATMoptionsandcallsthatarelessexpensivethanATMoptions.Thisisnotalwaysthecase,butifyoutakealookatthestructureofSPX,youcanseehowhedgingactivitiesaffectthevolatilitysurface.Hedgingactivitiesarenotconstant,andatanygiventimecallsandputscanbecomeoverpricedorunderpriced.Thecurve
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movesupordownconstantly.Dependingonthesteepnessofthecurve,differenttradescanbecomemoreorlessfavorableasyoubuyandsellrelativelycheaporrelativelyexpensiveoptions.Knowinghowexpensivethecurveiscanbeapowerfulweaponinyourarsenal.Ithelpsyoudeterminewhattradetoenterandwheretoexecute.
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EvaluateOtherProductsMostSPXtradingfirmsalsotradeOEX,RUT,NDX,ES,andmanyindividualoptionnamesbecauseofthecorrelationbetweenalltheindexes.Tradersmustbecertainnotto“fallinlovewith”oneproduct.Forexample,theOEXhasabetarelativetotheSPXofabout
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.98historically.YetbecauseofliquiditytherearetimeswhentheymaybesignificantlyoverpricedorunderpricedrelativetotheSPX.Ifyoutradeoneproduct,youmaybemissingoutonsignificantlybetteropportunitiesinanothercloselyrelatedone.Beforeenteringanytrade,figureoutwhetherthatistheabsolutebesttradeavailableatthattime.Ifyoulikeaparticular
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product,youmaytakethetimetoexplorehighlycorrelatedproductsandwalkthroughtheprocesswejustwalkedthroughinevaluatingthoseproducts.Remember,aninsurancecompanydoesnotcarewhoitinsures,onlythatitissellingstatisticallythebestproductatthehighestprice,withthemostreturn.
Trade
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Nowthatyouhavenarrowedyourdecisiontoaspecificproduct,itistimetodesignthetrade,thengetitexecuted.Togetthebesttrade,youneedtopickstrikes,andgetthetradefilled,asinexpensivelyaspossible.
PickingStrikes
Asalargecustomerbuysorsellsdifferentstrikesupanddowntheskewcurve,specific
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strikescanbecomeoverpricedorunderpricedrelativetoeachother.Consistentlybuyingtherelativelycheapstrikeagainstsellingarelativelyexpensivestrikecanproduceahigherrelativecreditoncreditspreads.Althoughitmightseemsmallatfirst,evensqueezingoutafewpenniespertradecanmakeabigdifferenceinaportfolio.AfullyfundedTOMICcan
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tradeasmanyas15to30tradesinandoutwithmorethan1,000contractspertradeinagivenmonth.Thatamountstobetween10,000and100,000contractspermonth.Improvingtheaveragefillpricebyaslittleasonecentpercontractcanadduptobigdollarsprettyquickly.Thekeyistonotbemarriedtodeltaorpercentageout-of-
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the-money.Ifyouwanttosella10deltaputorcall,butthe11or9deltaoptionisthebestsale,youarebetteroffsellingthatoption.Ifyouliketosellspreads5pointswide,butinrelativetermsthebestcreditisavailablebyselling10or15pointswide,youshoulddoso.Evaluatethesurfacewhensettingupatradeandsellthemostexpensiveoptionaroundthestrikeyoustudied.
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Price
Onethingnewtraderstendtoforgetisthatvolatilityequatestoprice.Witheverycentyougivetothemarketmakers,youaresellingaslightlylowerIV.IfyouknowtheIVyouaretryingtosell,youneedtoknowtheequivalentprice.Thenattempttoexecuteatthatgivenprice.Ifyoucannotgetthetradedoneatyourprice,
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youarebetteroffnotsellingthanconcedingtoomuchonthetrade.Remember,thereisanadvantageonlyifyoureceivetherightprice.Youmightnotbeabletogetafillatthemidprice,butyoumightnothaveto.Ifyouknowthelowestimpliedvolatilitylevelyouarewillingtoselldownto,youcaneasilycalculateyourminimumsaleprice.To
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determinehowmuchyouarewillingtoconcede,useIVandvega.Forexample,supposethesellsideofanoptionspreadhasanIVof21%.Thisproducesapriceof$2.00;youarewillingtosellthespreaddowntoanIVof20%.Thenetvegaofthespreadis.05.Multiplying.05×1%(×100)produces.05offlexibilityinthespreadprice.Thus,you
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arewillingtosellthespreaddownto$1.95,butnotanylower.
OrderEntryWhenMarkwasatraderonthefloor,heusedinstantmessagingtotalktobrokersallthetime.Someofthelargestinstitutionsintheworldwouldshowhimsomeoftheir“flow,”andsometimeshewouldtradeit.
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Thatwashisjob,tomakemarketsandtaketheothersidesoftrades.However,thereweretimeswhenhebecamethebroker.Itwasthenthathehadtochooseabrokertorepresentmyorder.Atfirsthetestedeverytypeofbroker:floorexecutionbroker,upstairsbroker—heck,heeventriedrepresentinghimselfinacrowdortwotogetanorderfilled.Overtimehebeganto
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learnwhichbrokerscouldgetthebestfillsfordifferentstocksandETFs.Thenumberofbrokersquicklyfellofftoveryfewandeventuallyheusedonlythree.Why?Because,aswithtraders,thecreamofthebrokersrisestothetop.Hefoundthebestbrokersforthespecificthingshewastryingtoaccomplishandusednooneelse.Theyrewardedhisloyaltyandconsistentflowwithbetter
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fillsandlowerrates.Heneverusedonlyone.Itwasimportanttohimtohavetheflexibilitytosendanordertothebrokerhethoughtwasmostlikelytogivemethebestfill.Youmightnottalktobrokerseveryday,butyouwilluseabrokereverydayifyouareexecutingaTOMIC.Selectionofthebestbrokermattersforseveralreasons:
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•Onebrokerisgoingtobebetterattradingdifferenttypesofproducts.IfyouaddfuturesoptionstoTOMIC,itmaybecomenecessarytoaddasecondbroker.Mostbrokersoffereverything,butthatdoesn’tmakethemgoodateverything.OnceyourTOMICisbigenoughtohave
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moneytotradeinfutures,itshouldbeallocatedtothebestfuturesbroker.Havemoneytotradeoptionsallocatedwiththeoptionsbroker.
•Ifyouareinterestedinlearningortradingaproductandthebrokerdoesn’tcarrytheproduct,consideropeningasmallaccount
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withanotherfirmtolearntheproduct.
•Onebrokermighthavebetteranalytics,whilelackinggreatexecution.Itmightbecomenecessarytoleaveafewdollarswithonebrokeroranotherjusttogetreal-timedataandgreatanalytics.
WhenselectinganoptionsbrokeratTOMIC,youshould
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keepafewthingsinmind.•Lowcommissions:Whenfirstlearning,alowornonexistentticketchargeisveryhelpful.However,aticketchargewithlowerper-contractcommissionstypicallyendsupbeingabetterdealovertime.
•Theabilitytoreadspreadbooks:Oneof
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thethingsmanytradersdonotrealizeishowvaluableorderinformationcanbe.Whenlookingthroughaspreadbookyoucanfindvaluableinformationsuchasbetteroffersthantheorderyouaretryingtofill,andcounterofferstoyourorders.
•Theabilitytoroute
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orderstoanexchange:Youneedtoknowthat“smartrouters”areinfactsmart,justnotinthewaytheyarepresentedtothegeneralpublic.Ordersareroutedviaanalgorithmthatcalculateswherethebrokerwillmakethemostmoneyfromtheorder,notbasedonwheretheorderismostlylikelytoreceive
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thebestfill.Withtheabilitytoroutetospecificexchanges,youtakeawaytheabilityofthealgorithmtostopfromgettingagreatfill.Althoughitmaysoundtrivial,routingtoaspecificexchangecangettradesfilledatbetterpricesrelativetothepriceoftheunderlying.Inotherwords,whenbuyingacall,youwill
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beabletogetfilledwiththestockpriceslightlyhigher.Itonlytakesseeingyourpricetradeonceonanawayexchangewhileyourorderdoesn’tfilltolearnthislesson.
Onceyouhavepickedthebestbrokerfortheproductyouwanttotrade,youshouldpickthebestexchange.Firstroutethetradetothe
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exchangewiththebestbidoroffer.Theexchangethathasthebestmarketwillgenerallyprovidethebestfill,unlessthebestofferisoneoftheso-called“makertakermodel”exchanges.Interestingly,thoseexchangeswiththebestofferwillhavelittleeffectonyourabilitytogettheorderfilled.Ifthecounterbidsoroffersareallthesame,thebiggest
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bidsorofferswillprobablyimprovethings.Thisbeliefisunfounded;however,ifthereisoneexchangeinparticularthattradesmuchlargersizesrelativetootherexchanges,itmaybebeneficialtoroutetothatexchange.Thekeyistoroutetoexchangesprovidingthebestfills.Thebestfillsoccurattwoexchanges,theCBOEandtheISE.Nextonthelist
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arethePHLX,NYSE-ARCA,andAMEX.Theseexchangesmaybethebesttoroutetoiftheyareparticularlydominantinaproduct.Neverroutea“makertakerexchange”unlessyouarehittingabidorliftinganoffer.Marketmakersalmostunilaterallyhatepayingtofillorderstheyarehitting,affectingthefillpricesignificantly.Nowthatyouknowwhatto
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trade,thenextstepishowtosendintheorder.Hereareafewwaystogetyourordersfilled.Thefirstthingyouneedtoknowishowsmallordersarefilled.Backinthedaysbeforecomputers,ifacomplexordercameintothecrowd,themarketmakerswouldpriceeachlegindividually,addandsubtractthebuysandsells,andcomeupwithamarket.
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Inthatenvironment,wherethemarketmakercouldlookattheorderbeforeitwastraded,marketmakerswerewillingtoimprovethepriceonindividualspreads.Spreadsofferedmoresecuritybecauseitwasbuyingoneoptionandsellinganother,meaningpartofthepositionwasalreadyhedgedandthetraderlikelyhadtoselllessunderlyingtohedgethepositionentered.Eventhenif
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anordergottoocomplex,marketmakersneverlikedtradeswithmultiplestrikes,differentmonths,weirdspreadsbetweenstrikes,oranythingelsethatwasunusual.Nowadays,thingsareverydifferent.Complexordersaremostlyexecutedbyanalgorithminsteadofbeingquotedbytheindividualtrader.Becauseofthis,
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marketmakershavetobeespeciallycarefulofhowmuchedgetheyarewillingtogiveonanytypeoforder.FirmslikeTimberHillandCitadel,muchlikecomputerhackers,areconstantlytestingtheexchangestofindweaknessesinthesystem.Iftheycanpickoffaquotingalgorithmtheywilldoitquickly,efficiently,andinasmuchsizeastheypossiblycan.
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Becauseofthis,thesimplerthetrade,themoreeasilyyouarelikelytogetitfilled.Individualoptionorderswillfillat,relativetotheunderlyingprice,betterpricesthanspreadsalmostallthetime.TheproblemisthatthisbringstheconceptofdirectionalriskintotheequationfortheTOMICtrader,somethingyouareconstantlytryingtoavoid.Sobuyingorsellingindividual
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optionstosetupaspreadisnotadvisableunlessyouareplanningtotradetheunderlyingbackandforthasyoufillthespread.Infact,eventhoughtheorderisgoingtobetoughertoexecute,newertradersshouldalmostexclusivelyputthedelta-neutraltradeinatonce.Asyoubecomemoreexperiencedatorderexecution,youshouldbegin
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tobreakordersapart.Infact,asaretailtraderyouwillfindthatyouhaveatonetimeoranothermispricedandcouldhavegottenbetterfillthanbreakingthetradeup.Remember,individualoptionquotesarethemostefficientlypriced;thus,youarelesslikelytogetmessedoverbymarketmakers,butyoumayalsobelesslikelytogetagreatpricefromthemarketplace.
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Asyoubecomemoreexperienced,firsttrytofillthewholeorder.Ifthiscannotbedoneatanefficientprice,breakupthetrade.Thismaybeyourbestchoice.Callandputspreadsaremucheasiertofillthanironcondorsorbutterflies.Inorderofdifficultytofill,youcanseethebestorderforbreakingapartyourtrade:
Nontraditionalspreads
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IroncondorsDoublediagonalsStraddlesStranglesButterfliesVerticalspreadsCalendarspreadsSingleoptiontrades
Onecaveat:Therearetimeswhenasmalltradewithunusualstrikesmayfallintoaspotinwhichanalgorithm
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wantstoexecutethetrade.Sonontraditionalspreadsmayfillatpricesthatsurpriseyou.
SizeofOrder
Tradesundertencontractswillhaveaneasiertimefillingthantradeslargerthanten.Mostalgorithmsaredesignedtoletthemarketmakerknowthatthereisanordertotradeandnotsettotradeamassivespread,unless
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ithasatonofedge,orthefirmrunsanairtightquotingsystem.Startingsmallwithaspreadoffewerthantencontractshelpsyougetabetterfill.
WorkinganOrder
Justbecausethequotegivesa“midprice”doesnotmeanthequoteisthemidprice.“Bookorders”canthrowoffthebid-askspread.Bookorderscan
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alsothrowoffvolatilitycalculationsbecausetheycanartificiallylowerorincreasetheIVofthecalculatedmidprice.Whatyouareusingasacalculationwhentradingvolatilityaffectsthis.Onceyouhaveestablishedthemidpoint,itneverhurtstotrytodobetterthanthatprice.Justbecauseitisacomputerquotingthepricedoesn’tmeanthatitcan’tscrewup.If
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youhavedumpedinthewrongIV,thecomputermightfilltheorder.Also,atraderortradinggroupmighttradeinamannerthatcausesthetradinggrouptofilltheorderevenifitisabovethequotedmidprice.Chalkthisoneuptothe“itneverhurtstotry”category.Mostmarketmakerstrainforatleastayearbefore“gettingonabadge.”AsaTOMIC
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trader,youareself-backed,tradingyourownmoney.Beasrigidaspossiblewithhowyoutradeandbecomeskilledingettingtheabsolutelybestpossiblepriceyoucan.Remember,saving.05onaten-contracttradeeverydayequatesto$12,500ayear.So,tomakethingseasy,hereisthethoughtprocessIgothroughandencouragealltraderstogothroughwhen
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theyenterthemarket.Byfollowingthischecklist,traderscandevelopanapproachthatwillhopefullyhonetheminonatradewithedge.
TradeExecutionChecklist
Beforethetrade:•Whatmarketareyougoingtotrade?
•Whatisthedirectionofthemarket?
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•Didyoucheckthevolatilityconditionsofthemarket?Whatisthehistoricalvolatilityofthemarket?Whatistheimpliedvolatility?Didyouchecktheskew?
•Whatisthestrategyyouwillbeusing?
•Ifthisisacomplexspread,howwillitbeexecuted?Isitworthexecutingatthe
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individualcomponentlevel?Willyoubeleggingintothespread?Willitbesentasacomplexorder?
•Whatisthemaximumallowedloss?
•Istheexpectedreturnwithintheunderwritingparameters?
•Whatisthetargetprofitforthistrade?
•Whatisthesizeforthis
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trade?•Doesitconformtothepositionsizingparameters?
•Atwhatpointwouldthetraderequireadjustment(ifany)?
•Doyouknowthepossibleadjustmentstomaketothetrade(ifneeded)?
Duringthetrade:
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•Hasthetradehitanadjustmentpoint?
•Hasthetradehittheprofit/losstarget?
Afterthetrade:•Didyoulogthetradeinthetradingdiary?
•Didyoufollowthetradingplan?
•Ifyoudidnotfollowthetradingplan,whynot?
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5.TheTradingPlan
“Failingtoplanisplanningtofail.”—AlanLakein
Noteverybusinesshasabusinessplan,buteverysuccessfultraderhasatradingplan.Tomakemoneyconsistently,youneedaplan
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givingyourselfaframework,definingtheparameters,andkeepingyourfocus.Havingaplanisnotaprerequisitetostartingabusiness.However,havingaplanisusuallyaprecursortocreatingasuccessfulbusiness.Manypeoplecanstartabusiness.Thenumberofstartupsperyearislarge;but,intheend,onlytheoneswithaplanthatcanbe
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implementedwellwillsurviveandflourish.Inthebusinessoftrading,successfultradershaveatradingplanthattheyfollow.Thereasonforcreatingatradingplanistoguardagainsttheemotionalswingsthatyougothroughwhentrading.Thetradingplanestablishesaframework.ItgivesyouasaTOMICtraderaprocesstofollow.Thetradingplandescribeswhatto
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doineachscenario.Itislikeaflightplanandanemergencyplaninone.Thetradingplancontainsguidelinesfortrading.Itdefineshowyouplantoplaythegame.Intradingyoumakeyourownrules,butthekeyistobeconsistent.Ifyourrulesdonotwork,getnewones,createanewplan.However,theonlywayyouwillknowwhethertheywork
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isbystickingtotheplanandevaluatingyourperformancecontinuously.Whenacasinosetsupablackjacktable,itgivesitsdealersspecificparameterstofollowwhendealingcardstoitsclients.Forexample,thedealermuststayon17andmusthit(takeacard)onlessthan17.Thisisaspecificrulethatthecasinoimposesonthedealertohaveconsistency
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acrossthecasino,anditisdonesothatthecasinohasanedge.Atradingplanworksthesameway;itgivesthetraderaframeworktogenerateaconsistentoutcome.Thetradingplangivesyouachancetowinbyfollowingaprocessprovidingmeasurableoutcomesthatcanbeimprovedcontinuously.
TheMind-Set
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Themind-setofasuccessfulmanagerofTOMICorofanybusinessisveryimportant.WhenaU.S.Marinegoesintothebattlefield,heknowsthatheisfightingforhiscountryandthatnomatterwhat,hewon’tbeleftbehind.Marinescangointoanyscenarioconfidentthattheirfellowmarinesarewatchingoutforthem.Thefeelingofconfidenceina
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tradingplaniswhatyouneedtomanagetheTOMICportfolio.Thebeliefinthetradingplankeepsyououtoftroubleandleadstoprofitsconsistently.However,confidenceorbeliefintheplanisnotenough.Followingtheplanwillgetdifficultattimes.Thatiswhy,asthesuccessfulmanagerofTOMIC,youhavetobededicated,disciplined,bold,flexible,andhumble.
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TOMICisabusiness,anditwilltakealotofdedicationandcommitmenttofollowthetradingplantomakeprofits.Therewillbealotofupsanddownsthatwillimpactyourmanagementpsyche.Itisnotaneasybusiness.Themarketwillconstantlychallengeyou.However,thecommitmenttothebusinesswillovercometheemotionalswings.
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Youwillneedtobeextremelydisciplinedinordertofollowthetradingplan,makingsurethattheentriesandexitsarefollowed,andthattheunderwritingisdonecorrectly.Thedisciplinehelpsyouovercometheemotionsoftrading.Oneofthebiggestreasonsthattradersblowuptheirportfoliosisnottakinglossesearlyenough.Thisisbecausetheemotionoflosingisso
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greatthattakingalossisundesirable.Eventhoughtheplanwillsaytotakethelossearlytoavoidalargeronelater,theundisciplinedtraderwillfreeze.Youhavetobepreparedforthissothatwhenthetimecomestotaketheloss,youactuallytakeitandfollowthetradingplan.AsthemanagerofTOMIC,youalsoneedtobeboldanddecisive.Therewillbetimes
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whenopportunitiesaboundandyoumustdecidewhethertotakethem.Thentherewillbetimeswhenyouwillneedtonottrade,whenopportunitiesarescarce.Also,beingboldallowsyoutomakecriticaldecisionsattheappropriatetime.FlexibilityisoneofthemostunderratedcharacteristicsofagoodTOMICmanager,butoneofthemostimportant.
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Beingflexibletogetherwithboldnessallowsyoutochangecoursewhenthingsarenotgoingyourway.Let’ssaythatyouhaveaportfolioleaningnetlongandthemarkethasreversedandgonefromabulltoabearmarket.Youneedtomakethedecisiontochangetheportfoliofromleaninglongtoleaningshort.Thisisnoteasytodoifyouarenotflexibleanddecisive.
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OnemoreimportantcharacteristicofthesuccessfulTOMICmanagerishumility.Themarketwillsendmanycurveballs.Itisveryunlikelythatyouwillhave100%successfultradeseveryyear.Remember,evenWarrenBuffetthashadhisshareofbadinvestments;forexample,SalomonBrothers,USAirways,silver(waybeforesilvertookoffin2010–11).However,thinkof
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badtradesaslearningopportunities.Badtradesprovidefeedbackthatteachesyouhowtodobetternexttime.Beinghumbleisthekeytonottakinglossespersonally.Lossesarepartofthebusiness.Iftherewerenolosses,noonewouldneedtoinsureandthenTOMICwouldbeoutofbusiness.Inconclusion,yourmind-setasthemanagerandtraderis
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thekey.Youneedtobededicated,disciplined,bold,flexible,andhumbleinordertobesuccessfulatTOMIC.Ifyouhaveastrongmind-set,youwillsucceed.Whenatradegoesagainstyou,bepreparedbutdonotpanic.Fortunesaremadeandlostintimesofgreatuncertainty.Mentaltoughnessisrequiredinthisbusiness.Itislikethegreatchampionsin
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sports,MichaelJordanandTigerWoods.Theyhavethementaltoughnesstobedisciplinedandcomethroughattheend.It’sthesameintrading:Youmusthavetheworst-casescenariosplannedoutsothatwhensomethinghappensyoudon’tfreezeandyouknowwhattodo.Justlikeacommercialairlinepilot,incaseofemergencyyoucalmlygothroughyourchecklist.Anexampleof
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havingaplanwasthatofCaptainChesleyB.Sullenberger,whohadtoditchaUSAirwaysjetintheHudsonRiverinManhattanonJanuary15,2009,whentheplanewashitbyaflockofCanadiangeese.Fortunately,CaptainSullenbergerhadtrainedforemergencysituations,andhehadaplanhewasabletoexecuteperfectly.Insodoing,hesavedthelivesofallhis
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passengers.Havingatradingplanwillhelpyouhavethescenariosmappedoutandwillgiveyouthatguideofwhattodoinanemergency.
TheImportanceofStickingtotheProcessWhenyou’rerunningabusiness,whatdoyouthinkisbetter:stickingtoaprocessor
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goingwithyourgut?Beingluckyorbeinggood?Thesayinggoes,“Itisbettertobeluckythantobegood.”However,youcan’tbeluckyallthetime.So,wheredoesthatleaveyou?Assumingthatyouknowhowtoplayblackjack,takealookatthefollowingscenario.Youaredealta10andan8,makingyourcount18.Thedealerisshowinga6.
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Potentially,thedealercouldhavea16,inwhichcasehewouldhavetodrawacardandprobablybust.Youhit(askforacard)andfortunatelygeta3,makingyourhand21,awinner.Therearehigh-fivesallaroundthetableandyouthinkyouareagreatgambler.IfyouhadbeenyourTOMICmanager,wouldyouhavebeenhappywithwhatyoudid?Hittingonan18withthedealershowing
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a6...wasthatagoodmove?Eventhoughyouwon,didtheoutcomejustifytheriskyoutook?Inreality,beingluckyworksgreat,ifyouareluckyallthetime.However,themoveyoumadeattheblackjacktablewasalousymove.Theoddsofyourbusting(losing)wereveryhighifyoudrewacard,whiletheoddsofthedealerhavinga16andhavingto
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drawwereveryhighalso.Thedealerhadagoodchanceofbusting.Soyoushouldhavestayedandletthedealerdrawinstead.Youhadamuchbetterchanceofwinningifyouhadstayedwith18.Takingthehitwasabad(onecouldsaystupid)decision.Hey,youwon.Butweabsolutelywouldnothireyoutomanageourmoney.Youwonbecauseyouwerelucky.Butdoyouthinkthat
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overthelongrunyouwouldcontinuewinningbymakingthosekindsofdecisions?HereatTOMIC,itisextremelyimportanttosticktoyourinvestingprocess.Whenyouseegoodtradesthatgiveyouawinningedge,youdothem.Itdoesnotmeanyouwillwineverytime,butoverthelongrunyouwillwinmoretimesthanyoulose.Youwillnotmake
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tradeswhereyouperceivenoadvantage.Youwillnotbetheblackjackplayerhittingonan18becauseyoufeellucky.Sometimesitmayappearthatothersarewinningandyouarenotinthegame.Sometimesyouwillbeplayingwhennobodyelseisplaying.But,overthelongrun,youexpecttowinmorethanyoulose.Sodoyoumeasurethe
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outcomesortheprocess?Tobesuccessfulconsistently,youneedtofollowtheprocess.However,youknowthatoutcomesareimportant,too.Overtheshortterm,processtakesprecedenceoveroutcomes,butinthelongtermtheoutcomestakeprecedenceovertheprocess.Ifyousticktoyourinvestmentprocess,eventhoughontheshorttermtheoutcomesmayshowlosses,
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overthelongtermtheoutcomesshouldshowwins.Otherwise,ifyoudon’twinoverthelongrun,theprocesswillhavetobechanged.Goingbacktotheblackjackexample,youwillnothiton18whenthedealershowsa6.Youmightlosesometimes,whenthedealeractuallyhasa6anda5tomake11andhitsitwitha10.Butoverthelongrun,stayingon18willwinmoretimesthanlose.
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Processmatters.Useachecklist,alistofthingsyouhavetocheckbeforeyoudosomethingorinordertodoitwell.Didyouknowthatbeforeanairplanetakesoff,thepilotgoesthroughapreflightchecklist?Theyaskthingslike,isthereenoughfueltogettowherewearegoing?Averycriticalquestion,don’tyouthink?Achecklistisaprocess.Thisiswhatthetradingplangives
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you,aprocess.Didyouknowthatachecklist(havingaprocess)saveslives?Dr.PeterPronovost,aphysician-researcheratJohnsHopkins,developedasimplefive-itemchecklistthatsaveslives.Inthearticle“InfectionRatesDropasMichiganHospitalsTurntoChecklists”thatappearedinAmerican
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MedicalNewsonMarch8,2010,wecanseethebenefitsofusingachecklistbyagroupofMichiganhospitals.Thearticlesaysthatcatheter-relatedinfectionshavebeenacommonplacecomplicationinthesickestpatientsinintensivecareunitsandwereresponsibleforaround17,000deathsannually.Accordingtothearticle,thecostforcaringforaninfectedpatientis$45,000.
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TheMichiganhospitalsimplementedasimplefive-stepchecklistandwereabletoreducetheircatheter-relatedinfectionrateby66%afteroneyear.Theyreducedtheircentral-lineinfectionratetozeroper1,000catheterdaysversusthenationalaverageof5.2infectionsper1,000catheterdays.Theirchecklistcontainedfiveitems:washingtheirhands,using-fullbarrierprecautions
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wheninsertingthecatheter,cleaningtheskinwithchlorhexidine,avoidingcertainareasforinsertion,andremovingunnecessarycatheters.1
Thefollowingisanexcerptfromthearticle“ABasicHospitalTo-DoListSavesLives”thatappearedintheNewYorkTimesonJanuary22,2008:
Usingthechecklist,in18
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monthstheaverageI.C.U.atthesediversehospitalsreduceditscatheter-relatedinfectionratetozero,from4percent.Alltold,thechecklistsavedmorethan1,500livesandnearly$200million.Theprogramitselfcostonly$500,000.2
Asimplefive-itemchecklistthathelpedmedicalpractitionersinanintensive
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careunittofollowaprocesssaveslives.Amazing.Doyouthinkachecklistforyourinvestmentdecisionswillsaveandmakeyoumoney?Itsurewill.AtTOMICyoufollowaprocess;thatiswhyyouhaveatradingplan.YouhaveachecklistforthedifferentfunctionsatTOMIC.Inunderwritingyouhaveaprocessfortradeselection
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andriskmanagement.Also,forexecutingatradeyouhaveaprocess.Eachstephasachecklisttohelpyouavoidmakingmistakes.Youwillnothitonan18whenthedealerisshowinga6.Youaredisciplinedandyoutakeyourjobseriously.Youarethecasino,notthegambler.Whenyoutrade,oddsareinyourfavor.Youhavewinningandlosingtrades,butyourprocesshelpsyoutostay
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disciplinedinordertomakesureyouwinmorethanyoulose.
QuestionsYourTradingPlanShouldAnswerEveryTOMICmanagerhasatradingstyle,justaseverycardriverhasadifferenttypeofcar(SUV,sedan,sportscar,minivan,andsoon).Each
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driverhasacruisingspeedtheyarecomfortablewithandarouteforgettingfrompointAtopointB.However,everydriverisgovernedbyasetoftrafficrulesinordertoavoidaccidents.Forexample,therearedifferentspeedlimitsforhighwaysandforschoolzones.ATOMICmanagersetshisownrules,hisown“speedlimits”thatheself-regulates
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usingatradingplan.Theobjectiveofatradingplanistoprovidespecificparameterstoassistyouwhenyouaretrading.Likethespeedlimitforthedriver,thetradingplanshouldgivetheTOMICmanagerasetofguidelinesandboundariesforhistrading.Everytradingplanwillhavedifferentparametersthatareimportanttothetraderand
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shouldanswersomecommonquestions.Thefollowingisalistofquestionsthatyoushouldanswerinyourtradingplan:
•WhatisthegoalofyourTOMIC?
•Whatmarketsareyougoingtotrade?
•Whichstrategiesareyougoingtouse?
•Whataretheconditionsneededtoputona
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trade?•Whataretheconditionsthatwillmakeyoucloseatrade?
•Whatareyourriskmanagementparameters?
•Howareyougoingtoexecutethetrades?
Trytoanswerthequestionswithasmuchdetailasyoucan.Bespecific.Askyourselfmorequestions,andanswer
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them.Herearesomemorequestionsthatcometomind:
•Goals:WhatisthegoalofyourTOMIC?IsyourTOMICdesignedtoreplaceyourcurrentincome?Isityourgoaltomakeconsistently20%annualreturnonyourcapital?IsTOMICatoolforlearningtotradeoptions?IsTOMICsupposedto
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alwaysproducepositivereturnsnomatterwhatthemarketdoes?
•Strategies:WhatstrategieswillyoubeusinginyourTOMIC?Willyoubeusingonlythetapositivetrades?Orwillyoudoboththetapositiveandthetanegativetrades?Willyoubeprimarilytradingironcondors,
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butterflies,calendars,andsoon?Whatarethethreestrategiesyouaremostcomfortabletradingandunderwhatconditions?Whichstrategiesshouldyouavoidandunderwhatconditions?
•Entryparameters:Foreachstrategyyouhavedecidedtotrade,whataretheconditionsyou
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needforyoutoenterthetrade?
•Exitparameters:Whataretheconditions,winningorlosing,thatwouldmakeyouexitatrade?
•Riskmanagement:Whataretheconditionsformakinganadjustment?Doyouhavesafetylimitsset?Whatareyourrisk
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thresholds?Whatdoyoudoifapositionlosesmorethan2%ofyourportfolio’sequity?Whatdoyoudoifyourportfoliolosesmorethan6%inamonth?
•Tradingjournal:Whatinformationwillyoubekeepinginyourtradingjournal?Istheinformationthathasbeenrecordedenough
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toprovideinsightsintothetradingdecisionswhendoinganafteractionreview?Willyoubeusinganyspecialsoftwaretokeepyourtradingjournal?
Answeringthesequestionswillhelpyouconstructyourtradingplan.Createyourplan,useit,andreviseitasyougrow.Notradingplanissetinstone,butitisthefirst
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“stone”thatyouwillneedtobuildasuccessfulTOMIC.InChapter10,“OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ,”wewalkyouthroughasampletradingplan.
Endnotes1.KevinB.O’Reilly,March8,2010,“InfectionRatesDropasMichiganHospitalsTurnto
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Checklists,”AmericanMedicalNews,www.ama-assn.org/amednews/2010/03/01/prsa0301.htmretrievedOctober2,2010.
2.JaneE.Brody,January22,2008,“ABasicHospitalTo-DoListSavesLives,”NewYorkTimes,www.nytimes.com/2008/01/22/health/22brod.html?pagewanted=print,retrievedOctober2,2010.
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6.TradingInfrastructureThetradinginfrastructureconsistsofthebackofficeelementsneededtoimplementTOMIC.Thisincludesbutisnotlimitedtoriskcapital,thebroker,tradingplatform,analyticalsoftware,portfoliomargin,informationsources,
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dedicatedspace,andbackupplans.
RiskCapitalTOMIC’stradinginfrastructurebeginsbydefininghowmuchmoneyyouwillneedtostartthebusiness.TOMICisascalablebusiness.Itcouldstartasasmalloperationandgrowintoalargeronewithoutyourhavingto
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changemuch.Whatreallychangesaretheskillsoftheoperator.Everybusinessstartsoffwithsomecapital,whetheritisalemonadestand,whichhastohavesomecapitaltobuythelemons,sugar,andice,orTheOneManInsuranceCompany,whichneedscapitaltocoveritsmarginrequirements.Themarginrequirementsarethe
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equivalentofthereservesofaninsurancecompany.Foraninsurancecompanytobeallowedtowriteinsurance,ithastohavereservessoitisabletocoveranyclaimsagainsttheinsuranceitwrites.Whatistherightamountofriskcapitaltostartwith?Dependingonyourplan,youcouldstartTOMICwithaslittleas$5,000.Ifyouarejust
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startingout,planforasmallaccount,andaddtoitasyougainexperienceandconsistentprofits.DependingonyouastheoperatorofTOMIC,thelevelsofriskcapitalwhichyoucouldstartoutinTOMICarethese:
Level0—Beginner:A
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beginnerisanoperatorjuststartingthejourneyintotradingoptions.Youarelearningthebasicsontradingoptions,sendingorderstothebroker,andyouknowenoughtoplaceandtakeoffatrade.Beginnersshouldstartwithasmallaccountallowingthemtotradesmalllotsandgainexperience.Somebrokersoffer“paperaccounts”thatallowyoutopapertrade,meaningyoucansimulate
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yourtraderswithfake(paper)money.TheCBOEalsohassuchavirtualsite.Thepaperaccountsarehelpfulforlearninghowtousethetradingplatform.However,theyarenothelpfulforlearninghowtooperateTOMIC.Thestressfromdecisionsmadewithrealmoneyisverydifferentfromthestressyougetwithpapermoney.Asabeginner,youshouldstartwitharealmoney
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account.Level1—Intermediate:Theintermediateoperatorisonewhohasagoodunderstandingofoptionsbasicsandknowstheanatomyofthedifferenttradestrategies(butterflies,condors,calendars,anddiagonals,forexample).Youunderstandtheusesofthestrategiesandhavesomeideaoftradeselectionandhowto
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applytradesindifferentenvironments.Youknowenoughtogetintrouble,andenoughtogetoutoftroublemostofthetime.Level2—Semiprofessional:Semiprofessionaloperatorshavemoreexperienceundertheirbelt.Youhavegoodmasteryofoptionstrategiesandknowwhentoapplyeach.Youknowwhattradesgivethebestrisk/reward
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ratio.Youknowhowtotradeandmakeadjustments.Youareatapointwhereyouknowhowtomakemoney.YoumanageTOMIConapart-timebasisandhaveanotherjoborareretired.AgoodportionofyourincomeisderivedfromoperatingTOMIC.Youareamasteratmanagingtrades.Level3—Professional:Theprofessionaloperatoroperates
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TOMICforaliving.AllormostofyourincomeisderivedfromoperatingTOMIC.YoumighthaveTOMICfundedpersonallyormightbemanagingotherpeople’smoneyinTOMIC.Youmanagetheentireportfolio.Thatmeansthatinadditiontomanagingtheindividualtrades,youmanagetheriskoftheentireportfolio.YoumanagetheGreeksnotonlyofindividualpositions,
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butoftheentireportfolio.YouknowhowatradeimpactstheGreeks.Youarelikeageneralinabattle;youmanagetheentirebattlefield.Usually,yourportfoliosarelargerandtheyhavemoretradesonthantheLevel0toLevel2.Onemorething:Yourreturnsarenotnecessarilyhigherthanthoseofthesemiprotraders,buttheyaremoreconsistent.YouknowhowtooperateTOMIC
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toalevelthatdeliversconsistentreturns.Bymanagingtheportfolio,youcansmoothoutthepeaksandvalleys,allowingformoreconsistentreturns.
TheTradingPlatform(Broker)Agoodtradingplatformisessential,especiallywhenyouaretradingoptions.The
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OneManInsuranceCompanydependsalotonthetradingplatform.Theeaseofenteringandexecutinganorderisofparamountimportancegiventhatthereisonlyonepersonatthehelm.TheOneManInsuranceCompanydoesnothaveatradingdeskstaffedwithtraderswhotakeyourordersandmakesuretheygetdone.Youarethetraderatthetradingdesk.Youarealsotheunderwriter,thechief
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executive,andthejanitoroftheentirecompany.Havingagoodtradingplatformwillsaveyoutimeandpreventcostlytradingerrors.Beforewereviewtheplatform,awordaboutbrokers.Herearesomeofthecharacteristicsyoushouldlookforinanoptionsbroker:
1.Optionspecialist:Alotofbrokersallowyoutotradeoptions;however,
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youshouldlookforabrokerspecializinginoptions.Thisisimportantbecauseitimpactsthetoolsthattheyofferandthemarginstheyprovide.
2.Understandingofcomplexordermargin:Ifbrokersspecializeinoptions,theyofferbettermarginterms.Forexample,somebrokers
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requiremarginforbothsides(verticalcreditspreads)ofanironcondor.Goodbrokerswillrequiremarginforonlyoneoftheverticalspreadsoftheironcondor.Iftheyknowaboutoptions,theyknowthatinanironcondoryoucanloseononlyoneside.Therefore,theyneedthemarginequivalentfor
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onlyonesideoftheironcondor.
3.Customerservice:Thisissomethingweallwant,expect,anddeserve.
4.Reputation:Useabrokerwhogivesyouconfidencethatthefirmisnotgoingtogooutofbusiness.MakesurebrokersaremembersofFINRAandSIPC.
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5.Tradingplatform:Thebrokershouldhaveagoodonlinetradingplatformthatallowsyoutotradeoptionseasily.
6.Tradingdesk:Inadditiontothetradingplatformsoftware,thebrokershouldhaveatradingdesk.Thisisforthetimeswhentheplatformisdown,ortheInternetisdown,oryou
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needtocallarealpersonforhelp.
Afteryouhaveselectedasetofbrokers,you’llneedtoseewhichplatformworksbestforyou.Theplatforminfluencesthebrokeryouchoose,unlessyouhavealargeraccountandcanaffordtohaveathird-partyplatformtointerfacewithyourbroker.Whatisimportanttohaveinatradingplatform?Thereare
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subjectiveelementslike“easeofuse”thatarelefttoyourdiscretion.Hereisthechecklistofwhatagoodplatformshouldhave:
1.Tradeanalysistools:Thisconsistsofgraphiccapabilitiestoplotriskgraphstoanalyzeanoptiontrade.
2.Charts:Theplatformshouldhavesomebasicchartingcapabilitiesthat
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willallowyoutoanalyzetheunderlyingmarket.
3.Easytouse:Theplatformneedstohaveaneasy-to-useinterface.Mostbrokershaveapapertradingplatformthatyoucantryoutbeforesigningup.
4.Customizablelayouts:Everyoneisdifferentandseesthings
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differently.Youshouldbeabletocustomizethelayoutsoftheinformation,whichhelpsyouspeedupyourdatagatheringanddecisionmaking.
5.ExternallinkstoExcel:Thisisnota“musthave”feature,butitisveryuseful.YoucanprogramspreadsheetsinExcelandgetreal-time
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datafromtheplatform.ThisgivesyoutheflexibilityofrunningcalculationsinExcelandisusefulwhenyou’relookingfortradesandmonitoringyourpositionsinrealtime.
Inmostcasestheplatformisbroker-related.However,ifyoustartmanagingasignificantamountofmoney,
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sayover$1million,thenthird-partytradingplatformsthatarebrokeragnosticmaybepreferable.Examplesofthird-partyplatformsareObsidian,Derivix,Microhedge,andRealTick.
PortfolioMarginAlmostalloptionbrokerageaccountsofferReg-Tmargin.Therefore,ifyouhaveanaccountthatallowsoptions
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trading,youshouldbefamiliarwithReg-Tmargin.Reg-Twastheonlychoiceavailabletoretailcustomersupuntil2007.After2007,somebrokersbeganofferingportfoliomargin(PM)toretailcustomers.Eachbrokerhashisorherownaccountminimumrequirementsforportfoliomarginaccounts.Portfoliomarginisanotherwaytocalculatethemargin
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requirement.InsteadofcalculatingthemarginoneachindividualpositionlikeReg-Tandthenaddingupthenumbers,portfoliomargincalculatesthemarginrequirementsovertheentireportfolio.Tocalculateportfoliomargin,thebrokerstress-teststheportfolioandcalculatesthemarginrequiredbasedontheoutcomeofthestresstest.
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WhatdoeshavingportfoliomarginmeanforTOMIC?Itmeansthatithasaccesstomuchmoreleverage.Here’sanexampleofReg-TversusPMonamarriedput:
SamplePosition:Long100SharesAAPL@$330Long1PutAAPLOCT320@$18Reg-Trequirement:
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50%ofEquityPurchaseCost($33,000)=$16,500+100%ofPutPremium=$1,800TotalReg-TMargin=$17,300PMRequirement:Maximumlossdown15%instock=$4,950–Equitylossoffsetby
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theoreticalgaininputoptionsof$3,950Netloss=$1,000TotalPM=$1,000
ThedifferencebetweenhavingPMandhavingReg-Twas$16,300.This$16,300iscapitalliberatedifyourTOMIChadPMwithnochangewhatsoeverintheriskprofileoftheaccount.Noteverypositionexperiencessuchdramaticsavingsin
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margin.However,thisexampleshowsthesignificantdifferenceyoucouldhavewithPMversusReg-Tmargin.Ifyourbrokerismoreconservative,thatwilladdadditional“haircuts”tothestandardportfoliomarginrequirement.Forexample,abrokercouldincreasetherequirementiftheportfolioistooconcentratedinone
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industrysector.So,whenlookingforabrokerwhooffersPM,makesureyouunderstandthebroker’sPMrequirements.Onecautionarynote:JustbecauseyouhavePMdoesnotmeanthatyouhavetouseittothemaximum.HavingPMgivesyoumoreflexibility,however.WhenmanagingTOMIC,youshouldalwaysbeawareof
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howmuchexposureyouhaveandactivelymanageyourrisk.Ifyouareabeginner,usethemoreconservativeReg-Tstandardsuntilyouaremoreadeptatmanagingriskforyourentireportfolio.
InformationResourcesandOtherAnalyticalToolsInthisInternetage,itiseasy
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togetoverloadedwithinformation.TherearemanyhundredsofWebsitesthathelpyougainperspectiveaboutwhatisgoingonintheworldasyoutradeandmanageTOMIC.Hereisalistofsitesthathavebeenusefultous:
www.bloomberg.comfinance.yahoo.comwww.seekingalpha.comwww.stocktwits.com
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www.thestreet.comwww.theflyonthewall.comwww.tradethenews.comwww.livevol.comwww.cboe.comwww.ivolatility.com
Somesitesarefree,somecharge.Exploreandfindtheonesmostusefultoyou.Thisdecisiondependsonthekindoftraderyouareandtheproductsandmarketsyou
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trade.Inadditiontogeneralmarketinformationandthetoolsprovidedbythebroker,youcanopttousethird-partyprovidersfordataandotheranalyticaltoolstohelpyouimproveyourtradeselectionandriskmanagement.Insomecasesanalyticaldataprovidedbyyourbrokermightnotbeasgoodorreliableasyouwant.For
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example,theGreeksprovidedarebasedonthemodeldefinedbythebroker.Somebrokerssimplify(orbecomelazy)anddon’tincludeallthevariablestocalculatetheGreeks.TheymightnotusedividendsintheircalculationoftheGreeks.Thismightnotseemtobeabigdeal,butforsomeprofessionalsitis.Hence,youmayopttobuydatafromaproviderwhodoescalculatetheGreeks
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usingmodelswithwhichyouaremorecomfortable.Otherusefultoolsareprogramstoviewandanalyzevolatilityskewsandtermstructures.Toolssimilartolivevolpro.comorivolatility.comareusefulforselectingtrades.Anotherusefultoolisasimulator,orbacktrader.Thistooltriesoutnewstrategiesandsimulatesthe
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behaviorandriskmanagementadjustmenttobeusedinyourtrades.Thisisgoodfortraderstryingtocreatesystems;theyarelessusefulfordiscretionarytraders.BrokerslikeThinkorSwimhavebacktradingtoolsintegratedintheirtradingplatform.Also,youmaypurchasesoftwarepackageslikeOptionvue,whichhasbeenapopularoptionbacktrading
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tool.
DedicatedSpaceNowadays,youprobablydonotthinkthathavingadedicatedspacefortradingisimportant.SomepeopleclaimthattheycantradefromanywhereintheworldgivenanotebookcomputerandanInternetconnection.Thatmightbetrue,butitdoesnotworkthatwellifyouare
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tradingforaliving.Itishelpfultohaveadedicatedworkspacewhereyoucanrunyouroptiontradingbusiness.Itcouldbeanofficeoutsideofyourhome,orahomeoffice,orevenadeskinyourbasement.Itshouldbesetwhereyoucanconcentrateandfocuswithoutdistractions.Yourtradingspaceshouldbeaplacethat
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•Isquietandallowsyoutoconcentrate
•Isfreeofinterruptions,suchasscreamingchildrenorvacuumcleanernoises
•Hashigh-speedInternet•Iscomfortable•Providesacalmandsereneenvironment
BackupPlans
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Whentradingforaliving,makesurethatyouhavebackupplans.Youneedredundantsystemsbuiltintoyourinfrastructure.Hereisalistofthingstoconsiderinyourbackupplan:
•HaveredundantInternetconnections,fromyourcableprovider,cellphoneprovider,orphoneprovider.
•Haveabatterybackup
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foryourcomputer.•Useatleasttwobrokers.
•Useatleasttwocomputers,aprimarydesktopandabackupnotebook.
•Haveyourbroker’stradedeskprogrammedonyourspeeddialorcellphoneincaseyourtradingplatformfails.
•Haveafuturesaccount
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tobeabletobuyorshortS&P500futures.KnowhowmanyS&P500deltasyouownintheportfoliosoyoucangoflatbysellingorbuyingthesefutures.
•Haveabackuplocationtogoincaseyourofficebecomesunavailable(duetoburstpipes,gasleaks,poweroutages,orairconditioning
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failures,forexample).ItcouldbeaStarbucks,Barnes&Noble,alibrary,ahotel,anairportlounge,oranyplacewithInternetconnectivity.
Havingabackupplanisimportanteventhoughyouprobablywon’tneedtouseit,butoccasionallyyouwillbegladyouhaveone.
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7.LearningProcesses“Itisnotthestrongestofthespeciesthatsurvives,northemostintelligentthatsurvives.Itistheonethatisthemost
adaptabletochange.”—CharlesDarwin
AsasuccessfulTOMIC
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manager,youhavetobeabletolearnandadaptasthebusinessenvironmentchanges.Everysuccessfulbusinessreceivesfeedback.Thefeedbackisfromcustomers,employees,competitors,andsuppliers.Thetrulysuccessfulbusinessesusethisfeedbacktocontinuouslyimprove.Tocreatecontinuousimprovementinyourbusiness,youneedtoembed
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alearningprocessintoyourbusinessDNA.Thereareseveralelementsyoucanusetoinstillalearningprocess.AsTOMIC’smanager,youneedatradingjournal,asoundingboard,andacontinuingeducationplan.
TheTradingJournalEverysuccessfulbusinesshasgoodrecords.Everygoodtraderalsohasgoodrecords.
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ThisisaprerequisitetooperatingTOMICsuccessfully.Whyaregoodrecordsimportant?Becausetheyprovidefeedback;theyhelpyourbusinesskeepscore.Youhaveheardcommentslike,“Atradingjournal?Seriously,isn’tthatawasteoftime?”Atradingjournalisagooduseoftime.InAmericanfootballdothe
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teamskeepscore?Dotheircoachestapethegamestoanalyzewhattheteamdoeswellanddoeswrong?HowdotheDallasCowboysprepareforagameiftheydon’tknowwhattheycanimprovefromthepriorgame?Anybodycantradeforashorttime.Butnotanyonecantradeoveralongperiodandbeconsistentlyprofitablewithoutfeedback.Whydo
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mostgoodcompanieskeepgoingandgoingandgoing?WhyhavegoodcompanieslikeCoca-Cola,GE,andApplesurvivedandflourishedoverthelonghaul?Itisbecausetheyadapttotheirmarketplace;theychangetheirstrategiesandadapt.DoyourememberwhenCoca-ColalaunchedNewCoke?Itwasadisaster;theychangedtheformulaandgotridoftheoriginal.Their
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salesplummeted,andtheircompetitorsgainedmarketshare.Whathappened?TheyhadtobringbackCokeClassic.Theywereabletodothisbecausetheylistenedtofeedback.TheconsumeroftheoriginalCokedidnotlikeNewCokeandstoppedbuyingit.Cokenoticedthedropinsalesandquicklyfiguredoutthattheyhadaproblem.
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Whydoairplaneshave“blackboxes?”TorecordeventsleadingtoacrashsothattheycanbereportedonCNN?No,itisforfeedback.Theonlywaytheairplanemanufacturersandairlinecompaniescancorrectaproblemonfutureairplanesisbyknowingwhathappenedinacrash.Hence,comingbacktoTheOneManInsuranceCompany
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(TOMIC),thetradingdiaryisyourblackboxrecorder.Itisdesignedtogiveyoufeedbackandtoimproveyourbusiness.Allthebesttraders,whetherinstocks,options,orfutures,keepatradingdiary.AgoodexampleofkeepingatradingjournalisgivenbyDr.AlexanderElderinhisbookComeintoMyTradingRoom:ACompleteGuidetoTrading.
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Whatinformationiscapturedinthetradingdiary?Table7.1showsthedatawesuggestyoushouldcaptureforeachtrade.YoumayaddtothislistanydatathatmaybeusefulforyoutomeasureyoureffectivenessasamanagerofTOMIC.Table7.1.DatatoCapture
inYourTradingLog
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Thesearevariablesthatyouneedtomonitorconstantly.ItisusefultosetupanExcelspreadsheettomonitorthepositionsyouhaveinTOMIC.TheExcel
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spreadsheetshouldincludeareal-timedatalinksoyoucanmonitoryourpositions.Oncethetradesareclosed,keeptheinformationinyourtradingjournal.Analyzeyourcumulativeresultsmonthly,quarterly,andannually.Thisgivesyouasenseofhowyouaredoing.Also,pickabenchmarkindextocompareyourselfagainstsoyoucantellwhetheryouaredoing
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wellrelativetotheenvironmentyouareworkingin.Forexample,answerthefollowingquestions:
1.Howmanytradesdidyouenterthismonth,quarter,andyear?
2.Howmanytradeswereprofitable?
3.Howmanywerelosingtrades?
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4.Whatwasyourwinrate?
5.Whatwereyouraveragedaysinthetrade?
6.Howmuchwasyouraveragewin?
7.Howmuchwasyouraverageloss?
8.Howmuchdidyouwinorloseonaveragepertrade?
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9.Whatisyouraverageyield(realizedprofit/marginused)pertrade?
Table7.2isanexampleofasummarytablewiththeanalysisofthemonthlytradesdoneatTOMIC.ThetableshowstherelevantdatafortrackingtheperformanceoftheTOMICmanager.Thefirstrowshowsthenumberoflosses,nine,thetotalvalueof
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thelosses,$(15,445),andtheaveragesizeofaloss,$(1,716).Thesecondrowshowstheinformationforthewins,andthethirdrowshowsinformationforthetotaltransactions.Thewinratio(percentageofwinningtrades)is94%,andthetotalcapitalriskedwas$1,833,878.Theaveragedaysintrade(DIT)was26,andtheaverageyieldwas3.6%,whichresultsfromdividing
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$66,417/$1,833,878.Ifyouannualizetheyield,yougeta63.8%return.1
Table7.2.ExampleoftheMonthlyTradeAnalysisat
TOMIC
Keepingtrackofyour
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performanceeverymonth,quarter,andyearwillhelpyouknowifyouaredoingwellorifyouneedtomakeadjustmentstoyourtrading.Forexample,let’ssaythatyourwinratefellto90%—wouldyouthinkyouhaveaproblem?Maybe,maybenot.Ifyoucheckyouraveragelossandyouseeitis$(500)andyouraveragewinis$500,youcouldsaythatyouareactuallybetter.Becauseeven
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thoughyourwinratehasfallenfrom94%to90%,your$loss/$winratiohasalsofallenfrom3.2to1.0,andyouractualexpectedpayoutincreasedfrom$0.75to$0.80.CompareTables7.3and7.4.Table7.3.WinRatio94%and$loss/$winRatio3.2
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Table7.4.WinRatio90%and$loss/$winRatio1.0
Thetradingjournalallowsyoutocheckyourperformanceagainstthetargetsyoudefinedinyourtradingplan.Inthisexample,Table7.2,thegoalofTOMICwastoearnbetween2%and4%permonth.Hence,
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assumingthatmostofthecapitalwasinvested,knowingthatTOMICearned3.6%thismonthletsyouknowthatyouarehittingyourgoals.ThisfeedbackisimportanttoyouasthemanagerofTOMICbecauseyougainconfidenceandknowthatyouaremakinggooddecisions.However,ifyouhadnotbeenhittingyourgoals,thefeedbackwouldhavealertedyoutomakecorrectionsto
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youtrading.
SoundingBoardTradingisalonelyprofession.Itisimportantthatyou,asthemanagerofTOMIC,begroundedinreality.OneofthekeysuccessfactorsofTOMICistheunderwritingskillsofyouasmanager.Toimproveyourunderwritingskills,meaningtradeselection,youhaveto
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beopentofeedback.Awaytoobtainfeedbackonyourtradesistohaveotherpeoplehelp.HavingasetofpeoplewhounderstandwhatTOMICisdoingandwhocangivefeedbackandadviceisusefulandadvancesyourskillsgreatly.Thereareseveralchoicesforhowyoucansetupafeedbacksystem.Thetwoeasiestwaysare(1)joiningatradinggroupand(2)hiringatradingcoach.
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JoiningaTradingGroup
SomepeopleclaimthattheybelongtotheCNBCtradinggroup.Thatistotallywrong;watchingTVtalkingheadsisnotbeingpartofatradinggroup.Beingamemberofatradinggroupgivesyouasoundingboardfortryingoutnewideas.Thegroupalsohelpswithaccountability.Eventhoughyouareultimately
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heldresponsibleforallofyourtrades,thegrouphelpsremindyouofyourtradingplanandkeepsyouonthereservation.Findagroupwithtradingstylesandbackgroundsimilartoyours.Somequestionsyoushouldaskyourselfwhenchoosingatradinggroupincludethefollowing:
•Whatarethegoalsofthetradinggroup?
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•Howwilltheinteractionsbe?Inperson,online,byphone?Willyoubeusingachatroomonline(forexample,Skype,AIM,GoogleTalk,andsoon)?
•Howoftenwillyoubemeeting?
•Howmanymembers?•Whataretheexperiencelevelsofthemembers?
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•Ifeveryoneisanovice,willitbeacaseoftheblindleadingtheblind?
•Iftherearedifferentexperiencelevelsinthegroup,willthemoreexperiencedmembersbewillingtosharewiththelessexperienced?
•Whatdoyoubringtothegroup?
•Doesthegroupkeepameetinglog?Iftheydo,
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reviewittoseewhattheyhavebeenworkingon.
•Doyoupoolresources?•Doesthegrouphaveacoach?
HiringaTradingCoachAtradingcoachissomeoneyouhiretolistentoyourtradingstrategies.Thecoachhelpsholdyouaccountableandhelpsyouconstantly
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improveonyourtrades.Thecoachissomeonewhoismoreexperiencedandhasawealthofknowledgeandexperiencetosharewithyou.Somequestionsyoushouldaskwhenhiringatradingcoachincludethefollowing:
•WhatcanIlearnfromthiscoach?
•Canthecoachprovidereferences?Talktothepeoplethathaveused
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hisorhercoachingservices.
•Howavailableisthecoach?Howeasyisittocontactthecoachifyougetintrouble?
•Howmuchtimewillyoubeinteractingwiththecoachperweek?
•Whatisthecommunicationmediumthatyouwillbeusing?Nowadays,usingan
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onlinemeetingservicelikeWebexorGoto-meetingiscommon.
•Doesyourcoachknowenoughtochallengeyou?Willheconstantlychallengeyoutoimprove?
•Isyourcoachanindividualorpartofalargercoachingorganization?
•Doesthecoachhave
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“student”tradinggroupsthatyoucouldparticipatein?
•Doesthecoachstillactivelytraderealmoney?Howishisperformance?
•Howgoodarehis/hercommunicationskills?
ContinuingEducationNomatterwhatprofessionyouarein,thereisalways
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somethingyoucanlearntoimproveyourbusiness.Allhighlyskilledprofessionals—medicaldoctors,dentists,lawyers,computerengineers—havetokeepupwiththeirfields.Theydosobyattendingseminars,goingtoclasses,andpursuingcontinuingeducation.AsthemanagerofTOMIC,youtooshouldfollowacontinuingeducationplanto
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stayatthecuttingedgeofoptionstrading.Continuingyoureducationandimprovingyourskillsetsarenecessarytosurviveintheoptionstradingprofession.Youshouldalwaysbelearningnewthingsinordertobepreparedforanyevent.Itislikeakaratepractitionerwhoknowshowtoblockandpunchreallywell.Hecouldprobablydefendhimselfwithjustblockingandpunching;
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however,learninghowtokickhelpshimhavealternativestocausedamagetoanopponent.ThesameprincipleappliestothemanagerofTOMIC.Youshouldbeskilledandfluentinallthedifferentoptionstrategies.Youshouldknowhowtoreadtheenvironmenttousethebestavailablestrategyforthemarketconditions.Youshouldalwaysbelearning.
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Youreducationplanshouldincludereadingbooks,attendingseminars,takingspecialclasses,orjoiningcoachingserviceslikeOptionPit.com.SeeAppendixA,“RecommendedReading,”foralistofrecommendedbookstocontinueyoureducation.Also,youmayfindinformationonOptionPit.comservicesinAppendixC,“OptionPit.com.”
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Endnote1.Toannualizetheyield,mostpeoplemakethemistakeofdividingtheyieldbythenumberofdaysandthenmultiplyingby365.Thisisnotcorrect.Toannualizetheyieldcorrectly,usethefollowingExcelformula:(1+yield)^(365.25/numberofdays)-1.
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PartII:ImplementingtheBusiness
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8.UnderstandingVolatilityYouareprobablyawareofhowthepricingmodelworks.Tofullyunderstandhowtotradeoptions,potentialhedgefundtradersneedastrongunderstandingofhowoptionsfunction.
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Alloptionpricingmodelsareverydifferent.TheolderoneslikeBlack-ScholesandtheWhaleymodelaresomewhatantiquated,butmuchlikeautomobilesorhouses,eventhemostadvancedmodelsrelyonacertainamountoffundamentalinformation.Allmodelsneedfivefactors:underlyingprice,strikeprice,timetoexpiration,costofcarry,andforwardvolatility.Fourofthefivearepretty
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simple...andthenthereisvolatility.Toahedgefundtrader(andalltraders,forthatmatter),volatilityisbyfarthenumberonedeterminantofsuccess.Forwardvolatilityistheonlyfactorthattradersdonotknow.Anyeducator,coach,book,software,orservicethatignoresvolatility,ordoesnotemphasizevolatilityastheprimaryandfundamentalkey
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tosuccess,islikelynotworthmuch.Ifyouareunfamiliarwiththeconceptofvolatility,stopreadingthisbookandgrababookonoursuggestedreadinglist.Evenwithafundamentalknowledgeofwhatvolatilityrepresents,itspracticalapplicationinandofitselfisnotaneasysubject.Thischapterexplainsthefactorsofvolatilityandwhatcausesvolatilitytooccur.
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WhatCausesVolatility?Themodelhastouseforwardvolatility,butamajorityoftradersdonotknowwhatforwardvolatilityisgoingtobe.Ifyoudidknowwhatforwardvolatilitywasgoingtobe,therewouldbelittlereasontotrade.Infact,theuncertaintyofvolatilityisyourbestfriend.Traderswho
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haveamasteryofthesubjectwillfindthattheroadtosuccessinanoptionhedgefundwillbesmoother.Masteringvolatilitydoesnotmeanthatyouneedasixthsenseofsomesort,butratheranunderstandingofhowhighorlowimpliedvolatilityismoving.Impliedvolatilityisthemeasureofvolatilitythatmostretailandinstitutional
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traderstrack,butitisalmostuniversallymisunderstood.Forstarters,mosttradersdonotunderstandwhatdrivesimpliedvolatility.Commonly,theretailpublicthinksthereissomesortofboilerroomofmarketmakersinwhichthetradingpriceoftheoptionisdetermined.Thegeneralassumptionisthatmarketmakerssettheoptionpriceandthusvolatility.Thiscouldnotbefurtherfromthe
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truth.Marketmakersmaydeterminethemarket,andthusimpliedvolatility,atanygivenmomentinthemarketstheypost.However,theydonot,inthelongrun,determinethepriceofoptions.Thatissetthroughpricediscovery.Ifmarketmakersplaceabidtoohighforanoption,themarketwillbegintosellthese
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unmercifullytomarketmakers.Tradershavechoices:eatalotofoptionsorlowerthebidprice.Oncemarketmakershavetakenonacertainamountofriskatagivenvolatilitylevel,theydropthebidpriceandlowertheiroffer.Thisisdoneasawaytomanageinventory,andvolatilityfallsasasideeffect.Ifmarketmakersovercompensateforadeluge
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ofsalesinanattempttomanageinventory,itwillnotbelongbeforetheystarttoseebidsforthoseoptions.Prettysoon,marketmakerswillbeforcedtoraisetheofferpriceinanefforttonotselltoomanyoptionsattoocheapapricerelativetowheretheyjustpurchased.Tradersraisetheiroffersandimpliedvolatilityincreasesalongwithit.
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Table8.1showsanexampleofhowthishappensinastreamedmarket.Table8.1.SampleofHowaMarketMakerMightMoveMarketsasCustomerPaper
Flows
Noticethatmarketmakersmovetheirbidlowerand
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lower.Thenoncethepriceoftheofferdropsto1.00,tradersfindbidsontheothersideoftheirtrade.Thisisthemarketmakers’signthatthebid/offerhasdroppedtoomuchbymovingto26%impliedvolatility.Realizingthatthemarketistellingthemthatvolatilityisoversold,marketmakersquicklyraisethebidprice.Thedeterminantofimplied
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volatilityisnotmarketmakers,butsupplyanddemandforoptions.Marketmakerstaketheothersideofpublicorders,andthoseordersdeterminethemarket.Thesmarthedgefundmanagercantakeadvantageofmarketmakersmuchthewaythebuyerdidinthepreviousexample,orbetteryet,takeadvantageofvolatilitythewaythesellerdidintheexample,inwhich
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thebesttradeacrosstheboardwasthefirstsaleof100at1.10.SinceTOMIChastheabilitytoinitiate,itshouldlookforopportunitiestoselltheovervaluedcontract.Impliedvolatilityisdeterminedbythemarket,notthemarketmakers.Sellingwhenothersarebuyingandbuyingwhenothersaresellingisthekeytosuccess.Smarthedgefundstakethe
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riskawayfromthosewhoarepanicking,orthosewhoareoverlycomplacent.
Three-DimensionalVolatilitymightseemsimple,butitisnot,because“vol”isnotaone-dimensionalconcept.Itisactuallythree-dimensional.Tradersusingvolatilitytodeterminepricehavetolookatallfacetsofoptions:theATMoptions
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priceinthenearterm,volatilityskew,andtermstructure.
ATMOptions
ThemostactiveoptionstradedatanygiventimearealmostuniversallyfrontmonthATMoptions.Tradingintheseoptionsdeterminestheoverallstructureofvolatilityinaproduct.ThinkofATMoptionsassails
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poweringaboat.Whileotherpartsoftheboataffectspeed,theeffectofwindonthesailmeansmore,nottomentionthesizeofthesailanditsangleagainstthewind.MovementsinATMoptionsaffectthepriceofOTMputs,OTMcalls,andtheentiretermstructure.IffrontmonthATMoptionIVisdropping,sowillmonthsfurtherout.Onthe
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flipside,ifIVisrallying,sowillallotherpartsoftheproduct’sstructure.Frontmonthdoesnothavethemost“vega.”However,frontmonthoptionsarefarmoresensitivetochangesinimpliedvolatility.TheTOMICmanagerwillfindthatthissensitivityiswhyfrontmonthoptionsarethenumberonedeterminantinthesuccessofatrade,evenifyoudon’tholdATMoptions.
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Becauseithaswhatissometimescalled“vomma”—thegreatestsensitivitytochangesinimpliedvolatility—youwillfindthatwatchingATMfrontmonthoptionswillindicatehowIVonanyoptionwillmove.
Skew
Skew,sometimescalled“kurtosis,”representshowdifferentoptions’volatilities
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relatetoeachotherinanygivencontract.Thereareseveraltypesofskew;however,withinequityandequityindexoptions,optionsusuallyhavean“investmentskew,”whereOTMputshaveahigherimpliedvolatilitythanATMoptions,andOTMcallshavealowerimpliedvolatilitythanATMoptions.Althoughthereareoccurrencesinwhichthisisnotthecase,mostnotablyin
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dealstocks,FDAannouncementstocks,andVIXoptions,equityoptionshaveaninvestmentskew.Themainreasonforthisskewisfoundinthedriversintheequitymarketplace:naturallongs.Whatdomost401(k)’sinvestin?Mutualfundsareforthemostpartlongstocks.Whatdomostpeoplehaveintheirpersonalaccounts?Mostindividualsholdlongstock.
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Infact,ifyouwanttogetshortinapersonalaccount,thereareallkindsofextraforms,questionnaires,andmarginrequirementsyouhavetomeet.Theentirestructureofthemarketissetuptomakeiteasiertobuystock,andhardertoshortstock.Sowhatdoesthishavetodowithoptions?Therearetwomainwaysthegeneralpublic
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hedgeslongstockpositions:1.Theybuyputs.2.Theysellcalls.
Ifalargeportionofthemarkethasthesametrade,andeveryoneistryingtobuyputsandsellcalls,itcausesademandshift.Putswillgetbidupandcallswillgetdepressed.Thisphenomenonhastobepricedinsomehow,anditshowsupinvolume.Sothemainreasonforskewis
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actionsbythegeneralpublic.
UsingSkew
LikeATMoptions,orderflowdetermineshowskewmovesupanddown.Iftherearetoomanytradersbuyingorsellingrelativelylow-pricedOTMputsorlow-pricedOTMcalls,IVcango“outofwhack.”Thisallowstraderstosetuptradesthatarestatisticallyfavorable.Anoverlyflatskewmaybethe
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biggestdeterminantofsuccessofabutterfly.Italsowilltypicallyleadtomoresuccessfulbackspreadsandfrontspreadtrades.OnamorebasictradeyoumayonlywanttosellOTMputorcallspreads.Bybuyinganoversoldoptionorsellinganoverboughtoptionina“creditspread,”youwillbeabletosqueezeuptoanextra.02to.10in
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andoutofthespread.Ifyoucansave.10onevery10trades,youwouldsave100ineverytrade.Thatmorethanpaysforthetypicalcommissioncost,andinanactiveaccountanextra100pertradequicklyaddsup.Doingthemath,afundtrading500contractspermonthsavesupto$5,000.Therelationshipofskewisacomplexone,andhasamajor
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effectonyoursuccess;youneedtomonitorskew.Onastrike-by-strike,trade-by-tradebasis,youshouldexaminethecurvebeforetrading.Findthemispricedoptionifthereisone.Forindextraders,thesolutionismorecomplex.Youneedtodotwothings:OnaglobalscalepickafewOTMputsandOTMcallsusingeitherpercentageOTMor,better
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yet,delta,andmonitorhowtheseoptionsarerelatedtoeachother.Forinstance,ifa10deltaputtrades30%andtheATMoptiontrades20%,the10deltaputtradesat150%ofATM.Asthe10deltaIVputmovesupanddown,youwillbeabletoseehowtherelationshipofthetwoalsomoves.CombinedwithmonitoringATMIV,youshouldhaveagoodgriponhowthecurveappears.
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Forthosetradingindexcreditspreads,monitortherelationshipoftheentirecurve.Youwillbeabletosqueezeafewpenniesoutofeverytrade.Althoughthisisimpossibletodobylookingatatradingplatform,programsthatmapthecurvepayforthemselvesandareworththeinvestment.
Units
Youneedtobeawareofthe
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wayOTMoptionspriceintermsofvolatility.Atacertainpointanoptionstopsbehavingwithvolatilityandbeginstotradefora“price.”Inotherwords,anoptionthatcosts.10ontheSPXdoesnothavevolatility;ithasalotteryticketprice.Althoughthechanceof.05to.10optionsbecomingworthanythingisslight,theriskoftheseoptionscannotbeoverstressed.A.10option
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thatmovesto15.00returns1,500%,andthereisnowaytopricethatdegreeofmovementinanoption.Optionpricingmodelswerenotdesignedtopricethe“humanrisk.”Wecall“humanrisk”theconceptthattradersarenotwillingtosellextremelycheapoptionsnakedbecauseoftheriskofcatastrophicloss.Althoughthefirstandsecondstandarddeviationsarefairlypriced,
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onceastockoranindexmovespastatwostandarddeviation,whichismorethanthepricingmodelpredicts,optionswillmovetothatfourthorfifthstandarddeviation.Therefore,
1.Nevershortoptionsworth.10orless.
2.Ifyouareshortanoptionworthlessthan.10,itisprobablyworthbuyingtocloseevenif
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thereisacommissionforthatclosingpurchase.
3.Ahedgefundthatsellspremiumshouldalwaysbenetlongthese“units.”
Byfollowingthesethreerules,youavoidatotalcatastrophiclossandmayfindyourselfsittingonasurpriseprofitintheeventofamajorupwardordownward
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move.Aninvestmentin5%to10%ofthefundinoptioninsurancewillinthelongrunpayout.
TermStructure
MuchlikeskewandATMoptions,variouscontractmonthswillseedifferentamountsofpaper.Thefurtheryougofromthenearterm,thelessliquidcontractmonthsbecome.Thus,abig
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ordercanmoveonemonthsubstantiallyrelativetoanothermonth.Althoughoverallvolatilityisimportanttothesuccessofacalendarspread,youwillfindthatbymonitoringtherelationshipofdifferentexpiries,youopenupanopportunity.Ifacontractmonthseesaninordinateamountofpaperflow,youshouldbeabletotakeadvantageofthe
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movementintherelationships.Iftheneartermisunderpriced,itwillmakesensetobuyneartermandselllong-termoptionsagainstit.Theretailpublicshouldavoidthistrade,butbeawarethatwhenthisconditionoccurs,alongcalendarisalosingproposition.Whentheneartermisoverpriced,itmakessensetoselltheneartermandbuythebackmonthsagainstit.
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FrontmonthoptionshavemuchmoresensitivitytoIVchangesthanbackmonths.Thebestopportunitiestotradecalendarspreadsarewhenthefrontmonthbecomesoverpricedorunderpricedinaquickmove.Sometradersmakealivingbysimplytrading“vomma”actionoffrontmonthoptionsagainstlong-termoptions.Thepriceactioninfront
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monthscanalsobeusedinamoregeneralsense.Ifyouwouldliketosimplysellironcondors,butterflies,andstrangles,monitorvolatilityrelationshipsagainsteachother.WhentheIVofonemonthbecomesoverbought,itmakessensetomoveacondororstrangletradeintothatoverboughtcontractmonth.Itcanalsobeahintthatyoucanavoidbuyingorsellingadifferentcontract
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month.Thereareafewpitfallsyouneedtobeawareofwhen“volatilityswapping”ormovingcontractmonths,especiallyinindividualequities.Beonthelookoutforthefollowing:
•Earnings•FDAannouncements•Corporateactions•Dividends
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Everyonelikessellingexpensiveandbuyingcheap,butaspreadcausedbyanyoftheprecedingactionscanbeagoodreasontoleavethatcontractmonthalone.Inaddition,ifaspreadisexorbitantlywide,eveniftheTOMICmanagerthinksthereisnoreasonforthespread,thereprobablyisareason.Doadditionalresearch,makephonecalls,anddigintothemessageboards.Ifaswap
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seemstoogoodtobetrue,itprobablyis.Don’tbeafraidtotradeswapsanddifferentcontractmonthsagainsteachother.Themonthsarecorrelatedbutnottied.Ifyoutakeadvantageofthesemovementsbetweenmonths,youwillseethattherearehigheroddsofsuccessthanthepricingmodelpredicts.
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VolatilityandtheModelIVisanoutputofthemodel,notaninput.TheGreeksareanoutputofthemodelandsoisIV;sotraderssittinginfrontofascreenhavelittlepowertocontroltheriskoutputs.Ifyouarenotmanagingyourownvolatilities,youcannotseeyourriskparameters.To
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properlymanagerisk,oneshouldmodelhowtheGreeksandprofitandlosswillmoveacrossawidevarietyofsituations.YoushouldalsoknowwhattheIVsareofeverycontractyouown.Byknowingthis,youcancircumventmanyofthepitfallsofretailtradingplatforms.Tomonitorvolatility,keeptrackofthefollowingin
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everystocktraded:ATMIVSkewThree-monthtermstructure
Forpositionsheld,keeptrackofthefollowing:
TheIVofeverycontractheldTheGreeksoftheentirepositionsExpectedGreeks
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ProfitandlossbasedonadeclineorincreaseinIVof5%,10%,and25%.
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9.MostUsedStrategiesInthischapteryou’llfindthefivemostusedstrategiesforTOMIC.Thisgivesyouanoverviewandanexampleofeachstrategy.Howshouldyousetupeachofthemajorshortpremiumspreads?Whatistheexactcriterionforevaluatinga
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decentsaleofinsurance?Clearly,notallsalesareequalandthekeytoanykindofsuccessistosellinsurancepremiumwhenitisata“goodprice.”Inthissectionyou’llfindfiveofthemajorspreads,fromconstructiontomanagementtoexit.Althougheverytraderhasadifferentapproachtotrading,youhavespenttimestudyingeachspread,tryingtofindwhatyoubelieveisthebest
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approachtotradingthem.Theissueisthateverytraderhasdifferentrisktolerancesandtradinggoals,soyouneedtothinkofthefollowingasguidelines,notrules.Asyoubuildyourinsurancebusiness,planontweakingandadjustingtheseguidelines.Youareconstantlyattemptingtoimproveandtweakyourapproach.Asconditionschange,partsofyouroverall
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strategywillhavetobeadjusted.
TheVerticalSpreadVerticalspreadisthegeneraltermforabullcallspread,bullputspread,bearcallspread,orabearputspread.Thenameverticalspreadreallyderivesfromtraderslookingatanoptionmontageandseeingthatthespreadismadeupofthedifferent
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strikesthatarelaidoutvertically.Theverticalspreadisoneofthebuildingblocksofothermorecomplexspreadsliketheironcondorandthebutterfly.Ifyouweretogetstrandedonadesertislandandcouldtradeonlyonestrategy,theverticalspreadwouldprobablybeyourchoice.Itisaspreadthatmanybeginnersusebecause
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itisfamiliartothem.Manybeginnersstartoutwiththecoveredcallornakedputs.Theverticalspreadmightconsistofashortputcombinedwithinsuranceorashortcallcombinedwithinsurance.Mosttradersuseitfordirectionalplays,eitherbullishorbearish.Bydefinition,averticalspreadiscomposedofalongandashortoptionatdifferent
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strikesinthesameexpiration.Verticalspreadscanbebullishorbearishandcanbeboughtforadebitorsoldforacredit:
Herearethesituationsinwhichtousethedifferentverticalspreads:
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Bullish(1)Verticalcalldebitspread:Usewhenpartiallybullishanddon’tmindthetadecay.
(3)Verticalputcreditspread:Usewhenpartiallybullishandwantpositivetheta.
Bearish(2)Verticalputdebitspread:Usewhenpartiallybearishand
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don’tmindthetadecay.(4)Verticalcallcreditspread:Usewhenpartiallybearishandwantpositivetheta.
Focusonthecreditspreads:theverticalputcreditspread(bullish)andtheverticalcallcreditspread(bearish).Thesespreadsarethetapositive.Assumingthatthereisnomovementintheunderlying,thetradeearnsmoneyastime
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goeson.
Conditions
Theverticalspreadisbestwhenyouhaveanopiniononthedirectionofthemarket.Volatilityrule:Useverticalcreditspreadsintimesofstableordecliningmarketvolatility.Thewidthofthespreaddependsonthesteepnessoftheskew.Insteepcurves,narrower
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spreadsarerecommendedsothelongoptionvolatilityhaslessofagapwithrespecttothevolatilityoftheshortoption.Iftheskewislesssteep,youmayusewiderspreadstosaveoncommissions.Time:Usuallyplaceverticalspreadtradeswith30to60daystoexpiration.Thisdependsonhowfarout-of-the-moneythespreadis
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placed.OnfarOTMspreadsthethetadecayismorelinear,sowhenyou’redoinglongertrades,asinanironcondor,startingatrade30to60daysfromexpirationisoptimal.
VerticalSpreadExample
HereisaverticalputcreditspreadonAAPL(Apple).OnOctober13,2011,30-dayimpliedvolatilityand10-dayhistoricalvolatilitywere38
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and37.IVwasgreaterthanHV,whichiswithinnormalparametersforthistrade.Next,checkIV,whichwastrendingdownfrom51onOctober4,2011.AfallingIVisagoodenvironmentforthisverticalspread.YouplacedtheverticalspreadonOctober13,2011,at10a.m.,whenAAPLwastradingat$405,shorted10AAPLNOV360,andbought
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the10AAPLNOV350foracreditof1.55perspread,net$1,550forthetrade.SeeFigure9.2forthedetails.TheriskprofileofthetradecanbeseeninFigure9.1.
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Figure9.1.Riskprofileofthe10NOV360/350verticalputcreditspread.(Source:
OptionVue6)
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Figure9.2.Openingdetailsofthe10NOV360/350
verticalputcreditspread.(Source:OptionVue6)
OnNovember4,AAPLwasat$401orbelowthepricewhenyousoldthespread.However,IVwasdown.ImpliedvolatilityoftheAAPLNOV360putwasat41.7%whenyousold,andonNovember4,2011,theIVoftheAAPLNOV360putwas
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at34.1%(seeFigure9.3).Thespreadatthispointwasworth$0.25.Youhadcaptured83%ofthecreditreceivedsoyouclosedthetradeandbookedtheprofit.Youboughttoclosethespreadfor$250.Yousoldthespreadfor$1,550andboughtittoclosefor$250,resultingina$1,300profitforthistrade.
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Figure9.3.Closingdetailsofthetrade10NOV
360/350verticalputcreditspread.(Source:OptionVue6)
TheReg-Tmarginforthis
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tradewas$8,450andtheprofitwas$1,300.Thisgaveyouareturnonmarginof15.4%inaspanof22days.
TheIronCondorTheironcondorconsistsoftwoverticalspreads,bothsetupout-of-the-money:ashortcallspreadsetabovethecurrentpriceoftheunderlyingandashortputspreadsetbelowthemoney.
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Thegoaloftheironcondoristosetuptheshortsatadistancetheunderlyingisunlikelytogettooverthelifeofthespread.Foraprimeronironcondors,youcanrefertoJaredWoodard’se-bookIronCondorSpreadStrategies.
Conditions
Volatility:Foranironcondor,impliedvolatilitydoesnotneedtobehigh,butonly
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higherthantheaveragetruerange(ATR)1oftheunderlying.Thus,anironcondorcanbetradedinjustaboutanytypeofvolatilitycondition.ItonlymattersthatexpectationsofimpliedvolatilityarehigherthanATR.Essentially,youthinkimpliedvolatilityistoohigh.Ironcondorsaremosteffectiveinlowervolatility.Inhighervolatilityyouare
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gettingahigherpremiumorsettinguptheironcondorwider,butoftenATRishigh.Thekeytotradingironcondorsinhighvolatilityistotrytosellwhenvolatilityisstableorfalling,notwhenimpliedvolatilityissimply“high.”Forexample,onAugust5,2011,theCBOEvolatilityindexwastradingover25%,historicallyelevated.
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However,thatvolatilitywasactuallylowrelativetowhatthemarketwasabouttodo.Ifyousoldanironcondorinthoseconditions,youmighthavebeenconsideredselling“highvol”butyouwerenotsellingvolatilitythatwastoohigh.Thereisamajordifference.InthecaseofAugust2011,volatilitywashigh,butitwasonanuptrend,notadowntrend.AnironcondorsoldonAugust5
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wouldhavehadsomemajorproblems.Anironcondorsoldonlyonemonthearlierwouldhavebeenadifferentstory.TheVIXwasnotnearlyashighasitreachedonAugust5,yetbecausevolatilitywasdeclining,anironcondorwouldlikelyhavebeenaquickexitforatraderwhoenteredaspread.Volatilityrule:Stableor
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decliningmarketvolatilityarekeytoasuccessfulcondor.Skew:Ifyouweresimplysellingstrangles,theskewcurvemightbethemostimportantpartofthetradeequation.Becauseyouaresellinganironcondor,thussellingashortandbuyingalongagainstit,skewseemstomatterless.Still,itcanhelpthetraderrecognizeredflags.Inlowvolatility,typically,
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youwouldpreferaslightlysteeperskew.BelowATM,anelevatedskewwillpushtheshortslightlyfurtherawayfromATM.AboveATM,theshortcallspreadwillreceiveslightlymorecredit.Thisisnotofmajorsignificance,butitdoesmatter.Anoverlysteepcurveshouldbeconsideredamajorwarningsign.Whenimpliedvolatilityhasyettorally,but
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thecurvehascaughtabid,thiscanbeasignofanimpendingvolatilityspike.Sellinganironcondorintorisingvolatilityisarecipefordisaster.Skewtendstobeverysteepintwoinstances:risingvolatilityandfallingvolatility.IfIVisreallylowandskewissteep,eitherdon’tenteranironcondororbackupthetruckoninsurance.
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Time:InJimBittman’sbookTradingOptionsasaProfessional(agreatprimerforthisbook,bytheway),oneofthemostcompellingpointsinthewholebookhastodowithdecay.Thereisaflawedbeliefthatoptiontimepremiumdecaysexponentiallyacrossallstrikesinthefinal30daysofanoption’slife.Thisiscompletelyflawed;inthefinal30days,studiesshow,
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onlyATMoptionsdecayexponentially.Aspricemovesfurtherawayfromat-the-money,optionsdecaymuchmorelinearly.Jimpointsoutthatforanoption10%out-of-the-money,theoptionlosesmorevaluefromday60today30thanitdoesday30today1.Uponfurtherstudy,optionsseemtohavea“coneoffeasibility”thatrelatesto
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whenandhowtheydecay.Asanoptionmovesfrombeinglogicallyin-the-moneytoanoptionthatcannotendupin-the-money,thisiswhenoptionsgiveupthebulkoftheirvalue.Thus,whentradinganironcondor,youshouldsetupthetradewhenitwilllogicallylosethebulkofitsvalue.Youwillprefertosetupinthe10–15deltarangewhencreating
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yourironcondor.Thus,underalmosteverycircumstance,rightaround60daysseemstobetheoptimaltimetosellanironcondor.Insuring:Thegreatestdangertoanironcondorisnotfoundwhenvolatilityislow.Thegreatestdangerisnotwhenvolatilityishigh.ItisduringthetransitionfromlowtohighwhenironcondorscancompletelydestroyaTOMIC.
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Theproperimplementationofunitputscansaveaportfolio.ThetransitionfromlowtohighcanrampupthevalueofOTMputs.Thus,ifvolatilityisinthelower25%ofitshistoricalrange,youshouldalwaysspendafewdollarsoninsuringthevalueoftheopenironcondor.Althoughtradersvaryinhowmuchtheybuy,nomorethan10%ofthecreditreceivedonasaleis
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necessarytoensurethattheironcondorisproperlyinsured.Ontheotherhand,whenvolatilityisatitshighestlevelsanddeclining,insuringmaybeunnecessary;itislikelythatthetradewasenteredwhenyouhadafullviewoftheriskassociatedwiththetrade.Itisalsolikelythatanyinsuranceboughtwouldbeineffective,asthe
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farOTMputswillalreadyhavealargeportionofriskpremiumbuiltintotheirprice.Thesetup:Onceyouhavedeterminedthatvolatilityis“toohigh,”youshouldlooktosella10–11deltacallandbuythenextcallstrike.However,thisisnotsetinstone.Asmarttraderexaminesstrikesaroundthe10–11deltastoseewhetherthereareanystrikesthatare
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mispriced.IhaveseensituationsinwhichanSPX1350–1360callspreadnettedmorethananSPX1340–1350callspread.Thisisgenerallyduetoa“publicorder”beinginthe“book.”Thenyoushouldlooktosellthe10–12deltaputagainstthecallspread.Youmaycheatupatouchontheputsideofthecurvetoincreasecreditandhelpflattendelta.Skewnaturallycausestheshortput
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spreadtobefurtherawayfromthecurrenttradingpricethantheshortcallspread.Althoughstocksdo“creepupandcrashdown,”cheatingputsinastrikeortwodoesnotmakeaprofounddifferenceintheoutcomeofthespread,especiallyifyouinsuretheironcondor.Thereturnshouldbeassuchthatyouaregettinggood“odds”beforeensuring.For
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instance,ifyoucanget2.00ona10-pointspread,thatequatestoarisk/rewardof200over800,or25%returnonrisk.Ifthetradehasan85%chanceofsuccessaccordingtoprobabilities,youareinaveryfavorableposition.Ifthetradehasonlya70%chanceofsuccess,youareinafarlessfavorabletrade.Althoughprobabilitiesandpayoutsareonlyafunctionofvolatility,itis
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importanttobeawareoftheserisk/rewardcomparisons.Bylookingforthebestspotstobuyandsellinanironcondor,youmightbeabletosqueezeafewpointsofprobabilityoutofthetrade.Intrading,every.05counts;anextra.05inaspreadmightbeenoughtocoverinsuringtheportfolioorpayforacommission.Goals:Aspreadwillalmost
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neverfullydecay,anditalmostnevermakessensetoallowaspreadtofullydecay.Thegoalshouldbetocapturethepremiumsoldasthetradeleftthe“coneoffeasibility.”Thatamountisslightlyover50%ofthevalueoftheironcondor.Thus,youshouldtrytocollectabout55%ofthevalueoftheironcondoryousold.Theintentistobeoutofthecondorby30daysuntilexpiration.
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Ifthetradepicksup25%ofthecreditsoldinunderfivetradingdays,youcaught“edge”inthesale.Youshouldexitthetrade,stop,reevaluatecurrentconditions,andthendecidetoenteranewtradeifyouaresoinclined.Profitmadequicklymeanstherewasedgeinthetrade,andedgeshouldalwaysbecapturedinatimelymanner.
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Risk:Inmanagingrisk,youneedawarenessoftwotypesoflosses:maximumlossandabsolutemaximumloss.Maximumlossisanumberatwhich,onceit’shit,youexitthetrade.Setthisnumbertoequalyourprofittarget,forexample.Inagivenyearyoumayexpecttohitthismaximumlossononeortwooccasions.Itispartofthebusiness.However,ifyoumanagethetrade,thenetof
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hittingseveralprofittargetsshouldresultinapositiveoverallreturn.InmanagingthetradeaThirdThirdThirdRuleisinvoked:firstadjustmentatone-thirdofmaximumloss,secondadjustmentattwo-thirdsofmaximumloss,andexituponhittingthefinalthirdofmaximumloss.Thisiswhereabsolutemaximumlossisimportant.Absolute
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maximumlossisanumberthatyoushouldneverallowatradetoexceed.Setthisnumberatthevalueofthecreditreceivedinthetrade,forexample.Ifatanypointa1.5standarddeviationmoveinonedirectionwouldputthetradebeyondtheabsolutemaximumloss,thetradeshouldbeadjustedorexitedevenifthetradeisnotyetatmaximumloss.
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Inmanagingtherisk,wearenotfansof“rolling”outatrade.Thekitespread,theratiospread,theverticalspread,andthebackratiospreadaremuchbetteradjustments.YouwillfindexamplesofthekitespreadadjustmentsinAppendixD,“KiteSpread.”Anironcondorissetwithsuchawideareathatmanagingtheunderlyingwithinthatareaisnotthatdifficult.Theideaof
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rollingoutandincreasingsizecanbecostly,difficult,andrisky.Inmoregeneraltermsthegoalshouldbetogetthemosteffectivehedgeandspendaslittleaspossible.Liketradesthemselves,eachadjustmentisrightforaspecificcircumstance.Forquickreferencehereareafewguidelinesforeachadjustment:Upside:
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Kitespread:Thisistheprimaryadjustmentforupsidemovement.Thistradereducesgammaandcoststypicallyverylittle.Theonetimethistradeisnottheoptimalspreadiswhenimpliedvolatilityisespeciallylow.Injustabouteveryothercircumstancethistradeworks.Backratio:Thisisthesecondaryadjustmentontheupside.Thistradealso
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reducesgammaandcostsverylittle.However,becauseofthestructureofthetrade,thisshouldbeusedonlyincaseswheretheimpliedvolatilityisatverydepressedlevels.Callspread:Thisisthetradeoflastresortwhenyouneedalotofdeltainahurry.Thismakessenseonlyifyouthinkthemarketisgoingto“roar”higherandimpliedvolatility
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isextremelydepressed.Itisthequickestandeasiestwaytogetalotofdelta.However,becauseofthecost,itshouldbeavoidedunlessyouareinatruepinch.Themargintrade:Thetimecallspreadisagreatspreadforthosethathaveportfoliomargin.Itinvolvesbuyingafrontmonthcallandsellingahigherbackmonthcallagainstit.Thisisagreat
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spreadinmanyconditionsandmaybecomethepreferredadjustmentforTOMIC.However,becauseitissomewhatcomplextotrade,youshouldfullyunderstandtermstructurebeforeenteringthetrade.Theone-by-twocallspreadmayalsobeagoodtrade,althoughtypicallyitwillcreateadebitontheupside.Iftradedproperly,itcanmake
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moneyevenifthemarketturnsback.Downside:Ratiospread:Whenyouexpectvolatilitytorallyasthemarketfalls,theshort1long2ratiospreadcanbeagreatwaytomanagethisrisk.Itwillnotexpandthetradeout;however,itwillquicklyflattenthecurve.Thisshouldbeconsideredtheprimaryadjustmentforthedownside
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ifvolatilityisnormal.Theputspread:Becauseofputskew,aputspreadisamuchcheaperoptionforanindextradethanacallspread.Thistradeisaversatile,ifstillsomewhatexpensive,adjustmentforthedownsideofthecurve.Thisshouldbeconsideredthesecondaryadjustment.Themargintrade:Ifyouhavemargin,aone-by-two
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frontspreadmakesalotofsense.Thetradeisinexpensive,itsetsaverywidetent,andunliketheothertrades,whenthemarketturnsaround,ifenteredproperly,thistradeaddstoprofitandloss.Exit:Whenagoalishit,goodorbad,itistimetocallthetradeaday.Itcanbetemptingtostayinatradebeyondyourgoal;however,
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disciplinemusttrump“gut.”Wehaveseenmoredollarslostongutfeelingthanjustaboutanyothertypeofloss.Whenexiting,makesuretoexittheentiretradeincludinginsurance.Thosedollarsandcentsmatter.Ifthelongputpurchasedforprotectionisworthlessthan.10,keepit.Thesale,aftercommission,islikeawaste.Wewouldalsonotethatalthoughadjustingmaychangemargin,the
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trade’sgoalssetfromtheoriginalonsetshouldnotchange.Addingorremovingcapitalfromthetradeshouldhavelittletonoeffectonthenettargets.
IronCondorExample
OnOctober19,2011,youevaluatedtheJanuarycontractmonthforapossiblecondor.YounoticedthatIVwastradingatapremiumto
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realizedvolatility,andyoualsonotedthatIVwastrendinglower.Skewwaselevatedbutnotoff-the-chartshigh.Yousetthetradesothatyouweretradingasmuchasyoucouldalongliquidstrikes.Youalsoreceivedafavorablepayoutrelativetotheoddsofsuccessonthecondor.Collectingabout2.50,yourgoalwastomakeatleast
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1,250andtobeoutofthetradeby30daystoexpiration.SeetheironcondordetailsinFigure9.4.TheinitialprofitandlossriskgraphoftheironcondortradeisillustratedinFigure9.5.
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Figure9.4.OpeningdetailsoftheSPX
990/1000/1340/1350ironcondor.(Source:OptionVue6)
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Figure9.5.RiskProfileoftheSPX990/1000/1340/1350ironcondoratthestartof
thetrade.(Source:OptionVue6)
Obviously,aslowgrinddownisthebestscenario,butifIVcameinandSPXrallied,youwouldhavebeenpleasedaswell.Overthenext30daysthereweretimeswhenthistradegotthreatened.However,it
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neveractuallytouchedtheThirdThirdThirdRule.After30days,yourcondorwasupabout1,000(seeFigure9.6).Notquiteyourgoal.However,thiswasprobablyworththeexitconsideringtheproximitytothetopofthechartandyourdesiretobeoutofthetradebyday30.
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Figure9.6.RiskprofileandcurrentP&Lline(T-0)of
theSPX990/1000/1340/1350ironcondoratthecloseofthetrade.(Source:OptionVue6)
Again,thesetupmadethetrade.Adjustingcanbe
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tempting,butaswithmosttrades,thekeytoriskmanagementistradeentry.
TheATMIronButterflyTheironbutterflyconsistsoftwoverticalspreads,bothat-the-money,ashortcallspreadwiththeshortATM,andashortputspreadsetATM.Thegoaloftheironbutterfly
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isfortheunderlyingnottomoveasthedecayfromtheshortATMstraddleoutpacesthedecayfromtheprotectivestranglesetaroundtheshortstraddle.
Conditions
Volatility:Muchlikeanironcondor,foranironbutterflyimpliedvolatilitydoesnotneedtobehigh,butonlyhigherthantheaveragetrue
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rangeoftheunderlying.Thus,anironbutterflycanbetradedinjustaboutanytypeofvolatilitycondition.ItonlymattersthatexpectationsarethatimpliedvolatilityishigherthanATR.Essentially,foryourironbutterflyyouthinkimpliedvolatilityistoohigh.Youwillfindthatironbutterfliesaremucheasiertomanageinlow-volatilityenvironmentsthaninhigh-volatilityenvironments.
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AnironcondorisaplayonhowhighimpliedvolatilityisrelativetoATR,whereasanironbutterflyisaplayonhowhighATRisrelativetohowhighATRisgoingtobeoverthetimeperiodinvolved,alongwithhighrelativeIV.ThisisbecausetheironbutterflyisATMandhasanarrowerwingspan.EvenifATRislowrelativetoIV,theflycanstillloseiftheunderlyingmovestoofarorif
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theunderlyingmakes“gappingmoves.”However,unlikewithacondor,thefinaldeterminantofsuccessforanironbutterflyistheoverallrelationshipofthewingsrelativetothevalueofthestraddle.Morethananyotherfactor,thefinaldeterminantofsuccessforanironbutterflyistheskew.Skew:Anironbutterflyis
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basicallyashortstraddleandalongstrangle.Thekeytoitssuccessisgoingtobethepriceyoupayforthestrangle.Thismakesironbutterfliesmoresuccessfulinalow-volatilityenvironment,aslongastherelativerelationshipofthewingsisinexpensivecomparedtothethoraxor“meat”oftheironbutterfly.Forequityfliestheputoften
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iseitheroverpricedorunderpriced.Yourironbutterflycontainsa“normalskew”andyouneedtoknowwhatthatis.Whentheputtradesovera6%discountinIVterms,thisisafavorabletimetoenteranironbutterfly.Ifittradesata10%discounttoIV,thisisanexcellenttimetoenterthetrade.Whentheputskewisflat,thetradewillbeashortandverylikelyprofitabletrade.
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Whentheputistoolow,ifIVrises,theOTMputwillskyrocketnotonlytoamorenormalskewbutpossiblyevenhigherasthedepressedputoverreactstomarketIVmovement.Thisprovidesthetradeadditionalpaddingonaspike.Solosingtradeswilltypicallyloseless.Ontheflipside,ifIVdoescomein,theOTMputwillprobablynotseeitsIVmoveasmuchinrelativetermsasthesinking
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ATMIV.WhenIVisfalling,skewwillrise,allowingtheflytooutperformthepricingmodel’sexpectationsinfallingIVmarkets.Forexample,intheSPXnormallythe10deltaputtradesat140%premiumtoATMIV.SoifATMIVis20%,the10deltaputwilltradeatabout28%.Ifthat10deltaputistradingat26%,theskewoftheputistooflat
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at130%ofATM.Oneofthreescenarioscouldoccur:
1.IfATMincreasesto22%andskewnormalizes,the10deltaputincreasesfrom26%toabout30.8%,oralmost5%,asopposedtolessthan3%itwouldnormallyincrease.ThisshouldmutemuchoftheIVspikefromtheATMs.
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2.IfATMIVdeclinesto18%,thereisagoodchancethattheskewwillnormalize.Thiscausestheputtodropfrom26to25.2,almostnothing.YouwillbeabletocapturealargerportionoftheIVmovedownwardthanthemodelpredicts.Thisreducesthetimeyouareinthemarketandletsyoucloseoutthespread
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onanydownwardIVmove.
3.IfATMIVstaysstable,thereisahighchancethattheputwillincreaseinIVby1%to2%regardless.Thisplaces1%to2%ofIVintoyourpocket.Itwillpushyoutowardaprofittargetmuchmorequickly.
Theout-of-the-moneycallis
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typicallylessimportantthantheputasittendstomovearoundless.Thecheaperthelongcall,thebetter,forthesamereason.Ontopofthis,whenyoupurchasethecallcheapenough,iftheunderlyingralliesandIVcomesin,youwillfindthatthepositionactsthewayyouexpected;thisisadistinctadvantage.Skewrule:Youwantaflat
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putcurveandasteepcallcurve,whichisnotasrareasyoumightexpect.Time:AsthetradeisplacedATM,itdoesmakesensetoputtradesoninsideof30daysinanattempttocaptureexponentiallydecayinginsurancevalues.Thereisno“tooclosetoexpiration”rule,althoughthemostexperiencedtraderswillnottrytoholdanironbutterfly
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intothefinalthreeorfourdaysuntilexpiration.AlthoughthesameIVandskewrulesapply,theexplodinggammathatcomeswithdecayinginsurancepremiumscanbearealchallenge.Withtheintroductionofweeklyoptions,thereisconsiderableopportunityforyoutosmoothoutreturnsbysellingshort-termiron
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butterfliesinweeklyissues.Insuring:Typicallyanironbutterflyhasaverytightlydefinedrisk.Insuranceshouldbeapartoftheoverallportfolio.WhenIVislow,andespeciallyifskewisflat,itpaysoffinthelongertermtoownonetotwounitputsforevery10ironbutterfliessold.Thesetup:Insideof30days,onceyouhavefounda
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productwithstableorfallingATR,astableorfallingATMIV,andaflatputcurveandsteepcallcurve,youprobablyhaveagoodcandidate.Settinguptheironbutterflyissimple:SellthatATMstraddle.Buythewingsataonestandarddeviationforthemaximumnumberofdaysyouwanttobeinthetrade.Foranironbutterflywith30daystoexpiration,thismightbe15to20days.Oncethe
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wingshavebeenplaced,youwillbeshortdelta;thatdeltashouldbeflattened.Flatteningthedeltamakesyourtradesvolatilityplaysandnotdirectionaltrades.Toflattendelta,buyacallortwoinsidethetentoftheironbutterfly.Buyingfewercallsclosertothemoneyisabetterwaytoflattendeltathanbuyingmanycallsout-of-the-money,duetothe
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predictabilityofreturnsforcallsclosertothemoney.Youmightalsoflattendeltawithstockorfutures.Oncethedeltahasbeenflattened,ifyouaregoingtobuyafewunits(whichisadvisable),thisshouldbedonenow.Thetradewillendupflatdelta,althoughtheunitsboughtmightmakethetradenominallyshort.Goals:Thegoalofaniron
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butterflyistogetinandoutasquicklyaspossible.Awell-constructedironbutterflymakes5%to10%inonlyafewdaysiftradedproperly.Beyond10%youareprobablygivingupyour“edge”inthetrade.Althoughitmightbetemptingtoshootfor15%to20%returnonanironbutterflyandhopethatdayspasswithnothinggoingwrong,thisapproachisnotalong-termwaytomakea
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profit.Thus,at10%startlockinginaprofit.Youcandothisbyemployingastrangle-tighteningtechnique.Risk:Well-constructedironbutterfliesareveryeasytomanage.Typically,ifthetradegetsoutsideofthetent,itshouldbeaboutawash.Exitthetradeatthatpoint.Thekeyistocutironbutterfliesforascratchwhentheybreakoutsideandkeep
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winnersprofitable.Onceanironbutterflyhasreachedtheprofittargetagain,takethetradeoff,oratleasttightenupthestrangle.Figure9.7showsanexampleoftighteningthebutterfly.
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Figure9.7.Riskprofilecomparingtheoriginal
butterflyandthebutterflyafterthetighteningadjustment.(Source:
OptionVue6)
Onceatradeisup10%,typicallythewingswillhavelostmuchofthelonggammatheyofferasprotection;thecurrentprofit-and-losscurvewilldevelopsomeshapeandbegintolookmorelikethe
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ironbutterflyatexpiration.Ifyousellthefar-outwingsandbuywingsinside,ineffectbuyinganironcondor,youwillfindthatyouhavecompletelyflattenedtheprofitandlosscurveagain.Thisisanexcellentwaytostayinthetradeyetensurethatprofitsarelocked.Oncethestrangleistightened,iftheday’sprofit-and-losscurvebreakstheexpirationtent,closeupthetradeand
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takethemoneyout.Beyondtighteningthestrangle,therearenotalotofgreatavailableadjustments.However,afewareeffectiveifyouchoosetoactivelymanageriskaggressively.Upside:Oneapproachfornonmargintradingnotinvolvingbuyingorsellingtheunderlyingsecurityisbuyingacalltocleanupsomeofthedeltaswhileat
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thesametimetighteningthespreadonthedownsideoftheironbutterfly.Ifthestockhasralliedenoughtothreatenthetoppartoftheironbutterfly,itmakesalotofsensetotightenuphalfofthestrangleandbuyacall.Youmightalsousecallspreadstoachievethesameresult.Formarginedtraders,muchlikewiththecondor,thecalltimespreadandtheone-by-
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tworatiospreadworkwondersinrepairinganironbutterfly.Undernocircumstancesshouldaddingabutterflybeusedasanadjustmentunlessyouwouldexecutethatironbutterflyonitsown.Althoughitwillextendthetrade,theseironbutterfliesarenotadd-ondevicesinthebestofconditionsandaddalargeamountofmargin.
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Everymajorlossinironbutterflytradingthatwehaveseeninvolved“tranchingflies.”Ingeneralwehavefoundthatthrowingcapitalatatradeisnotalong-termsolutiontomakingmoneyinoptions.Downside:Awell-constructedironbutterflywillnotloseifitbreaksthetenttothedownside.Yourfirstchoiceshouldnormallybeto
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shutdownthetradeinthosecircumstances.Intheeventthatyouinsistonstayinginthetrade,anironbutterflywilladjustverymuchlikeanironcondor.Ratiospread:Whenyouexpectvolatilitytorallyasthemarketfalls,theshortone-long,two-ratiospreadisagreatwaytomanagerisk.Itwillnotexpandthetradeout;however,itwillquickly
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flattenthecurve.Thisistheprimaryadjustmentforthedownsidewhenvolatilityisnormal.Putspread:Becauseofputskew,aputspreadisamuchcheaperselectionforanindextradethanacallspread.Thistradeisaversatile,ifsomewhatexpensiveadjustmentforthedownsideofthecurve.Thisisasecondaryadjustment.
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Themargintrade:Ifyouhavemargin,aone-by-twofrontspreadmakesalotofsense.Thetradeisinexpensive,itsetsaverywidetent,andunliketheothertrades,whenthemarketturnsaround,ifenteredproperly,thistradeaddstoprofits.Exit:Ironbutterfliesshouldmakeorlose10%orless.Ifthetrade“breaksout,”itis
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probablyaclose.Ifthetradehitsthat10%,theedgeisgoneandit’stimetocloseortighten.
ATMButterflyExample
AfterChristmas,younoticethatSPXskewisespeciallyflat.Thisisnotunusualduringholidayweeksasfewopenpositionsequatestolessinsurancebought.Thiscanflattenskew,especiallywhen
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overallIVisaverageorhigh.YoulookupthedeltasoftheputsinFigure9.8.Thenyoucalculatetheskewbetweenthe10deltaputsandtheATM.Next,yourefertoFigure9.9andlookatthecallsandnoticethe25deltacallisalsotradingwithinrange.Youdeterminethatnowisthetimetoenteranironbutterfly.Noticetherelationshipofthe1270sandthe1170s.
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Figure9.8.OptionmontagewithSPXputinformation.(Source:OptionVue6)
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Figure9.9.OptionmontagewithSPXcallinformation.(Source:OptionVue6)
Callsarealsoingoodshape.NoticetherelationshipbetweenOTMcallsandATMoptions(seeFigure9.9).Nextyoucalculatea17-daystandarddeviationbasedonthe1270strike(Figure9.81270puts)andanATMIVof18.5%:0.185*SQRT(17/365)*
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1270=51Youroundto50,settingupthetradeat1220/1270/1270/1320(seeFigure9.10fordetails).Withadeltaof–28youbuyacalltoflattenthedelta.Then,likeallsmarttraders,especiallythosetradingfliesinaflatskewenvironment,youbuyafar-out-of-the-moneyunitput,asshownatthebottomofFigure9.10.Thetraderisk
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graphisillustratedinFigure9.11.
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Figure9.10.1220/1270/1270/1320SPXbutterflydetails.(Source:
OptionVue6)
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Figure9.11.1220/1270/1270/1320SPXbutterflyriskprofileatthestartofthetrade.(Source:
OptionVue6)
Sellingtheironbutterflyat41.35(beforeaddinginthewingandtheunit),yourgoalistoreturn5%to10%inafewdays.Recallthatyoumarginoffthefly,notthehedges.Thisshouldnotbethatdifficultbecausethetrade
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isatafavorableprice.Whilethestockdoesmoveupanddownoverthenextfewdays,atnopointisthiswell-constructedtradeeverinanyrealtrouble.OnJanuary5youareupalmost900,morethanyour10%goal(seeFigure9.12).
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Figure9.12.1220/1270/1270/1320SPXbutterflyriskprofileatthecloseofthetrade.(Source:
OptionVue6)
Ifyouhadheldoneortwomoredays,youwouldhavemadeatotalkillingwiththe
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trade,butyoushouldnevercomplainabouttakingasmartanddisciplinedprofit.Asmartsetupwithproperscreeningcreatedaneasytrade.Youmayhavenoticedamajorpatternhere.Well-constructedtradesareeasytomanage.
TheCalendarSpreadorTimeSpread
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Thecalendarspread,eithershortorlong,canbethebesttradeahedgefundcanuse.Ifyouaresaying,“Ican’tsellcalendars!”rememberhowsimilartheS&P500futuresoptionsaretoSPXoptions.Theycanofferanalternativewhenyouwanttoselltimespreads.Unlikebutterfliesandcondors,thisspreadreliesontherelationshipbetweenoptionswithdifferenttermdatestradedoffoneanother.
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Whileacalendarspreadcanbeaneffectivetradeandiseasytoexplain,itisalsothemostsensitivetoproperexecution.Bothlongandshorttradesareexcellentforanyfund.Tounderstandcalendars,youneedtounderstandtheconceptofweightedvega,theideathatthedifferentmonthshavedifferentvegasbutalsohavedifferentsensitivitiestochangesinrealizedvolatility.
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Inaperfectworldyouwouldhaveabookofcalendars,bothlongandshort,withlittletonopositiveornegativethetaandwithallthetradesputontheperfectconditions.Thiswouldproduceaportfoliooffavorabletradesinwhichtheoverallweightedvegawasnotoverlyhighorlowandprotectedyourportfoliofromhugeswings.
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ConditionsVolatility:
Long:Forthelongcalendarspread,youusuallypreferbelow-averageimpliedvolatilityandverylowrealizedvolatility.Inaperfectworldyouwouldseelittletonomovementbutanincreaseinimpliedvolatilityatthesametime.Althoughthatmightsoundgreat,itneverhappens.Infact,ifimplied
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volatilityistoolow,thelongcalendarspreadislikelytogetbeatenuponapopinrealizedvolatility.Itdoesn’tmatterwhatIVyoubuy;iftheunderlyingmarketmovesaround,thecalendarisgoingtolose.Therefore,youwillfindyourselfinamuchhappierplaceifyoubuynormalvolatility,notthebottom15%ofIVrange.Short:Fortheshortcalendar
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youwillfindtherearetwotimeswhentheseworkbest:whenIVissuperdepressed,andwhenIVisveryhigh.Inbothcasesthebreakoutoftheextremesmakestheshortcalendarworksowell.Thekeytotheshortcalendaristoputitonwhengammaismosteffective.InthecaseofhighIV,thecombooflonggammaandIVcominginatthesametimemakestheshortcalendarabigwinnercomingoffof
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highvolatility.Thelonggammainthetradeoffersyousomeprotectionagainstthemarketmovinghard.Onthelowend,termstructurecomesintoplayonacalendar.BecausefrontmonthoptionsaresosensitivetochangeinrealizedIV,frontmonthIVcanmoveandthegammacanworkwithoutbackmonthoptionsmoving.ThisislikelytohappenwhenIVisextremelylow.
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Skew:Becausebothoptionsareboughtorsold,skewisnotamajorfactor.Termstructure:Acalendarspread,eithershortorlong,isreallyatermswapinwhichyousellonemonthagainstanother.Overallimpliedvolatility,thespreadbetweenfrontmonthoptionsandbackmonthoptions,isgoingtobethenumberonedeterminantofsuccess.Thecombination
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oftherightIVandtherighttermstructuremakestradingbothshortandlongcalendarsalayup.Longcalendar:Thekeytothelongcalendaristoselltheshortatahigherlevelrelativetothebackmonthoptions.TakealookatanindividualproductmonitorinwhichtheIVrelationshipisbetweenwherefrontandbackmonthoptionsnormallytrade.Begin
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tosellthefrontmonthwhenittradesatasignificantpremiumtothenormalspread.Asignificantpremiumisatleast10%offrontmonthIV(thus,iffrontmonthIVis20,youwantthatfrontmonthtradingata2%premiumtothenormalrelationship).Atthesametime,makesurethatIVisnotout-of-controlhigh.Ifitishighacrosstheboard,thatcanbeasignthatthereisan
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eventcoming.Anothersignthatthereissomethingwrongiswhenthemonthsaretradingattoohighapremium.Generally,ifthefrontmonthistradingatapremiumofmorethan25%overthefrontmonthIV,lookatwhytherelationshipisoutofwhack(infact,alwaysbewaryofacalendarifthemonthsareoutofwhack).Thekeywithalongcalendaristoselloverbought
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volatility,notvolatilitythatishighforareason.Shortcalendar:IVconditionsthatmakealongcalendarbadaretheexactconditionsthatmakeashortcalendargreat.Thecontractmonthboughtshouldtradeata10%discountofnormalATMIV.Alsobewaryofanoverlywidespread.ThekeywithashortcalendaristobuyoversoldIV,notsellhighIV.
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Time:Theruleappliedtobutterfliesalsoappliestocalendars:Tradethemwithin30daysofexpiration.Therearetwoexceptions.IfIVsareoutofwhack,anycontractmonthcanbetradedagainstanother.Soacontractwithfivemonthstoexpirationcanswapagainstonewithsix,seven,oreightmonths,especiallyinETFsorindexfunds.Ifonemonthisoutofwhackinthefar-outmonths,
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itislikelycausedbyliquidity,notanevent.Tradingacalendarinthefinaldaysofexpirationismuchmoredifficulttohandlethanabutterflybecauseofthewaythegammaexplodesagainstthebackmonthoptions.Also,theIVrelationshipsloserelevanceinthelastcoupleofdaysoftrading.Inthefinalfewdaysofacontract’slife,thishaslesstodowithIVand
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moretodowithabsolutestraddleprice.Anythingwithinoneweektoexpirationisstraddleprice,notanIVtrade.Thesetup:Forthelong,sellanATMcallorputandbuyanATMinthenextmonthoutwhentherelationshipisthat10%outofline.Oncetheyareinline,unwindthetrade.Itisthatsimple.Pickthemonthsandpickthe
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strikes.BuyrelativemidrangeIVandthetradeislikelytosucceed.MakesureIVhasbeenstable.Youdonotwanttotrytocatchafallingknife,butifIVisinthemidrangeandstable,thatisagoodlongsetup.Fortheshort,lookforultra-lowoverallIVorultra-highIVandaspreadinwhichthemonthboughtischeaperthanthemonthsold.Oncethe
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spreadmovesintolineagain,closethetrade.ThereareoccasionswhenyoucantradeoverallhighIVandignoretheIVspreadtosomedegree;however,thisapproachisforonlythemostexperiencedhedgefundtrader.Goals:Thegoalofthecalendarspreadistomake5%to10%inafewdays.Goingforanymoreimpliesyouareclosingyoureyesand
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hopingthattheunderlyingdoesn’tmove,orthatIVdoesn’tmoveagainstyou.Hedgefundtraderstradevolatility,notthetadecayofcalendars.Getin,takethe5%to10%,andgetout.Ifthetradetouchesthebreakevenatexpiration,killthetrade.Itistemptingtoaddtothetrade,butyouwilllikelybeflattoslightlydown.Withabookofcalendars,taking10%andgivinguplessthan
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5%willleadtoaprofitablebookoftrades.Risk:Italmostneverpaystoaddtoawell-constructedcalendarspread.Mostbigcalendarspreadlossesareincurredwhentheyareoutofthetentandyouaddabunchoftimespreadstothetrade.However,therearesomechancestoaddtocalendarsoradjust,especiallyontheshortcalendarspreadside.
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Ifthelongspreadisstilloutofwhack,youmightaddtothecalendaraslongasyouflattenupthedeltaatthesametime.Toputanadditionalcalendarspreadon,conditionsmustbeasgoodasorbetterthantheoriginaltrade.Ifnot,donotadjustusingacalendarspread.Inthatcase,youmightbuyanoptiontocutdeltadown,butmakesureyoubuythecontractinthelessexpensive
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month.Ontheshortsideofthetrade,anymoveintheunderlyingshouldallowyoutoprofit.However,astheunderlyingmovesaround,thereisachancethatconditionswillnotchange.Ifthatisthecase,youmighthavethechancetoscalplonggamma.Considerusinga“paythedecay”approachinscalping,butdothisonlyinsmallincremental
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moves.Ifthemarketismovinglessthanaone-daystandarddeviation,oncetheunderlyingmakesarun,unwindthetrade;donotattempttoscalpgammabackandforth.Scalpinggammawascreatedtodefendagainsttimedecay,notasawaytoactuallymakemoney.Ifthetradehits10%,takethemoneyandrun.Exit:Neverlosemorethan
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10%onthemarginoftheoriginalcalendarspread.Exitifthathappens,andshootfornomorethan10%returnonacalendar.If5%happensinlessthanaday,consideritagiftandkillthetrade.
LongCalendarSpreadExample
Hereisanexampleofalongcalendarspread.OnNovember16,2010,at3
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p.m.,younoticedthattheOEXDecember-Januarycallspreadprovidedagreatsetupforacalendarspread.Overallvolatilitywasrelativelylowataround19%(seeFigure9.13).Atthesametime,theDecemberIVwas,duetoaminormarketshock,increasedinIVtothepointthatittradedatanIVpremiumtoJanuary.
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Figure9.13.OEXDecandJanATMimpliedvolatility.
(Source:OptionVue6)
YouenteredcontractssellingDecemberandbuyingJanuaryfor4.80.TheATMcalendarhadGreeks,asshowninFigure9.14.
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Figure9.14.ATMcalendarGreeks.(Source:OptionVue6)
YourhopewasthatthespreadwouldcollapseandDecemberwouldfallbelowJanuary.OrthatthespreadwouldholdandJanuarywouldcreepslightlyhigher.Thenextday(Figure9.15),yourluckwasevenbetter.By3p.m.,notonlywasDecemberlower,butJanuary
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wasslightlyhigher.
Figure9.15.NextdayOEXDecandJanATMIV.(Source:OptionVue6)
Overnightyourtrademadeover5%.Thisisexactlywhatyouarelookingforinacalendarspread.Thepointoftheswapisnottoholdfordecay,itistomakemoneyoffmispricedvolatility.TheblackdotinFigure9.16
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showswhereyourprofitwasasyouunwound.
Figure9.16.ProfitandlossoftheOECcalendaratclosingdate.(Source:
OptionVue6)Calendarspreadssetuplikethisallthetime.Theymight
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notalwaysmake5%overnight,butifdoneconsistentlyintherightconditions,overtime,thebankededgewillpayout.
ShortCalendarSpreadExample
Whenalongcalendarspreadlooksbad,ashortcalendarspreadcanlookgreat.OnDecember16,Januaryoptionsbecamegreatly
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oversoldrelativetoFebruaryoptions.Atthesametime,overallvolatilitywaselevated.YouenteredaSPXDec-JanShort1220callspreadtakinga1.6%volumecreditandsellingFebat24.4%IV.Thenetsalewas14.10(seeFigure9.17).
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Figure9.17.SPXDec-JanShort1220callcalendaratstartofthetrade.(Source:
OptionVue6)
Youwerehopingforthefrontmonthtotightenuprelativetothebackmonth.Fortherelationshiptoholdsteady,theunderlyinghastomoveandIVshavetohold,orsomecombinationofthese.ByDecember20,thetradewasawinner.Whilethefront
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monthdidfallmore,theunderlyingmovedandthebackmonthoptionssoldoffmuchharderthantheJanuary(seeFigure9.18).
Figure9.18.SPXDec-JanShort1220callcalendaratcloseofthetrade.(Source:
OptionVue6)Thetradecanbeboughttoclosefor$13.40,aprofitofabout$0.80in4days.You
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mademorethan5%injustamatterofdays(seeFigure9.19).
Figure9.19.ProfitandlossoftheSPXshortcalendarspreadatclose.(Source:
OptionVue6)Whenyouarepatient,youdo
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evenbetterastheunderlyingkeepsrallying.Youcouldhavemade20%onthiscalendarspreadjustbyowningoversoldoptions.
TheRatioBackandFrontSpreadTheratiospreadcanbeoneofthebesttradesahedgefundcanapply.Forthosewithoutportfoliomargin,
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buyingtwoandsellingoneisnormallytheonlyspreadtouse.Ifyouhaveportfoliomargin,lookatbuyingoneandsellingtwo(oftencalledafrontspread).Thekeystotheonebytwo,muchlikethebutterfly,areskewandvolatility.However,thisspreadaddsathirdcomponent:direction.Tosucceedintradingratiospreads,youneedtoberight
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onskewandvolatility.Forthespreadtobewildlysuccessful,youneedtoberightondirectionaswell,althoughyouwillfindthatthisdoesnotalwayshavetobethecase.
Conditions
Volatility:Theratiobackspreadisalmostalwaysalongvegaspreadatonset.Thetwolongpositionshavea
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highernetvegaweightedorunweightedthantheoneshort,atleastatonset.However,astimepasses,thatgoesawayifallothermattersareequal.Thisiswhywhenyou’reputtingonaratiobackspread,thelowertheimpliedvolatility,thebetter.NeverputonaratiospreadunlesstheIVisinthelower40%ofthecurrentIV.UnlessthistradeisinapositionwhereIVcangoup,thetradeis
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likelytonotsucceedwithoutabigdirectionalmove.Skew:BecauseyousellanATMIVandbuytwoOTMputsorcalls,theskewisgoingtomatter.Basedonthediscussioninbutterflies,theflattertheskew,thebetter.Youhopetobuythecurveatanextracheapprice.Thecheaperthebetter,especiallyifIVisalsolow.Youhopethegeneralpublicrecognizes
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thattheOTMoptionsarethecheapestandbidsthemup,evenifIVdoesn’talsomove.IfIVgoesup,theskewnormalizesandthetwoOTMputscandowell.ApopinIV,skew,orbothcangetyououtofatradewithoutthestockevenmoving.Addinbeingrightdirectionallyandyoucanmakeakillingonthesespreads.BeontopofIVandskew
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whentradingratios.Nottakingthisintoaccountisthrowingmoneydownthedrainonaratiobackspread.Asteepskewandhighvolatilitywillcausethesetradestoloseevenifyouarerightondirection.Time:Aratiospreadcanbeexecutedinanytimeframe.Thekeyistopicktherightmonth,whichhasthelowestrelativeIV(at60daysto
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expiration,comparethetwo-monthoptiontothe60-dayIVinthepast).Addinginskew,thiscanmakeanymonthawinner.Thereareimportantissuestonote:Tradesexecutedclosetoexpirationrelyontheunderlyingmoving,andtradesexecutedfurthertoexpirationrelymoreonmovementsinvolatility.Ifyoumakeadirectionalbetandaratiospreadsetsup
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nicely,useit.IfyouwanttosetuparatiospreadasaportfoliohedgeorasalongIVplay,usemonthswithatleast60daystoexpiration.Thesetup:Ifthegoalistoplayvolatility,thekeyistogetthatsameflatskewyouwantedinabutterfly.Youwanttheskewtotrade7%to10%underpricedandIVtobeinthelower40percentileofhistoricalrange.Selloneat-
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ornear-the-moneyputorcall,thenbuytwoOTMcallsorputsagainst,andthenetpremiumpaidforthetwoshouldbelessthanthevalueoftheonesold.Youwantacreditorwantatleastzerocost.Thisway,ifyouarewrongondirection,youcanstillwinfromvolatility.Donotgofora“bigcredit”butacceptaslittlecreditaspossible.Thiswillallowthetwolongpositionstohangin
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foraslongaspossible.Goals:Whenyou’retradingvolatility,thegoalistogetin,takethemoney,andgetout.Ratiospreadsarejustlikeanyvolatilityplay.Yourgoalisabout10%,andyouwillnevertakemorethan10%.Risk:Therearefewadjustmentsthatmakesenseforratiospread.Ifthetradedoesnotworkout,closeit.Ifconditionschangeforthe
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betterandthetradeislosing,closethetrade.Ifthetradeislosingandconditionshavemadethetradepotentiallyevenbetter,addtoit,assumingyouhavenotovercommittedcapital.Exit:At10%takethewinor,ataminimum,lockitup.Neverallowatradetolosemorethan10%oforiginalmargin.Ifthetradewasaddedto,youmightusethat
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margin.Theone-by-twoorone-long-twoshorts:Theone-by-twocallspreadismuchlikeacalendar.Theconditionsthatareawfulforabackratioaregreatfortheonebytwo.Oneimportantdifference:Makesurethatthetradegeneratesacredit.Unlikearatioinwhichyouwantthetradetomoveinyourdirection,aone-by-twocallspreadisbasedonthe
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underlyingmovingintheoppositedirection.Onceitmovesawayfromthetwoshorts,theskewshouldflattenandIVshouldcomein.Atthatpointitislikelythattheonebytwosoldatacreditcanbeboughttocloseforacreditaswell.Thisisasuresignthatitistimetokilltheone-by-twospread.Aswithanytrade,youarenotgoingforahomerun,youaretryingtomakeyour10%.
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RatioSpreadExample
Theratiospreadmaybetheeasiestspreadofall.OnJune6,2011,withtheVIXnearall-timelows,youdeterminedthatnotonlywasIVlow,buttheskewwasrelativelyflatwiththe10deltaputtradingat135%ofATM.Realizingthatskewisrelative,youboughtputscheap.Youwerenotsurethemarketwasgoingtodrop.Thus,youentereda
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ratiobackspreadsellingtheJulyATMSPX1280putsandbuyingtwiceasmanyoftheJuly1230puts(seeFigure9.20).
Figure9.20.JulyATMSPXratiobackspread.(Source:
OptionVue6)
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Thetradewaslonggamma,longvega,andslightlyshortdelta.ItalsowouldnotlosemuchifyouwerewrongandtheSPXrallied(seeFigure9.21).
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Figure9.21.JulySPXrationbackspreadGreeks.(Source:OptionVue6)
ThepayoutisshowninthegraphinFigure9.22.YourgoalwasforIVtorallyandtheunderlyingtofallatthesametime.Becausethecurvewasflat,yourhopewasthatskewwouldalsosteepen,causingthe1290stogainevenmorethanthemodelpredicted.
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Figure9.22.6/6SPXratiobackspreadprofitandloss
graph.(Source:OptionVue6)
OnJune15,thetradestartedtomakesomedecentmoney.TheIVwentupandSPXdroppedasskewincreased
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incrementally(seeFigure9.23).
Figure9.23.6/15SPXratiobackspreadprofitandloss
graph.(Source:OptionVue6)
Youhityourgoal,abletosellyourspreadatadecentcredit
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(seeFigure9.24).YouflipoutofthepositiononJune16upquitesignificantly.Youdidn’thaveanymajorproblemsbecauseyousetupyourtradeproperly.Skew,time,andvolumewereallonyourside.
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Figure9.24.6/16SPXratiobackspreadexitthetrade.(Source:OptionVue6)
Thedirectionhelpedbutwastheleastimportantpartofthetrade.
Endnote1.Averagetruerange(ATR):AmeasureofvolatilityintroducedbyWellesWilderinhisbook
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NewConceptsinTechnicalTradingSystems.ATRisamovingaverageoftrueranges(generally14daysofthetrueranges).Truerangeisthegreatestof:1)currenthighlesscurrentlow,2)absolutevalueofthemostrecentperiod’shighlessthepreviousclose,3)absolutevalueofthemostrecentperiod’slowlessthepreviousclose.
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10.OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZIsthereasecretsauceformakingasuccessfuloptiontradingbusiness?Thereis.Oneofthebestbookson
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learningtobeasalesmanisYouCan’tTeachaKidtoRideaBikeataSeminar,byDavidSandler.Asthetitleofhisbookconveys,youprobablywillnotlearneverythingthatyouneedifyoudon’ttrade.Youwillneedtotrademanytimesuntilyoulearnhowtobeconsistentandmakemoney.Inthischapteryou’llfindguidelinesforoperating
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TOMIC.TosucceedatTOMIC,ittakescommitment,dedication,andpractice.Sofar,youhavereviewedtheingredients.Youhaveexaminedthemostusedtrades:verticalspreads,calendarspreads,ironcondors,butterflies,andratiospreads.Thequestionishowtomixalltheingredientstoobtainasucculentmeal.ReviewtherecipetobesuccessfulatTOMIC.Recall
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thatthekeysuccessfactorsofaninsurancecompanyarethese:
•Tradeselection•Riskmanagement•Tradeexecution
Todoallthreefunctionseffectively,youalsoneedtohaveyoursupportstructuresinplace:
•Atradingplan•Tradinginfrastructure
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•AprocessforlearningInthischapteryouwillexamineasampleportfolioforTOMIC1.0.Youwillfollowthedecisionswetake.Therearemanywaystocookameal.Likewise,everyportfolioisuniqueandeveryTOMICisunique.Therearemanyvariablesthatdependonyourcomfortlevelandstyleoftrading.Thefollowingisanexampleof
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TOMICcalledTOMIC1.0.Asyourskillsprogress,yourportfolioevolvesandbecomesuniquetoyourstyleoftradingandcomfortlevel.
TradingPlanEveryTOMICbeginswithatradingplan.Youshouldbeabletoanswerthesequestions:
•WhatisthegoalofTOMIC1.0?
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•WhichmarketsamIgoingtotrade?
•WhatarethestrategiesIwillemployforeachmarket?
•Whataremyriskmanagementparameters?
•Whatisthebestwaytoefficientlyexecutethetrade?
Goals:TOMIC1.0isaportfoliousedtolearnand
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conditionyouasanoptiontrader,intotheframeworkofmanaginganoptionportfoliolikeaninsurancecompany.Theprofitabilitygoalistonotlosemoneyoverany12-monthperiodandtohaveanannualabsolutereturngreaterthan10%.Themonthlygoalistomakearound1%returnontotalcapital.Markets:Youwillfollowatotalof10markets,including
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indexes,ETFs,andequities.ThemarketsyouwillfollowareSPX,RUT,NDX,RTH,OIH,AAPL,CAT,EXC,MCD,andWMT.Strategies:AsyouprogressinproficiencyasamanagerofTOMIC,youwillhavemoreandmorestrategiesinyourarsenal.Youwillusedifferentstrategiesfordifferentmarketsetups.However,forthisexample
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youwillusejustahandfulofmostusedstrategies.Youwillusethefollowingstrategies:
•Verticalspreads(creditanddebit)
•Ironbutterflies(andtheirvariations,broken-wingbutterflies)
•Ironcondors(andtheirvariations,unbalancedcondors)
•Calendarspreads
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•RatiospreadsTable10.1showsthefivestrategiesusedinTOMIC1.0andtheconditionsinwhichtousethem.Table10.1.StrategyCheat
Sheet
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RiskManagementParametersforTOMIC1.0:
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Maximumlossallowedpertrade:2%.Maximumportfoliolossallowedpermonth:6%.Portfolioconcentrationlimits:Nomorethan20%inanyoneindustrysector.Stayincashifconditionsarenotfavorableforanytrade.Tradeduration:Lessthan90days.
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Execution:
Youwillbeusinganonlinebrokerwhospecializesinoptions.Thebrokershouldhaveaneasytouseinterfaceforsubmittingcomplextrades(suchasverticalspreads,condors,butterflies,orcalendars).Youwon’trequireportfoliomarginforTOMIC1.0;aReg-Tmarginaccountwillsuffice.
Setup:
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•StartTOMIC1.0with$100,000.
•KeepatradingloginExcel.
•UseanInternetconnectionprovidedbyyourphoneorcableoperatorandusetheInternetconnectionfromyourcellphoneasabackup.
•Usealaptopcomputertotrade,incaseofa
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powerfailure.•Programthebroker’sphonenumberintoyourcellphonewithouraccountnumberinhand.Ifonlineaccessisdown,youcancallthebrokerbyphoneinanemergency.
Figure10.1showsanexampleofhowyourtradingloglooksforaverticalspread.
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Figure10.1.ExampleofanentryinthetradelogofanAAPLverticalspread.
ExecutingtheTradingPlanYoustartoutwith$100,000,andmonitorthemarketsyou
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wanttotrade:SPX,RUT,NDX,RTH,OIH,AAPL,CAT,EXC,MCD,andWMT.Youknowthatyoucanriskupto2%ineachtrade.Thismeansthateachtradeshouldnotriskmorethan$2,000(2%of$100,000).Youwilltrytodoatleastthreetradespermonthaslongasmarketconditionspermit.Assumethatconditionsare
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righttodoaverticalspreadinAAPL.Let’swalkthrutheexampleinFigure10.1.AnAAPLverticalputspreadconsistsinthisexampleoftenpoints.TheReg-Tmarginis$9,010.IsthiswithintheriskparametersofTOMIC1.0?Yes.The$9,010isthepotentialmaximumlossthetradewouldhaveifnoadjustmentsoractionsweretakenwhileinthetrade.However,TOMIC1.0isan
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activelymanagedbusiness,andpartofriskmanagementisadjustmentsyoumakeduringthetrade.Inthistradeyouplacea“maximumloss”pointat150%ofthecreditreceived.Inthisexamplethecreditreceivedwas$990(includingcommissions),soyour“maximumloss”is($1,485).Thismeansthatifthetradegottothepointoflosing($1,485),youwouldcloseandtaketheloss.This
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wouldrepresent1.49%ofthe$100,000fund,withinyour2%riskpertradeallowed.Makesurethatwhenyouenteratradeconditionsareright.Alsomakesureyouknowyourexits.Knowwhentoexitwhetheryouaremakingmoneyorlosingmoney.NoticethatintheAAPLexampleyouhadanexitof($1,485)ifyouwerelosingmoneyandanexitat
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$693ifyouweremakingmoney.Thistradewasclosedmaking$710becauseyouhityourtarget.Haveamixoftradesintheportfolio.Followyourmarketseverydayanddeterminethebesttradesavailablegiventheconditionsofeachmarket.Haveanopinionofthedirectionofthemarket.Followtheimpliedandhistoricalvolatilitiesof
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eachmarket.Thishelpsyoudeterminethebesttradesavailable.Keeptrackofthebestavailabletradesonatable.Table10.2showsanexample.
Table10.2.ListofBestAvailableTrades
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Fromyouravailabletrades,selectthebesttocreatea
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portfoliooftrades.Trytocreateabalancedportfoliobasedontheoverallmarketenvironment.Table10.3givesanexample.Table10.3.TOMIC1.0PortfolioExample
Noticethatnotradehada
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“maximumloss”greaterthan$2,000or2%oftheassetsundermanagement.Iftheportfoliolostmorethan6%inthemonth,youshouldcloseallthetradesintheportfolioandgoflat.Thenreassessyourstrategiesandstartfreshthefollowingmonth.Yourtotaltargetwinfortheportfoliowas$3,530,whichrepresents4%returnonAUM(assetsundermanagement),andyour
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averageofdaystoexpirationwas36ifeverythingwenttoexpiration.Inreality,tradeswouldbeclosedbeforeexpiration.Inourexperiencethistypeofportfoliowouldhaveaveragedaysintradebetween25and30days.Oncetheportfolioisworkingandyouhitexittargetsonatrade,youshouldclosethetradewhetheryouaremakingmoneyorlosingmoney.
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Whenyouhityourprofittarget,closethetrade.Itlocksinprofitsandreducesyourexposure.Onceyoutakeoffatrade,gobacktotheavailabletradeslist,andselectthebestavailableatthattimeandplaceit.Thus,youreplacethetradeyouclosedandkeepTOMIC1.0makingmoney.However,iftheenvironmentishostileandthereareno
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goodtradesavailabletoplace,donotplaceatrade.Waituntilconditionsarefavorablebeforeenteringareplacementtrade.TobecomeaproficientTOMICmanager,youmustmaketrades.Itislikebeingaheartsurgeon:Themoreoperationsyouperform,thebetteryoubecome.Makesuretowriteyourtradingplanwithasmuchdetailas
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possible.Defineyourgoals,riskparameters,strategies,andentryandexitsparameters.Goaheadandexecutethetradingplan.Createafeedbackloop.Keepatradinglogwithdetailednotestolearnfromeachtradeyoumake.Attheendofeachmonth,checkyourperformanceandseewhatyoucanimproveonthefollowingmonth.Repeatthiscyclecontinuously,andyou
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willbecomeabetterTOMICmanager.
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PartIII:LessonsfromtheTrading
Floor
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11.LessonsfromtheTradingFlooronVolatility
UnderstandingWeightedVegasinSPXIndexOptionsMarkSebastianwrotethe
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followinginhisOptionPit.comblogon12/06/2010:Somepeoplecallacalendaragoodwaytohedgetheshortvegafromincomespreads.Thismightbetrueinsomecasesbutnotinallcases.Itisbettertounderstandthemovementsofimpliedvolatilityacrossoptions.Oneshouldunderstandhowvolatilityspikesaffect
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volatility.Thechartbelowisagraphof30-dayimpliedvolatility(higherline)comparedto90-dayimpliedvolatility(lowerline).Whatdoyounotice?
(Source:Livevol©www.livevol.com)
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Noticehowthe30-dayismuchmorefreneticthanthe90-dayvolatility.Icallthistheveganeutralizer.Itistruethatcalendarsarelong,whatweonthefloorwouldcallrawvega.However,tradersneedtorememberthatthemovementinthefrontmonthcanneutralizeanymovementinthebackmonthoptions.Thisextramovementinthefrontmonthisinmanyways
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causedbythegammaofthespread.Whilethebackmonthvolatilityisincreasing,becauseofthelongtimetoexpiration,thusthepricemovementsmatterless.Meanwhile,inthefrontmonth,thesecrazypricemovementscanhaveamorepermanenteffectandcanreallymovedeltasofthespreadaround.Thiscanmakebeingshortalotoffrontmonthoptionsadangerous
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game.Tradersneedtocompensateforthispricemovement.Onthefloortheonlywaytodothiswastojackupthefrontmonthimpliedvolatilitymorethaninthebackmonth.Sincebackmonthoptionshavemoretimetorelax,weraisedthevol,notwantingmarkettogettoooutofwhack.But,ifoneremembershowmuchvegaareinback
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monthoptions,ifthingsgetreallyexpensive,owningthosesuckerscanbeaverydangerousgame.WewerealwaysafraidtoownexpensivebackmonthpremiumbecausetheIVcomingincouldbedeadly,sowedidn’traisetheIVthatquickly.Thesamemusthappenonthewaydown;tradersonlyhavealimitedtimetogetoutofa
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losingvolatilityposition,orapositionwheretheunderlyinghasstoppedmoving,especiallywhendealingwithATMoptions(wehaveallseenwhy;ifnot,seethefollowinggraph).Theactionofthemarkethaltingcausesthewholeworld(retailtradersincluded)tosellpremiumprettyquickly.Tradersonthefloorwhodonotwanttohaveto
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chokeonpremiumkilltheIVofthefrontmonthinordertoavoidgainingtoomuchinventoryoflongoptions.Withmoretimeforbackmonthoptionstotakeadvantageofanotherspikeinmarketvolatility,tradersarenotasquicktokillthebackmonthoptions.Wecanclearlyseethishappeningbetweenthegraphsbelow,whichisthewaythetermstructurelookedon11/30:
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(Source:Livevol©www.livevol.com)
Thefollowingistoday’sclosingvol.NoticehowDecemberandJanuaryimpliedvolatilitywassoldoff
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farharderthanFeb:
(Source:Livevol©www.livevol.com)
Thistypeofunderstandingcanhelptradersnotonlytradecalendars,butdouble
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diagonals,butterflies,andcondorsaswell.
TakingontheSkewMarkSebastianwrotethefollowinginhisOptionPit.comblogon5/13/2010:
Themarketcontinuestohaveaniceintradayandinterdayrange.Evenifitisgoingupanddowntonowhere.Withimplied
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volatilityatcurrentlevels,though,Ithinksellingvolmakessomesense.TheproblemformosttradersisthattheywanttoselltheATMvol,whichwhilethejuiciestalsoisthemostfairlypriced.Theskew,whichstillissomewhatelevated(althoughnottothelevelitwas),islikelythebettersale.Theproblemisitishardtodothiswithoutgettinglong
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premium,butitcanbedone,inafewways:1.RatioSpread.Thisisnotabadtrade,exceptthatifthemarketreallyfallsout,thetradercouldloseonthisone.Iftradingaratio,IthinkthebestmoneywouldbeinbuyinganATMputandsellingOTMputs.Atthesametime,makesuretobuysome
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extraprotectiononthewaydownside(that’srighttraders,units).
2.Condor/Strangle.Ilikethestranglebetter,butbecauseofmargin,tradersmighthavetosettleforcondors.Thekeyistosellattheinflectionpointwherethevegaoftheoptionreallyfallsoff.Thiswaythetradercantake
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thebestadvantageoftheelevatedimpliedvolatility.Still,thetraderhastobuyvolatilityevenlowerandhigheronthecurve.
3.Finally,themostunderutilizedandpossiblythebestplayforthemoneyrightnow,inmyopinion,isthedoublediagonal.Iwouldbelookingtosell
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thefrontmoneyOTMcallandput,andbuythebackmonthOTMevenfurtherout.HereisoneplayIamlookingat:Mayisdone,itisallgamma,Iwouldstayaway.ThisleavesJune,which,whilenotsky-highintheskewlikeMay,isstillveryelevatedinitsputsandcalls.JulyandAugustareelevatedbutnot
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nearlythewaythatJuneis.NowIneedtodecidewhatstrikestotrade.Iamgoingtosetupthetradevegapositive,butafterIweightthevega,Ishouldbenegative.HereisoneexampleintheOEX.
Atfirstglancethespreadhasavegaofabout82.Forthesizeoftheposition,Iamgoingtocallthatprettyflat.
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However,onceIweightthevegaIfindthatIamshortabout170.00weightedvega.
Thisspreadwillmakemoneyiftheskewflattens,ifthespreadbetweentheJuneandJulytightens,orevenifIVingeneralfallsrelativetohowit
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ranup.Ifatraderwantstotradethefrontmonthsmile,withoutahugeoutlayofcapital(relativetoastrangle),Ithinkthisisadecenttrade.
FourTipsWhentheVIXCashIsDepressedMarkSebastianwrotethefollowinginhisOptionPit.comblogon
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3/23/2010:ItisallovertheblogospherethattheVIXfuturesarefarexceedingthecashVIX.“Sowhat?”thetradermayask.“Howisthisofanyusetome?”Itisprettysimple:tradingapproach.WhentheVIXfuturesarefaraheadoftheVIXcash,itbecomesvisibleintheoptionsviathetermrisk.Thefront
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monthischeaprelativetothebackmonth.OnthefloorIwouldhavetriedtobuygammaandsellvega.Aprettyeasytask;allthetraderhastodoisselltimespreads.Fortheretailtraderthisprocessisalittleharder.Thisisbecausemostretailtradersdonotsitonatonofmargin.Thisdoesnotmeanthatthetraderneedn’theedtheVIX-
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Futuresspread.Herearefourthingsretailtraderscandowithoptionswhenthetermspreadiswide.1.Avoidlongterm-riskplays—Thismeanscalendars,doublediagonals,younameit.Ifatraderinsistsonputtingonacalendar,tryoverlayingalittleextrabackmonthIV,orbuyingsomecheap
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frontmonthstranglesagainsttheposition.
2.Don’tfearthefrontmonth—NoticeIdidn’tsay,“Don’tsellthefrontmonth.”ItcanbeokaytotradebutterflieswhenIVislow,aslongasthetradersetshisorherwingsusingastandarddeviationcalculation.WhatIliketodoisassumeIwillbe
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inthetradefor18.5days.ThensetmywingwidthbasedontheATMstrikeimpliedvolatility.ThiswillcausemywingstobewiderinhighIVmonthsandtighterinlowIVmonths.ThisisagreatwaytomitigateriskintheinstanceofabreakoutoflowIVs(postacommentortwoifyoutraderswouldlike
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amoredetailedexample;thismightbeagreattopicforthenextarticle).
3.Ifthebackmonthisstillelevatedoverthefront,thenwhyfearthecondor?—TheIVtermstructureofoptionsiscurrentlyverysimilartowhatitwasinJanuary.Traders,condorsdidFINEin
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thatcycle.Thisisbecausecondortradersweresellingthemonththatwasrelativelyhigh.
4.Asstatedinnumber1,don’tbeafraidtospendalittlebitofcashonsomecheapputs—Nothingwillcostsolittleandletthetradersleepsowell.AsmyfriendandSevenTimeBrokerofthe
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YearKevinKennedyusedtosay:“Buy’emwhenyoucan,notwhenyouhaveto!Becausewhenyouhavetobuythem,youcan’t!!!”
HowtoFindandTrackVolatilitySkewMarkSebastianwrotethefollowinginhis
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OptionPit.comblogon4/02/2009:
Howdoesonefindvolatilityskew?IsthisaccomplishedbystudyingthematrixwithimpliedvolatilityandcomparingdailyIV?Byfindingrichercondors?Everystockhasvolatilityskew.Somewillbesteeperthanothers.Thebestwaytotrackskewisbylooking
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atthevolatilityofseveraloptionswithaspecificdelta.Youkeeptrackoftheskewbychartingthechangesinthevolatilityofthesespecificdeltaoptionsandthespreadsbetweenthem.Forinstance,onemightwanttokeeptrackofthe5deltaput,the20deltaput,the50deltacall,the25deltacall,andthe10deltacall.Whytheseoptions?I
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thinkusingtheseoptionscangiveafairlyaccuraterepresentationoftheskewcurve.Afterpickingyouroptions,keeptrackofthevolatility,butmoreimportantly,thevolatilityspreadsfromstriketostrikeandoptiontooption.PutthemintoExcel,andfillitineveryday.Runagraphoverthevolsandyouwillreallybeabletoseetheskewcurve.
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Runasecondgraphoverthedifferencesinthevolspread,andyouwillreallybeabletoseehowthecurveismoving.Generally,whenwegettoabout15daystoexpiration,Iliketoswitchtothenextmonthout.Here’saniceremindertoswitch:Whenyouhitthefirstofthemonth,youshouldnolongerbeusingthatmonthtochartskew.
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Inyourcharts,makesuretonotewhenyouswitchmonths.Youwillactuallybegintonoticepatternsinhowtheskewcurvemoves.Asfarascondors,thoseareagoodindicatorthatsomethingishappening,andmaybeaveryquickshortcut.However,it’snotawonderfulwaytoreallytrackskew.
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SPXSkew:It’sAllRelativeMark’sstudentsconstantlyreviewhowimportantthevolatilitysurfaceis.Theyallknowthedifferencebetweenahighskewandalowskew.However,theysometimesfailtograsponeimportantfactor:SkewisapercentageofATMIVandonlyarelativenumber.ATMimplied
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volatilitymatters.Hereisanexample:Youhavetwotradesyoucouldenter:Trade1:SPXironcondorsoldat15deltaDownsideskewissomewhatsteep—thetendeltaputtradesat140%ofATMIV.ATMIVis19%,andmedianIVofthestockis23%.Upsidecallskewisflat,and
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25deltacallistradingat90%ofATMIV.Trade2:SPXironcondorsoldat15deltaDownsideskewissomewhatnormal—thetendeltaputtradesat135%ofATMIV.ATMIVis25%,andmedianIVofthestockis23%.Upsidecallskewisnormal,and25deltacallistradingat85%ofATMIV.
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Conclusion:Whichtradeisbetter?Notethat140%of19isIVof26.6%,whereas135%of25is33.75%.Onthecallendofthetrade,85%of25is21.25%,whereas90%of19is17.1%.Eventhoughtheskewislow,thefactthattheIVitselfwassomewhatelevatedmakesabigdifference.ThePoint:
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Volumesgoupanddown.Thelowerthevolume,themoreyouneedskewtomakeupforit.Thehigherthevolume,thelessskewmatters,althoughacomboofhighskewandhighATMIVisthebestsetup.
UnderstandingImpliedVolatilityinIronCondors
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Markhadaninterestingdiscussionwithoneofhisoptionmentoringstudents.Hewasinthemiddleofcommentingonhowhedidnotlikethewayironcondorslookedatthemoment.Markhadgoodreasons:
•Impliedvolatilitywasrelativelylowintermsofwhereithadbeenoverthelastfewmonths(notintermsof
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realizedvolatility).•PutskewwasflatnotjustinDecember,butalsoinJanuary.
•TherewasnotabigvolatilitypremiuminsellingtheDecemberorJanuaryrelativefrontmonthvolatilityorrealizedvolatility.
Theoptionmentoringstudentrespondedbysayingthathecouldstillget.60whenhe
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soldhisshortputandcallstenpointswideatthe10deltastrike.Didn’tthatmeanthatthetradewasstillokay?No.ExaminetheputsideofanSPXironcondorsold36daysoutatthe10deltastrike,asshowninFigure11.1.
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Figure11.1.SPX1115/1105DEC10putspread
information.(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrative
purposesonly.TDAmeritrade,Inc.,andOptionPitLLCareseparateunaffiliatedcompaniesandarenot
responsibleforeachother’sservicesorpolicies.)
SPXtradesat1218andthe
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tradecollects.60.Itplacesatthe1115/1105strike,about8.5%out-of-the-money.Lookatthecondoronlyonemonthprior,asshowninFigure11.2.
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Figure11.2.SPX1055/1045NOV10putspread
information.(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrative
purposesonly.)
WithSPXclosingatjustunder1170,yousoldthe1055/1045spreadandcollectedthesame.60.However,the1055swerenot8.5%out-of-the-money;theywerejustunder10%out-of-
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the-money.Inabsolutetermsthespreadisanextra15pointswideonthedownside.Thesamewouldholdtrueifyoudidtheupsideofthespreadaswell(althoughthetwowouldlikelybeasmallerdifferenceinabsoluteterms).Allcreditsarenotcreatedequal.Justbecauseyoucollect.60froma10deltaspreaddoesn’tmeanit’sagoodtrade.Volatilityand
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volatilityskewwillpullinthewingsofanironcondor.Unlikeabutterfly,inwhichthiscanmitigaterisk,thismakestheironcondormorevulnerabletotroubleintheeventthatimpliedvolatilityblowsup.
TheStagesofSkewMarkSebastianwrotethefollowinginhisOptionPit.comblogon
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8/29/2011:AstudentaskedmewhytheSPXhadsuchasteepvolatilityskew(sometimescalledsmile)inSeptemberandOctober.TheVIXwascomingin;shouldn’tskewflattenasimpliedvolatilitiesdrop?SPXskewissteep,moresoinOctoberthaninSeptember(althoughit’selevatedtheretoo),where
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the10deltaputistradingatavolatilityofabout152%oftheATMstraddle.Whileit’sclearthatIViscomingdownandfearhassubsidedsubstantiallyintheshorttermwiththeFedmeetingoverand[Hurricane]Irenepassing,wearecertainlynotinastageofcalmeither.AVIXofover32is
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historicallyastronomicallyhigh,asitismorethan50%elevatedrelativetothelong-termmeanoftheVIX.OnethingtorememberiswhenIViscomingin,themarkettypicallywillwanttokeepbiddingupthosebabyputsforalongtime,becauseofoverallfearofIVgoinghigherinsteadofbacktowardthemean.Thisbringsustothe5
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Inthisphase,impliedvolatilityislowandskewisnormaltoflattish.Thisphaseiswhatwewouldcall“normaltimes,”wheretheVIXisbetween16%and18%.Themarketmayhave
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upsanddowns,butthereislittlefearofa“majorevent”oramulti-standarddeviationoutlierday.Phase2:CalmBeforetheStorm
Inthisphase,IVisstill
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somewhatlow,butmaybeslightlyelevatedornot15-20intheVIX.However,thereissomedevelopingfearofamajorstandarddeviationevent.ItcanalsooccurwhenIVis“oversold”andthereissomepent-upselling.Thisphasecanleadtothenextphaseorrightbacktocalm(Phases2and4canmoveineitherdirection).Basically,themarketisstartingtobuyprotection,butdoesn’twant
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toownATMoptions,thusbuyingof“unitputs”pushesupskew.Phase3:TheTyphoon
Inthisphase,thereisextremefearinthemarketandtheVIXisat30%to40%or
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greater.Wewerejustinthisphaseaslateaslastweek.IVonthedownsideofthecurveisstillhigh,butATMIVisupsomuchthatskewactuallyflattens.Thisisaconditionofborderlinepanic.Phase4:TheCalmingStorm
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IVisstillquitehighinthisphase,butitisfalling.Themarketthinksthingsmightbegettingbetterbutisafraidthatthingscouldgetbadagain.ATMIVisbeingsoldoff,butmanyofthosesellingATMvolatilityarebuyingout-of-
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the-moneyputs.Unitprotectionisatitsmostexpensiveinthisphase,asATMIViselevatedandskewissteep.TheVIXcanbeanywherefrom20%to35%inthisphase.LikePhase2,theCalmingStormcanblowupintoaTyphoonagain,oritcanmovetowardPhase5.Phase5
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Alliswell,inthisphase,asIVreturnstonormal,butskewstaysslightlyelevatedforaperiodoftimeasthemarketlicksitswoundsfromrecentlosses.TheonlydifferencebetweenthisphaseandPhase1isthatskew
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mightbeslightlysteeper,andIVmaymovealittlemorequicklyoffoflows.ThisphasecanjumptoPhase1orPhase2.Itcantakeupto6monthsforPhase5toturnintoafullycalmsituation.Inbetweenthe5mainphasestherearemanysmallphasesandtransitions,butIthoughtitmightinterestyoutraderswhowatchskewtoseeaclearexampleofhowskew
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cangofromcalmtocrazytocalm.
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12.LessonsfromtheTradingFlooronRiskManagement
CashIsaPositionCashisapositionyoucantake.Beingincashhassomeseriousadvantages,yetmanyareafraidoftheposition.
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Table12.1showstwoannualreturnsinwhich$10,000tradedinironcondors.Table12.1.TwoScenariosforIronCondorReturns
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Thenetsimplereturnonthedatasetwas$700or7%,notbadatall.
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Nowexaminethisseconddataset.Thenetsimplereturnonthedatasetwas$1,300or13%,almostdouble.TheonlydifferencebetweenthetwosetswasinSeptember.Youdecidedtostayincash.Believeitornot,youmademoremoneynottrading.Youmightknowthisurgetotrade,thisneedorwant.Itshouldberesisted
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whenyoudon’tseeanythingthatyoulike.Ifyoudonotlikewhatyousee,skiptradinganddrinkaDietCoke.Youwillbefarmorerelaxedandwilllikelyhavemoremoney.Itmaynotbesexy,butintheendI’dratherberichthansexy.Betteryet,thereisanoldsayingthatthereisalwayssomethingworthtrading.Ifyoudonotlikewhatyousee,
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startexpandingyourknowledgebasesothatyoucanrecognizeopportunities.Itcanmakeahugedifferenceinyourtradinglife.
TheCardGameValueOneofthemostlovedtradesbytheretailpublicisthe“creditspread.”Oneofthebiggestmistakestheretail
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publicmakesisfailingtoexitcreditspreadswhentheshortoptionbecomesinexpensive.Thisisnotbecausetheywanttoholdthetradetoexpiration.Itisbecausemostdonotunderstandthatthereisasecondcomponentinthevalueofoptionsthatmostoptionpricingmodelscannotcalculate.Thiscomponentwillcausethefinalportionofthevalueofanoptiontotakemuchlongertodecaythanthe
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modelpredicts.Thisvalueexistsbecauseofthepayoutdisparityiftheoptiongoessour(unitrisk).ThisisTheCardGameValue.Understandingthisallowsyoutoexittradesatanearlierdateandmovemoneyintotradesthatfollowthestandardoptionmodel.TheCardGame:Twomenaregoingtoplayacardgame;theywillplayitonly
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once.Thereare100cards.Ninety-nineofthecardshaveavalueof0andonecardhasavalueof1,000.Oneofthemenwillpaytheotherforthechancetodrawonecard.Ifhedrawsthe0,hegetsnothing;ifhedrawsthe1,000,theothermanmustpayhim$1,000.Theoretically,thecardgameisworth$10(1,000×1/100).Butwhatdoyouthinktheonemanshouldchargetheothertoplaythe
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game?Ifthisgamewereplayedoverandover,themanwouldprobablychargeaverylownumber,say$11.Hewouldknowthatovertimeprobabilitiesareinhisfavorandhewillcomeoutahead(thisishowLasVegaspaysforallthosenicehotels).However,thisgamewillbeplayedonlyonce.Theoddsarethesame,butifthe$1000cardisdrawn,themanonthehookwillhaveno
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opportunitytomakethemoneyback.Myguessisthatitwouldtakealotmorethan$11togetsomeonetoplaythisgame.Thisthoughtprocessisexactlywhatthrowsoffthevalueofcheapoptions.Theprobabilitiessaythattheoptionshouldbeworthnothing,buttheoptionwillmaintainavalueof.10to.25foranexceptionallylong
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time.Thatisbecausethepersonwhosellsthecheapoptionisthesameasthemanwhoissellingthedrawinourcardgame.ThepersonwouldmakemoneyovertimeinaVegasworld,butoptionmonthshavealimitedlife.Ifthesellerofthecheapoptionhasthetradegobad,hewillneverseethatmoneyagain.Thetraderwillnothaveanunlimitednumberofchancestoplaythisgame.Themajor
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movehashappened;thetraderhaslost.Tomakemattersworse,unlikeinthecardgame,thetraderhasanundefinedrisk,meaningthathehasnoideahowmuchhewillloseifthetradegoesagainsthim.Thefinal0.25ofanoptiontakesmuchlongertodecayout.Whatdoesthismeantoyouasacreditspreadtrader?Takeoffcreditspreadswhen
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theynolongerfollowthemodelandonlyhaveCardGameValue.Thisimprovesyourperformancebecauseyoufreeupcapitalearliertomoveintoothertrades,whichpricingmodelsandGreekscanvalue,andcanbeoutofyourtradesearlier(alwaysagoodthing).Creditspreadsareagreatwaytomakemoney,butittakesonlyonebaddrawtowipeyouout.Don’tgetcaughtplaying
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cards.
WhyAreOptionTradingHandsSoHardtoSitOn?MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/28/2010:
OnceIhavebeenworkingwithanoptionsmentoringstudentforalittlewhile,
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theycanusuallyfigureouthowtoproperlysetupatrade.Thatisabouthalfofthebattle;thenextstepismanagingandadjusting.ThisiswhereIcanrunintoproblems.Mostofmystudentsgetthewaytoadjust,andcanevenunderstandthewhen;it’sthewhennottothatseemstokillthem.HereisaDIApositionthatwearecurrentlyworkingonin
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theAMPitReport:
(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrativepurposes
only.)
Lookingattheposition,doesitneedadjusting?Ifso,whatshouldIdotofix
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thisposition?
IfyouranswerwasanythingbesidesNOandNOTHING,youmayhaveacaseofover-adjustingdisease.Iamnotsurewhypeoplegetthisdiseasebutitisrampantinthetradingworld.Themainsymptomisthatatradermakestradesinapositionthatisnotintroublebutisnearapointwherethepositionmightstarttogetinto
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trouble.Thisdiseasekillsmoretradesthanthemarket,andhereiswhy.Everytimeyoumakeanadjustmentonaposition,itputsthetraderinthetradelongerandcoststhetradercommissions.Thelongeroneisinatrade,thelongeroneislikelytogetamajormulti-standarddeviationmove.Itisthebighugemovesthatkillatrade,nottheslowcreepsup
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ordown.Wecanadjustapositiontosmallupsanddowns.Thesmallmovescanalsoturnaroundwithoutushavingtoadjust;remember,justbecauseapositionisNEARtroubledoesn’tmeanit’sgoingtogetintrouble.Underlyingsecuritiesdoturnaroundorstopmovingsometimes.Ontheotherhand,multi-standarddeviationmoveswilllikelyhurtanytradeevenifitis
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adjusted.Youcanprotectapositionfromalotofmoves,butnotall.SohowcanItellifIshouldadjustaposition?Thatishardtosay.However,hereisatestIliketouse:Pushyourcurrentpositionforward3days,thenlookattheposition.Askyourself,IfIdonothing,amIlikelytomakemoney/breakevenifwestayhere,rallyastandard
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deviation,orfallastandarddeviation?Iftheanswerisyestoatleast2outof3ofthose,donothing,ifitisnot,thenconsiderlookingatadjusting.Tradingisn’taneasyjob;thelastthingtradersshouldbedoingismakingitmoredifficultbyaddingcommissionandtimetotheirincometrade.
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HowOptionTimeValuePremiumDecaysovertheWeekendThefollowingisfromMarkSebastian’sOptionPitBlogon10/29/2009(atthetimeitwascalledOption911):
Aretailtraderhadonacalendarspread(longtimespread)thatwasgoing
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verywell.OnaFriday,hiscalendarpositionwasup18%.Hewasexcitedbecauseifhecouldjustholdonthroughtheweekend,hewasgoingtocollectanother4%returnonhiscapital.
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OnMondayhewasquitedespondent.Hehadheldhispositionovertheweekend,andafterthemarketmovementthatMonday
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morning,hewasdownfromFriday.Thestudentsaid,“Mark,Idon’tgetit.Ididmyanalysis.IshouldbeupatleastafewhundreddollarsfromlastFriday.HowcomeIdidn’tmakeanythingovertheweekend?”
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Hereistheshortanswer:WeekendthetaisdecayedoutofapositionbyFridayafternoonat4:00p.m.Mostretailtradersassumethatthetadecayislinear.Over
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time,thetadecaysattheratethatyourtradesoftwaresaysitdoes.Forinstance,ifcertaintradingsoftwaresaidapositionhadapositivedecayof10,mostretailtraderswouldassumetheywouldhaveanextra10dollarsbythefollowingtradingmorning.Butwhatabouttheweekend?Marketmakersarenotstupid(well,someare).Theydon’t
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likegivingawayfreemoney.Ifthepositiondidn’tdecayoutbeforeFriday’sclose,othertraderswouldcomein,sellalargeamountofpremiumattheendofthedayonFriday,andthenbuytoclosefirstthingonMondaymorning.Traderswhosoldthepremiumwouldbehappy.Theywouldhavegottentheentireweekend’sdecay,21/2days(Friday4p.m.toMonday9:30a.m.),forthe
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priceofonewake-up(Sunday4:00p.m.tillMondaymorning).Sowhatdomarketmakersdo?It’sprettysimple.Webegintodecaytheentireweekendasearlyaspossible.Althougheverymarketmakermanagesweekenddecaydifferently,Markmighthavedonethis:OnThursdayaboutmiddayMarkwouldturnoffallofhisquotes.Hewouldgo
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intohisoptionsquotingsoftwareandbeginmovinghissoftware’stheoreticaldayforwardFriday(thisisverysimilartousingthedatefunctioninTOS,OV,orTradeStation).Markwouldnoticethatothertradersbegansellingpremium.Hewouldnotwanttobuypremiumthatwoulddecayfortwodayswhilethemarketisclosed.Sohehad
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twochoices.Hecouldlowerthetheoreticalvolatility.Thiswouldreducehisoptionpricesbasedonpremiumsellers’activity.Orhecouldmovethetheoreticaldateforward.Thiswouldreducethetheoreticalvalueoftheoptionsusingdaystoexpirationinsteadofloweringtheimpliedvolatility(thisistheonetimewherethedaystoexpirationportionofthefivefunctionsofapricing
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modelcanmatterasmuchasvolatility).OnFridaymorning,MarkwouldalreadyhavethetheoreticaldatetosetSaturday’sdate.Thislethimstayaheadofthegame.Oncehesawpremiumsellersacting,hewouldmovethetheoreticaldateforwardtoSunday.AtthecloseofthedayonFriday,Markwouldhavehissystemsetto4p.m.
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ESTonSunday.Thesystemwouldhaveonewake-up(Sunday4p.m.toMonday9:30a.m.)oftheoreticaldecayleftpricedintotheoptionshetraded.Therewasno“free”premium.Sohowdoesthisknowledgeaffectyouasaretailoptionstrader?Youmaynotethatcurrentsoftwaredoesnottakeweekenddecayintoaccount.
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You,asasavvyoptiontrader,can.IfyouareinanoptiontradeonthecuspofexitonaFridayafternoon,getoutoftheposition.Thereisnot21/2daysofpremiumtobemadeovertheweekend,andyouhavealreadymadeachunkoftheta.Afewpeoplemaythinkthattheycanmakemoneybybuyingpremium;thisisalsonotthecasebecauseyoustillhavetopaythewake-updecay(Sundayat
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4p.m.tillMondayat9:30a.m.).Thereisno“weekendedge.”Thereisonlythetrader’sedge—yourabilitytoperformbetterthanothertraders.
WhenIstheTimetoDe-riskYourPortfolio?Theterm“de-risk”meanstoexecuteanactivityoraseries
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ofactivitiestolowertheriskstoyourportfolio.Formostpeoplede-riskingaportfoliomeansreducingpositions,whichinturnreducesexposure.Sowhenshouldyoutakeoffrisk?Inthesesituations:
•Theportfolioissovolatilethatyoucan’tsleepatnight.
•Themarketenvironmenthas
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changedandyoudon’thaveareadonthenewenvironment.
•Youhavehityourportfoliotradinglosslimits.
•Yourtradingmodelisnotworkinginthecurrentmarketenvironment.
•Youneedtorebalancetheportfolio.
•Yourpositionshavehit
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theirtargetprofits.De-riskingisaveryimportantpartofsuccessfullymanagingTOMIC.Makesureyouknowwhentopulltheparachutechord.Don’thesitateinpullingit.Itisbettertobesafethansorry.
HowtoTradeWhenYouGoonVacationHowatradershouldtrade
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whengoingonvacationissimple:Goflat.Don’tleavetradeson.Ifyoudo,theyshouldbelong-term.Assumethatyouwon’thaveaccesstotheInternet,andthatyourtravelingpartnerwillnotbehappywithyouifyouareconstantlycheckingyouraccount.Itisnofuntobeonvacationandtradeatthesametime.Thatiswhyitiscalledavacation.
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YoumightfindyourselfonacruiseshipclaimingtohaveInternetavailable.However,whenyouarecruisinginAlaskainthemiddleofglacierterritory,thatInternetconnectiondoesnotwork.Youmightbeunabletocheckyouraccountforseveraldays.Befullyengagedwhenyouaremanagingyourportfolio,butletgowhenyouareonvacation.Ifyoudon’thavetheluxuryofgoingflatwhen
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yougoonvacation,youshouldgetatradingpartnertotakecareoftheportfoliowhileyouareaway.
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13.LessonsfromtheTradingFlooronTradingandExecution
WhatEverybodyShouldKnowAboutPaymentforOrder
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FlowMarkSebastianwrotethefollowinginhisOptionPit.comblogon12/20/2009:WhenIfirstbegantradingin2001,amarketmakingfirm,let’scallitFirmXYZ,cameupwithanewandinnovativeideatobringoptionvolumetothePitswheretheycontrolledthemostvolume,
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thePitswheretheyweretheSpecialist,ortheDesignatedPrimaryMarket-MakerorDPM.Thiswascalledpaymentfororderflow.Theexchangescallthem“marketingfees”andyourbrokermaycallitoneofmanynames.Whatseemedlikeabrightideaatthetimehasblossomedintoasituationthatis
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•Badforthecustomer•Badfortheliquidityprovider
•GREATforyouronlinebroker
Inthefollowingyears,thesystemwouldslowlybecomeintegratedbytheexchangesandtakenoutoftheindividualfirm’shands.Thesystemhasessentiallymorphedintoahierarchythatputstradingfirmswhoare
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willingtopaytoseelargerordersinthedriver’sseat,andthepublicinthetrunk.Iwillnotbroachthehierarchysubjectforlargeorders,butIwillexplainwhyitisimportantthatonetakesthetimetoreviewthestatusoftheirorder.
GettingtheFirstLook
BacktoFirmXYZ,thewell-meaningmarketmakingfirm
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thatopenedPandora’sbox.(IwillbepickingonFirmXYZduringthisarticle,butthisisindustrypractice.Idonotwantthereadertothinktheyaretheonlyfirmthatdoesthis.Asstatedabove,mostEXCHANGESnowengageinthispractice.)Theymadeagreementswithmanytradingfirmstogeta“firstlook”atallofthepaperthatacertainfirmhas.Butwhatdoesthat“firstlook”really
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mean?•IfFirmXYZismatchingtheNBBO,andtheorderishittingtheNBBO,theorderwillroutetoFirmXYZ’spit.
•IfFirmXYZwasn’tthebestbidoroffer,dependingontheorder,FirmXYZmightstillgetfirstlookattheorder.Byrouting
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throughlinkage,theorderwouldgetsenttotheexchangewiththebestbidoroffer.
•IfFirmXYZwasmatchingtheNBBO,andanorderdidnothittheNBBO,theorderwouldstillroutetoFirmXYZ.Asaretailtrader,onemightlookatthatdealandthinkthatitisn’tsobad.That
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traderwouldbesorelymistaken.
ThefirstpartofthedeallikelyhaslittleeffectonretailtradersastheyarehittingtheNBBO.Likelytheirorderwillgetfilled.Theonlytimethiswouldbeaproblemisifthetraderissendingalargetradeandtheorderisbeingsenttotheexchangewiththesmallestbidoroffer.Itispossiblethatasmallportion
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ofthetrader’sordercouldgetfilled,andwhilebeinglinkedtoanotherexchangethemarketchangesonthetrader.Thiswouldleavethetraderopenonaportionofhisorhertrade.Thesecondsituation,wherethemarketmakingfirmisn’tmatchingtheNBBO,yetseestheorderfirst,thenroutestheorderthroughlinkage,isslightlymoreproblematic.If
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thereisonlyoneexchangebidatacertainlevel,thesecondsittakestheordertomovefromtheFirmXYZthroughlinkagetotheexchange,amarketcancertainlymove(actuallyIbelievemanyfirmsthatacceptpaymentfororderflowhavesomesortofmatchingguaranteetoprotecttheircustomersfromthisoccurrence).
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Finally,therealculprit,anon-marketableordergetssenttothemarketmakingpit.TheexampleIamabouttorunthroughactuallyhappenedtomeinIBM.ImaginethattheISEiswillingtopay50centsforanoptionupto5,000timesandthePHLXiswillingtopay50centsupto30times.Ifatraderhadanordertosellanoptionfor55cents10times,
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wouldthetraderexpectittobesenttotheISEorthePHLX?ThetraderwouldexpectittogototheISE;thefirmacceptingPaymentforOrderFlowwouldsendittothePHLX.Thisisbadnewsforthetraderbecausetheorderisbeingsenttoaplacewiththefewestnumberofeyesonit.Thismatters!!IhaveseenofferssittingonthePHLXwhilethatpriceistradingontheCBOE.AsI
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havestatedbefore,theonlythingsmartaboutasmartrouteristhatitissmartforyourbrokertomakethemostmoney.
WhenShouldYouWorryAboutAssignment?MarkSebastianwrotethefollowinginhisOptionPit.comblogon
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2/07/2010:Iwanttodiscusssomethingsomewhatbasicthatseemstohoundmeconstantly:retailtradersaskingmeifIamworriedaboutbeingassignedonashortputposition.TheveryneophytetraderswillsometimesgosofarastoaskifIamworriedaboutcallassignment.Iam
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goingtogivetheshortansweronassignment,andthenIamgoingtoproveit.ThenIwilldiscusswhenitisokaytoconsiderassignment.Veryquickly,astradersbeingassignedshouldbeoneofthelastthingsweworryabout.Thereasonbeing,itisn’tsomethingthathappensveryoften.Thecircumstanceswhena
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traderwillbeassignedareactuallysomewhatrare.Thisisespeciallytruenowwithinterestratessolow.Hereiswhy:Iamgoingtostartwiththisstatement,anditwasoneofthefirstthingsIlearnedasatrader.Aputisacallandacallisaput.Almosteverytradeprotradersmakeisconvertingcallstoputsandviceversa.Forinstance,theprotective
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put:Ifonechartsthegraphofaprotectiveput(longput+longstock),whatdoesthetradernotice?Itlooksexactlylikeacall.Thepositionhasalimitedloss,andunlimitedupside.
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Anothercommontrade,thecoveredcall(longstock+shortcall)looksexactlylikeashortput.Thepositionhasalimitedupsideandanunlimiteddownside.
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Ifallcombinationsofstocksandoptionscanbeconvertedintootherpositions,thentheremustbesomesortofforceholdingthesecombinationstogether.SimilartoE=MC2,theoption
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worldhasaformulathatholdsittogethercalledput-callparity.Put-callparityistheformulathatensuresthattraderscannotmakemoremoneybuyingcallsthantheycanbuyingputsandstock.Whenoptionsareoutofparity,arbitragebegins;thisquicklybringsoptionsbacktoparity.ThisFormulaisCall−Put=StockPrice−StrikePrice+(Interest−Dividends).TheshortequationisC−P=S
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−X+(I−D);theI−DisoftenreplacedwithaKforcostofcarry.Usingthisformula,ifacustomerwantstoselltheFebruary50callat9dollars,withthestocktrading55.00andacostofcarryof0.20,whatwouldtheputbetrading?9−P=55−50+.20.Theputshouldbetradingaround3.80.Iftheputhadabidof4.00,themarket
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makerswouldbuyasmanycallsastheycouldfor9dollars,sellthestockagainstthecalls(convertingthemintoputs),thenselltheputs.Thiswouldallowthemtosyntheticallybuytheputandthenselltheactualput.Let’sthinkaboutput-callparityandassignment.IfIamlongaput,andlongtheunderlyingagainstthatput,whatpositiondoIreally
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have?Iamlongacall.IfIreallyhaveonacall,thentheonlywayIwouldexercisemyputwasifthevalueofthecallwaslessthanthevalueoftheput,stock,andcostofcarrycombinationorC.IfIhadboughtanATMbutterflyinOEXonJanuary19th,ImayhaveenteredintotheOEX500/530/560putfly.OnFebruary5th,theOEXis40pointslowertradingat
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491.35;the530putsaretrading41.50.Withamarketmakerinterestrateof.25andacashaccrueddividendofabout$2.95,ourcostofcarryendsupbeingabout-2.90.Thecallsaretrading.15cents.WouldIexercisetheputs?Is.15<491.35–530+(–2.90)+41.5?491.35–530+(–2.90)+41.5=–.05.Theanswerisno;thusdespiteamajor
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downswing,itisnotinmycounterparties’bestinteresttoexercisetheput.Withinterestratesthislow,assignmentsarefewandfarbetween.TheMarketMakerratewillhavetoincreasebyatleast1%beforethispositionbecomesasomewhatattractiveexercisecandidate,evenwithan8%downmove.Hopefullybynowonecanseetherearefewscenarios
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wheretheputshouldgetassignedtoseller.Callsareaslightlydifferentstory;nondividendpayingcallsshouldneverbeearlyexercised.However,tradersareatriskofassignmentiftheunderlyingpaysadividend.TakeEXCforinstance:OnFebruary11th,EXCgoesex-dividendpaying52.5centspershare.IfIamshortthe40calls,shouldIworryaboutgettingassigned?
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Icanfigureitoutbypluggingthenumbersintoputcallparity.Thecallistradingaround4.25,theputaround.05.Thestockistrading44.25andthecostofcarryendsupbeing(.01–.525).Pluggingthesenumbers,4.25–.05=44.25–40+(.01+.525),the40callshaveaproblem;theC–PdoesnotequaltheS–X+K.Thosecallswilllikelygetassignedtome.
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Nowthatwehaverunthroughthemath,tradersshouldcertainlybeclearabouthowtotelliftheywillbeassigned,usingslowlonghand.IwillgiveyouwhatIamcallingthe“TradersShortHand”tofigureoutassignment:
1.Ifthe(i−d)isgreaterthanthevalueofthecalloppositethetrader’sshortput,the
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tradermaygetassignedontheposition.Generally,Idonotpayattentiontothisuntilthecallisworthlessthan.25orso.Withratesaslowastheyare,itiscloserto.05.
2.Ifthedividendisgreaterthanthevalueoftheputoppositethetrader’sshortcallposition,thetraderis
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likelytogetassignedonhisorhershortcallposition.Ifthecalldoesnothaveadividend,tradersshouldneverbeassignedontheshortposition.
Tradershavemanyrisksassociatedwithaposition.Itisimportanttoconcentrateonthemostimportantrisks,whileignoringtheinsignificantrisks.Inalmost
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everycase,savedividends,assignmentriskisatornearthebottomoftraders’risks.
ASuccessfulShortSPXCalendarMarkSebastianreviewedanexampleofashortcalendartradeinhisblogentryof8/24/10:
YesterdayduringtheMid-DayPitReportIwas
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pointingouthowwidetheIVspreadwasbetweenSeptemberandOctober.WiththemarketuponthedayIpointedoutthattheimpliedvolatilityspreadbetweentheat-the-moneySeptembercallsandtheat-the-moneyOctobercallswasalmost2points.Thisdrovethepriceover14.00atonepointyesterday.
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(Source:Livevol©www.livevol.com)
Thistraderdidnotgetthebestexecution,butIwantedtorelaytheactualtrade.ThetradesoldtheSep-Oct1085callspreadwiththeSPXaround1080
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foracreditof13.25.
(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrativepurposes
only.)
Thatvolatilityspreadwas
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stillover1.5pointsonthistimespread.Thetraderthenputinabidtobuythespreadbackfor12.20.Thiswouldhavebeenareturnof8%onastandardlongcalendar.However,thefillontheopenthismorningwasgoodandittradedat11.75.Thatisareturnof150.00inaday,or11.3%.ThisisinasingleDAY.
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(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrativepurposes
only.)Thislayupofatradeisnolongerthere,butwilllikelyreappeartotraders
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whounderstandhowoptionsfunction.Traders,thisisthepowerofunderstandingvolatilityandtermstructure.Yes,itisveryimportanttounderstandhowtosellpremium.Butforanytraderthereisalotmoretolearnthansimply“sellacondor.”Onethingtoremember,theothersideofthiscalendarhaslostwhatmytraderhasmade.
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Thatiswhywedonotsimplyslapthesametradeoneverymonth.
ButterflyTradingChecklistMarkSebastianwrotethefollowinginhisOptionPit.comblogon9/13/2010:
Optionmentoringisnotaneasybusiness.Weare
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alwayslookingforeasy,simpleanswerstoverycomplicatedquestions.Onesubjectthatoneshouldreallyconcentrateonistradeselection.Therearementorsouttherewhosuggestthatthesametradeeverymonthworks;thesepeopleareprobablynottrading.Theysaytradethesametradeeverymonthbecauseitissimple.Tradingisnot
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simple,tradingishard.However,wewanttohelp.Thus,wedevelopedathree-partchecklisttotellwhetheritissafetoenterabutterflytrade.Thereisalotmoretothesuccessofaflythanthesethreethings,butthisisagoodplacetostart.1.MakesurethatatraderpaysattentiontotheIVofthebutterfly.Believe
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itornot,thetraderdoesnotwanttoentertheflywhenimpliedvolatilityissky-high.WhenIVsaresky-high,thereislikelytobeasnapbackrally.IfIVsaretoolow,thatisbadtoobecausethetradeislikelytohaveIVpop.Ifindthatmiddle-of-the-roadimpliedvolatilityisactuallythebestplacetoenterbutterflies.If
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theIVsareinbetween25%-75%ofthe90-daymeanimpliedvolatility,feelfreetochecknumberoneoff.Iftoohighortoolow,nocheckbox.
2.Makesurethattheinter-monthskewisn’ttoowide.Ifinter-monthskewistoowide,thisisanotherwarningsignofabreakout.Wheninter-
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monthskewistoonegative,itcanmeanthatinrelativetermsthefrontmonthistoohigh.Butterfliesareafrontmonthtrade,thuswewanttoavoidthisproblem.Iftheskewistoopositive,thatlikelymeansthemarketismovingaroundalotinrelativeterms.Consideringthatbutterfliesareagamma
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trade,thisisalsobadnews.Therearesomereallygreatwaystotrackthisskew;onequickwayistocompareVIXtoVXV.Thiscangiveaprettygoodideaofhow30-dayvolatilityisbehavingrelativeto90-dayvol.Ifthetermspreadisnottoohighortoolow,putacheckinthebox;otherwise,weareanogo.
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While90-dayvolisusuallyhigherthan30-dayvol,Ithinktraderscanseehowpointsofwideningcoincidewithmajormoves:
(Source:Livevol©www.livevol.com)
3.WatchIntra-Month
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skew.Whenskewishigh,butterfliesareaverytoughtrade(seeMay,June,andJulyfordetails).Whenskewislow,butterfliesareaneasytradeandcheaptoensure(seeAugust).Whatdoesthisskewlooklike?Let’stakealook.
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(Source:Livevol©www.livevol.com)
Again,thisisnottheanswertoalltradingquestions.Wedidnotattachanynumericguidelines,asshouldbedone,forcheckboxes2
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and3.Also,therearemorethingstolookatthanjustthesethree.Butthisisastartingpoint.Thatsaid,ifallthreeofthesecanbecheckedoff,thebutterflyisprobablyafavorabletradetoenteratthatgiventime.Inthisexample,wedon’tthinkwecancheckoffanyofthesethreeitems.
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WhatIstheProperWidthforanIndexButterfly’sWings?MarkSebastianwrotethefollowinginhisOptionPit.comblogon11/29/2009:
IwasrecentlymentoringastudentwhohadasplitstrikebutterflyinMNX,orsohethought.Ilookedatthetradeforasecond;I
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quicklynoticedthathiswingswerespacedREALLYwide.Icalmlyspoke:“Thisisnotabutterfly,thisisanunhedgedstrangle.”Thestudentwasflabbergasted.(BTW,isthereacoolerwordthanflabbergasted?IthinkIhavelovedthewordeversinceDonMusicwroteasongaboutthewordon
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SesameStreet.)“WHAT!”hesaid.“Ihavelongsee,andI’mlongthiscallandthisput!”“Yes,”Istated,“butthosearen’tahedgeagainstthisposition.Thoseoptionswillhavenoeffectonprofitandloss.Whenyouboughtthoseoptions,youhedgedNOTHING!”TheaboveconversationwasnotthefirstI’vehad
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concerningwingplacement,norwillitbethelast.Mosttraderscanfigureoutwhichoptionstheywanttosell.It’stheoptionstobuythatcanturnintoabignightmare.Whilesomestudentssettheirlongstoclose,themorecommonproblemissettinglongsfartoodistantfromtheat-the-moneystrikes.
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Thepurposeofthelongoptionsinaspreadistoreducemargin,reducetheriskoftheposition,andmaximizeefficiencyofcapital.Ifatradersetsupabutterflywherethelongsdonotsignificantlyreducethemarginofthetrade,itisawarningsignthatthetradehaswingstoodistantfromtheat-the-moneystrikes.Whenabutterfly’sriskis
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significantlygreaterthanthereward,thisisanotherwarningsignthatthelongoptionsaretoofarfromatthemoney.Iftheunderlyingcanmoveonestandarddeviationwithouthavingasignificantimpactonthepriceofthelong,thewingissetouttoofar.Thisisabigproblembecauseitcannotonlyputtoomuchcapitalatrisk;itcanmesswith
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thetrader’scalculatedreturnoncapital.Thiscantrickthetraderintostayinginatradetoolong,openupthetradertosubstantialunnecessaryloss,orboth.Withtheseinmind,herearesomeguidelinestraderscanfollowtosetupbutterflywings:1.Optionsthatareworthlessthan$0.25donot
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hedgeanything.Ifatraderissettingupabutterflythathashimorherbuyingawingunder.25,thetradershouldnotbuythatoptionforahedge(noteIamnottalkingaboutunitswhicharetobeusedasblackswaninsurance;thisisacaseinwhichtheoptionisactuallyapartofthespreadbeing
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entered).Hereiswhy:IfIbuyacalloptionfor.25asapartofabutterfly,theunderlyingralliesthreedollars,myshortcallsareprobablylosingasignificantamountofmoney,mylongstrikethatIboughtfor.25isprobablystillworthabout.25.Traderswillfindthatbuyingoptionsworthmorethan.25when
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settinguptradeswillperformbetterandactuallycostless.
2.Lookforatleastaone-to-oneriskreward.Ifthetradersetsupabutterflywheretheriskismorethanthemaximumpotentialprofit,thetradercanlikelyreducethemargineasilyatlittleornocosttothetrade.
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3.Alwayscheckthenextcloseststrike.Whensettingupatrade,ifatradercanpushthecalldownastrike,ortheputuponestrikeanditcoststhetradelessthanonetofivemargintoprofitpotential,itisprobablyworthstrikesin.Forinstance,ifatradercanmakeaonelot
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butterfly’swingsfivepointscloseranditcoststhetraderlessthanonehundreddollars,thetraderlikelyhashislongwingssettoofarfromhisshortstrikes.
4.Ifatradersetsuplongsproperly,whenthatdecaygetsdowntounder$0.25,thetradershouldconsidereitherpullingoutofthetrade
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andtakinghisorhermoney,orkickingthewingsintoreducethemarginonthetrade.
Traderswhokeeptheseguidelinesinmindwhentradingwillfindthattheyareusingtheircapitalmoreefficiently,puttinglessatrisk,andmostlikelymakingmoremoney.
TheImportanceof
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GoodExitsHavingtherightconditionsbeforeenteringatradeisprobablythemostimportantfactorinordertoconsistentlymakemoney.However,exitingatradeisthesecond-most-importantcondition.Infact,itisprobablythemostimportantconditioninordertonotlosemuchmoney.Itislikehavingabalancedfootballteam,agoodoffense
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andagooddefense.Thegoodtradingoffenseisknowingyourentrypoints.Thatmeansplacingtradeswhenconditionsareinyourfavorandyouhaveanedge.Thegoodtradingdefenseisknowingwhentoexit.Thatmeansclosingatradewhenyouhavewonenoughorbeforeyoulosetoomuch.Whenyouboardanairplane,thefirstthingtheflight
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attendantspointoutistheemergencyexits.Thisknowledgeofthepositionoftheemergencyexitsmaysaveyourlifesomeday.IntradingoptionsforTOMIC,youneedtoknowwhatyourexitconditionsareforthetrades.Whenthingsstarttogowrong,andwhentheydotheygoveryquickly,youneedtoknowwheretheemergencyexitis.
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AtTOMIC,beforeyouenteratrade,youneedtoknowexactlywhentoexit.Therearealwaysatleasttwoexitpointsforatrade:
1.Theexitwhenthetradeisgoingagainstyou.
2.Theexitwhenthetradeisgoinginyourfavor.
Whenthetradeisgoingagainstyou,whenitisnotworkingout,youshouldexitwithouthesitation.Likethat
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emergencyexit,itmustbeused.Thispreventsmajorlossesintheportfolio.Youmighthesitateintakingtheexitbecauseyoudon’twanttheloss.Youcouldbelievethatthemarketcouldchangedirectioninthenextminutesorhoursandthingswillimprove.Thisthinkingmightormightnotwork.Butifyouarenotdisciplined,asmalllosscouldbecomeagiantloss.Thatgiantlossmightbe
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unrecoverable.Thisisthesamethinkingthatmakesgamblersgobroke.Thelosinggamblerskeepplayinguntiltheylosealltheirmoneybecausetheyalwaysthinkthattheirluckmustturnaroundinthenextbet.Takingthelossatapredeterminedpointhelpscontrolthisimpulseandlimitsthelosses.Thebestlossisthefirstloss.Whenatradeisgoinginyour
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favor,youneedtoknowwhentoexitthetradeandtakeprofits.Youmightkeepthetradeonbecauseyouthinkthattherearemoreprofitstobemade,whensuddenlythemarketreversesandwipesouttheentireprofit.Considerusingapercentageofmarginastheparametertotriggertheexit.Hereisanexample.Whenenteringanironcondortrade,
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youmightsettheexitatalossof20%ofmarginoratagainof15%ofmargin.Ifthetradegoesagainstyou,youmightmakeadjustmentstotrytomanagethedeltas.However,whenthetradehitsalossof20%,youneedtoexit.Thesameholdsifthetradehitsaprofitof15%.Therearevariationsonthis.Sometradersmanaginglargepositionsmightdecidetoexit
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usingscales.Soifatradeisgoinginyourfavor,insteadofwaitingforthe15%gain,youmightsellpartofthepositiongaining10%,andthensellanotherpart,gaining15%.Theexitpointsarejustexamples.Inreallifeyoushoulddefineyourownexitparameters,butitisimperativebeforeenteringthetrade.Bedisciplinedandfollowyourpredefinedexitcriteria.Havingpredefined
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exitsforyourtradessavesyoumoneyandmakesyourtradesmoreprofitable.
PreparingtoTradeforaLiving,HowMuchCapitalIsNeeded?Totradeforalivingasaprofessional,youneedtobeprepared.Youneedknowledge,mentaldiscipline,
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andfinancialmeans.Peoplewhotradeforalivingarethosewhotradeontheirownhook.Theyarethemastersoftheirowndestinies.Theyreporttothemselves,andtheyknowwhethertheyarewinningorlosinginthegameoftradingbylookingatthebalanceintheirtradingaccounts.Beforeyoubegintotradeforaliving,youneedtoknow
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yourannualexpenses.Howmuchdoyouneedtoliveon?Thenmakesureyouhaveatleasttwoyears’worthofsavings.Soifyourannuallivingexpensesare$60,000,youshouldhave$120,000savedliquid.Next,youneedtoknowthereturnsyouhavebeenaveragingonyourpart-timetrades.Beforeyouembarkontradingforaliving,youneedtofirstexperiencetrading.Soifyou
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havebeenaveraginga2%profit(returnonReg-Tmargin)permonthoverthepasttwoyears,youhavemorethan500tradesunderyourbelt.Hence,ifyouaverage2%permonth,youareabletoproduce24%returnperyear,assumingthatyouarefullyinvestedallthetime.Inreality,youprobablywon’thaveallyourcapitalinvested.Mostlikelyyouwillhavebetween40%and60%
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onanormalbasis.Onaverage,assumeyouwillbe50%invested.Now,dothemathtofigureouthowmuchmoneyyouwillneedtohavebeforestartingyourtrading-for-a-livingventure.Hereisthecalculationtostartyourventure.First,youwillneedenoughsavingstocovertwoyears’worthoflivingexpenses,whichis$120,000.Next,youneedenough
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investmentcapitaltoearnenoughtocoveryourlivingexpenses.Soifyoucanconsistentlyearn2%permonthoneachtradeandyouneed$60,000peryearor$5,000amonth,youwillneed$5,000/0.02=$250,000.Butwait—ifyouareinvestingonaverageonly50%ofyourcapital,thenyouwillneed$500,000ofinvestmentcapital.
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Sotostarttotradeforaliving,youneedtohave$120,000(savings)+$500,000(workingcapital)=$620,000.Bepreparedpsychologicallytorunyouroptiontradingasabusiness,likeTOMIC.Ifintwoyearsyouhavebeenabletocoveryourexpensesandincreaseyoursavings,youaredoingverywell.Ifintwoyearsyouhaveearnedyourlivingandmaintainedyoursavingsat
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thesamelevelatwhichyoustarted,youaredoingwell.However,ifintwoyearsyouhavedepletedyoursavingsandhavenotbeenabletocoveryourexpensesbytrading,considerthepossibilitythattradingforalivingisnotforyou.Ifthisisthecaseandyoustillwishtocontinue,hireacoachandrereadthisbook!
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TheImportanceofFocusHaveyouever...
•Feltoverwhelmedbytoomuchinformation?
•WantedtotradeeverymarketthatatalkingheadonTVrecommended?
•Tradedmultiplemarketswithdifferentstrategiesatthesame
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time?Andlostoneverytrade?
•Frozenlikeadeerintheheadlightsduringaflashcrash?
•Analyzedatradeoverandoveragainwithoutplacingit,onlytoplaceitwhenthetradehadalreadyplayedout?
•Feltlikeswitchingstrategieseveryday?
•Boughtanew
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investmentnewslettereverytimeyougotane-mailabouthowgreatthenewsletterwas?
•Wantedtochangeprofessionsafterthemarketmovedagainstyou?
•Tradedwhenyouwereupset,andmadealotofcostlymistakes?
•Lostmoneywhentradingafteraclose
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friendorrelativedied?Ifyouansweredyestoanyofthesequestions,youmighthaveproblemsfocusing.BeingabletofocusisakeyabilitytobesuccessfulasamanagerofTOMICorinanyotherendeavor.Whenasurgeonoperates,hehastoconcentrateondoingeverythingcorrectlytosavethepatient’slife.Hemustnotbethinkingabouthisdinner
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datewithhisnewgirlfriend.Heshouldbefocusedongettingthesurgerydonesuccessfully.Wouldyoubecomfortablegoingintoaneyesurgerywhenyourdoctortellsyouthathismotherjustdied,butnottoworrybecausehecandoyoursurgeryinhissleep?Ofcoursenot.ThesameappliestothepersonrunningTOMIC.You
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havetobefocusedonwhatyouaredoingwhenyouaretrading.IfyouarerunningTOMIC,youarerunningabusiness.Thewell-beingoftheshareholders(youandyourinvestors)dependsonyourdecisions.WhenMichaelJordanhadtheballwithonlyacoupleofsecondsleftinthegame,whatwashethinking?Didhehearthecrowdcheering?Did
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helistentotheopponentplayers’trashtalk?No,hewasinthezone;hewastotallyfocusedononethingandonethingonly:scoringtowinthegame.WhenyouaremanagingTOMIC,yourfocusmustbelikealaser.Youneedtobealertandmaintainyourdisciplineinordertomanagerisksandbookprofits.SteveJobs,Apple
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Computer’sinnovator,wasverygoodatwhathedid.Hefocusedoncreatingelegantandsimpledevicesfortheconsumer.Becauseofhisfocus,hewasabletorevealtheneedsthatpeopledidn’tknowtheyhadandthattechnologycouldsolve.ThemanyusesoftheiPadwerenotimaginedbyconsumersuntiltheyhadaniPad.Daniel(RalphMacchio),in
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themovieKarateKidII(1986),wasabletobreaksixslabsoficewithoneknife-handstrikebecausehewasabletofocusandconcentratealltheforceofhisbodyintoonesmallareaofimpact.Whatdoesallthismeantoyou,asTOMICmanager?Itmeansthatyouneedtodefinewhoyouare.Knowyourinvestmentstrategyandhowyouaregoingtoimplement
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it.Onceyoudo,don’tgetsidetrackedbyotherinvestors,markets,strategies,orproducts.Stayfocusedonwhatyouaredoing.
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14.LessonsfromtheTradingFloorontheOtherGreeks
WhatHappenstotheGammaofITMorOTMOptionsWhenIVIncreases?
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MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/29/2010:WhenIamworkingwithoptionmentoringstudents,forthemostparttheycanfigureoutat-the-moneyoptions.TheygetthatasthestrikebecomesmoreATM,thedeltachangefrom50deltatothenextstrikeineitherdirectionhasdecreased
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becauseofvolatility.Butwhataboutout-of-the-moneyoptions?Doout-of-the-moneyoptionslosegamma,orgainwithanincreaseinIV?Theanswerisboth!Foroptionsthatarewelloutofthemoney(belowa15delta),ingeneralanyincreaseinimpliedvolatilityisgoingtoincreasegamma.Thisisverysignificantforcondorandstrangletradersto
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understand.Theyneedtoknowthatinitially,whentheIVincreasesontheircondor,thecondorisgoingtohavemoredeltasensitivityinadownturnthanthemodelpredicts.Takealook;hereisanMNXcondorwithstrikesthatare10%outofthemoney.
(Source:TDAmeritrade,
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Inc.Usedwithpermission.Forillustrativepurposes
only.)
NowweraiseIV5%.Noticethatinfactthepositiondoesgetshortergamma,andformosttradersthisisalltheywillneedtoknow.
(Source:TDAmeritrade,Inc.Usedwithpermission.
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Forillustrativepurposesonly.)
However,thecrazythingwithOTMoptionsrearsitsheadifweincreaseIVsignificantly,inthiscase15%.NoticethenthatthegammaactuallyFALLS!!!
(Source:TDAmeritrade,Inc.Usedwithpermission.
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Forillustrativepurposesonly.)
Whydoesthishappen?WhenIVincreases,OTMoptionsgothroughaprogression.AsIVincreases,atfirstOTMoptionsgaingammaastheybecomemorelikeanATMoption(rememberATMoptionshavethemostgamma).OncetheseoptionsgainenoughIVthattheyactuallyBECOMEsosimilar
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toATMoptions,theybeginlosinggammawithincreasesinvolatility.Whilethiscanseemconfusing,thinkaboutitthisway.Way-out-of-the-moneyoptionsgaingammawithincreasesinvolatility,untiltheyarenolongerway-out-of-the-moneyoptions.
WhyDoINeedtoWeightMyOption
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Portfolio?MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/29/2010:
DeepdownIamafloortraderatheart.ThisiswhyIgetsofiredupwhenIseetraderstradingwithoutunderstandingtheconceptofweightingthatIamabouttorunthrough.
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WhenIwasafloortrader,thegroupIworkedfortradedSPX,SPZ,ES,DJX,DIA,andmanyotherindexoptionsagainsteachother.Needlesstosay,thiswasacomplexprocess.Inordertoreallymakethesetradesworkproperly,wehadto“weight”thedeltaandthegamma.Meanwhile,withvegaandthetawehadtodoverylittlewhen
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combiningtheGreeksofseveralproducts(therewerealotofotherthingstomanagewithvega,butpracticallynothingfortheta).Whywouldweneedtodoabunchofworkfordeltaandgammaandpracticallynothingforvegaandtheta?Theanswerliesinthedefinitionofadelta.Adeltarepresentsthe
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correlationtotheunderlyingproductfora1-pointmove.The1-pointmoveistheimportantwordinthatstatement.A1-pointmovecanmeandifferentthingstodifferentunderlyingproducts.IfIBMgoesuponedollar,wouldatradernoticethatitwasup?Probablynot!IfFordralliesonedollar,wouldatradernoticethat?Yes,of
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coursethetraderwould.ForIBM$1.00isbarelymorethan.5%;inForditiscloserto6%!!Aone-dollarmoveinIBMmeansalotlesstotheshareholderthana1-pointrallyinFord.Whydoesthismatter?Itmattersbecausemosttradersaretaughttothinkinpercentages(andmoststrategiesaredesigned
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thatway).WhatifIhadaportfoliowhereIthoughtFordwasgoingtooutperformIBM(Iknow,itwouldbeaweirdportfolio).IfIsold100sharesofIBMandbought100sharesofFordinmy“pairs”trade,thenFordrallied5%andIBMrallied2%,wouldImakemoney?NO,Iwouldbeahugeloser:
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FReturn:100*16.75*.05=+83.75IBMReturn:−100*146.52*.02=−293.04Congratstomeonbeingright;bootomefornotunderstandinghowtoweightthesestocksaccordingtoprice.IfIwantedthistradetoreallywork,Iwouldhaveneededtobuyaboutnine
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sharesofFforeveryoneIsoldinIBM(thatstrategywouldmake$460.00).ThisconceptisevenmoreapparentinwhatweweredoingwhenconvertingSPYtoSPX.WhentheSPXrallies1.00,howmuchofaneffectontheindexisit,basedonthereactionfromtraderstoday,whentheSPXralliedlessthan
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2.00?NOTHING!IntheSPY,though,1.00isnotaninsignificantmoveintheunderlying,amountingtoabout.8%(toabout.08%intheSPX).Becauseofthese,weknewthatifIsold1000SPYcallsthathadadeltaof30,therewasnoneedtopanic;itwastheequivalentofselling100callsintheSPX.
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SowhenwewereconvertingOEXandSPX,wewouldbetradingabout2.23OEXforeverySPX;inDIAitwasmorelike11,inSPYalittleunder10,andsoon.Regardlessofriskbeta,understandingthesizeofthecontract’sunderlyingwasakeytohavingabalancedportfolio.Sotraders,remember,intrading,sizedoesmatter!!
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GammaScalpingMarkSebastianwrotethefollowinginhisOptionPit.comblogon10/27/2010:
Igetaskedallthetime,“HowshouldIscalpgamma?”Itisasurprisinglydifficultquestiontoanswer.AsamarketmakerIhadveryfewconstraintsonmy
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tradingactivity.IcouldhedgeabackspreadanywayIwanted.IfIwantedtohedgebysellingstock,thatwassimple.Ipulledupmystockexecutionsystemandunloadedtheunderlying.IfIwantedtotradeoptionsagainstthegamma,Icouldtradejustaboutanyoptioninthespectrum.IfIthoughttherewasmoreedgeintradingtheJanuary2012
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monthtohedgeafrontmonthbackspread,Iwould.
IfIwantedtohedgecallswithputs,orputswithcalls,thatwasalsonotaproblem.Retailtraderslacktheabilitytotradeandexecutemanyhedgingstrategies.Isoonrealizeditreallydoesn’tmatterwhatthetraderusestohedge.Itmattershowthetraderhedges.Whilethereare
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endlessoptionstoscalpgamma,therearetwowaysIteachstudents.OnemethodisforveryactivetradersthatIcall“paythedecay,”andtheotherisforlessactivetradersthatIcall“delta/gammaratiohedging.”
PaytheDecay
WhenIfirststartedteachinggammascalping,theonlymethodItaughtwas“paythe
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decay.”Thisisanintenseandinvolvedformofscalpingandisprobablymoreusefulforfull-timetradersthanretailtraders.Alltradersshouldunderstandthetechnique.Thetraderusesthetaofthepositiontocalculatehisdaily“nut.”Thetraderusestheformulaforchangeinslopetocalculatehowmovementisneededintheunderlyingto“paythedecay.”
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Lookingattheblindstraddleon10/16/09,thepositionislong8.25gammaandshort6.09theta.Thetraderwouldplugin7/5*6.09asthesolution(7/5totaketheweekenddecaysomewhatintoaccount),andusethegammaasthechangeinslopeforthecurve.Thevariablethetraderissolvingforisthechangeinprice.Theformulaendsuplookinglikethis:
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7/5*Theta=0.5*Gamma*X^2OrsolvingforX:X=SQRT(7/5*Theta/0.5*Gamma)Whichreducesto:X=SQRT(2.8*Theta/Gamma)Solvingtheequationinthiscase:X=SQRT(2.8*6.09/8.25)=$1.43767
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TheSPYneedstomove$1.44inordertocoverthethetadecayforthatday.Thisformulahastobereruneverymorningasdecayandgammachange(bothgetlargereveryday).Amajorcomplaintisthatanyonewhohasa“realjob”maynotfeellikedoingthiscalculationdaily.Thereisamuchbiggerproblemwiththisformulathough:Itdoesn’tanswerwhento
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adjust.Mostofmystudentsassumethattheyshouldsetthescalp$1.43fromthepreviousday’sclosingprice.Notthecase!Settingthescalpthatfarwillonlygethitaboutonceevery3days.Personally,Isetmyscalpsat50%oftherequiredmove,andsellallofmydeltasatthatpoint.ThenIbuythembackwhenthestockmoves
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backtounchanged.Thiscreatestwoscalpsthatequal72centsofmovement.Ihavetomakethistypeofscalptwice,eitherroundtrippingtheunderlyingmoving72centstwice,orgettingacomboofroundtripstotheupsideandthedownside.Atday’send,Ialwayszerooutdeltas.Iftheunderlying“gaps”pasttherequiredmove,Iwould
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sellalloftheposition’sdeltas(oratleast75%ifIthinkthemovecouldcontinue).Iftheunderlyinghitsascalpandcontinuestoruninthatdirection,Iusethescalpingpointasmynewstartingpoint.Thismethodrequiresalotofworkandcanbeveryfrustratingwhentheunderlyingreallyruns(I’llbehonest,ifIsensemomentumIwilllettheunderlyingrun
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andsettrailingstopordersinstead).Thistypeofscalpingwillcertainlycoveraportionofmydecayandsurprisinglyisfarmorelikelytocovermydecaythensettingthescalps$1.43apart.Why?Volatilitypredictspricemovement,notdirection.Scalpinggammaatcloserintervals,Iendupmakingfar
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morescalpsthansettingthescalpsfurtherapart.WhenIwasonthefloor,tradingSunMicrosystems,thereweretimeswhenIwouldscalp10to30timesinaday.BytheendofthedayIcouldhavethousandsofdollarsinmypocket,evenifSUNW(theoldsymbol)didn’tmove.Oneoftheneatthingsaboutlonggammaisthatthetraderwantstogetinasmanyscalpsaspossible.This
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methodallowsforthat.The“paythedecay”methodisveryinvolvedbecauseofthelargenumberoftrades.Ontopofthat,gammaandthetaareconstantlychanging.Traderswhocan’tsitinfrontofacomputeralldayhaveaseriousproblem.AsamentorIwantedtobeabletohelpmystudentstradestraddlesandscalpgammaiftheywantedto.Iasked
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myself,“Howcanaretailtradertradeastraddle?”Thisbroughtmebacktomyfloortradingdays.Atanygiventime,Icouldbemanagingasmanyas60positions.Ihadabouttenstocksthatweremybread-and-butterstocks.Thesewereconsistentlybusy.Thentherewereusuallyaboutfivetotenotherstocksthatwouldheat
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upfromtimetotime(theserotated).Fortheslowerfortystocks,Ididnothavethetimetositthereandscalpgammabackandforthbasedonthe“paythedecay”formula.Iactuallyhadadifferentmethodforverysmallpositions.Dependingonhowhecticthemarketwas,andtheindividualstockwas,Iwouldtradethesecurityona
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delta/gammaratio.For,moststocks,Iwouldtradethemonetoone.Essentially,whenmydeltaequaledmygamma,Iwouldflattenmydeltas.Atfirstthismayseemalittlearbitrary,butonceyouthinkaboutit,maybeit’snot.TheGreeksareallinterrelated.WhenoneGreek,inthiscasedelta,clearlybecomesthedominantGreek,itintuitively
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makessensetocutthatriskdown.(ItworksoutinthemodelbutIwillspareyouguystheproof.)Tradingthedelta/gammaratioaccomplishesthis,withoutforcingthetradertositandstareatthetrader’scomputer.Inthemorning,youcanmovethepriceupuntilthedeltaequalsthegamma,thensetapricealertthere,andthendo
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thesameonthedownside(ifthetraderisusingstockinsteadofoptions,heorshemayconsiderrestingasmallstockorderthere).Forsmallerpositionsorstocksthattendtotradewithamomentum,Isuggestthatyouuseasomewhatlargerratio,becauseofcommissionsortotakeadvantageofthestocks’momentum.Gammascalpingisreallynot
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formostretailtradersunlesstheyhaveaVERYstrongunderstandingofthemechanicsandthetraderhasclearreasonswhyheorshewantstogetlongpremiuminthatunderlying.However,properimplementationcan:
•ReduceP&Lvolatility•Reducethepainofthetadecay.Thisallowsyoutostayintheposition
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longerwhileyouwaitforyourpositiontowork.
ObviouslyIambacktrading,butIdidmybestnottoMonday-morningquarterbackandputthescalpsinwheretheygo.Becauseofthesizeofthisposition,Iwentwitharatiooftwotoone.Istillendedupmakingseveralscalpsusingputsandcalls.Onethingyoushouldnote:
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Ifyouareusingoptionstoscalpgamma,nomatterwhatmonththestraddleisplaced,thefrontmonthoptionsshouldbeusedtohedge.Why?Becausetheyhavethemost“pure”deltas(basically,theseoptionshavetheleastvega).Ifthepositionislarger,deepcallsandputscanbeaseffectiveasstock.Inthis
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case,thepositionwassosmallIhadtousefrontmonthout-of-the-moneyoptionstotradeinandoutofmydeltas.Thisisnotaverydesirablewaytomanagedeltas,butIhadtodealwiththecardsIwasdealt.So,Iendeduptradinginandoutofdiagonals.WhenIexitedthetrade,Imadeslightlylessthanthatnakedstraddle;however,mypositionhadfarlessP&Lvolatilityandwas
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neverdownasmuchasthenakedstraddle.
TradeSummary
(Source:OptionVue6)TradeDetails
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(Source:OptionVue6)16Oct2009at11:00AM
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(Source:OptionVue6)20Oct2009at9:00AM
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(Source:OptionVue6)27Oct2009at9:00AM
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(Source:OptionVue6)28Oct2009at3:00PM
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(Source:OptionVue6)29Oct2009at3:00PM
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(Source:OptionVue6)30Oct2009at12:00PM
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(Source:OptionVue6)30Oct2009at3:00PM
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(Source:OptionVue6)5Nov2009at3:00PM
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(Source:OptionVue6)
WhyDoOptionTradesBetaWeightGamma,andnotThetaandVega?
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Mostoptiontraderscangetdelta,andeventheweightingfactor.Gammaseemstobedifferent;Ioftenhavenewoptionmentoringstudentswhodonothaveafullgraspofhowgammaworks,especiallywhencomparingsomethinglikeSPYandSPX.However,nowthatIhavewalkedthroughdeltaweighting,gammaweightingshouldbeabreeze.
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GoingbacktoSPYandSPX,wecanclearlyseewhygammamattersintheseverityofthepercentmovements.IfSPYdrops3dollarsfrom126to123,whatpercentageofadropisthat?Well,3/126isalmost2.5%.Thatisamassiveone-daydropinastock.The126strikewouldlikelydropfroma50deltatosomewhereinthe30–40deltarange.Thatwouldbeachangeindeltaofabout15
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deltasacontract.Thus,thegammawouldbeabout5.InSPXadropof3dollarswouldbetheSPXgoingfrom1260to1257,notexactlyexciting.Inthatprocessthedeltaofthe1260mightdropfrom50to48.5.Thatwouldbeagammaofabout.3.Samepointmove,verydifferentdeltaeffect.Thereasonisthepercentchangeintheunderlying.Three
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pointsintheSPXisabout.25%vs.2.5%intheSPY.Gammaisalwayssetfora1-pointmoveintheunderlyingregardlessofthesizeofthecontract.Itmightbeconfusingbutitworks,becauseiftheSPYwasdown3.00theSPXwouldneverbedown3,itwouldbedown30!Thenthechangeindeltasactuallymatchup:ForSPY:3*5=15deltas
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ForSPX:30*.5=15deltasThegammaisn’tweightedbecausethepricemovementoftheunderlyingproductsis!
VegaandThetaThiswillbeaquickandeasyone.Thetaandvegaaredirectlytiedtotheamountofpremiuminthecontract,nottheunderlyingproduct.Itisthisfunctionthatallowsustocrosshedge.IfIsell$3,000
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ofpremiuminSPYorSPXwith30daystodecay,thenthat$3,000needstogoawayin30daysregardlessofwhatproductitwassoldin.ItmaytakemorecontractsinSPY,butifthepremiumsarethesame,soshouldthethetasbe(savetheextradayoftradinginSPY).Thus,thetaistheta,regardlessofwhatproductitissoldin.Becauseofthisfunction,ifI
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amshort$3,000inpremiumIwillbeshortthesameamountofvegaorvolatilityexposure.Thus,ifIVgoesup1pointinSPYor1pointinSPXIwillhavethesameloss.Thus,vegaisvega,regardlessoftheproduct.Hopefullythismakesthingsalittleclearer.
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15.TheBeginningWe’vegotnewsforyou.Thisissupposedtobethefinalchapter,butitisn’t.AsBuzzLightyearfromDisney’sToyStorymoviewouldsay,“Toinfinityandbeyond!”Itisonlythefinalchapterofthebook,butnotthefinalchapterinyourquesttobuildThe
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OneManInsuranceCompany.Whenyoudecidetostartbuildingyourownoptionportfolioorhedgefund,youwillneverstoplearning.Thisbookisonlyoneofmanyyouwillreadonyourpathtobecomingasuccessfulmanagerinyouroptiontradingbusiness.Tobuildyourfundyoumustmasteralltheprimaryandsupportfunctionsofthe
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OptionTrader’sHedgeFundvaluechain.Makesureyouunderstandandareabletodothefollowing:
•Tradeselection•Riskmanagement•Tradeexecution
Also,makesurethatyouhaveinplacethesupportingfunctions:
•Tradingplan•Tradinginfrastructure
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•AprocessforlearningUnderstandvolatilityandusethisunderstandingtoobtainanedgeinyourtrades.Youshouldbeascomfortablereadingvolatilityasyouarereadingthespeedometerinacar.Learnallthedifferentoptionstrategies.Thenselectandusethestrategiesyouarecomfortableusing.Intime,likeakaratemaster,youwillmasterallthestrategies.
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However,asyoulearnandgrow,youwillfigureoutthat80%ofthetimeyouwilluse20%ofyourstrategyarsenal.Wesuggestthatyouuseverticalspreads,ironcondors,butterflies,calendar(ortime)spreads,andratiospreads.ThesearetheonesthatweusethemostattheOptionsTrader’sHedgeFund.InFigure15.1,wehavegivenyoutheframeworktosetup
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theOptionTrader’sHedgeFundasTheOneManInsuranceCompany(TOMIC).Manyofyouwouldsaythatitseemstobesimpleenoughandthatitisnotrocketscience.Butthemajoritywouldputtheideasasideandnotfollowthrough.Thisbusinessisnotforeveryone.Weappreciatethatyoutookthetimetoreadourbookandweappreciateyoursupportifyoupurchasedit.If
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youwouldliketoinvestlikeTOMICanddonotwanttodothework,youcanlookforfundsthathavesimilarinvestmentphilosophiesandoutsourceyourinvestmentdutiestothem.ForthoseofyouwhochoosetodevelopTOMIC,congratulationsinadvancefortakingthepathlesstraveled.
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Figure15.1.TheOptionTrader’sHedgeFundvalue
chain.
BuildingtheOptionTrader’sHedgeFundisabigendeavor.Dennisstartedand
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continuestogrowSmartIncomePartners,Ltd.,withalotofsmartwork,discipline,andcommitment.Markconstantlypushestheenvelopeinunderstandingandusingvolatilitytogainatradingedge.Bedisciplined.Usetheguidelinessetforthinthisbook.Usethebookasacollectionofsignpostsmarkingapath.However,rememberthatthepathneverendsandthatyourpathmight
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notbethesameasthepathforothers.Everyreadercouldhaveauniquepathbecauseeveryonehasadifferentwayofseeingtheworld.Soyourwaytomakingmoneytradingoptionsmightbedifferentfromours.Infact,evenwe(DennisandMark)havedifferenttradingstyles.Butourgoalisthesame,tomakemoneyconsistently.Thisisthebeginningofyour
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journey,ofyourquesttobecomeaTOMICtrader.Congratulationsagain.Neverstoplearningandimprovingyourskills.Followthepathtoconsistentprofits.
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A.RecommendedReadingOneofthequestionsMarkgetsfromhisoptionmentoringstudentsis,“Whatarethebestbookstolearnoptionstrading?”It’sagoodquestionbecausetherearehundredsofbooksoutthere
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allclaimingtobethebestoptionsbooks.Thetruthis,foreverygreatoptionsbooktherearenineortenthataretotaljunk.SohereareMark’srecommendedbooks,thosethatprovideenoughtheoreticalknowledgetobeatthelevelofadvancedoptionstrader.
Category1:TheStarter
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TheRookie’sGuidetoOptions,byMarkD.Wolfinger:Yesheisalittleirritablesometimes,butintheendthemancaresaboutpeople.Hewantstohelpnewtraders,andhewroteaprettygoodbeginner’sbook.Thereareotherdecentrookiesbooksoutthereaswell.OptionSpreadTrading,byRussellRhoads,andOptionsfortheStockInvestor,byJimBittman,arebothgreatbooks
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aswell.However,ifyouwanttopickone,MarkWolfingerismychoice.
Category2:GettingReadytoStartPaperTradingTradingOptionsasaProfessional,byJimBittman:Moremathematicalthanabeginnerbook,butlessmathematicalthanan
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advancedbook,butintheendbeautifullywritten,highlyeducational,andonefinebook.Wehaveyettofindanintermediate-levelbookthatisashigh-qualityasthisone.Hedidamasterfuljob.OneotherbookthatwelikeinthisclassisOptionsVolatilityTrading,byAdamWarner.Thisisprobablyoneofthehardestareastowriteinandbothoftheseauthorsdiditwell.
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Category3:ReadytoTradeOptionVolatilityandPricing,bySheldonNatenberg:Consideredbymostprofessionalstobethebibleoftheindustry,thisisthebest-writtenupper-levelintermediatebookavailableinthemarketplace.Thisshouldbeoneverytrader’sshelfandistheclosestthing
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toatextbookthatisactuallynotatextbook.TheothergreatbookisLarryMcMillan’sOptionsasaStrategicInvestment.Iftradersbuyonlyoneotherbook,Iwouldmakeitoneofthese.
Category4:AdvancedandMathematical
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DynamicHedging,byNassimTaleb:Muchmorenuts-and-bolts,andlesspreachythanhislaterbooks.Ifyouwanttounderstandadvancedconceptsofvolatility,thisisthesource.Togetanydeepermeansyouarereadingamathbook.WewouldalsosuggestJeffAugen’sTheOptionTrader’sWorkbookatthislevel.Itwillhelpyouapplyallthatyouhavelearned.
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Thereareseveralbooksthatdon’tfitintoanyofthesecategoriesthatareinterestingreads;however,theymakesenseassupplements.AnythingbyJeffAugeniswortharead.WhenJaredWoodardpublishes,wearesurethatitwillbegood,andpartsofCharlesCottle’slatestbookhavetremendousvalue.However,wewouldskiptheseuntilyouatleastgetthoughMcMillanor
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Natenberg.
OtherBooksThatMightBeUsefulThefollowingaresuggestionsmadebyDennistogiveyouawiderperspectiveoftheinvestmentworld:
AgainsttheGods:TheRemarkableStoryofRisk,byPeterBernstein.Thehistoryofrisk
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managementfromitsbeginningstotoday.OneUponWallStreet,byPeterLynch.Aninvestmentclassiconinvestinginequities.ReminiscencesofaStockOperator,byEdwinLefevre.Amustreadforanyprofessionaltrader.Itisaclassic.TheInnerVoiceofTrading,byMichael
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MartinTheTaxGuideforTraders,byRobertA.Green.AgoodreadforoptionandfuturetraderswhopayU.S.taxes.TradingforaLiving,byDr.AlexanderElderComeintoMyTradingRoom,byDr.AlexanderElder.Goodexamplesoftradingjournals.MoreMoneyThanGod,
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bySebastianMallaby.Ahistoryofhedgefunds.TheDailyTradingCoach,byBrettN.Steenbarger.Agoodbookontradingpsychology.TheCMEGroupRiskManagementHandbook,byJohnW.Labuszewski,JohnE.Nyhoff,RichardCo,andPaulE.Peterson.Thisisagoodreferencebook.
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TradingintheZone,byMarkDouglasTheSnowball:WarrenBuffettandtheBusinessofLife,byAliceSchroederTheParadoxofChoice:WhyMoreisLess,byBarrySchwartzTheDhandhoInvestor,byMohnishPrabaiTrendFollowing,byMichaelW.Covel
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TheIntelligentInvestor:TheDefinitiveBookonValueInvesting,byBenjaminGrahamDeepSurvival:WhoLives,WhoDies,andWhy,byLaurenceGonzales
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B.StrategyLearningSequenceTableB.1showsarecommendedsequenceforlearningthedifferentstrategies.
TableB.1StrategyDevelopment:P=
Proficient,E=Expert
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Youcanlearnallthedifferentstrategiesinanyorder,butthisisasuggestedguideline
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ofthesequencetofollowbasedonthelevelofcomplexityofthetrade.Itisjustlikelearningkarate.Youbeginwithzeroskillsasawhitebelt.Then,asyougainskills,youarepromotedtodifferent-coloredbeltsuntilyouobtainablackbelt.However,youarenotdoneatthispointandyouwillneverbedone.Therearemanylevelsofblackbelts;youhavejustbegunyourtraining.
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ForadetaileddescriptionofeachspreadyoucanrefertoOptionSpreadTradingbyRussellRhodes.
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C.OptionPit.com
OptionPitprovidestop-to-bottomoptiontradereducationconcentratingontraderswhowanttobecomefull-timeprofessionaltradersandtraderswhoarealready
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tradinglargeamountsofcapital.Wearefocusedonhelpingoptiontradersunderstandkeytradingskillsandtechniques,whilenotemptyingthetraders’accountstopayforeducation.Studentswhoenrollinanyofourserviceswillemergefromourprogramwithmoreconfidenceintheirabilitytotradeoptions.Weofferanarrayofcost-
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effectivemonthlynewsletterservices,educationalcourses,andindividualcourses:
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valuable.2.OurSilverpackageisdesignedtointroducethebasicconceptsthatallprofessionalsneedtoknow(andmostretailtradersdonotknow)withinthefirstmonthoftraining.Thisintroductorycoursewillintroduceconceptsthateventhemostexperiencedtradermay
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notfullyunderstand.Silverwillprovidethetraderwithanunparalleledfundamentaleducation.
3.OurGoldpackageisdesignedtoprovidetraderswiththemaximumamountofeducationattheminimumcost.TheknowledgetaughtinOptionPit’sGold
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Courseistheknowledgerequiredbyanyprofessionaltradingfirm.Goldisanintense,challenging,andrewardingliveeducationcourse.Itwillputthetraderinpositiontoactivelytradeandnotbelost.
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Goldalongwiththeone-on-oneguidancetradersneedastheybegintotradeactively.AnextrathreemonthsofOPLiveplusaminimumofsevenhoursofone-on-onetimewithourdemandingstaffwillensurethatoptiontradersareinapositiontosucceedwithoutgimmicks.Traderswill
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beabletotradeanymarket,fromcalmtovolatile.
5.OurProfessionalTrader’sClubisdesignedtoprovideprotraderswitheverythingtheyneedinordertoincreaseROI.Thisistheonlyprogramonthemarketthatfocusesonusingportfoliomargintoone’sadvantage.
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Tradersinthiscoursearetaughttothinkthree-dimensionallywhentrading.ThiscoursealsoincludesaccesstotheProTrader’sClub,acombinationofinstantmessaging,weeklygroupmeetings,andspecialdealsonsoftware.
Ourprogramsfocusonour
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threepillarsthatmakeasuccessfulprofessionaloptiontrader:TradeStructure,RiskManagement,andEfficientUseofCapital.Callusat888-TRADE-01(872-3301)orreadaboutourOptionTraderMentoringProgramsatwww.optionpit.com.Asaspecialintroductoryoffertothepurchasersofthisbook,OptionPit.comisofferingyouonemonthof
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OptionPitLiveaccessfree.UsecodeTOMIC1whensubscribingtotheservice.
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D.KiteSpreadAkitespreadinvolvesthebuyingofalongoptionbelowwheretheshortspreadiscurrentlyplacedandthensellingmoreoftheoriginalspreads(nowatahighercredit)againstthelongpositioninanattempttopayformuchofthecostofthelongoption.Generally,thetrader’sgoalshouldbetopay
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foratleasthalfofthelongoptioninordertoreducecost.Ithassimilarcharacteristicstoaratiospread,buthaslessvegaandexplosivegamma.FigureD.1showscallcreditspreadandoverlaysthekitespreadadjustment(theonethathasapointlikeakiteatthe1390price).
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FigureD.1Riskprofileoftheverticalcallcredit
spreadoverlaidbythekitespreadadjustment.(Source:
OptionVue6)
Benefits:
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Thetradeislonggamma,andastheunderlyingralliesshortvega,itinmanywaysactslikearatiospread.Astimepasses,thetradewillbecomelongergammaandwillcontinuetohedgetheposition.Thetradeisrelativelyinexpensive,hedgeseffectively,andhassomewhatpredictable
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returns.Itdoesnotaddnearlyasmuchriskasrollingbackandrampingupsize.
Detractions:Thereisa“sourspot”wherethistradecanlosemoney.Itaddstomargin.Itdoesnotaddalotofgamma.
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Isalmostimpossibletoexecuteonthedownsideofacondorasthespreadreliesonverticalskewtomakethecallspreadsproduceenoughcredit.
Execution:Buy1callbelowthespread.Sell2-3callspreadsaddingtothespread.InFigureD.2,weboughtone
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1370andsoldthree1390/1400callspreads.
FigureD.2Kitespreadtradeexecution.(Source:
OptionVue6)Oncethetradeison,leaveitonuntiltheentiretradeisunwound.Itisacheap
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enoughadjustment;itisworthkeepingonthroughthetrade.
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Index
Numerics2008financialcrisis(UnitedStates),38401(k)plans,47
Aaccess
leverage,67redundantInternet
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connections,71accounts
futures,71trades.Seetrades
acquisitioncustomers,6,7risks,14
actions,corporate,87actuarialtables,11addressablerisks,37-38adjusting.SeemodifyingAFLAC,21
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AgainsttheGods:TheRemarkableStoryofRisk,196AIG,20
bailouts,13systemicrisk,37
Allstate,21analysis
results,75tools,69-70trades,66
Apple,38,74
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arbitrage,159assignment,157-161ATM(at-the-money)options,47
ironbutterflies,100-108straddles,140volatility,84-86
attacks,terrorist,38at-the-moneyoptions.SeeATM(at-the-money)optionsAugen,Jeff,196autoinsurance,tooptions
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comparisons,9averages,76
records,75avoidinglong-termriskplays,136
Bbackmonths,136backtraders,70,97backupplans,70-71badtrades,34,36bailouts,AIG,13
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basketofequities,22.SeealsoETFs(exchange-tradedfunds)batterybackups,71bearmarkets,verticalspreads,90benchmarkindexes,75benefitsofkitespreads,204BerkshireHathaway,8,39.SeealsoBuffett,WarrenBernstein,Peter,196bestavailabletrades,126Bittman,Jim,95,195
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Black-Scholesmodel,81blackswanevents,38-41BPAmoco,35
GulfCoastoilspill,38brokers
multiple,71platforms,65-67selection,49-50
Buffett,Warren,8,57riskmanagement,33
bullcallspreads,28,52,89-93,122
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bullmarkets,verticalspreads,90butterflies,41,52,64,90
iron,ATM(at-the-money)options,100-108risk,165-167tradingchecklists,163-
165buying
calls,159kitespreads,203-204puts,85,159
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Ccalculations
Greeks,69livingexpenses,170portfoliomargins,67
calendarspreads,52,64,108-114,123
SPXindexoptions,161-163weekendtimevalue
premiumdecays,149-152calls
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assignments,157buying,159parity,160selling,85VIXoptions,45
capitalgains,21risk,63-65
CardGameValue,146-147cashpositions,145-146catastrophes
events,44
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relatedlosses,20,38CaymanIslands,29-30CBOE(ChicagoBoardOptionsExchange),23,28,51
volatility,94CDSs(creditdefaultswaps),13,20characteristicsofbrokers,65charts,66checklists
butterflytrading,163-
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165functions,60
Chevron,35ChicagoBoardOptionsExchange.SeeCBOEclaimsprocessing,6-7CMEGroupRiskManagementHandbook,The,197CNBC,78Co,Richard,197coaches,hiring,79Coca-Cola,74
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companyrisk,37-38comparisons
autoinsurancetooptions,9valuechains,14
computers,backup,71conditions
ATMironbutterflies,100-105calendarspreads,109ironcondors,93-98markets,43-44
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ratiospreads,115verticalspreads,91
condors,41,64iron,52,66,90,93-100,
122cashpositions,145impliedvolatility,
138-140RUT,35strangles,134
confidence,management,56-58connections,Internet,71
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ConocoPhilips,35consistency,65.Seealsodisciplinecontinuingeducation,79-80contracts
insurance,9.Seealsoinsurancestrikes,43termstructures,87-88
convertingOEX/SPX,176corporateactions,87costofcarry,81,160
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Cottle,Charles,196Covel,MichaelW.,197crashes,flash,39,45creditdefaultswaps,13,20.Seealsoswappingcustomers
acquisition,6-7service,66
customizinglayouts,67
DDailyTradingCoach,The,
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197daysintrade(DIT),76decay,95
gammascalping,179weekendtimevalue
premium,149-152decision-makingskills,57dedicatedspace,70dedication,57definingtradingstyles,60-62deltas,103,175
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delta-neutraltrades,52management,169spreads,140
de-riskingportfolios,152designingtrades,48-49detractionsofkitespreads,204DhandhoInvestor,The,197diagonals,64
double,52discipline,56
exercising,58-60
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marketconditions,43-44DIT(daysintrade),76diversification,portfolios,35-36dividends,87doublediagonals,52,134Douglas,Mark,197durationoftrades,29.SeealsotimeDynamicHedging,196
E
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earnings,87easy-to-useinterfaces,66education
continuing,79OptionPit.com,201-202
Elder,Alexander,33,197emotions,conquering,56Enron,38enteringorders,49-54entryparameters,62equities,21
optionson,24-25
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ETFs(exchange-tradedfunds),21-24evaluating
months,46products,47skews,47
eventsblackswan,38-41catastrophic,44macro,38
Excelexternallinksto,67
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tradingjournalsas,73-77
exchange-tradedfunds(ETFs),21-24execution
kitespreads,204trades,15-16,43,126-
129designing,48-49evaluatingmonths,
46impliedvolatility,
44-46
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maintainingdiscipline,58-60
marketconditions,43-44
orderentry,49-54product
evaluations,47skews,47TOMIC(TheOne
ManInsuranceCompany),122
volatility,44exits
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calendarspreads,112parameters,62ratiospreads,116strategies,168-169
expectationsmarkets,46payouts,76
expirationcalendarspreads,110timeto,81
exposure,portfoliodiversification,35-36
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externallinkstoExcel,67Exxon-Mobil,35
FFDA(FederalDrugAdministration)announcements,87feedback,74,77findingvolatilityskews,137firstlook,definitionof,156fixedpricing,30flashcrashes,39,45
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flatteningdeltas,103flexibility,57,68Florida,29-30focus,importanceof,170-172forwardvolatility,81.Seealsovolatilityframeworks,5frontmonths,87,136frontspreads,115-119functions.Seealsoprocesses
checklists,60
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ofinsurancecompanies,6TOMIC(TheOneMan
InsuranceCompany),17ofvaluechains,15
futures,21accounts,71VIXoptions,136
Ggammas,40,102,132
scalping,176-190
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GE(GeneralElectric),74GEICO,8,21GeneralRe,8,39goals,61
ATMironbutterflies,103calendarspreads,111ironcondors,96ratiospreads,116TOMIC(TheOneMan
InsuranceCompany),122Greeks,173-174
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calculations,69gammascalping,176-
190management,64portfolios,weighting,
175-176Green,RobertA.,197groups,joining,78guidelines.Seealsorules
butterflywings,165-167discipline,market
conditions,43-44positionsizing,34-35
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Hhedgefunds,1-2,5,47highskews,137.Seealsoskewshiringcoaches,79historicalvolatility(HV),44holdingpositions,147-149humility,57HurricaneKatrina,19hurricanes,29
pricing,30HV(historicalvolatility),44
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Iimpliedvolatility,44-46,81,131.Seealsovolatility
ironcondors,138-140indexes,21-23
benchmark,75skew,86SPXindexoptions,
weightedvegas,131-134individualretirementaccounts(IRAs),47informationresources,69-
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70infrastructure,trades,17-18,63
analytictools,69-70backupplans,70-71dedicatedspace,70platforms(brokers),65-
67portfoliomargins,67-68riskcapital,63-65
InnerVoiceofTrading,The,197insurance
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ATMironbutterflies,102autotooptions
comparisons,9blackswanevents,38-
41howmoneyis
lost,12-14made,8-12
hurricanes,29operations,8-12overviewof,5-8portfolios,38
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pricing,44success,driversof,14-
18interfaces,easy-to-use,66intermediateoperators,64InternalRevenuecode,21Internetconnections,71in-the-moneyoption.SeeITMoptionIntra-Monthskews,165investments
operations,6,8,14
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profits/losses,12IRAs(individualretirementaccounts),47ironbutterflies,122
ATM(at-the-money)options,100-108
ironcondors,52,66,90,93-100,122
cashpositions,145impliedvolatility,138-
140IronCondorSpreadStrategies,93
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ITM(in-the-money)option,12,45
ATMironbutterflies,89
JJobs,Steve,38JohnsHopkinsHospital,59joininggroups,78Jordan,Michael,57journals,trades,73-77
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KKatrina(Hurricane),19Kennedy,Kevin,136King,Rawle,19kitespreads,97,203-204kurtosis,84.Seealsoskews
LLabuszewski,JohnW.,197layouts,customizing,67learningprocesses,73
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sequencestrategies,199-200soundingboards,77-80tradingjournals,73-77
Lefevre,Edwin,196leverage,access,67links
toExcel,67real-timedata,74
liquidETFs(exchange-tradedfunds),22Livevol,133
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livingexpensecalculations,170locations,backup,71logs,trading,73-77longcalendars,110.Seealsocalendarspreadslongoptions,kitespreads,203-204longterm-riskplays,avoiding,136losses,127.Seealsoprofits
catastrophe-related,20insurancecompanies,
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12-14ironcondors,97ratios,76reducing,36
lowskews,137.Seealsoskewsluck,58Lynch,Peter,196
Mmacroevents,38maintainingrecords,73-77
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makertakermodelexchanges,51Mallaby,Sebastian,197management,5
deltas,169Greeks,64importanceoffocus,
170-172risk,14-16,31-32,62,
68addressablerisks,
37-38blackswanevents,
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38-41cashpositions,145-
146modifyingtrades,
36money
management,33-34overviewof,32-33portfolios,35-36,
152positionsizing,34-
35TOMIC(TheOne
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ManInsuranceCompany),122styles,60-62TOMIC(TheOneMan
InsuranceCompany),56-58tradingjournals,73-77
margins,66portfolios,67-68trades,98
marketingfees,155marketmakers,82,151markets
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conditions,43-44expectations,46risks,37selection,20-25TOMIC(TheOneMan
InsuranceCompany),122verticalspreads,90
Martin,Michael,197maximumlosses,127McMillan,Larry,196measuringoutcomes,59mentaltoughness,57
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modelsBlack-Scholes,81pricing,81volatility,88Whaley,81
modifyingpositions,148trades,36
moneymanagement,33-34monitoring.Seealsojournals
variables,75
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volatility,88months
back,136evaluating,46front,136
MoreMoneyThanGod,197mortgage-backedsecurities,13,20multiplebrokers,71multiplestrikes,51
N
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Natenberg,Sheldon,196neutralizers,132nontraditionalspreads,52Nyhoff,JohnE.,197
Oofficespace,70one-by-twocallspreads,98one-to-oneriskrewards,167OneUponWallStreet,196operations
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insurance,8-12investments,6,8,14TOMIC(TheOneMan
InsuranceCompany),121-122
operatorsintermediate,64professional,64semiprofessional,64
OptionPit.com,131,134-135,140,147,155,157,175,201-202options
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ATM(at-the-money),47ironbutterflies,
100-108volatility,84-86
autoinsurancecomparisons,9onequities,24-25ITM(in-the-money),12,
45,89long,kitespreads,203-
204OTM(out-of-the-
money),10,12,39,84
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portfolios,weighting,175-176primarytaxadvantaged
index,22SPXindex,Weighted
Vegas,131-134VIX,45,94weekly,28
OptionsasaStrategicInvestment,196OptionsfortheStockInvestor,195OptionSpreadTrading,195
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OptionsVolatilityTrading,195OptionTrader’sWorkbook,The,196OptionVolatilityandPricing,196Optionvue,70orderflow,payments,155-157orders
entries,49-54trades,sizing,53working,53-54
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OTM(out-of-the-money)option,10,12,39,84
gammascalping,181outcomes,measuring,59out-of-the-moneyoption.SeeOTMoption
Ppanics,40ParadoxofChoice,The:WhyMoreisLess,197parameters
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entry,62exit,62tradingplans,61
parity,put-call,160payments,orderflow,155-157payouts,expectations,76pensionfunds,47Peterson,PaulE.,197Petrobras,35piranhathreats,33planning
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backupplans,70-71preparingtotradefora
living,169-170riskcapital,63-65trades,55,122-124
confidenceofmanagement,56-58
definingstyles,60-62
exercisingdiscipline,58-60
platforms,brokers,65-67portfolios,127
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blackswanevents,38-41diversification,35-36exitstrategies,168-169insurance,38management,56-58,64margins,67-68riskmanagement,152units,39-41weighting,175-176
positionsassignment,157-161
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cash,145-146holding,147-149monitoring,74risk,161short,40sizing,34-35volatility,monitoring,88
Prabai,Mohnish,197predictions,volatility,40premiums,8.Seealsoinsurancepreparingtotradefora
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living,169-170pricing,6,48-49
ATMironbutterflies,101insurance,44models,81tradeselection,29-30VIXoptions,45
primarytaxadvantagedindexoptions,22processes
discipline,maintaining,58-60
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learning.Seelearningprocesses
products,evaluating,47professionaloperators,64profiles,risk,103.SeealsoriskProfitandLosssummaries,8profits,76
insurancecompanies,8-12monitoring,75successdrivers,15
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Pronovost,Peter,59protectionagainstblackswanevents,39.Seealsoblackswaneventsputs
buying,85,159parity,160spreads,98
Rrates,taxes,21ratios
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loss,13spreads,98,115-119,
123strangles,134win/loss,76
rawvegas,132real-timedatalinks,74recommendedreading,195records,maintaining,73-77reducing
losses,36volatility,180
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redundantInternetconnections,71Reg-T,67
portfoliomargins,68reinsurance,6-7,38relationships,volatility,87ReminiscencesofaStockOperator,196reputations,66reserves,13-14resources
information,69-70
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recommendedreading,195
results,analysis,75reversion,46Rhoads,Russell,195risk,5.Seealsolosses;profits
acquisition,14ATMironbutterflies,
103butterflies,165-167calendarspreads,111capital,63-65
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cashpositions,145-146long-termriskplays,
avoiding,136management,14-16,31-
32,62,68addressablerisks,
37-38blackswanevents,
38-41modifyingtrades,
36money
management,33-34
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overviewof,32-33portfolios,35-36,
152positionsizing,34-
35TOMIC(TheOne
ManInsuranceCompany),122one-to-oneriskrewards,
167positions,161ratiospreads,116selection,14
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subprimemortgages,14typesof,37underwriting,6
Rookie’sGuidetoOptions,The,195rules
positionsizing,34-35riskmanagement,33sharkthreats,34styles,defining,60-62ThirdThirdThirdRule,
97
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trades,43.Seealsotrades
RUTcondors,35
SSalomonBrothers,57scalpinggammas,176-190Schroeder,Alice,197Schwartz,Barry,197Sebastian,Mark,131,134-135,140,147,155,157,161,175
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Section1256oftheInternalRevenueCode,21sectors,risks,37securities,mortgage-backed,13selection
brokers,49-50market,20-25risks,14strikes,48trades,15,19-20
ETFs(exchange-tradedfunds),22-24
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indexes,21-23optionsonequities,
24-25pricing,29-30strategies,25-28timeframes,28-29volatility,29
sellingcalls,85semiprofessionaloperators,64September11,2001,attacks,38services,customers,66
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sharkthreats,33shortpositions,40simulators,70singleoptiontrades,52sizing
positions,34-35tradeorders,53
skews,84-86ATMironbutterflies,
101-102calendarspreads,109evaluating,47
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Intra-Month,165ratiospreads,115SPXindexoptions,137-
138viewing,70volatility,134-135
stagesof,140-144tracking,137
skills,decision-making,57smallorders,filling,51Snowball,The:WarrenBuffettandtheBusinessofLife,197
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soundingboards,77-80specialists,options,65speeddial,71spreads,51
calendar,52,64,108-114,123
SPXindexoptions,161-163
weekendtimevaluepremiumdecays,149-152delta,140front,115-119
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ironcondors.Seeironcondorskite,97,203-204one-by-twocall,98puts,98ratios,98,115-119,123time,41vegas,135vertical,28,52,89-93
SPXindexoptionscalendarspreads,161-
163
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skews,137-138weightedvegas,131-134
stagesofvolatilityskews,140-144StateFarm,21Steenbarger,BrettN.,197straddles,52
ATM(at-the-money)options,140
strangles,52,104condors,134ratios,134
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strategies,61,89ATMironbutterflies,
100-108calendarspreads,108-
114CardGameValue,146-
147cashpositions,145-146discipline,market
conditions,43-44exits,168-169frontmonths,136frontspreads,115-119
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holdingpositions,147-149ironcondors,93-100learningsequences,199-
200ratiospreads,115-119riskmanagement,37.
Seealsomanagement;risksimulators,70TOMIC(TheOneMan
InsuranceCompany),122-123trades,25-28,48-49
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vacations,152-153verticalspreads,89-93weekendtimevalue
premiumdecays,149-152stresstests,67strikes
butterflywings,167contracts,43multiple,51price,81selection,48
structures,term,87-88
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styles,trading,60-62subprimemortgages,13-14successdriversofinsurance,14-18Sullenberger,ChesleyB.,58swapping
trades,88volatility,87
systemicrisk,37
Ttables,actuarial,11
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Taleb,Nassim,196TaxGuideforTraders,The,197taxrates,21TDAmeritrade,Inc.,139termstructures
viewing,70volatility,87-88
terroristattacks,38tests,stresstests,67TheOneManInsuranceCompany.SeeTOMIC
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thetas,gammascalping,190ThinkorSwim,70ThirdThirdThirdRule,97three-dimensionalvolatility,83-88time
toexpiration,81frames,tradeselection,
28-29ratiospreads,116spreads,41,108-114
TOMIC(TheOneManInsuranceCompany),2,5.
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Seealsotradesde-risking,152exitstrategies,168-169functions,17ironcondors,95learningprocesses,73management,confidence
of,56-58operations,121-122portfoliodiversification,
35-36riskmanagement,31,
38.Seealsomanagement;
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risktrades.Seealsotrades
execution,43,126-129
planning,122-124timeframes,28
tradingplatforms,65-67valuechains,14,17
tools,analysis,69-70trackingvolatility,76,88,137.Seealsomonitoringtrades
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analysis,66ATMironbutterflies,
104bad,34,36bestavailable,126butterflychecklists,163-
165CardGameValue,146-
147coaches,hiring,79delta-neutral,52execution,15-16,43,
126-129
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designing,48-49evaluatingmonths,
46impliedvolatility,
44-46marketconditions,
43-44orderentry,49-54product
evaluations,47skews,47volatility,44
exitstrategies,168-169
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gammascalping,176-190groups,joining,78holdingpositions,147-
149infrastructure,18,63
analytictools,69-70
backupplans,70-71
dedicatedspace,70platforms(brokers),
65-67
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portfoliomargins,67-68
riskcapital,63-65journals,73-77margins,98modifying,36orders,sizing,53planning,55,122-124
confidenceofmanagement,56-58
definingstyles,60-62
exercising
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discipline,58-60positionsizing,34preparingtotradefora
living,169-170riskmanagement,32-33selection,15,19-20
ETFs(exchange-tradedfunds),22-24
indexes,21-23optionsonequities,
24-25pricing,29-30strategies,25-28
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timeframes,28-29volatility,29
singleoption,52swapping,88tradingdesks,66typesof,52vacations,152-153
TradingforaLiving,197TradingintheZone,197TradingOptionsasaProfessional,95,195transitions,ironcondors,95
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TrendFollowing,197types
ofrisks,37-38oftrades,52
Uunderlyingprice,81
ironcondors,93underwriting,6,8,20-25
profits/losses,13unemployment,20units,86
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portfolios,39-41USAirways,57
Vvacations,152-153valuechains,TOMIC(TheOneManInsuranceCompany),14,17variables,monitoring,75vegas,40
gammascalping,190spreads,135
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verticalspreads,28,52,89-93,122viewingskews,70VIXoptions,45,94
volatility,135-136volatility,29,81,131
ATM(at-the-money)ironbutterflies,101options,84-86
calendarspreads,109causeof,81-83implied,44-46,131
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ironcondors,93,138-140marketconditions,43-44models,88monitoring,88portfolios,152.Seealso
portfoliospredictions,40pricing,29.Seealso
pricingreducing,180skews,84-86,134-135
SPXindexoptions,
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137-138stagesof,140-144tracking,137
SPXindexoptions,131-134termstructures,87-88three-dimensional,83-88trades
execution,44selection,29
VIXoptions,135-136volume,skews,138.Seealso
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skewsvomma,84,87
WWarner,Adam,195Websites,resourcesandanalytictools,69-70weekendtimevaluepremiumdecays,149-152weeklyoptions,28weightedvegas,SPXindexoptions,131-134
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weightingportfolios,175-176Whaleymodel,81wings,butterflies,165-167.Seealsobutterflieswinratios,76Wolfinger,MarkD.,195Woodard,Jared,93,196Woods,Tiger,57workingorders,53-54workspace,70WorldTradeCenter,9/11attacks,38
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