the option trader’s hedge fund: a business framework for...

TheOptionTrader’s

HedgeFundABusinessFrameworkforTradingEquityandIndex

Options

DennisA.Chen

MarkSebastian

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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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LibraryofCongressCataloging-in-PublicationData

Chen,DennisA.(DennisAnthony),1970-Theoptiontrader’shedgefund:abusinessframework

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

332.64’524--dc232012007222

ForMelinda,Thankyoufor

encouragingmeandstandingbyme

inallofourendeavors.FormypartnersatSmartIncomePartners,Ltd.,

Thankyouforyourtrustandsupport.Thankyouforbelievingandinvestinginour

business.—Dennis

ToLauren,thankyouforputtingupwithmethroughthickandthin;withoutyouallofthis

isnothing.Tomyparents,thankyouforpushingmetoconstantlytryto

exceedexpectationsandnever

settle.Tomyson,maythe

roadthatliesaheadbeallyoucouldhopefor.Tomypartner,co-workers,andallofthoseassociatedwith

OptionPit,thankyouformakingwhatIdonotseemlike

work.—Mark

ContentsIntroduction

Endnote

PartITheFramework

Chapter1TheInsuranceBusiness

HowInsuranceCompaniesMakeMoneyHowInsurance

CompaniesLoseMoneySuccessDriversoftheInsuranceBusiness

Chapter2TradeSelection

MarketSelectionStrategySelectionTimeFrameVolatilityPricing

Endnote

Chapter3RiskManagement

RiskManagementMoneyManagementPositionSizingPortfolioDiversificationAdjustingtheDifferentTradesAddressableRisks

InsuringthePortfolioAgainstBlackSwanEvents

Chapter4TradeExecution

ConditionsoftheMarketEvaluatePotentialRealizedVolatilityEvaluateImpliedVolatilityEvaluatetheMonths

EvaluatetheSkewEvaluateOtherProductsTradeOrderEntry

Chapter5TheTradingPlan

TheMind-SetTheImportanceofStickingtotheProcessQuestionsYour

TradingPlanShouldAnswerEndnotes

Chapter6TradingInfrastructure

RiskCapitalTheTradingPlatform(Broker)PortfolioMarginInformationResourcesandOtherAnalyticalTools

DedicatedSpaceBackupPlans

Chapter7LearningProcesses

TheTradingJournalSoundingBoardEndnote

PartIIImplementingtheBusiness

Chapter8UnderstandingVolatility

WhatCausesVolatility?Three-DimensionalVolatilityandtheModel

Chapter9MostUsedStrategies

TheVerticalSpreadTheIronCondorTheATMIronButterflyTheCalendarSpread

orTimeSpreadTheRatioBackandFrontSpreadEndnote

Chapter10OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ

TradingPlanExecutingtheTradingPlan

PartIIILessonsfromtheTradingFloor

Chapter11LessonsfromtheTradingFlooronVolatility

UnderstandingWeightedVegasinSPXIndexOptionsTakingontheSkewFourTipsWhentheVIXCashIsDepressed

HowtoFindandTrackVolatilitySkewSPXSkew:It’sAllRelativeUnderstandingImpliedVolatilityinIronCondorsTheStagesofSkew

Chapter12LessonsfromtheTradingFlooronRiskManagement

CashIsaPosition

TheCardGameValueWhyAreOptionTradingHandsSoHardtoSitOn?HowOptionTimeValuePremiumDecaysovertheWeekendWhenIstheTimetoDe-riskYourPortfolio?HowtoTradeWhenYouGoonVacation

Chapter13LessonsfromtheTradingFlooronTradingandExecution

WhatEverybodyShouldKnowAboutPaymentforOrderFlowWhenShouldYouWorryAboutAssignment?ASuccessfulShortSPXCalendarButterflyTrading

ChecklistWhatIstheProperWidthforanIndexButterfly’sWings?TheImportanceofGoodExitsPreparingtoTradeforaLiving,HowMuchCapitalIsNeeded?TheImportanceofFocus

Chapter14Lessonsfrom

theTradingFloorontheOtherGreeks

WhatHappenstotheGammaofITMorOTMOptionsWhenIVIncreases?WhyDoINeedtoWeightMyOptionPortfolio?GammaScalping

Chapter15TheBeginning

AppendixARecommendedReading

Category1:TheStarterCategory2:GettingReadytoStartPaperTradingCategory3:ReadytoTradeCategory4:AdvancedandMathematicalOtherBooksThat

MightBeUseful

AppendixBStrategyLearningSequence

AppendixCOptionPit.com

AppendixDKiteSpread

ForewordAsDirectorofResearchandCo-PortfolioManagerofJimCramer’sCharitableTrust,Icontinuouslylookformoreeffectivewaystooverseethefundandimprovereturns.Althoughitisalong-onlyequityfund,itisimperativetohaveaworkingknowledgeofallassetclassesandtheireffectsonthebroadermarket

andtradingpsychology.Oneofthemostimpactfulmetricsofmanagingmoneyintoday’smarketis,withoutquestion,volatility.Volatilityasanassetclassisarapidlygrowingconceptinthemarketplace.Indexesandproductshavebeenintroducedtotrade,hedge,anduseasforecastingmechanisms.Financialmediacommonly

portraystheVIX,orCBOEVolatilityIndex,asanindicationof“fear”inthemarket.Typically,whentheVIXistradinghigher,stocksaremovinglowerandtheinverseapplies.Yetitisfarmoreimportantthanthat,astheVIXandvolatility-basedproductshavebroughtthemarkettoitsnextstageofevolution.TheChicagoBoardOptions

ExchangebeganitsacademicworkontheVIXintheearly1990s.Today’sindexhasevolvedintoaproductwithfuturesandoptionscontractsbasedontheS&P500,whichallowsforamoreaccurateviewofinvestors’expectationsonfuturemarketvolatility.Followingthefinancialmeltdowninthebackhalfof2008,impliedvolatilityexplodedasthemarketimploded,andthatis

whenmarketparticipantsembracedvolatilityasadiversificationtool.Otherexchangeshavenowdevelopedtheirownfuturesandderivativesproductsacrossmultipleassetclassesandcommodities,includingcurrency,gold,andoil.MarkSebastianistrulyamasteroftradingoptionsandfuturesonvolatilityderivatives.Whenitcomesto

thetechnicalsubtletiesofcomplicatedmarkets,hisanalysisandabilitytobreakdownthemathematicalandquantitativecomplexitiesinanintelligentandunderstandablestyleissecondtonone.Markforcesyoutothinkindifferentwaysabouttheoptionandfuturesmarkets,ofteninwaysthatareoutsidethecomfortzone.Forthisbook,Markjoined

forceswithhisfriendDennisChenandconvincedhimtosharetheframeworkandprocessesusedwhenmanaginghishedgefund.Bydoingso,theyprovideyouwithareal-worldperspectivetothebusinessoftradingoptions.AlbertEinsteinsaid,“Anyintelligentfoolcanmakethingsbigger,morecomplex,andmoreviolent.Ittakesa

touchofgenius—andalotofcourage—tomoveintheoppositedirection.”MarkandDennis’suncannywaytoconsistentlycomeupwithout-of-the-boxstrategiesencouragestraderstodigdeepandreallyunderstandtheworldofderivative-basedproducts.Frommyperspective,MarkandDennis’sideas,strategies,framework,andconceptsaresophisticatedyeteasyto

understandandimplement,whichisinvaluablewhentryingtobeatthecompetitionandthebroaderaverages.TheOptionsTrader’sHedgeFundisauniquetoolthatcarefullyexplainshowtraderscaneffectivelyidentifyandmanagepositionslikethetopvolatilityexpertsdousingkeystrategiesintrend,time,andvolatility.Asuniqueasitsauthors,itencourages

investorstoembracetheirindividualitywhendevelopingatradingplananddisciplinefortradingoptions.Acaptivatingandmasterfulread,TheOptionsTrader’sHedgeFundisamust-haveguidethateveryprofessionaltradershouldhaveinhisorherlibrary.Thebiggesttakeawayscenteronmethodology,riskcontrol,andeffectiveuseofcapital—

thecornerstonesforsuccessfulmoneymanagementandtrading.Tradewell,StephanieLinkDirectorofResearch,Co-PortfolioManager,&VPofStrategyTheStreet

AcknowledgmentsThisbookistheresultofasetofexperiencesthatwehavecollectedovertheyears.Whetherknowinglyorunknowingly,manypeopleandorganizationshavedirectlyandindirectlyhelpedshapethecontentofTheOptionTrader’sHedgeFund.Wewouldliketothankthefollowingpeopleand

organizationsforsharingwithusexperiencesthathelpedcreatethisbook:

•AdamParis,CofounderoftheOptionPit.com

•AlexanderElder,TradingCoachandauthorofTradingforaLiving

•JimBoyd,ExecutiveEditor,FTPress

•CheriClark,CopyEditor,FTPress

•BetsyHarris,ProjectEditor,FTPress

•HarryStrachan,PartneratBain&Co.andMesoamericaPartners

•JeremySiegel,FinanceProfessorattheWhartonSchoolandauthorofStocksfortheLongRun

•KerryLovvorn,TradingCoach

•Livevol

•OptionVue•PaulHayward,MichaelShore,NinaYoo,andtheCMEGroup’sCorportateCommunicationsteam

•RobbieGarcia,Cofounder,SmartIncomePartners,Ltd.

•RobertWalberg,StephanieLink,JillMalandrino,andTheStreet

•ShawnandShellyHowton,ProfessorsatVillanova

•TheChicagoMercantileExchange

•TheChicagoBoardOptionsExchange

•TheOptionsInstitute•TheteamatFTPresswhoassistedintheproductionofthisbook

•TDAmeritradeand

ThinkorSwim

AbouttheAuthorsDennisA.Chenisahedgefundmanager,investor,managementadvisor,andentrepreneur.HeisthefounderandChiefInvestmentOfficerofSmartIncomePartners,Ltd.,ahedgefundspecializingingeneratingincomeusingindexand

equityoptions.Dennishasbeeninvestingandtradingequitiesandoptionsformanyyears.HehaspreviouslyservedasamanagementconsultantatBain&Companywherehefocusedonfinancialservices(bankingandinsurance).HewasaprincipalatDiamondTechnologyPartners,Inc.Asanentrepreneur,Dennishaspurchased,improved,andsoldseveralsmallbusinesses.

Hehasexperienceinmultipleindustries,includingbanking,insurance,realestate,computertechnology,Internet,publishing,advertising,construction,commodities,quick-servicerestaurants,andautomotive.Hisbroadbusinessexperienceenableshimtomakebetterinvestmentdecisionsathishedgefund.DennisearnedhisMBAfromTheWhartonSchoolof

Business.HealsoholdsaMaster’sinComputerSciencefromArizonaStateUniversityandaBachelor’sdegreeincomputersciencefromtheUniversityofTexas.MarkSebastianisaformermemberofboththeChicagoBoardOptionsExchangeandtheAmericanStockExchange.HeistheChiefOperatingOfficerofOptionPitMentoringand

Consulting,aChicago-basedoptioneducationfirm.SebastianhasbeenpublishednationallyonYahoo!FinanceandhasbeenquotedinTheWallStreetJournal,Reuters,Bloomberg,andonJimCramer’sMadMoneyshowonCNBC.HehasappearedonCNBC,FoxBusiness,andBloomberg.Heisan“all-starcontributor”forTheStreet’sOptionProfitsTeam.MarkisalsotheManagingEditorfor

ExpiringMonthly:TheOptionTradersJournaldigitalmagazinefocusedexclusivelyonoptionstrading.HehasspokenfortheCBOE,theISE,CME,andVOLX;isaco-hostonthepopularOptionBlockpodcast;andtheVolatilityViewspodcast.MarkhasaBachelor’sofScienceinfinancefromVillanovaUniversity.

PrefaceTheideaofthisbookbeganinLasVegasin2010.MarkandIwereattendingaconferenceandwewereworkingongrowingourrespectivebusinesses.Markisthefounder,COO,andDirectorofEducationatOptionPit.com.HeisaformermarketmakerattheCBOEandAMEX.Hehas

appearedonCNBC,FoxBusiness,andBloomberg.HehasalsobeenquotedinTheWallStreetJournalandisafeaturedcontributoratOptionProfitsofTheStreet.com.Heisanexpertinthefieldofoptionstrading.Ontheotherhand,Iammoreofabehind-the-scenesguy.IoperatemorelikeaKGBorCIAoperative.Uptonow,youwouldhaveknownwhatIhavebeendoingonlyifyou

wereapartneratmyhedgefund.Itradeoptionsforaliving.Iamtheco-founderandChiefInvestmentOfficerofSmartIncomePartners,Ltd.,ahedgefundthattradesoptionstogenerateconsistentincomeforitspartners.IearnedanMBAfromTheWhartonSchool.Ihaveexperienceinmanydifferentbusinesses,includingfinancialservicesandinsurance,thatIgainedasa

managementconsultantatBain&Co.andasanentrepreneur.MarkandIshareapassionfortradingoptionsprofitably.Wehavereadmanybooksonoptionsandoptionstrading.Mostofthemanswerthequestionof“what”optionsare.Theyareverydescriptiveandprovideusefulinformation.However,rarelydoyoufindabookthat

answersthequestionof“how”tomakemoneyinanoptiontradingbusiness.Howdoyoudeveloptheframeworkforanoptiontradingbusiness?Howdoyouimplementasystem?Howdoyouactuallytrade?Howdoyoumakemoneyconsistently?Howdoyoubuildabusinessoutoftradingoptions?Giventhatvoid,wedecided

towritethisbook.Webelievethatwebringadifferentperspectivetothebusinessoftradingoptions.Thisbookbringsyouourcombinedexperiencestohelpyoubuildasuccessfuloptiontradingbusiness.Wewillshowyouthe“how-to”andgiveyouaframeworkinwhichtooperate.ThebookisbasedonthewayImanageSmartIncomePartners,Ltd.SmartIncomePartnersisahedge

fundthatspecializesintradingoptionstogenerateconsistentmonthlyincomeforitspartners.Thefundismanagedexactlylikeaninsurancecompany.Itusesthebusinessmodelofaninsurancecompany.InthisbookwewillsharewithyoutheconceptofTheOneManInsuranceCompany(TOMIC).TOMICisthebusinessframeworkthatisusedatSmartIncome

Partners,Ltd.ThebookalsooffersinsightsdrawnfromthevastexperienceintradingoptionsthatMarkhashadasmarketmakerattheCBOEandNYSE.MarkalsodrawsfromallhisexperiencesfromcoachingstudentsatOptionPit.com.Imustsay,notbecauseheismyfriendandco-author,thatMarkprovidesoneofthebest

optioncoachingprogramsavailabletoday.IhighlyrecommendOptionPit.com,whereIpersonallyamsubscribedasaprofessionalmember.Markisconsistentlythoughtprovoking,andhepushestheenvelopeonoptiontrading.YoumayrefertoAppendixC,“OptionPit.com,”foranoverviewofOptionPit.comservices.

Imustwarnyou,thisbookshouldnotbeyourfirstbookindealingwiththeoptionsworld.Itisworthwhileifyouhaveaworkingknowledgeaboutoptionsorifyoucurrentlytradeoptions.Ifyouareanoviceintradingoptions,wesuggestyoureadsomeotherprimersonoptionsbeforereadingthisbook.Readerswillbenefitmostiftheyhavesomeknowledgeofoptions.

Asmallbutnecessarydisclaimer:TheOptionTrader’sHedgeFundisintendedforeducationalpurposesonly.ThebookreflectsthephilosophyofhowSmartIncomePartnersismanaged.However,duetoregulatoryrestrictions,thisbookdoesnotshareanyperformanceinformationaboutSmartIncomePartners,Ltd.,andisnotintendedtosolicitanybusinessforthe

hedgefund.Thefundisofferedonlytoqualifiedinvestorsonaone-on-onebasisthroughaprivateplacementmemorandum.IfyouwouldlikeinformationaboutSmartIncomePartners,Ltd.,youmaycontactmedirectlyatdchen@smart-advisors.com.MarkandIwanttothankyouinadvancefortakingthetimetoreadthisbook.Wehope

thisbookwillhelpyoubuildaprofitableoptionportfolio.DennisA.ChenJanuary2012

IntroductionTheworldofinvestmentsisverylarge.Youcaninvestinstocks,bonds,options,realestate,CDs,commodities,orfutures.Regardlessofwhereyouchoosetoinvestyourmoneyandtime,itwouldbeverywisetohaveaframeworkwithwhichtomanageyourinvestments.Thisbooksuggestsa

frameworkfortradingoptionsprofitably;thisframeworkhasbeenusedbyanoptiontradinghedgefund.Thebookisaroadmapforanyonewantingtotradeoptions.Weprovideguidelinesonhowtorunanoptiontradingbusinesssuccessfully.Wealsoprovideyouwithourownexperiences,learnedalongthewayasaprofessionalhedgefundmanager(DennisChen)andaformermarket

makerandtradingcoach(MarkSebastian).Ifyouarereadingthisbook,youalreadymayhaveexperiencedtradingoptions.Wewillnotteachyouhowtosetupahedgefundorhowtoinvestinhedgefunds.Thereareotherbookstohelpyousetupahedgefundifyousodesire.Thisbookgivesyouaglimpseofhowaparticularhedgefund,SmartIncome

Partners,Ltd.,successfullytradesoptionsforitspartners.SmartIncomePartners,Ltd.,isanoptiontradinghedgefundmanagedbyDennisChen,aco-authorofthisbook.Athishedgefund,Dennisviewstradingoptionsinadifferentlight.Hethinksofhisbusinessnotasahedgefund,butasaninsurancecompany.Whenaskedthe

question“Whatdoyoudoforaliving?”mosthedgefundmanagerswouldsay,“Imanageahedgefund,”or“I’mamoneymanager.”WhensomeoneasksDenniswhathedoesforaliving,heanswers,“Imanageriskforafinancialinsurancecompany.”Letusintroducetoyoutheconceptof“TheOneManInsuranceCompany,”orTOMIC.TOMICisthebusiness

frameworkDennisusestooperateandguidehishedgefund.TOMICisaframeworkthatanyonecouldusetomanagetheiroptionportfolio.YoutoocouldrunTheOneManInsuranceCompany.Inthefollowingpagesweintroducetheconcept,explaintheframework,andshowyouhowtomanageyouroptiontradingbusinesslikeDennisdoesathishedgefund.Also,youwillfindthroughoutthe

bookkeylessonstheyhavelearnedduringtheirtradingcareers.PartIofthebook,“TheFramework,”showsyoutheframeworkdetailsofTOMIC.Chapter1,“TheInsuranceBusiness,”providesanoverviewoftheinsurancebusinessandcomparesittothewaythehedgefundthinksaboutitsoptiontradingoperations.Youwillreview

thevaluechainofatraditionalinsurancecompanyandcompareittothevaluechainofTheOneManInsuranceCompany.YouwilllearnwhatkeysuccessfactorsareneededtorunasuccessfulTOMIC.YouwillgainabetterunderstatingofthebusinessofTOMIC.Chapter2,“TradeSelection,”providesyouwithguidelinesoftradeschosenforTOMIC.

Youwilllearnaboutmarketselection,direction,timing,volatility,andpricing.Eachofthesefivefactorsimpactyourtradeselection,whichistheunderwritingfunctionatTOMIC.Itisthekeytomakingmoneytradingoptions.Chapter3,“RiskManagement,”reviewstheriskstakenatTOMICandhowtomanagethoserisksto

avoidaterminallossofthebusiness.Thischapterdiscussespositionsizing,moneymanagement,diversification,protectionagainst“blackswan”events,1andtradeexits.Chapter4,“TradeExecution,”explainshowtoimplementthetradesyouplace.Itshowshowtogetthemdoneefficiently.Thischaptergivesyouabetter

understandingoftheconditionstolookforbeforeplacingthetradeandhowtoplacethetradeinordertogetbetterfills.Chapter5,“TheTradingPlan,”discussestheimportanceofhavingaplan,anditreviewstheprocessofcreatingyourtradeplan.Chapter6,“TradingInfrastructure,”reviewsallthetoolsandservicesyou

needinordertobeabletorunasuccessfuloptiontradingbusiness.Chapter7,“LearningProcesses,”reviewstheimportanceofafeedbackloop.Weincludesuggestionsonsupportingfunctionsnecessarytomaintaintheedgeinthebusinessoftradingoptions.InPartIIofthebook,“ImplementingtheBusiness,”

wegiveyouatasteofhowtoimplementthebusiness.ThispartofthebookshowsyouspecificexamplesofdifferenttradesthatareusedatthehedgefundthatyoucouldimplementinyourTOMIC.Youwillseehowtotradeaverticalspread,anironcondor,abutterfly,acalendarspread,andaratiospread.Chapter8,“UnderstandingVolatility,”showsyouwhat

youneedtoknowaboutvolatilitytoimplementtheTOMIC.Chapter9,“MostUsedStrategies,”showsyouindetailthefivemostfrequentlyusedstrategiesatTOMIC.Itprovidesyouwiththekeycriteriaforusingeachstrategy.Chapter10,“OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ,”

providesguidelinesforcreatingTOMIC1.0.ItprovidesyoutheanswertohowtocreateyourownTOMIC.PartIII,“LessonsfromtheTradingFloor,”isaselectionofblogswrittenbyMarkSebastianforOptionPit.com,withanoccasionalguestblogwrittenbyDennisChen.Thesectioncoverslessonslearnedattheoptionpitsondifferent

topics.Youwillfindwordsofadviceonriskmanagement,volatility,tradingandexecution,andtheGreeks.Onceyouhavefinishedreadingthisbook,youwillhaveagoodunderstandingoftheinsurancecompanyframeworkusedtobuildaprofitableoptionportfolio.Asyoubuildyouroptiontradingbusiness,youmightdecidetoreadthebookagainbecause

thereareadditionalinsightsyouwillgetafteryou’veexperiencedrealtradingconditions.Themarketsareconstantlychanging.Weencourageyoutocontinuouslylearnandseektoimproveyourtradingeveryday.Thisbookwaswrittentobeaguide,butyoumustwalkyourownpath.

Endnote

1.Ablackswaneventisanunexpectedeventoflargemagnitudeandconsequence.TheblackswantheorywasdevelopedbyNassimN.Taleb.RefertohisbookTheBlackSwan.

PartI:TheFramework

1.TheInsuranceBusinessInthischapterweshowyouhowtocreateabusinessoftradingoptionssuccessfullybyusingtheframeworkofaninsurancecompany.ThisisthesameframeworkusedatahedgefundmanagedbyDennis(theco-authorofthisbook).So,forthisbook,we

createtheconceptofTheOneManInsuranceCompany(TOMIC).Youwillneedtoknowhowtheinsurancebusinessworks.Whatisthegood,thebad,andtheuglyoftheinsurancebusiness?Howdoesaninsurancecompanymakemoney?Howdoesitlosemoney?Whatarethekeyprofitdriversofthebusiness,andwhatarethekeysuccessfactors?

Insuranceistheequitabletransferofriskfromoneentitytoanotherinexchangeforcompensation,calledapremium.Theinsurancecompaniesmakemoneybytakingrisksfromothersinexchangeforapremium.Forexample,ifyouownavehicle,youprobablyhavecarinsurancethatprotectsyourassetagainstabiglossliketheftoraccident.Theinsurancecompanycollectsa

premiumeachyeartoprotectyouagainstthebigloss.Theinsurancecompanypaysyoutomakeyouwhole.Foraninsurancecompanytofunction,itmustknowwhatrisksitiswillingtoinsure.Italsoneedstoknowhowmuchpremiumitneedstochargetobeabletobacktherisksandstillearnaprofit.Itwillneedtoknowthecar-theftstatisticsandaccidentstatisticsforyourcar’smodelandyear.

Usingthatinformation,thecompanyisabletopricecoverageandchargeapremiumthatallowsthecompanytomakeaprofitonthelargepoolofcarinsuranceitwrites.Figure1.1illustratesagenericvaluechainofaninsurancecompany.

Figure1.1.Insurancecompanyvaluechain.

Themainfunctionsinaninsurancecompanyarethese:

•Underwriting:Definingandselectingriskstoinsure

•Pricing:Identifyingtheinsurancepremiumfortherisktaken

•Reinsurance:Divestingorredistributing

unwantedrisk•Claimsprocessing:Dealingwithcustomersandpayoutofinsurancelosses

•Customeracquisition:Sellinginsurancepolicies

•Investmentoperations:Earningadditionalincomeonreserves(float)

Theunderwritingfunction

selectsriskstheinsurancecompanyiswillingtoinsure.Thisfunctiondefinescharacteristicsoftheriskandanalyzesthestatisticaloutcomesoftherisk.Forexample,theunderwritingfunctionofapropertyandcasualtyinsurancecompanywouldlookattheautoinsurancemarketanddecidewhichsegmentofthemarkettheywouldliketoinsure.Theunderwriters,throughtheir

analysis,mayfindoutthatthesmall-SUVsegmentdrivenbymarriedwomenbetweentheagesof24and36haveonlya1%chanceofanaccidentversusthegeneralaverageSUVaccidentrateof5%.Theunderwritersmaydecidethatthisisasegmenttheywouldliketohaveintheirportfolioofinsurancepolicies.Thepricingfunction

determinestheamountofpremiumtochargefortheriskbeinginsured.Continuingthisexample,theinsurancecompanypricesthesmallSUVdrivenbymarriedwomenbetweenages24and36atapricethatgeneratesapositiveexpectedreturn.Theypriceitatanexpectationofa20%returnonpremiumswrittenfortheyear.

Thereinsuranceoperationdivestsorrelocatesunwantedrisk.Theinsurancecompanybuysinsurancefromotherinsurancecompaniesorreinsurancecompaniestospreadriskamongmany.Ineffect,ittransferstheunwantedrisktootherentities(reinsurancecompanies)thatarewillingtobeartheunwantedrisksinexchangeforcompensation.Anexampleofthisisa

propertyandcasualtyinsurancecompany(AutoInsuranceCo.)withalargebaseofautoinsurancesubscribedintheSanFranciscoBayArea.Thecompanyisnotwillingtotaketheriskofanearthquakewipingoutalltheinsuredvehicles.AutoInsuranceCo.iscomfortableinsuringthevehiclesfornormalaccidentsandtheft,butiftheBigOne(earthquake)happensitwill

causedamagetoallthecompany’sinsuredcars.Therefore,theinsurancecompanyreinsuresearthquakeriskbybuyingearthquakeinsurancefromareinsurancecompany(let’scallitReinsuranceCo.)thatspecializesincatastrophicinsuranceandiswillingtoassumetheearthquakerisk.So,iftheBigOnehits,AutoInsuranceCo.wouldnotlosebecauseReinsuranceCo.

wouldpaytheAutoInsuranceCo.fortheearthquakeclaims,whichinturnusesthefundstopaytheindividualautoclaims.Hence,itsriskofanearthquakewasundertakenbythereinsurerandnottheautoinsurancecompany.Theclaimsprocessingfunctiondeterminesthecostofalossandpaysclaimstotheinsured.Goingbacktotheautoinsurancecompany

example,theclaimsprocessingunitsendsoutadjusterstoanaccidenttoevaluatethelossandtostarttheclaimprocess.Thisinvolvescustomerserviceaswellascompensationsincetheadjusterdealswiththeinsuredandwantstoprovidegoodserviceinordertokeepthemasaclient.Thecustomeracquisitionfunctionisexecutedthrough

agentsandbrokers.Theyareresponsibleforsellingtheinsurancepolicies.Theagentsmaybeexclusiveagentsoroutsideagents.Thechannelscouldbethroughphysicalagencies(offices),byphone,oronline(usingtheInternet).Thisfunctionisalsosupportedbymarketingandcustomerservicedepartments.Theinvestmentoperation

functionisaprofitcenterofaninsurancecompany.Therearetwotypesofprofitsgeneratedininsurance:underwritingprofitsandinvestmentprofits.Theunderwritingprofitsaregenerateddirectlyfromwritinginsurancepolicies.Underwritingprofitsarewhatisleftafterthepremiumsarecollectedandclaimsarepaid.Theinvestmentprofitsaregeneratedfrominvestingthe

premiumsandreservessetupwhenpoliciesarewritten.Somepeoplerefertoinvestmentprofitsasincomegeneratedfromthe“float”ontheinsurancecompanies.WarrenBuffettisamasteratinvesting.TheinsurancebusinessesinBerkshireHathaway(GEICOandGeneralRe,forexample)arerequiredtocreateasetamountofreserves.Thesereservesareinvestedby

WarrenBuffetttogenerateincome.Thisistheincomederivedfromtheinvestmentoperations.

HowInsuranceCompaniesMakeMoneyInsurancecompaniesmakemoneyfromunderwritingandfromoperations.Underwritingprofitscome

fromsellinginsuranceandtakingonrisks.Investmentprofitsareprofitsintheformofinvestmentreturns.TOMICmakesalmostallofitsmoneyfromunderwritingoperations.TOMICcouldmakemoneyfrominvestmentsalso,butthistopicisnotcoveredinthisbook.Hereisanexampleofhowaninsurancecompanymakes

moneysellingautomobileinsurance.EachyearABCAutoInsuranceCo.insures10,000carswithaveragevalueof$20,000percar,anditchargesonaverage$1,000annualpremiumforeachcar.Eachyearithasonaverage1,000claimswheretheaveragecostofaclaimis$4,500.Lookingattheinsuranceoperations,ABCAutoInsuranceCo.earnsaprofitof$5,500,000.

ThisishowagrossProfitandLosssummarylooks:

Ofcourse,therewillbeadministrativeoverheadbeyondthisgrossprofit.Also,whileABCiswaitingtopayoutclaims,itmakesmoreprofitfrominvestingthemoneyitcollectsaspremiumsandearns

investmentincome.So,assumingABCcanearnabout3%onthepremiumsitcollectedanditmaintainedanaveragefloat(premiumcollectedandnotpaidoutasclaims)of$2,750,000($5,500,000/2),itwouldmakeanother$82,500ininvestmentincome.ABCAutoInsuranceCompanymakesmoneybychargingsufficientpremium

tocovertheactuallossesincurredandleavingaprofitforthecompany.ThekeytomakingmoneyforABCistheexpertiseinunderwritingrisk.A20-year-oldsinglemaledrivingatwo-doorsportscarpaysahigherautoinsurancepremiumthana30-year-oldmarriedfemaledrivingaminivan.ThatdeterminationismadebytheunderwritersatABCusingstatisticalestimatesofthecustomerand

typeofvehicle.So,bynowyouareprobablywonderinghowanoptionsellinghedgefundworkslikeaninsurancecompany.Howisoneoptiontraderabletodoeverythinganinsurancecompanydoestomakemoney?Keeponreading.Wewillshowyouhowtotradeoptionsexactlylikerunninganinsurancecompany.Aside-by-sidecomparisonof

theautomobileinsurancetowriting(orselling)aputisshowninTable1.1.Table1.1.AutoInsuranceComparisonstoOption

Selling

Table1.1showsaside-by-sidecomparisonofautoinsuranceandoptionselling.Rememberthatoptionsareaformoffinancialinsurance.Theytransferrisksfromthe

optionbuyertotheoptionseller.Autoinsuranceisjustlikeoptions:

1.First,thereisanassetbeinginsured.Inthecaseofautoinsurance,theassetinsuredisthecar.Inoptionstheassetbeinginsuredisthestock,index,orfuture.

2.Everyinsurancecontractisineffectforaspecifictimeperiod.In

autoinsurancethepolicyusuallyisfor12months.Inoptionstheperiodvariesdependingontheoptionsyoubuyorsell,anditcouldrangefromadurationofoneweekto30months.Inthisexampletheoptionexpiresin30days.

3.Forautoinsurancethereisanamountthatis

insured,thevalueofthevehicle.Inthisexampleitisa$20,000car.Inoptionsthestrikepricedefinestheamountinsured.Inthiscaseit’s$90;thismeansthattheowneroftheputhastherighttosellXYZstockat$90beforetheoptionexpires.Thisislikeautoinsurance:Ifthevehicleisworth$20,000andgetsintoanaccident

thatcauses$4,500indamages,thentheautoinsurancecompanyneedstomakethepolicyholderwholeandpayfortherepairsneededtobringbackthevalueofthevehicleto$20,000.

4.Topaylessforautoinsurance,somecarownersarewillingtotakesomeriskby

agreeingtoadeductibleinthecarinsurancecontract.Inthisexample,thecarowneriswillingtopayforthefirst$2,000ofdamagesinaclaim.Hence,ifthecargetsinanaccidentandtherepairsare$4,500,theinsuredwillhavetopay$2,000andwillbereimbursed$2,500fromtheinsurancecompany.

ThisisanalogoustosellingOTM(out-of-the-money)puts.Theoptionbuyer,topaylessfortheputthat’sprotectingXYZstock,iswillingtoassume10%ofthelossifXYZstockgoesdown.So,insteadofbuyingaputwitha$100strikeprice,hebuysaputwitha$90strikeprice.ThatmeansthatifXYZstock’s

pricefallswithin$0to$10,orupto10%,thentheowneroftheputwillnotgetanythingbackfromtheputifheldtoexpiration.Heiswillingtoabsorbthefirst10%ofthefallinXYZ.

5.Apremiumispaidforinsurance,thesameasforoptions.Inbothautoinsuranceandoptions

thefeepaidforthecontractiscalledapremium.Intheexample,thecarownerpaid$1,000toinsurethecarfor12months.Theoptionbuyerpaid$3toinsure100stocksofXYZatapriceof$90for30days.

6.FromtheABCAutoInsuranceCo.pointofview,thereisaloss

ratiobasedonactuarialtablesexpectedfromsellingtheautoinsurance.InthisexampleABCexpectstohavea10%lossratio.Thismeansthatonaveragefromtheautoinsurancesegment,itexpectstohaveclaimson10%ofitspolicies.Fromtheoptionsellerperspectivewhenwritingtheput,

accordingtotheanalyticalmodelused,theXYZputhasa90%probabilityofexpiringworthless.Theunderwritingisveryimportantwhenoneisrunninganinsurancebusiness.Thistopicisaddressedinalaterchapter.

7.Inautoinsuranceeitherthecompanypaysouta

claimwhenthereisaloss,oritdoesnothavetopayoutanythingifthepolicyholderisclaimsfree.Inthelattercase,theinsurancecompanywouldhavemademoneysinceitkeepstheentirepremium.Itisthesamecasefortheoptionseller.Iftheputoptionsoldexpiresin-the-money(ITM),the

optionsellerwillhavetobuyXYZstockfor$90fromtheputoptionowner.Iftheputexpiresout-of-the-money(OTM),meaningthatXYZwasabove$90atthetimeofexpiration,thentheputsellerkeepsthepremiumcollected.

8.Mostinsurancecompaniesreinsurepartoftheirrisk.For

example,ABCInsuranceCompanymightbuyearthquakeandtsunamiinsurancefromareinsurancecompanytocoveralltheautomobilesforwhichABChaswritteninsurance.Thisisdonetoavoidacatastrophicevent.Iftherewereatsunami,mostlikelytherewouldbecloserto100%lossinsteadof

10%expectedloss.Hence,reinsuranceagainstcatastrophiclossesisagoodidea.Theoptionsellercandothesametoprotectagainstacatastrophicevent(e.g.,9/11/2001,afinancialmeltdown,orapresidentialassassination)bybuyingaputatlowerstrikes(OTM)inXYZorbybuyinganOTMputat

themarket(S&P500index).Bydoingthis,theoptionssellerreinsuresjustliketheinsurancecompaniestoavoidcatastrophiclosses.

Theexampleshowsthatsellingoptionsisverymuchlikerunninganinsurancecompany.Thebusinessofaone-maninsurancecompanyistocollectpremiumsfrom

optionbuyersinexchangefortherisksoflossesintheunderlyingmarketsoftheoptionsandearnprofitsfromthetimedecayoftheoptions.

HowInsuranceCompaniesLoseMoneyUnderstandingthebusinessiscrucialtoyoursuccess.Nowthatyouknowhowinsurance

companiesmakemoney,let’stalkabouthowtheylosemoney.Theinsurancebusinessisfabulous;justmakesureyouknowwhatyouaregettinginto.Makesureyouunderstandtherisks.Insurancecompaniescanlosemoneyintheirinvestmentsorontheinsurancecontractstheyhavewritten.Lossesfrominvestmentsarelossesthatthecompanyhadwiththe

float(itsreserves).Thelossesfrominsurancecontracts,commonlyknownasunderwritinglosses,comefrominsurancecontractsonwhichthecompanyhadtopayclaims.Whentheclaimsaremorethanthepremiumsreceived,thereisanunderwritingloss.Theinsurancecompanylostmoneybecauseitmispricedtheinsurancebyunderestimatingtherisk.This

iswhyknowingtheriskisextremelyimportantinordertonotlosemoneyinthisbusiness.Themostimportantfunctionintheinsurancecompanyisunderwriting.Underwritersselectandpricerisk.Theymakesurethatactuariallythepolicieswrittenareexpectedtohaveapositivereturn.Forexample,inalifeinsurancepolicy,theunderwritingunit

istheonethatfiguresouthowlonga40-year-oldmale,nonsmoker,withacleanbillofhealthisexpectedtolive.Thenwiththisinformationtheyfigureouthowmuchtopricethepremiumforthelifeinsuranceforthissegmentofthepopulationinordertohaveapositiveexpectedreturn.Iftheunderwritingunitiswrong,thelossratiowillbe

higherthanexpected,andthecompanywilllosemoney.Theywillpayoutmorethantheycollectinpremiums.Thissoundslikeasimplebusiness,butitisnot.Thecompanyestimatestheprobabilityoflossestoasegmentitwantstoinsure.Next,basedonthoseestimates,itpricesthepremiumneededtomakeaprofit.Then,itsellsthe

insurancepolicies.Itcollectsthepremiumsandinveststhemwhileitwaitsforthepolicytoexpireortheeventtohappen.Finally,iftheeventhappensitpaysouttheclaim,oriftheeventdoesnothappenitpocketsthepremiumsasprofits.Whereistheugly,youask?Overall,insuranceisagoodbusiness.However,theuglycomeswhentherearerisks

thatarehardtocalculate.Thefinancialcrisisof2008,whenAIGalmostwentunderandtheU.S.Governmentbaileditout,isanexampleoftheugly.AIGwassellingcreditinsurance,creditdefaultswaps(CDS),toinsuremortgage-backedsecurities.However,itdidnotcalculatetheriskscorrectly,andwhensubprimemortgagesstartedblowingup,AIGwasinbigtrouble.AIGsold$450

billionofcreditinsurancewithoutaclearunderstandingofhowtherisksbehaved.Whenthesubprimemortgagesstartedtodefault,theunderlyingmortgage-backedbondsinsuredbyAIGstartedfailingandAIGwascaughtwithoutenoughliquiditytobackthesecuritiesithadsold.Itturneduglyveryfastandwasduetopoorunderwriting.AIGdidnotknowtherisksittookonand

didnotcollectthenecessarypremiumstocovertherisks.Infact,itdidn’tmanageitsportfolioofriskscorrectlybecauseitwasoverexposedtosubprimemortgageriskswithoutknowingtheirmagnitude.Itwasadisasterthatalmostbroughtdowntheentirefinancialsystem.That’stheugly.Insurancecompaniessell“paper,”apromisetopayin

thefutureinexchangeforcashnow.Inthefuturewhoknowswhetheritwillhavetopayornot,butmostlikelyitwillpayoutlessthanthecashitcollected.

SuccessDriversoftheInsuranceBusinessThekeyforaninsurancecompanytobesuccessful

boilsdowntodoingfourthingsright:

1.RiskSelection:Identifyingtheriskitiswillingtotake,whichmeansbeinggoodatunderwritingandpricing.

2.RiskManagement:Managingrisk,reinsuringunwantedrisk,andmanagingclaimseffectively.

3.RiskAcquisition:Subscribinginsurance,usingsaleschannels,andeffectivemarketingtoattractclientsandsellinsurancepolicies.

4.InvestmentOperations:Earninggoodreturnsonthereserves(orfloat).

Reviewingthevaluechain,Figure1.2,asyoucomparethetraditionalinsurancecompanyvaluechainto

TOMIC’ssimplifiedvaluechain,youseethattheirfunctionsandtheirsuccessfactorsarethesame.TheinvestmentoperationsofTOMICareverysimple.TOMICkeepstherequiredreservesinmoneymarketfundsorincash.

Figure1.2.ComparisonbetweenvaluechainsofatraditionalinsurancecompanyandTOMIC.

TOMIC’svaluechainhasthreeprimaryfunctions:

1.TradeSelection:Encompassesunderwritingandpricing.Selectsthemarketandstrategiestotrade.

2.RiskManagement:

Encompassesmoneymanagement,tradesizing,hedging(reinsurance),tradeadjustment(claims),andtradedecisions.

3.TradeExecution:Istheequivalentofclientacquisitioninthetraditionalinsurancecompany.InthiscaseTOMICgoestotheoptionexchangestosell

itsoptions(insurancepolicies).

Thesesuccessdriversneedtobemanagedinanyinsurancecompanythatwantsprofits.AtTheOneManInsuranceCompanyyouneedtoconstantlywatchandmanagethesedriverstoavoiduglyresults:

1.Tradeselection.Thisfunctionencompassesselectingmarkets,

pricingtherisk,andselectingastrategyandatimeframe.AllstateandStateFarmselectgeographicregionswheretheysellhomeownersinsurance.ItisthesameprocessinTheOneManInsuranceCompany(TOMIC),butinsteadofhomesindifferentgeographies,TOMICselectswhichunderlyingindexesor

equitiesmarketsitwillwriteoptionson.TOMICcouldwriteoptionsontheSPX,RUT,NDX,DIA,AAPL,IBM,PG,JNJ,orGOOG,tonameafew.Pricingoftheinsuranceisveryimportant.InaninsurancecompanylikeAllstatetheunderwritingdepartmentdefinesthe

expectedlossesforaspecificgroupofinsured.Forexample,forautomobileinsurancetheywouldusevariablestopredictexpectedlossesfromasegmentofdrivers.Theyknowtoexpectfewercrashesfrommarriedwomenage32,drivingaminivan,thanforsinglemalesage18,drivingatwo-seat

convertible.AtTOMICthepricingisverysimilar.Thedifferenceisthatyouaretheunderwriterandwillneedtoknowthevolatilityandpriceoftheunderlyingequityorindexyouaregoingtoinsure(writeoptionsagainst).Onceyouknowthemarketandtheriskyouwanttotake,youselecta

strategy.Yourstrategyselectioncouldbeaverticalspread,calendarspread,condor,andsoon.Finally,youshoulddecideonatimeframeforthetrade—aweek,20days,30days,andsoon.Homesareusuallyinsuredonanannualbasis.

2.Riskmanagement.Thisfunctioncouldbemore

accuratelycalledactiveriskmanagement.Thisfunctioncontinuouslymonitorstheriskportfolioanddivestsanyriskthatisnotwanted.AtAllstateifthelossratioonmarriedwomendrivingminivansstartsincreasingyearafteryear,theyhavetodeterminewhathaschanged.Maybeitis

thatthewomenhavemorechildrenwhocausedistractionswhenthewomenaredriving.Giventhattheyareconstantlymonitoringtheirinsuranceportfolio,Allstateadjusts(raises)thepriceoftheinsuranceforthismarket,ortheymightnotinsuremarriedwomenwithkidsdrivingminivans.The

sameshouldhappenatTOMIC.Forexample,ifTOMICinsuresdefensecontractorsandnewlegislationfromCongresscutsdefensespendingbyhalf,TOMICmightstopwritingoptionsondefensecontractorsoritmightreinsureitspositionbybuyingputs.TOMIChastoconstantlybeawareof

changesinvolatilitiesandpricesoftheunderlyingmarket.RiskmanagementatTOMICinvolvespositionsizing,moneymanagement,tradeadjustments,portfolioinsurance,andportfoliodiversification.

3.TradeExecution.Thisfunctionisequivalenttothesalesofinsurancepoliciesbythe

traditionalinsurancesalesforce.InsteadofhavingagentslikeAllstate,atTOMICwehavetheoptionexchanges.TOMICgoestoanoptionexchange,usingabroker,tobuyorselloptions.Thereisnoneedforasalesforcetosellinsurance,onlyacomputerconnectedtoanexchange.The

efficiencyandeffectivenessinwhichTOMICcanexecuteatradewillhaveadirectimpactonprofitability.Therearedifferentwaystoexecuteacomplextrade,andtherearemanyfactorsthatimpacttheexecution.Thefactorscouldbethesizeofthemarket,sizeofthetrade,thetimeofday,theexchangesthe

marketistradedon,andthemarketmakers.ThisfunctionisacruciallinktohavingasuccessfulTOMICornot,andyoumustknowhowtoexecuteyourtradeswell.

AllthekeysuccessfactorsofaninsurancebusinessneedtobeinplaceatTOMICinordertohaveanongoingsuccessfulbusiness.TOMIC

operatingprofitablyandsuccessfullyis,intheory,achievable.Figure1.3showswhatTOMIClookslikewhenyouincludeallofitsfunctions:primaryandsupport.

Figure1.3.TOMICvaluechain.

Everybusinesshassomekindof“infrastructure”beforeitbeginstooperate.Forexample,afast-foodfranchiseneedsrealestate,stoves,refrigerators,andtelephones.AtTOMIC,youneedhardware(computers,Internetconnections,andtelephones),software(tradingsoftwareandaplan),andworkingcapitalinordertooperate.ForTOMICtoexecuteitsfunctions(trade

selection,riskmanagement,andtradeexecution),itneedstohaveasetofsupportingfunctionsinplace.ThesupportingfunctionsallowyoutooperateTOMICsuccessfully.Thesefunctionsaredividedintotradingplan,tradinginfrastructures,andlearningprocesses.Table1.2showsanoutlineofthesupportingfunctionsandtheirimportantprocesses.

Table1.2.TOMICSupportingFunctions

Thetradingplanistheoperationalplanofa

traditionalinsurancecompany.Thetradingplanspecifiestradegoals,themarketstotrade,thestrategies,theriskmanagementparameters,andtheentriesandexits.ThetradingplanistheoperationalguidelineforthemanagerofTOMIC.ItdescribestheparametersinwhichTOMICshouldoperate.Thetradinginfrastructureis

thecollectionofbrokers,executionsoftware,analysissoftware,informationresources,portfoliomargin,andriskcapital.ThelearningprocessesareasetofhabitsTOMICneedsinordertocontinuouslyimproveitsbusiness.Thisfunctioncontainsatradingjournal,atradinggroup,atradingcoach,andacontinuingeducationplan.

Inthischapter,weprovidedyouwithanoverviewoftheinsurancebusiness,andweshowedyouhowTOMICisjustlikeatraditionalinsurancecompany.InthesubsequentchaptersofPartI,wediscussindetaileachoftheprimaryfunctionsandsupportfunctionsofTOMIC’svaluechain.

2.TradeSelectionTradeselectionatahedgefundistheequivalentoftheunderwritingfunctioninaninsurancecompany.Ifunderwritingisexecutedcorrectlyandtheriskispricedfairly,thebusinessissound.Thebusinessshouldmakemoneybecause

premiumscollectedareadequatecompensationfortherisktaken.Ifunderwritingisexecutedpoorlyandtheriskbeingtakenisnotwelldefined,thepremiumscollectedmightnotbeenoughtocovertherisks.Agoodexampleofthisisthecontrastoftwobigevents.OneeventislossesfromHurricaneKatrinain2005,andthesecondislosseson

mortgage-backedsecuritiesthatledtotheimplosionofAIGin2008.Botheventswerebighitstotheinsuranceindustry.Thefirstevent,HurricaneKatrina,causedalotofdamagesandclaims.However,theinsurancecompanieswereabletosurviveandprofitevenwithclaimsresultingfromtheevent.InareporttoCongressin

2008,RawleKinganalyzedtheinsurancelossesincurredduetoHurricaneKatrinaandconcludedthattheinsurerswereabletoabsorbthelosseswithoutanyproblem:

Catastrophe-insuredlossesin2005totaled$66.1billionfrom24disasters.EstimatedinsuredlossesfromKatrinaalonewere$43.6billionstemmingfrom1.75millionclaims.

Despitetheseverityofstormdamages,HurricaneKatrinaandothercatastrophesin2005didnotthreatenthesolvencyandclaims-payingabilityoftheproperty/casualty(p/c)insuranceindustry.Insurersbenefitedfromfavorablemarketconditionsduringthelastthreeyearsandexperiencedsignificantgrowthinpolicyholder

surplus.Insurers,infact,earnedrecordprofitsineachofthelastthreeyears—2004-2006.1

TheinsurancecompanieswereabletoprofitfromKatrinabecauseofsoundunderwriting.Theyhadpreviousexperiences(HurricaneAndrew,forexample)thathelpedthemdeterminetheirriskandenabledthemtocollectthe

correctamountofpremiums.Thesecondevent,AIG’ssellingof$450billionofcoverageincreditdefaultswaps,wasnotwellunderwritten.AIGdidnothaveaclearunderstandingofhowtherisksbehaved.Pricinginsuranceforthebondswasnotlikepricingfireinsuranceforhouses.PricingCDS(creditdefaultswaps)isverydifferentfrom

pricingfireinsurance.Ifahouseinaneighborhoodburnsdown,itdoesn’tincreasetheriskofahouseinanotherneighborhoodtenmilesawayburningdown.IntheCDSmarket,ifamortgage-backedsecurityfailedduetoweakeningeconomicconditions,forexampleanincreaseinunemployment,othermortgage-backedsecuritiescouldalsofail.AIGdidvery

poorunderwritinganditpaiditsduesin2008whenthegovernmenthadtobailitout.Itdidnotunderstandtherisksitwastakingon,itdidn’tpriceitcorrectly,anditdidn’tmanageitsportfoliocorrectly.Italmostwentunder.Hence,tradeselection,likeinsuranceunderwriting,isthekeytothisbusiness.TOMICisbuiltbyhavingaportfolio

ofriskstakeninexchangeforpremiumscollected.TOMICmustknowtherisksitistakingon.TOMICcannotinsurewhatitdoesn’tknow.Thisiswheretradeselectioncomesintoplay.ItisprobablythemostimportantfunctionatTOMIC,underwritingandthedecision-makingprocessontheriskstobeacquired.Thereareseveraldecisionstobemadewhenyou’re

selectingatrade.First,youhavetoselectwhichmarketstotrade.Second,youneedtofindthebestavailablestrategytouseforthatmarket.Third,youhavetosetthedurationofthetrade.Fourth,youhavetoknowtheimpactofvolatilityinyourtrade.Finally,youwillhavetodecidethepriceatwhichyouarewillingtoenterthetrade.

MarketSelectionTheselectionofmarkets(underwriting)isveryimportant.Eachmarketisunique;themarketsbehavedifferently.Forexample,GLD(SPDRGoldTrust)isaproxyforgoldanditbehavesmuchdifferentlythanSPY(SPDRS&P500ETF),theexchange-tradedfund(ETF)thatreplicatestheS&P500.Thedifficultyleveloftrading

optionsonamarketdependsonyourfamiliaritywiththatmarket.Forexample,GEICOspecializesinautoinsurancewhileAFLACspecializesindisabilityandworkers’compensationinsurance.Bothareinsurancecompaniesbuttheyareindifferentmarkets.You,astheoperatorofTOMIC,willhavetodefinethemarketsyouwanttoplay.Youcouldbeaspecialistlike

AFLACandinvestinoneortwomarkets,oryoucouldbelikeStateFarmorAllstateandmanagemultipleanddifferentmarkets.AtTOMICthemarketsarebrokendownintofourclasses:

1.Indexes:SPX,NDX,RUT,OEX.

2.Exchange-tradedfunds:SPY,QQQ,IWM,OIH,RTH,XLF,XLE.

3.Equities:AAPL,IBM,MCD,WMT,GS,FCX.

4.Futures:Thesearenotcoveredinthisbook;however,theycanbetradedthroughdiversifiedcommoditiesindexesorETCs,exchange-tradedcommodities.

Indexes

Tradingoptionsofindexes

providetaxadvantagestoU.S.citizens.Section1256oftheInternalRevenueCodeaddresseshowbroad-basedequityindexoptionsaretreated.Basically,anygainonthesaleoftheseindexoptionsistreatedas60%long-termcapitalgainincomeand40%short-termcapitalgainincome.Thisremainstrueregardlessofthelengthoftimeyouholdtheindexoption.Italsoapplies

whetheryouare“long”or“short”theseindexoptions.IRCSection1256providesadiscountbecausethemaximumblendedtaxrateofanindexoptionis23%(assuming35%ordinarygainsand15%long-termcapitalgains).Thisrateof23%isasignificantdiscountagainstthe35%ofordinarygainsyoupayifyouareinthetopbracket.Beaware,

though,thattheInternalRevenuecodeisconstantlychanging,soyouandyourtaxadvisorhavetomakesuretheserulesstillapply.TheindexeswesuggestusingareSPX,NDX,RUT,DJX,andOEX.Thefollowinglistshowsthetickersymbolsforthedifferentindexes.PrimaryTaxAdvantagedIndexOptions

•DJX—DowJonesIndustrialAverage

•OEX—S&P100IndexOptions(Americanstyle)

•XEO—S&P100IndexOptions(Europeanstyle)

•SPX—S&P500IndexOptions

•XSP—Mini-S&P500IndexOptions

•NDX—NASDAQ100IndexOptions

•MNX—CBOEMini-NDXIndexOptions

•RUT—Russell2000IndexOptions

ThefollowingarethebenefitsofIRCSection1256.Makesuretoconsultwithyourtaxadvisor.60-40TaxTreatment

•Appliestobroad-based,

cash-settledindexoptions.

•IRSSection1256contracts.

•Regardlessofholdingperiod,profitsaretreatedas60%long-termand40%short-term.

•ReportedonForm6781andScheduleD.

•Positionsare“MarkedtoMarket”atyearend

andtaxedasifclosed.Year-endpricesbecomecostbasisforthenexttaxyear.

Ifyoudecidetotradeoptionsonindexesyoushouldmakesurethattheoptionshaveenoughliquidity.Youcandothisbycheckingtheoptionopeninterest(seeFigure2.1).TheindexwiththemostoptioninterestistheSPX.Thismarketisveryliquidand

shouldbeonthetopofyourlist.

Figure2.1.ChicagoBoardOptionsExchange(CBOE)

optionsopeninterest.(Source:

www.cboe.com/data/IntraDayVol.aspx

Exchange-TradedFunds

(ETFs)

Exchange-tradedfundsareverysimilartoindexes.ETFsconsistofabasketofequitiesthattradelikeastockandmayalsomirroranindex.ItisbesttouseliquidETFswithoptionstrading.ForacurrentlistofETFswithoptions,refertotheChicagoBoardOptionsExchange(CBOE)Websitewww.cboe.com.The

followingisasamplelistofETFoptionstradedontheCBOE.

DIA—OptionsonDIAMONDSDVY—iSharesDJSelectDividendEEM—iSharesMSCIEmergingMarketsIndexEWZ—iSharesMSCIBrazilIndexFundFXE—CurrencyShares

EuroTrustFXI—iSharesFTSA/XinhuaChina25GLD—OptionsonSPDRGoldSharesIBB—iSharesNasdaqBiotechnologyILF—iSharesS&PLatinAmerica40IndexIWM—iSharesRussell2000IndexFundIYR—iSharesDJU.S.

RealEstateIYT—iSharesDowJonesU.S.TransportationAverageIndexFundKRE—KBWRegionalBankingETFMDY—Standard&Poor’sMidCap400IndexMOO—MarketVectorsGlobalAgribusinessETFOIH—OilServicesHOLDRsTrust

QQQ—PowerSharesQQQTrustRTH—RetailHOLDRsTrustSPY—SPDRS&P500ETFTrustSLV—iSharesSilverTrustTLT—iSharesLehman20+YearTreasuryBondFundUSO—UnitedStatesOil

FundXBI—SPDRBiotechETFXES—SPDRSPDROil&GasEquipment&ServicesETFXHB—SPDRHomebuildersETFXLB—MaterialsSelectSectorSPDRXLE—EnergySelectSectorSPDRXLF—FinancialSelect

SectorSPDRXLI—IndustrialSelectSectorSPDRXLK—TechnologySelectSectorSPDRXLP—ConsumerStaplesSelectSectorSPDRXLU—UtilitiesSelectSectorSPDRXLV—HealthCareSelectSectorSPDRXLY—Consumer

DiscretionarySelectSectorSPDRXME—SPDRS&PMetals&MiningETFXOP—SPDRS&POil&GasExploration&ProductionETFXRT—SPDRSPDRS&PRetailETF

Youneedtoensurethatoptionsareliquid(withopeninterestgreaterthan500perstrikeprice);alsomakesure

thatthereisadequatedailyvolumeintheETF.VolumedataisprovidedbyCBOEorotherexchanges.

OptionsonEquities

Usingoptionsonliquidequitiesisadvisable.Liquidequitiesarethosewithenoughtradingvolumeandwithoptionstradingallowed.ChecktheCBOEforaveragedailyvolume.Table2.1

showsasampleofthemonthofApril2011.Thistableshowsthetop50(sortedbyaveragedailyvolume)underlyingequityoptionsinthatmonth.Table2.1.Top50OptionMarketsSortedbyAverage

OptionDailyVolume(Source:

www.cboe.com/data/AvgDailyVolArchive.aspx

Ifanunderlyingequityhasoptionswithdailyvolume

greaterthan50,000contracts,youcanconsiderthatmarketliquid.Selectafewequitiesandfollowthemcloselytolearntheirbehavior.Also,diversifyyourmarkets.Selectmultipleindustriesorsectors.Forexample,ifyouwantedtousefivedifferentmarkets,adiversifiedselectioncouldbeAAPL,JPM,FCX,LVS,andBP.

StrategySelectionStrategyselectionandtradeconstructionarethecruxofthebusiness.YourabilitytoselectthestrategiesandsetuptradesgivingyouthebestchanceofprofitingisoneofthemainfactorsinasuccessfulTOMIC.Toselectyourstrategy,answerthefollowing:

1.Whichmarket(s)are

yougoingtotrade?2.Whatisthedirection?3.Whatisthetimeframe?4.Whatisthevolatilityoftheunderlyinganditsoptions?

5.Whatistherisk/reward?

Themarketyouchooseimpactsyourstrategyselection.Thecurrentpriceoftheunderlyingandits

liquidityinfluencesthenumberofstrikesavailabletotradeandthedistancebetweenstrikes.Stockpricedat$15doesnotpriceoutthesameasstockpricedat$300.Forexample,inthe$15stockitwouldbehardertotradeverticalspreadsthanitwouldbeina$300stock.Asforthedirectionoftheunderlying,therearethreepossibilities:up,down,or

sideways.Havinganopinionofthedirectionthattheunderlyingwillmoveisimportantindeterminingthestrategyselectionyouwilluse.However,itispossibletostillmakemoneywithoutbeing100%correctinthedirection.Toobtainanopinionofdirectionoftheunderlying,sometradersusetechnicalanalysis,someusefundamentalanalysis,andsomeuseacombinationof

both.Studybothandusewhatismostcomfortableforyou.

TimeFrame“Youwinbattlesbyknowingtheenemy’stiming,andusingatimingwhichtheenemydoesnotexpect.”—MiyamotoMusashi,17th-centuryJapanese

swordsmanandr ninThetradingtimeframeisanotherfactorintradeselection.Forexample,whenyoubuyinsurance,doyougowithasix-monthpolicyoranannualpolicy?Thepricevariesdependingonthetimeframeyouinsure,soyoupaylessperdayifyoubuyanannualpolicy.AsaTOMICtrader,youwilldecidewhethertowriteasix-month

orannualpolicy.Infact,thetimeframesusedatTOMICcouldbeweeks,months,quarters,semesters,oryears.Youcantradeweeklyoptionsinmanyindexesandstocks.Forexample,theCBOEoffersweeklyoptionsontheSPXandselectequitieslikeAAPL.YoumayalsowritemonthlyoptionsorLEAPSasfarawayas30months.Yourdecisionontimeframe

isbasedonyourpredictionofbehavioroftheunderlyingandthevolatilityoftheoptionsinthedifferenttimeframes.Forexample,ifyouthinkSPXwillgosidewaysforthenextyearandvolatilityacrossthedifferentmonthsseemstohaveastablerelationship,thenacalendarspreadmightworkwellforyou.Anotherchoiceisashorterdurationtradesuchasamonthlyironcondoror

butterfly,dependingonvolatility.

VolatilityThevolatilityoftheunderlyingandtheoptionsusedinthestrategycreatesanotherfactor.IfyouoperateaninsurancecompanysellinghurricaneinsuranceinFloridaandintheCaymanIslands,assumeyouhavedatarevealingthatforthepast150

yearsFloridagetshitbyamajorhurricaneonaverageevery12years,andtheCaymanIslandsgetshitevery2years.WillyouchargethesamepriceforinsuringhomesofequalvalueinFloridaandintheCaymanIslands?Ofcoursenot.YouwouldexpectthattheCaymanIslandshurricaneinsurancewouldcostmore.Bythesamereasoning,volatilityimpactsthe

selectionofmarketsandthepriceofinsurance.Mostpeopleignorethisfactorinstrategyselection.However,knowingvolatilitywillhelpyouinyourchoices.Tofigureoutwhichisbetterbetweenacalendarspreadandabutterfly,forexample,ifyoubelievethemarketisgoingsideways,thedecidingfactorwillbevolatility.Youusenotonlythevolatilityof

theunderlying,butalsothevolatilitycurveoftheoptions(volatilityacrossdifferentstrikeprices),andthetermstructure(volatilityacrossdifferentexpirations).Therisk/rewardfactorsintoyourselection.Thisdefinesyouredge.Yourrewardgoeshandinhandwithrisk.However,sometimesyougetanasymmetricrisk/rewardfunctioninwhichyour

rewardpaysbetterfortherisktaken.Inthesescenariosthetradehasanedge,whichisaverylargefactorinselectingyourtrade.ThistopiciscoveredinmoredetailinChapter8,“UnderstandingVolatility.”

PricingThepriceofatrade,whetherbuyingorselling,isthefinalfactorintradeselection.

Volatilityandpricegohandinhand.Ifyoucompareanoptioninahigh-volatilityenvironmentagainstthesameoptioninalow-volatilityenvironment,theoptionpricesshouldbedirectlyproportionaltovolatility.ThisisthecaseoftheexampleofahouseinFloridaandthesamehouseintheCaymanIslands.Intheory,underidealconditions,assumingthatallhurricanes

causethesameamountofdamage,theCaymanhurricaneinsuranceshouldbepricedatsixtimesthepriceoftheFloridainsurance.Pricesininsurancearenotfixed,justaspricesintheoptionsexchanges;itisamarket-basedsystem.SoifthepriceofCaymanhurricaneinsuranceisonlytwicethepriceofFlorida’sinsurance,somethingdoes

notaddup.Oneortheotherispricedpoorly.Underthisscenario,whereisyouredge?ShouldyousellFloridainsuranceorshouldyousellCaymaninsurance?Thepriceimpactsyourdecision,right?ThecorrectthingtodoistosellCaymaninsuranceandbuyFloridainsurance.Thishurricane-insurancescenarioisthesame

reasoningprocessforeverytradeinTOMIC.Pricingdetermineswhetheryoudoatrade.Andpricingisdrivenbythesefactors:underlying,strategy,timeframe,andvolatility.Puttingallthistogether,youselectatrade.Youunderwritetheriskanddecidewhattoinsureandatwhatpriceinordertomakeaprofit.

Endnote1.RawleKing,1/31/2008,CRSReporttoCongress,“HurricaneKatrina:InsuranceLossesandNationalCapacitiesforFinancingDisasterRisks,”summary.

3.RiskManagement

“Risk.Riskisourbusiness.That’swhat

thisstarshipisallabout.That’swhywe’reaboard

her.”—JamesT.Kirk,USSEnterprise,StarTrek,“ReturntoTomorrow,”Ep.

51/4768.3Anyhedgefund,includingTOMIC,isinthebusinessofrisktaking.Itisnotinthebusinessofriskavoidance.AccordingtoWillRogers,“You’vegottogooutonalimbsometimesbecausethat’swherethefruitis.”ThebusinessofTOMICistosubscriberisk.TOMICmakesalivingfromtakingotherpeople’sriskinexchangefor

apremium.TakingriskiswhatpaysthebillsatTOMIC.Infact,everythinginlifecarriesacertaindegreeofrisk.Ifpeopledidnotperceiverisk,theywouldnotbuyinsurance.Ifthestockmarketdidnothaverisk,noonewouldpaythepremiumsfortheoptions.Wecannotavoidrisk,butwecanmanageit.Whenyoucrossastreetyouaretakingarisk.Acarcouldhityou.Butyou

managetheriskbylookingbothwaysbeforecrossing.Evenso,acrazysnipercouldshootyoufromthetopofabuildingwhenyouarecrossingthestreet.Ifyouareliving,youareconstantlytakingrisksandyouareconstantlymanagingthoserisks.ThetricktomakingmoneyatTOMICismanagingtheriskbybeingawareofexactlywhatriskyouarewillingtotakeand

divestingorreinsuringtheriskyoudonotwanttotake.Intheprecedingchapterontradeselection,yousawhowTOMICidentifiestherisksitwantstotakeandatwhatprice.TOMIChastomakesureitreceivesenoughcompensationfortherisk.TOMIChastomanagetheportfoliorisktoavoidlossesduefromunexpectedrisks.Takinglossesfromidentified

risksisacceptable,butgettingblindsidedfromunexpectedrisksisnot.

RiskManagementRiskmanagementisacontinuousprocessinvolvingeverythingfromunderwriting(selectingthetrade),sizingofpositions,andactivemoneymanagement.RiskmanagementshouldbeingrainedineveryTOMIC

trader’sDNA.RiskmanagementshouldbepartoftheentireprocessofmanagingTOMIC.TomanagetheriskofTOMIC,youneedtobeabletoanswerallthefollowingquestions.Beforethetrade:

•Whatistherisk/rewardratioofthistrade?

•Whatistheprobabilityofsuccessofthistrade?

•Whatisthemaximumlossacceptableforthistrade?

•Whatistheexpectedreturnandtargetprofitofthistrade?

•Doesthenewtrademaintainthebalanceordiversificationoftheportfolio?Isitoverexposedinanyonesector?

Duringthetrade:

•Hasthetradereachedthemaximumallowedloss?

•Hasthetradereachedthetargetprofit?

•Istherewardofkeepingthetradeopenworththerisk?

Afterthetrade:•Didyoufollowtheriskmanagementrulesonthistrade?

•Ifyoudidnot,whynot?YoumayhaveheardsuccessfulinvestorslikeWarrenBuffetsay,“Rulenumberoneisneverlosemoney.Rulenumbertwoisneverforgetrulenumberone.”ThesecrettoimplementingBuffet’srulenumberoneistohaveadisciplinedriskmanagementprocessinplace.Tomanageitsrisk,TOMIC

needstodothefollowing:1.Createamoneymanagementpolicy.

2.Defineapositionsizingpolicy.

3.Maintainadiversifiedportfolio.

4.Adjustthetradesorexitwhenatradegoesbad.

5.Buyportfolioinsurancetoprotectagainstblackswanevents.

MoneyManagementManytradershaveblownuptheiraccounts.Insomecasestheyhaveblownupseveralaccountsandhadtostoptradingforatime.Someofthemhavehadtogiveuptradingaltogether.Moneymanagementisaveryseriousissue.Mostpeople,whentheystarttrading,aresoexcitedthattheyarequicktoopenandfundtheaccount.

Assoonastheaccountisopened,thefirstthingtheydoisplaceatrade.However,thefirstthingyoushoulddoismakesureyouhavemoneymanagementrulesinplace.Moneymanagementrulesareyoursafetynettohelpavoidblowinguptheaccount.Theworstthingthatcouldhappenislosingyourcapitalandbeingunabletotradeanymore.OneofDennis’s

tradinginstructors,Dr.AlexanderElder,toldhimthattherearetwotypesofthreatseveryoneshouldwatchoutfor:sharksandpiranhas.Thesharkthreatisthatlosingtradethattakesoutabigchunkofyouraccount.Itisabigpainfulbitethatwillseverelydamageyouraccount.Italsodamagesyoupsychologically.Justimagine

wipingout35%ofyourequityinonetrade.Thatisarealsharkbite.Thepiranhathreatiswhathappenswhenyouhaveasequenceofsmalllossesthatoverwhelmyou.HaveyouseenthevideosofhowpiranhaskillacowintheAmazons?Theytakealotofsmallbitesandendupeatingthecow.Samewithyourtradingaccount:Ifyouhavea

lotofsmalllosses,youraccountwillshrinkanddie.Itisveryimportantthatyouraccountprevailagainstyourbadtrades,whetherpiranhasorsharks.Specificmoneymanagementrulesarewise.Forexample,youcansettwoprimaryrules.First,neverriskmorethan2%ofcapitalonanysingletrade.Second,ifinanysinglemonththeaccountlosesmorethan6%,

stoptradingfortherestofthemonth.Thefirstrule,neverriskmorethan2%onanysingletrade,protectsagainstthesharkattack.Ifyoukeepyourriskto2%onanyonetrade,youraccountwillbeabletosurviveevenifyouhaveabigloss.Yes,losing2%isnotnice,butitwon’tkillyouraccount.Thesecondrule,stoptrading

whenyouhavelost6%inasinglemonth,protectsagainstthepiranhaattack.Whenyouhavemultipletradesgobadinarowandthingsaregoingagainstyou,stopandreassessyourtradingstrategies.Maybeyoursetupsarewrong.Maybetheenvironmentchangedandyoudidn’tnotice.Maybeyouarenotmakinggooddecisions.Thepointisthatifyouaredown6%inamonth,stop

tradingandstartfreshthefollowingmonth.Why6%?Thisisanarbitrarypercentage.Yourpercentagecouldbe5%,6%,7%,10%,oranypercentageyoucanlivewith.Thekeyistonotletthepiranhaskillyou.Youneedtobeabletotradeanotherday.Remember;don’tletbadtradeskillyouraccount.Makesureyouhavestrict

moneymanagementrulesinplaceandabidebythem.Whenyoudothis,youwillbeastepclosertomakingmoney.

PositionSizingThesizeofthetradesshouldbestructuredbyfollowingsoundmoneymanagementrules:Noonetradecanriskmorethan2%ofthecapital,andinanymonththatyou

lose6%thefundgoesflatandstopstradingforthatmonth.Assumethatafundhas$2millionundermanagement.Followingthe2%rulemeansthefundcouldriskupto$40,000ononetrade.IfyoutradeaRUTcondorwith10-pointwing-spreadswherecondoruses$1,000ofmargin(assumingReg-T),youwouldthinkyoucoulddo40RUT

condors.Thatis40×$1,000=$40,000,whichis2%of$2million.Actually,thisiscorrectifyouassumeyouwillletthecondorlosethemaximumitcan.Inpractice,weusuallyuseasmallerallowedlossbeforewepullthetrade.Forexample,intheRUTcondorwemighthaveaprofittargetof15%ofmarginandanallowedlossof20%ofmargin.Soifonecondorlost$200(20%of$1,000),

youwouldexitthetradeinsteadoflettingitlosethemaximum$1,000.Ifyouonlyallowthetradetorisk$200ifyoucanrisk$40,000(2%of$2million)pertrade,thenyoucouldtradeupto200RUTcondors.Aquestionthatcomesupalotisthatifthesecondruledoesn’tallowyoutolosemorethan6%inamonth,doyouhaveonlythreetradeson

atanytimeduetothe2%rule?Theanswerisno.Youcanhavemultipletradesonwhenfollowingthe2%rule,becausenotallthetradesarelikelytogoagainstyouatthesametime.Iftheydo,youarechoosinghighlycorrelatedtrades,whichshouldnotbedone.Onaverage,ifyouhave15to20tradesonatatimeandassumean80%successrate,youwouldhavethreetofourtradesgoagainstyouin

anygivenmonth.Sohittinga6%lossinamonthisunlikely.Ifyouhadfourbadtradesat2%,thelosswouldaddupto8%.However,youhavetocountthecontributionsfromthewinningtrades.Thesewouldhavetomakelessthan2%toyieldanet6%lossforthemonth.Ifyoudidlose6%,youshouldstopandreassessyourstrategies.

Followstrictpositionsizingbasedonyourmoneymanagementparameters.Theseruleswillkeepyourfundssafeandkeeptheaccountfromblowingup.

PortfolioDiversificationInadditiontopositionsizing,TOMICneedstomaintainadiversifiedportfolioinorder

toavoidgettinghitbyanyonesector.Eventhougheachpositionhasamaximumexposure,ifallthepositionsareincorrelatedmarketsthepositionsizingwillnotsafeguardtheportfolio.Forexample,let’ssayTOMICpositionsizingguidelinesprescribeamaximumportfolioexposureof2%perposition.However,ifallitspositionsareinintegratedoilcompanies,Exxon-Mobil,

Chevron,BPAmoco,ConocoPhilips,andPetrobras,thepositionsizingwillnotsafeguardtheportfoliobecauseallpositionsareheavilycorrelated.Forpositionsizingtowork,TOMICmustbeawareofportfoliodiversification.TOMICshouldtrytoincludemultiplesectorsorindustriesintheportfolio.Thiswillhelpavoidhavingtoomuch

investedinonesector.TodiversifyTOMIC’sportfolio,agoodideaistohaveatleastfivesectorsrepresented.Also,noonesectorshouldrepresentmorethan25%oftheportfolio.Forexample,TOMICcouldhaveoptionspositionsinfivemarkets,suchasSPX,AAPL,GS,FCX,andBP.Thismixwillcreategooddiversification.Inaddition,

noonepositionshouldberiskingmorethan2%ofTOMIC’scapital.

AdjustingtheDifferentTradesWhileTOMIChasopentrades,ithastoactivelymanagerisks.IfatradeisgoingagainstTOMIC,itmustreducethelossescausedbyabadtrade.Therewillalways

bebadtrades.Noonecanwin100%ofthetime.Youcanavoidlosingonlyifyoudon’ttrade.Adjustingyourtradesispartofriskmanagement.Afteryouhaveenteredintoatrade,makingadjustmentswillmakethedifferencebetweenlosingalotofmoneyandlosingalittle.TOMICmakesadjustmentstoprotectitscapitalandminimizelosses.

Makingadjustmentsdoesnothelpyoumakemoremoney,butitdoeshelpyounotloseasmuch.Youmakeadjustmentstoatradewhenitisgoingagainstyou,notwhenitisdoingfine.Oneadjustmentthatshouldnotbeoverlookedisclosingthetradecompletely.Takingalossearlyissometimesbetterthanstayinginalosingtrade.Somepeoplebelievethatit

doesnotmatterwhattradeyouarein—aslongasyouareanexpertatmakingadjustments,youwillmakemoney.Othersbelievethatselectingthetradeandthetradeentryismoreimportantthantheexit.AtTOMICwebelievethattradeselectionismoreimportantthantradeexits;however,makingadjustmentsisalsoveryimportant.Youneedtomasterentries,adjustments,

andexitstobesuccessfulinthisbusiness.

AddressableRisksInthischapterdifferentsolutionstomanageriskhaveincludedthefollowing:

•Moneymanagement•Positionsizing•Diversification•Unitinsurance•Adjustments

Everypositionisimpactedbydifferentforcesgoingfromamacroleveltothemicrolevel.Whenselectingriskmanagementstrategiesforaportfolio,youneedtobeawareofthefollowingrisks:

•Systemicrisk•Marketrisk•Sectorrisk•Companyrisk

Systemicriskistheriskofa

financialsystemcollapsethatinturncanbringdownthelargereconomy.AnexampleofsystemicriskwastheeffectofthecollapseofLehmanBrothersin2008ontherestofthefinancialmarket.ThiscollapsestartedachainreactionthatfrozethecreditmarketsintheU.S.andallovertheworld,andalmostbroughtdowntheentirefinancialsystem.Afailureofonecompanyshouldnot

bringdownanentiresystemorhavesuchagreatimpacttothelargereconomy.However,itdid.Theworldeconomycametoitsknees.Itisverydifficulttohedgeagainstsystemicrisk.Ifthefinancialsystemsfail,youmightnotknowwhetherthepaperhedgedwillhold.Forexample,theownersofcreditdefaultswapsbackedbyAIGmighthavelosttheirprotectionifAIGhadgone

under.Thewaytoguardagainstasystemicfailureistoownrealassetssuchasphysicalgoldandsilver.Marketrisksaremacroeventsimpactingtheentiremarket,inwhichalmostallstockswillgethit.Examplesofmacroeventsincludethe9/11attacksontheWorldTradeCenterandthe2008financialcrisisintheU.S.Theseeventsmovedthemarkets,andit

didn’tmatterwhichstocksyouhad.Marketriskscanbehedgedwithoptions.Buyportfolioinsurance,forexample.Unitputsprovidegoodprotectionforthesekindsofevents.Sectorrisksareeventsaffectingaspecificsector.Forexample,iftheU.S.iscuttingdefensespending,thedefensesectorcompanieswillallbehitnegatively.Another

example:IftheU.S.weretoimposeanewtaxonfinancialinstitutions,theentirefinancialsectorwouldbeimpacted.Companyrisksareeventsspecifictotheindividualcompany.ExamplesoftheseeventsincludethetotalcollapseofEnronandtheBPspillintheGulfCoast.AnotherexampleisthedeathofakeyexecutivelikeSteve

JobsatApple.Theseareeventsspecifictoindividualcompanies.Thecompanyriskscanbehedgedeasilywithoptions,andbykeepingadiversifiedportfolio.Risksrangefromthemacrotothemicroandtherearedifferentwaystomitigatethedifferentlevelsofrisks.Table3.1containsexamplesofriskmanagementsolutionsfordifferenttypesofrisk.

Table3.1.RiskMitigationExamples

InsuringthePortfolioAgainstBlackSwanEventsInsuringorreinsuringunwantedriskisaveryimportantfunctionat

TOMIC.TOMICisnotwillingtotakecatastrophicrisks.Anexampleofacatastrophicriskisa25%lossinthemarketinasingleday.TOMICshouldmanageitsrisklikeatraditionalinsurancecompany.Forexample,atraditionalautoinsurancecompanywouldreinsuretheriskitdoesnotwanttocarry.AssumethatABCInsurance

Co.(afictitiousAmericanpropertyandcasualtyinsurancecompany)hasalotofcarsinsuredintheSanFranciscoBayArea.Thisregionispronetoseismicactivity.IfSanFranciscoweretosufferalargeearthquake,allthecarsthatABCInsuranceCo.insuredwouldsufferdamages.ABCwouldhavealotofclaims.ABCInsuranceCo.wantstoinsurecarsagainstnormal

drivingscenarios,butnotabigearthquake.ABCwouldn’twanttotakethecatastrophicriskofhavingalltheirinsuredvehicleshavinglossesatthesametimeduetoanearthquake.Hence,ABCwouldreinsurethecatastrophicriskwithareinsurancecompanylikeGeneralRe(aBerkshireHathawaysubsidiary),thustakingonlytheriskofthenormaldailyroutines,and

givingsomeoneelsetheearthquakerisk.ThedivestingofunwantedrisksisexactlythesamethingthattheriskmanagementfunctionsperformatTOMIC.TOMICiswillingtotaketheriskofnormalmovesinthemarket,suchasplusorminus5%pricemovement,butitreinsuresthecatastrophicriskbeyond.Toreinsurethisrisk,TOMICcouldbuyout-of-the-

moneyputsontheS&P500toprotectagainstalarge(25%)downturninthemarket.Anotheralternativetoreinsurecouldbetobuyout-of-the-moneycallsontheVIX.ThisassumesthatalargedropintheS&P500wouldleadtoalargespikeintheVIX.DependingonthepricingoftheSPXputsandtheVIXcalls,TOMICcoulduseoneorbothoptionstooffloadthecatastrophicrisk.

UnitsCanSaveYourPortfolio

Thefollowingisanexampleofhowtoprotectyourportfolioagainstablackswanevent.LookbacktotheflashcrashofMay2010.AfundhadenteredaMayOEXbutterflythathadbeendoingreasonablywell,untilthefirstweekofMay.Themarketbegantofallawayfromtheshortstrikes.Atonepointthe

tradewasdownalmost10%onthebutterfly,evenafterallthehedgingandadjustinghadbeendone.ThenonMay6,theflashcrashhappened,andthepositionmadeakilling.Why?Becausethefundwaslongwhatmostmarketmakerscall“units.”Theseunitsenabledthebutterflyposition,whichbyitselfgotkilledbythecrash,tobeprotectedbytheoptions.

AunitisaninexpensiveoptionwithunpredictableGreeks.Youcanbreakthemdownrelativetoproduct,sothatthemoreexpensivetheunderlying,themoreexpensivetheunit.Forinstance,inSPYanoptionbecomesaunitaround20cents;intheSPXanoptionisaunitcloserto2.00.Allunitswillhavedeltasbelow5andlittletonogammaorvega.Sohowdotheseunitswork?

Oneofthemajorissueswithmostmodels,especiallythoseusedbytheretailworld,isthattheypredictuniformincreasesinvolatility.Thissimplyisnotthecase.Whenthemarketmakesaviolentmovedownward,twothingshappen:

1.Frontmonthoptionsincreaseinvaluefarmorethananyothermonth,inrelativeterms.

2.Downsideputsgainfarmorevaluethanthemodelpredicts.

Thinkofthevolatilitycurveinastrongdownmovelikeathinpieceofwoodevenlybalancedoverafulcrum.Ifafatguyjumpsononesideofthewood,whatwillhappen?Aswithaseesaw,themoreyoumovedowntheboardawayfromthefulcrum,themoreindistancethewood

willhavemoved.Thereisanotherfactorthough:Sincethefatguyjumpedonthepieceofwood,thewoodwillhavemovedviolently,causingthewoodfarthestfromthefulcrumtotemporarilybendupward.Thisisthewaycheapputsactinamajordownmove.Inthepanic,theworldisbuyingATMputs.Everytradersellingorshortingtheseputs

racestobuysomethingtoprotectthepositionincasethemarkettanks.Theseshortsbuy“units”andallofthisbuyingcausestheunittogainalittleprice,whichincreasesvega,whichincreasesdelta,whichincreasesthevalueoftheunitasthemarkettanks.Thisinturncausestheunittogainmorevalueastradersracetobuythesetoprotectsales,

whichraisesthevega...yougetthepoint—thereisasnowballeffect.HereisanexampleofexactlywhathappenedwiththefundintheOEXonApril20.ThefundboughttheOEXMay505putsasahedgeagainstashortironbutterfly.Theputswereboughtfor$1.20.WhenthemarketfellonMay6,theseoptionswereworthalmost$10,andonMay7,

theyclosedat$14.50,areturnofover1,200%.Notbadforanoptionthatcost$1.20.Sohowcantheordinarytraderuseunitstoincreasethereturnsofhisportfolio?Buyunits,notahugeamount,butabout5%to10%ofallocatedtradingmoney(notthetotalaccountvalue),shouldgointoputs,againstastandardsetofspreadtrades(condors,butterflies,andtime

spreads).Thisamountshouldbeenoughsothat,adjustedforanyincreaseinvolatilityifthemarketdrops10%,yourpositionnolongerlosesmoneyandpossiblygains.Ifthemarketdrops20%,youshouldbemakingmoney.Themathisnotthatsimple.Understandinghowunitsworkcomeswithunderstandingvolatility.Byproperlyimplementingunits,

youarewillingtobetthatyouwillneverhavetosellyourhousebecausethemarketdropped25%.

4.TradeExecutionPlanningneedstobedoneinsports,inconstruction,andintrading.Insportsorconstruction,oncethegamehasbegunthoseplanscangooutthewindow.Conditionsonthefieldcanchangeorrealestateconditionscanaffectthedevelopmentofa

skyscraper.ThesamecanholdtrueinimplementingaTOMICtradingplan.However,unlikewithsportsandconstructionprojects,theTOMICtraderhasamuchgreaterabilitytocontroloutcomes.Thekey,asitisinmanybusinesses,isexecutingaplaninawaythatisdisciplinedbutadaptive,aformofhavingguidelinesandanapproachwithouthaving“tradingrules.”Justasina

JamesDeanmovie,rulesaremadetobebroken,sotradersneedtobeflexible.InthissectionyouwillwalkthroughtheprocessofimplementingaTOMICplanfromstarttofinish.Todoso,youwillfollowachecklistthatdemandsathoughtprocess,guidingyouinyourtradingdecisions.Thenyouwillwalkthroughgettinganorderfilledeffectively.

ConditionsoftheMarketThefirststepistoevaluatethemarket.Atanygiventimethemarketcanbeeithervolatileorcalm.Itcanhaveinflatedorundervaluedimpliedvolatility.Differentcontractmonthscanbeunderpricedoroverpriced.Withinacontractmonthdifferentstrikescanbe

overpricedorunderpriced.Withallofthesemovingpartsgoingbackandforthatanygiventime,themarketisgoingtobemoreorlessfavorabletospecifictrades.Manybooksandcoursesteachtradingbasedonenteringthesametradeeverymonthregardlessofconditions;thisisanextremelyflawedapproach.Instead,takethesameapproachaninsurance

companywouldtake:Seewhatconditionthemarketisin,andsellaninsurancepolicythatisleastlikelytobeexercisedbythebuyer.Todoso,youneedtofirstunderstandhowtoevaluatethesituations.

EvaluatePotentialRealizedVolatilityWhenMarkwasatraderon

thefloor,oneofthethingshequicklyrealizedwasthathedidnotneedtohaveanopiniononacompany’searningsoranFDAdecision,buthedidneedtoknowthattheeventwascomingup.TOMICtradersneedtohavethesameapproach,especiallyfornondirectionalpolicyselling.Doesthecompanyhaveearnings,isthefederalgovernmentreleasingimportantdatathisweek,is

thefederalreservehavingapolicymeeting,oristherepotentialtroubleinafar-offplacethatcouldpotentiallyaffectfinancialmarkets?Theseareallquestionsyouneedtobeabletoanswerbeforemovingon.Itissomewhatdifficulttoevaluatethepremiuminaparticularinsurancepolicywithoutknowingwhatfactorscouldcausethatpolicytobeenacted.

Alltheresearchintheworldwillnotpredictearthquakes,terroristbombings,andothercatastrophicevents.ReasonnumberoneisthatlookingatHV(historicalvolatility)canequateto“pissinginthewind.”Thisiswhyyouneedtoevaluateandhaveyourworst-casescenariointhebackofyourheadatanygiventime.Lookingintothepastgivesyouinsightintohowthemarketmightreact.

Ifyouassumevolatilityismeanreverting(anassumptiontheentireoptionuniverserelieson),astockorindexmovingatanextremelyhighrateofspeedislikelytoslowdown.Astockmovingmuchmoreslowlythannormalislikelytoincreaseinvelocity.Takingthisintoconsiderationhelpsyouevaluatehowexpensiveorcheapaninsurancepolicymightbe.

EvaluateImpliedVolatilityThepriceofaninsurancepolicyisconstantlyinflux.Atanygiventimetheinsurancepolicymightbeexpensiveorinexpensive.IfyouassumethatHVismeanrevertingandthisisthebasisofIV(impliedvolatility),youcanalmostbecertainthatimpliedvolatilitymeanwill

revertaswell.Thisisanimportantassumptionforanytradersellinginsurance.ButisthereawaytoprovethatIVreverts?Ratherthanrunabunchofnumbers,amoreinterestingwaytoseeproofofexpectationofimpliedvolatilitymeanreversioncanbeaccomplishedbylookingatVIXoptions.TheVIXoptionsarecashsettledandEuropean-style.

Becausethereisnoriskofearlyassignment,ifIVgetstoolowortoohigh,theVIXoptionsshouldnotpricetothecashmarket,buttowardsomeexpectationoftheVIXrevertingtoitsmean.Thus,onanIVspike,in-the-moneycallsshouldappearunderpriced,andwhentheVIXisoversold,callsshouldappearoverpriced.Duringtheflashcrash,at

3:30ESTtherewasstillalotofconfusion.TheVIXwastradingatjustunder40%.TakealookatthepricedifferentialbetweentheVIX30callsandtheVIX47.5calls,asshowninFigure4.1.

Figure4.1.Noticetherelativepriceofthe47.5

callstothe30calls.(Source:OptionVue6)

Despiteonebeingin-the-moneyandoneout-of-the-money,thetwowerenotthatfarapartinprice.ThisisbecausetheVIXfuturewasactuallytrading29.20,sobothweretechnicallyout-of-the-moneyifyoulookatthefutures(althoughyouwould

considerthe30stheATMoption).Evenwiththemarketexploding,theexpectationsofcalmingdownstoppedVIXfutures(andthusVIXoptions)fromhittingthe40%thattheVIXcashwastradingatthetime.Oneinterestingthingtonoteisthatthe30swereout-of-the-moneyinrelationtothefutures.Therelativevalueofthisfuturecomparedtothe47.5callswasquiteclear.Oneofthe

worsttradesintheworldistobuyVIXOTMcallsinthemiddleofacrash.ThemeanreversionofVIXwillkillmostofthesetrades.Youwillfindmarketexpectationsofmeanreversion,andyoucanseehowtousethisassumptioninsellinginsurance.Ingeneral,whenimpliedvolatilityistradingatapremiumtoitsmean,itislikelytobea

bettersellthanabuy.Thetraderissellingapolicythathistoricallyisoverpriced.However,thisequationisnotthatsimple.TherecanbegoodreasonsthatIViselevated.Thisiswhyyouneedtowalkthroughsteponebeforeevaluatingimpliedvolatility.IfthereisagoodreasonforIVtobehigher,thesalemaynotbenearlyasgoodasitappears.Forapolicytobesold,youneedto

haveaclearpictureoftherisksofthepolicywhentrading.Onlythencanyoudecidethatapolicyisoverpriced.

EvaluatetheMonthsOnceyouhaveanoverviewofvolatility,itistimetogetyourhandsdirtyanddigintothenitty-gritty.Evaluatingoverallvolatilityisnotenough.Foraneffective

TOMIC,youneedtoevaluatetheoverallsurface,startingwithtermstructure.Thisishowthedifferentmonthswithinaproductarepricedagainstoneanother.Contractmonthsaretightlycorrelatedtoeachother;however,thatdoesnotmeantheyaretiedatthehip.Atanygiventime,paperflow,thedirectionandsizeofcustomersbuyingorsellingoptions,cancauseonemonthtobemoreorless

expensivethananother.Byevaluatinghowthedifferentcontractmonthsarepriced,youcanspotthebestmonthtobuyorsellatanygiventime.Itcanalsopresentdifferentchancestospreadonemonthagainstanother.Remember,yourgoalistosellthemostexpensivepolicyrelativetotherisk.Findingthemostexpensivecontractmonthgreatlyimproves

collectedpremiums.Therecanbedifferentdriversindifferentmonths.Ifyouaresellingaspecificmonth,orspreadingonemonthagainstanother,doingalittlebitofdiggingtoseewhythemonthsarepricedmightrevealatradethatisnotnearlyasgoodasitfirstappears.However,sometimesalargetraderwithanaxtogrind(amajorpositiontoputonortakeoff)canpullthe

contractmonthsoutofwhack.Whenthishappens,youshouldusethisinformationtoyouradvantage.

EvaluatetheSkewOneofthemostunderusedandcommonlymispricedpartsofoptionsistheskewcurve.SkewisatermforhowcheaporexpensivecallsandputsarerelativetoATM

optionsinreactiontohedgingactivities.Forinstance,inequities,IRAs,401(k)’s,andpensionfunds,everyonewantstoprotectagainsttheunderlyingfalling.Todothis,mostfundsemployingoptionscollartheirpositions.Thismeanstheybuyputswithstrikesbelowcurrentmarketpriceandsellcallswithstrikesabove,tohelpfinancetheput.Thiscreatesputsthataremoreexpensive

thanATMoptionsandcallsthatarelessexpensivethanATMoptions.Thisisnotalwaysthecase,butifyoutakealookatthestructureofSPX,youcanseehowhedgingactivitiesaffectthevolatilitysurface.Hedgingactivitiesarenotconstant,andatanygiventimecallsandputscanbecomeoverpricedorunderpriced.Thecurve

movesupordownconstantly.Dependingonthesteepnessofthecurve,differenttradescanbecomemoreorlessfavorableasyoubuyandsellrelativelycheaporrelativelyexpensiveoptions.Knowinghowexpensivethecurveiscanbeapowerfulweaponinyourarsenal.Ithelpsyoudeterminewhattradetoenterandwheretoexecute.

EvaluateOtherProductsMostSPXtradingfirmsalsotradeOEX,RUT,NDX,ES,andmanyindividualoptionnamesbecauseofthecorrelationbetweenalltheindexes.Tradersmustbecertainnotto“fallinlovewith”oneproduct.Forexample,theOEXhasabetarelativetotheSPXofabout

.98historically.YetbecauseofliquiditytherearetimeswhentheymaybesignificantlyoverpricedorunderpricedrelativetotheSPX.Ifyoutradeoneproduct,youmaybemissingoutonsignificantlybetteropportunitiesinanothercloselyrelatedone.Beforeenteringanytrade,figureoutwhetherthatistheabsolutebesttradeavailableatthattime.Ifyoulikeaparticular

product,youmaytakethetimetoexplorehighlycorrelatedproductsandwalkthroughtheprocesswejustwalkedthroughinevaluatingthoseproducts.Remember,aninsurancecompanydoesnotcarewhoitinsures,onlythatitissellingstatisticallythebestproductatthehighestprice,withthemostreturn.

Nowthatyouhavenarrowedyourdecisiontoaspecificproduct,itistimetodesignthetrade,thengetitexecuted.Togetthebesttrade,youneedtopickstrikes,andgetthetradefilled,asinexpensivelyaspossible.

PickingStrikes

Asalargecustomerbuysorsellsdifferentstrikesupanddowntheskewcurve,specific

strikescanbecomeoverpricedorunderpricedrelativetoeachother.Consistentlybuyingtherelativelycheapstrikeagainstsellingarelativelyexpensivestrikecanproduceahigherrelativecreditoncreditspreads.Althoughitmightseemsmallatfirst,evensqueezingoutafewpenniespertradecanmakeabigdifferenceinaportfolio.AfullyfundedTOMICcan

tradeasmanyas15to30tradesinandoutwithmorethan1,000contractspertradeinagivenmonth.Thatamountstobetween10,000and100,000contractspermonth.Improvingtheaveragefillpricebyaslittleasonecentpercontractcanadduptobigdollarsprettyquickly.Thekeyistonotbemarriedtodeltaorpercentageout-of-

the-money.Ifyouwanttosella10deltaputorcall,butthe11or9deltaoptionisthebestsale,youarebetteroffsellingthatoption.Ifyouliketosellspreads5pointswide,butinrelativetermsthebestcreditisavailablebyselling10or15pointswide,youshoulddoso.Evaluatethesurfacewhensettingupatradeandsellthemostexpensiveoptionaroundthestrikeyoustudied.

Onethingnewtraderstendtoforgetisthatvolatilityequatestoprice.Witheverycentyougivetothemarketmakers,youaresellingaslightlylowerIV.IfyouknowtheIVyouaretryingtosell,youneedtoknowtheequivalentprice.Thenattempttoexecuteatthatgivenprice.Ifyoucannotgetthetradedoneatyourprice,

youarebetteroffnotsellingthanconcedingtoomuchonthetrade.Remember,thereisanadvantageonlyifyoureceivetherightprice.Youmightnotbeabletogetafillatthemidprice,butyoumightnothaveto.Ifyouknowthelowestimpliedvolatilitylevelyouarewillingtoselldownto,youcaneasilycalculateyourminimumsaleprice.To

determinehowmuchyouarewillingtoconcede,useIVandvega.Forexample,supposethesellsideofanoptionspreadhasanIVof21%.Thisproducesapriceof$2.00;youarewillingtosellthespreaddowntoanIVof20%.Thenetvegaofthespreadis.05.Multiplying.05×1%(×100)produces.05offlexibilityinthespreadprice.Thus,you

arewillingtosellthespreaddownto$1.95,butnotanylower.

OrderEntryWhenMarkwasatraderonthefloor,heusedinstantmessagingtotalktobrokersallthetime.Someofthelargestinstitutionsintheworldwouldshowhimsomeoftheir“flow,”andsometimeshewouldtradeit.

Thatwashisjob,tomakemarketsandtaketheothersidesoftrades.However,thereweretimeswhenhebecamethebroker.Itwasthenthathehadtochooseabrokertorepresentmyorder.Atfirsthetestedeverytypeofbroker:floorexecutionbroker,upstairsbroker—heck,heeventriedrepresentinghimselfinacrowdortwotogetanorderfilled.Overtimehebeganto

learnwhichbrokerscouldgetthebestfillsfordifferentstocksandETFs.Thenumberofbrokersquicklyfellofftoveryfewandeventuallyheusedonlythree.Why?Because,aswithtraders,thecreamofthebrokersrisestothetop.Hefoundthebestbrokersforthespecificthingshewastryingtoaccomplishandusednooneelse.Theyrewardedhisloyaltyandconsistentflowwithbetter

fillsandlowerrates.Heneverusedonlyone.Itwasimportanttohimtohavetheflexibilitytosendanordertothebrokerhethoughtwasmostlikelytogivemethebestfill.Youmightnottalktobrokerseveryday,butyouwilluseabrokereverydayifyouareexecutingaTOMIC.Selectionofthebestbrokermattersforseveralreasons:

•Onebrokerisgoingtobebetterattradingdifferenttypesofproducts.IfyouaddfuturesoptionstoTOMIC,itmaybecomenecessarytoaddasecondbroker.Mostbrokersoffereverything,butthatdoesn’tmakethemgoodateverything.OnceyourTOMICisbigenoughtohave

moneytotradeinfutures,itshouldbeallocatedtothebestfuturesbroker.Havemoneytotradeoptionsallocatedwiththeoptionsbroker.

•Ifyouareinterestedinlearningortradingaproductandthebrokerdoesn’tcarrytheproduct,consideropeningasmallaccount

withanotherfirmtolearntheproduct.

•Onebrokermighthavebetteranalytics,whilelackinggreatexecution.Itmightbecomenecessarytoleaveafewdollarswithonebrokeroranotherjusttogetreal-timedataandgreatanalytics.

WhenselectinganoptionsbrokeratTOMIC,youshould

keepafewthingsinmind.•Lowcommissions:Whenfirstlearning,alowornonexistentticketchargeisveryhelpful.However,aticketchargewithlowerper-contractcommissionstypicallyendsupbeingabetterdealovertime.

•Theabilitytoreadspreadbooks:Oneof

thethingsmanytradersdonotrealizeishowvaluableorderinformationcanbe.Whenlookingthroughaspreadbookyoucanfindvaluableinformationsuchasbetteroffersthantheorderyouaretryingtofill,andcounterofferstoyourorders.

•Theabilitytoroute

orderstoanexchange:Youneedtoknowthat“smartrouters”areinfactsmart,justnotinthewaytheyarepresentedtothegeneralpublic.Ordersareroutedviaanalgorithmthatcalculateswherethebrokerwillmakethemostmoneyfromtheorder,notbasedonwheretheorderismostlylikelytoreceive

thebestfill.Withtheabilitytoroutetospecificexchanges,youtakeawaytheabilityofthealgorithmtostopfromgettingagreatfill.Althoughitmaysoundtrivial,routingtoaspecificexchangecangettradesfilledatbetterpricesrelativetothepriceoftheunderlying.Inotherwords,whenbuyingacall,youwill

beabletogetfilledwiththestockpriceslightlyhigher.Itonlytakesseeingyourpricetradeonceonanawayexchangewhileyourorderdoesn’tfilltolearnthislesson.

Onceyouhavepickedthebestbrokerfortheproductyouwanttotrade,youshouldpickthebestexchange.Firstroutethetradetothe

exchangewiththebestbidoroffer.Theexchangethathasthebestmarketwillgenerallyprovidethebestfill,unlessthebestofferisoneoftheso-called“makertakermodel”exchanges.Interestingly,thoseexchangeswiththebestofferwillhavelittleeffectonyourabilitytogettheorderfilled.Ifthecounterbidsoroffersareallthesame,thebiggest

bidsorofferswillprobablyimprovethings.Thisbeliefisunfounded;however,ifthereisoneexchangeinparticularthattradesmuchlargersizesrelativetootherexchanges,itmaybebeneficialtoroutetothatexchange.Thekeyistoroutetoexchangesprovidingthebestfills.Thebestfillsoccurattwoexchanges,theCBOEandtheISE.Nextonthelist

arethePHLX,NYSE-ARCA,andAMEX.Theseexchangesmaybethebesttoroutetoiftheyareparticularlydominantinaproduct.Neverroutea“makertakerexchange”unlessyouarehittingabidorliftinganoffer.Marketmakersalmostunilaterallyhatepayingtofillorderstheyarehitting,affectingthefillpricesignificantly.Nowthatyouknowwhatto

trade,thenextstepishowtosendintheorder.Hereareafewwaystogetyourordersfilled.Thefirstthingyouneedtoknowishowsmallordersarefilled.Backinthedaysbeforecomputers,ifacomplexordercameintothecrowd,themarketmakerswouldpriceeachlegindividually,addandsubtractthebuysandsells,andcomeupwithamarket.

Inthatenvironment,wherethemarketmakercouldlookattheorderbeforeitwastraded,marketmakerswerewillingtoimprovethepriceonindividualspreads.Spreadsofferedmoresecuritybecauseitwasbuyingoneoptionandsellinganother,meaningpartofthepositionwasalreadyhedgedandthetraderlikelyhadtoselllessunderlyingtohedgethepositionentered.Eventhenif

anordergottoocomplex,marketmakersneverlikedtradeswithmultiplestrikes,differentmonths,weirdspreadsbetweenstrikes,oranythingelsethatwasunusual.Nowadays,thingsareverydifferent.Complexordersaremostlyexecutedbyanalgorithminsteadofbeingquotedbytheindividualtrader.Becauseofthis,

marketmakershavetobeespeciallycarefulofhowmuchedgetheyarewillingtogiveonanytypeoforder.FirmslikeTimberHillandCitadel,muchlikecomputerhackers,areconstantlytestingtheexchangestofindweaknessesinthesystem.Iftheycanpickoffaquotingalgorithmtheywilldoitquickly,efficiently,andinasmuchsizeastheypossiblycan.

Becauseofthis,thesimplerthetrade,themoreeasilyyouarelikelytogetitfilled.Individualoptionorderswillfillat,relativetotheunderlyingprice,betterpricesthanspreadsalmostallthetime.TheproblemisthatthisbringstheconceptofdirectionalriskintotheequationfortheTOMICtrader,somethingyouareconstantlytryingtoavoid.Sobuyingorsellingindividual

optionstosetupaspreadisnotadvisableunlessyouareplanningtotradetheunderlyingbackandforthasyoufillthespread.Infact,eventhoughtheorderisgoingtobetoughertoexecute,newertradersshouldalmostexclusivelyputthedelta-neutraltradeinatonce.Asyoubecomemoreexperiencedatorderexecution,youshouldbegin

tobreakordersapart.Infact,asaretailtraderyouwillfindthatyouhaveatonetimeoranothermispricedandcouldhavegottenbetterfillthanbreakingthetradeup.Remember,individualoptionquotesarethemostefficientlypriced;thus,youarelesslikelytogetmessedoverbymarketmakers,butyoumayalsobelesslikelytogetagreatpricefromthemarketplace.

Asyoubecomemoreexperienced,firsttrytofillthewholeorder.Ifthiscannotbedoneatanefficientprice,breakupthetrade.Thismaybeyourbestchoice.Callandputspreadsaremucheasiertofillthanironcondorsorbutterflies.Inorderofdifficultytofill,youcanseethebestorderforbreakingapartyourtrade:

Nontraditionalspreads

IroncondorsDoublediagonalsStraddlesStranglesButterfliesVerticalspreadsCalendarspreadsSingleoptiontrades

Onecaveat:Therearetimeswhenasmalltradewithunusualstrikesmayfallintoaspotinwhichanalgorithm

wantstoexecutethetrade.Sonontraditionalspreadsmayfillatpricesthatsurpriseyou.

SizeofOrder

Tradesundertencontractswillhaveaneasiertimefillingthantradeslargerthanten.Mostalgorithmsaredesignedtoletthemarketmakerknowthatthereisanordertotradeandnotsettotradeamassivespread,unless

ithasatonofedge,orthefirmrunsanairtightquotingsystem.Startingsmallwithaspreadoffewerthantencontractshelpsyougetabetterfill.

WorkinganOrder

Justbecausethequotegivesa“midprice”doesnotmeanthequoteisthemidprice.“Bookorders”canthrowoffthebid-askspread.Bookorderscan

alsothrowoffvolatilitycalculationsbecausetheycanartificiallylowerorincreasetheIVofthecalculatedmidprice.Whatyouareusingasacalculationwhentradingvolatilityaffectsthis.Onceyouhaveestablishedthemidpoint,itneverhurtstotrytodobetterthanthatprice.Justbecauseitisacomputerquotingthepricedoesn’tmeanthatitcan’tscrewup.If

youhavedumpedinthewrongIV,thecomputermightfilltheorder.Also,atraderortradinggroupmighttradeinamannerthatcausesthetradinggrouptofilltheorderevenifitisabovethequotedmidprice.Chalkthisoneuptothe“itneverhurtstotry”category.Mostmarketmakerstrainforatleastayearbefore“gettingonabadge.”AsaTOMIC

trader,youareself-backed,tradingyourownmoney.Beasrigidaspossiblewithhowyoutradeandbecomeskilledingettingtheabsolutelybestpossiblepriceyoucan.Remember,saving.05onaten-contracttradeeverydayequatesto$12,500ayear.So,tomakethingseasy,hereisthethoughtprocessIgothroughandencouragealltraderstogothroughwhen

theyenterthemarket.Byfollowingthischecklist,traderscandevelopanapproachthatwillhopefullyhonetheminonatradewithedge.

TradeExecutionChecklist

Beforethetrade:•Whatmarketareyougoingtotrade?

•Whatisthedirectionofthemarket?

•Didyoucheckthevolatilityconditionsofthemarket?Whatisthehistoricalvolatilityofthemarket?Whatistheimpliedvolatility?Didyouchecktheskew?

•Whatisthestrategyyouwillbeusing?

•Ifthisisacomplexspread,howwillitbeexecuted?Isitworthexecutingatthe

individualcomponentlevel?Willyoubeleggingintothespread?Willitbesentasacomplexorder?

•Whatisthemaximumallowedloss?

•Istheexpectedreturnwithintheunderwritingparameters?

•Whatisthetargetprofitforthistrade?

•Whatisthesizeforthis

trade?•Doesitconformtothepositionsizingparameters?

•Atwhatpointwouldthetraderequireadjustment(ifany)?

•Doyouknowthepossibleadjustmentstomaketothetrade(ifneeded)?

Duringthetrade:

•Hasthetradehitanadjustmentpoint?

•Hasthetradehittheprofit/losstarget?

Afterthetrade:•Didyoulogthetradeinthetradingdiary?

•Didyoufollowthetradingplan?

•Ifyoudidnotfollowthetradingplan,whynot?

5.TheTradingPlan

“Failingtoplanisplanningtofail.”—AlanLakein

Noteverybusinesshasabusinessplan,buteverysuccessfultraderhasatradingplan.Tomakemoneyconsistently,youneedaplan

givingyourselfaframework,definingtheparameters,andkeepingyourfocus.Havingaplanisnotaprerequisitetostartingabusiness.However,havingaplanisusuallyaprecursortocreatingasuccessfulbusiness.Manypeoplecanstartabusiness.Thenumberofstartupsperyearislarge;but,intheend,onlytheoneswithaplanthatcanbe

implementedwellwillsurviveandflourish.Inthebusinessoftrading,successfultradershaveatradingplanthattheyfollow.Thereasonforcreatingatradingplanistoguardagainsttheemotionalswingsthatyougothroughwhentrading.Thetradingplanestablishesaframework.ItgivesyouasaTOMICtraderaprocesstofollow.Thetradingplandescribeswhatto

doineachscenario.Itislikeaflightplanandanemergencyplaninone.Thetradingplancontainsguidelinesfortrading.Itdefineshowyouplantoplaythegame.Intradingyoumakeyourownrules,butthekeyistobeconsistent.Ifyourrulesdonotwork,getnewones,createanewplan.However,theonlywayyouwillknowwhethertheywork

isbystickingtotheplanandevaluatingyourperformancecontinuously.Whenacasinosetsupablackjacktable,itgivesitsdealersspecificparameterstofollowwhendealingcardstoitsclients.Forexample,thedealermuststayon17andmusthit(takeacard)onlessthan17.Thisisaspecificrulethatthecasinoimposesonthedealertohaveconsistency

acrossthecasino,anditisdonesothatthecasinohasanedge.Atradingplanworksthesameway;itgivesthetraderaframeworktogenerateaconsistentoutcome.Thetradingplangivesyouachancetowinbyfollowingaprocessprovidingmeasurableoutcomesthatcanbeimprovedcontinuously.

TheMind-Set

Themind-setofasuccessfulmanagerofTOMICorofanybusinessisveryimportant.WhenaU.S.Marinegoesintothebattlefield,heknowsthatheisfightingforhiscountryandthatnomatterwhat,hewon’tbeleftbehind.Marinescangointoanyscenarioconfidentthattheirfellowmarinesarewatchingoutforthem.Thefeelingofconfidenceina

tradingplaniswhatyouneedtomanagetheTOMICportfolio.Thebeliefinthetradingplankeepsyououtoftroubleandleadstoprofitsconsistently.However,confidenceorbeliefintheplanisnotenough.Followingtheplanwillgetdifficultattimes.Thatiswhy,asthesuccessfulmanagerofTOMIC,youhavetobededicated,disciplined,bold,flexible,andhumble.

TOMICisabusiness,anditwilltakealotofdedicationandcommitmenttofollowthetradingplantomakeprofits.Therewillbealotofupsanddownsthatwillimpactyourmanagementpsyche.Itisnotaneasybusiness.Themarketwillconstantlychallengeyou.However,thecommitmenttothebusinesswillovercometheemotionalswings.

Youwillneedtobeextremelydisciplinedinordertofollowthetradingplan,makingsurethattheentriesandexitsarefollowed,andthattheunderwritingisdonecorrectly.Thedisciplinehelpsyouovercometheemotionsoftrading.Oneofthebiggestreasonsthattradersblowuptheirportfoliosisnottakinglossesearlyenough.Thisisbecausetheemotionoflosingisso

greatthattakingalossisundesirable.Eventhoughtheplanwillsaytotakethelossearlytoavoidalargeronelater,theundisciplinedtraderwillfreeze.Youhavetobepreparedforthissothatwhenthetimecomestotaketheloss,youactuallytakeitandfollowthetradingplan.AsthemanagerofTOMIC,youalsoneedtobeboldanddecisive.Therewillbetimes

whenopportunitiesaboundandyoumustdecidewhethertotakethem.Thentherewillbetimeswhenyouwillneedtonottrade,whenopportunitiesarescarce.Also,beingboldallowsyoutomakecriticaldecisionsattheappropriatetime.FlexibilityisoneofthemostunderratedcharacteristicsofagoodTOMICmanager,butoneofthemostimportant.

Beingflexibletogetherwithboldnessallowsyoutochangecoursewhenthingsarenotgoingyourway.Let’ssaythatyouhaveaportfolioleaningnetlongandthemarkethasreversedandgonefromabulltoabearmarket.Youneedtomakethedecisiontochangetheportfoliofromleaninglongtoleaningshort.Thisisnoteasytodoifyouarenotflexibleanddecisive.

OnemoreimportantcharacteristicofthesuccessfulTOMICmanagerishumility.Themarketwillsendmanycurveballs.Itisveryunlikelythatyouwillhave100%successfultradeseveryyear.Remember,evenWarrenBuffetthashadhisshareofbadinvestments;forexample,SalomonBrothers,USAirways,silver(waybeforesilvertookoffin2010–11).However,thinkof

badtradesaslearningopportunities.Badtradesprovidefeedbackthatteachesyouhowtodobetternexttime.Beinghumbleisthekeytonottakinglossespersonally.Lossesarepartofthebusiness.Iftherewerenolosses,noonewouldneedtoinsureandthenTOMICwouldbeoutofbusiness.Inconclusion,yourmind-setasthemanagerandtraderis

thekey.Youneedtobededicated,disciplined,bold,flexible,andhumbleinordertobesuccessfulatTOMIC.Ifyouhaveastrongmind-set,youwillsucceed.Whenatradegoesagainstyou,bepreparedbutdonotpanic.Fortunesaremadeandlostintimesofgreatuncertainty.Mentaltoughnessisrequiredinthisbusiness.Itislikethegreatchampionsin

sports,MichaelJordanandTigerWoods.Theyhavethementaltoughnesstobedisciplinedandcomethroughattheend.It’sthesameintrading:Youmusthavetheworst-casescenariosplannedoutsothatwhensomethinghappensyoudon’tfreezeandyouknowwhattodo.Justlikeacommercialairlinepilot,incaseofemergencyyoucalmlygothroughyourchecklist.Anexampleof

havingaplanwasthatofCaptainChesleyB.Sullenberger,whohadtoditchaUSAirwaysjetintheHudsonRiverinManhattanonJanuary15,2009,whentheplanewashitbyaflockofCanadiangeese.Fortunately,CaptainSullenbergerhadtrainedforemergencysituations,andhehadaplanhewasabletoexecuteperfectly.Insodoing,hesavedthelivesofallhis

passengers.Havingatradingplanwillhelpyouhavethescenariosmappedoutandwillgiveyouthatguideofwhattodoinanemergency.

TheImportanceofStickingtotheProcessWhenyou’rerunningabusiness,whatdoyouthinkisbetter:stickingtoaprocessor

goingwithyourgut?Beingluckyorbeinggood?Thesayinggoes,“Itisbettertobeluckythantobegood.”However,youcan’tbeluckyallthetime.So,wheredoesthatleaveyou?Assumingthatyouknowhowtoplayblackjack,takealookatthefollowingscenario.Youaredealta10andan8,makingyourcount18.Thedealerisshowinga6.

Potentially,thedealercouldhavea16,inwhichcasehewouldhavetodrawacardandprobablybust.Youhit(askforacard)andfortunatelygeta3,makingyourhand21,awinner.Therearehigh-fivesallaroundthetableandyouthinkyouareagreatgambler.IfyouhadbeenyourTOMICmanager,wouldyouhavebeenhappywithwhatyoudid?Hittingonan18withthedealershowing

a6...wasthatagoodmove?Eventhoughyouwon,didtheoutcomejustifytheriskyoutook?Inreality,beingluckyworksgreat,ifyouareluckyallthetime.However,themoveyoumadeattheblackjacktablewasalousymove.Theoddsofyourbusting(losing)wereveryhighifyoudrewacard,whiletheoddsofthedealerhavinga16andhavingto

drawwereveryhighalso.Thedealerhadagoodchanceofbusting.Soyoushouldhavestayedandletthedealerdrawinstead.Youhadamuchbetterchanceofwinningifyouhadstayedwith18.Takingthehitwasabad(onecouldsaystupid)decision.Hey,youwon.Butweabsolutelywouldnothireyoutomanageourmoney.Youwonbecauseyouwerelucky.Butdoyouthinkthat

overthelongrunyouwouldcontinuewinningbymakingthosekindsofdecisions?HereatTOMIC,itisextremelyimportanttosticktoyourinvestingprocess.Whenyouseegoodtradesthatgiveyouawinningedge,youdothem.Itdoesnotmeanyouwillwineverytime,butoverthelongrunyouwillwinmoretimesthanyoulose.Youwillnotmake

tradeswhereyouperceivenoadvantage.Youwillnotbetheblackjackplayerhittingonan18becauseyoufeellucky.Sometimesitmayappearthatothersarewinningandyouarenotinthegame.Sometimesyouwillbeplayingwhennobodyelseisplaying.But,overthelongrun,youexpecttowinmorethanyoulose.Sodoyoumeasurethe

outcomesortheprocess?Tobesuccessfulconsistently,youneedtofollowtheprocess.However,youknowthatoutcomesareimportant,too.Overtheshortterm,processtakesprecedenceoveroutcomes,butinthelongtermtheoutcomestakeprecedenceovertheprocess.Ifyousticktoyourinvestmentprocess,eventhoughontheshorttermtheoutcomesmayshowlosses,

overthelongtermtheoutcomesshouldshowwins.Otherwise,ifyoudon’twinoverthelongrun,theprocesswillhavetobechanged.Goingbacktotheblackjackexample,youwillnothiton18whenthedealershowsa6.Youmightlosesometimes,whenthedealeractuallyhasa6anda5tomake11andhitsitwitha10.Butoverthelongrun,stayingon18willwinmoretimesthanlose.

Processmatters.Useachecklist,alistofthingsyouhavetocheckbeforeyoudosomethingorinordertodoitwell.Didyouknowthatbeforeanairplanetakesoff,thepilotgoesthroughapreflightchecklist?Theyaskthingslike,isthereenoughfueltogettowherewearegoing?Averycriticalquestion,don’tyouthink?Achecklistisaprocess.Thisiswhatthetradingplangives

you,aprocess.Didyouknowthatachecklist(havingaprocess)saveslives?Dr.PeterPronovost,aphysician-researcheratJohnsHopkins,developedasimplefive-itemchecklistthatsaveslives.Inthearticle“InfectionRatesDropasMichiganHospitalsTurntoChecklists”thatappearedinAmerican

MedicalNewsonMarch8,2010,wecanseethebenefitsofusingachecklistbyagroupofMichiganhospitals.Thearticlesaysthatcatheter-relatedinfectionshavebeenacommonplacecomplicationinthesickestpatientsinintensivecareunitsandwereresponsibleforaround17,000deathsannually.Accordingtothearticle,thecostforcaringforaninfectedpatientis$45,000.

TheMichiganhospitalsimplementedasimplefive-stepchecklistandwereabletoreducetheircatheter-relatedinfectionrateby66%afteroneyear.Theyreducedtheircentral-lineinfectionratetozeroper1,000catheterdaysversusthenationalaverageof5.2infectionsper1,000catheterdays.Theirchecklistcontainedfiveitems:washingtheirhands,using-fullbarrierprecautions

wheninsertingthecatheter,cleaningtheskinwithchlorhexidine,avoidingcertainareasforinsertion,andremovingunnecessarycatheters.1

Thefollowingisanexcerptfromthearticle“ABasicHospitalTo-DoListSavesLives”thatappearedintheNewYorkTimesonJanuary22,2008:

Usingthechecklist,in18

monthstheaverageI.C.U.atthesediversehospitalsreduceditscatheter-relatedinfectionratetozero,from4percent.Alltold,thechecklistsavedmorethan1,500livesandnearly$200million.Theprogramitselfcostonly$500,000.2

Asimplefive-itemchecklistthathelpedmedicalpractitionersinanintensive

careunittofollowaprocesssaveslives.Amazing.Doyouthinkachecklistforyourinvestmentdecisionswillsaveandmakeyoumoney?Itsurewill.AtTOMICyoufollowaprocess;thatiswhyyouhaveatradingplan.YouhaveachecklistforthedifferentfunctionsatTOMIC.Inunderwritingyouhaveaprocessfortradeselection

andriskmanagement.Also,forexecutingatradeyouhaveaprocess.Eachstephasachecklisttohelpyouavoidmakingmistakes.Youwillnothitonan18whenthedealerisshowinga6.Youaredisciplinedandyoutakeyourjobseriously.Youarethecasino,notthegambler.Whenyoutrade,oddsareinyourfavor.Youhavewinningandlosingtrades,butyourprocesshelpsyoutostay

disciplinedinordertomakesureyouwinmorethanyoulose.

QuestionsYourTradingPlanShouldAnswerEveryTOMICmanagerhasatradingstyle,justaseverycardriverhasadifferenttypeofcar(SUV,sedan,sportscar,minivan,andsoon).Each

driverhasacruisingspeedtheyarecomfortablewithandarouteforgettingfrompointAtopointB.However,everydriverisgovernedbyasetoftrafficrulesinordertoavoidaccidents.Forexample,therearedifferentspeedlimitsforhighwaysandforschoolzones.ATOMICmanagersetshisownrules,hisown“speedlimits”thatheself-regulates

usingatradingplan.Theobjectiveofatradingplanistoprovidespecificparameterstoassistyouwhenyouaretrading.Likethespeedlimitforthedriver,thetradingplanshouldgivetheTOMICmanagerasetofguidelinesandboundariesforhistrading.Everytradingplanwillhavedifferentparametersthatareimportanttothetraderand

shouldanswersomecommonquestions.Thefollowingisalistofquestionsthatyoushouldanswerinyourtradingplan:

•WhatisthegoalofyourTOMIC?

•Whatmarketsareyougoingtotrade?

•Whichstrategiesareyougoingtouse?

•Whataretheconditionsneededtoputona

trade?•Whataretheconditionsthatwillmakeyoucloseatrade?

•Whatareyourriskmanagementparameters?

•Howareyougoingtoexecutethetrades?

Trytoanswerthequestionswithasmuchdetailasyoucan.Bespecific.Askyourselfmorequestions,andanswer

them.Herearesomemorequestionsthatcometomind:

•Goals:WhatisthegoalofyourTOMIC?IsyourTOMICdesignedtoreplaceyourcurrentincome?Isityourgoaltomakeconsistently20%annualreturnonyourcapital?IsTOMICatoolforlearningtotradeoptions?IsTOMICsupposedto

alwaysproducepositivereturnsnomatterwhatthemarketdoes?

•Strategies:WhatstrategieswillyoubeusinginyourTOMIC?Willyoubeusingonlythetapositivetrades?Orwillyoudoboththetapositiveandthetanegativetrades?Willyoubeprimarilytradingironcondors,

butterflies,calendars,andsoon?Whatarethethreestrategiesyouaremostcomfortabletradingandunderwhatconditions?Whichstrategiesshouldyouavoidandunderwhatconditions?

•Entryparameters:Foreachstrategyyouhavedecidedtotrade,whataretheconditionsyou

needforyoutoenterthetrade?

•Exitparameters:Whataretheconditions,winningorlosing,thatwouldmakeyouexitatrade?

•Riskmanagement:Whataretheconditionsformakinganadjustment?Doyouhavesafetylimitsset?Whatareyourrisk

thresholds?Whatdoyoudoifapositionlosesmorethan2%ofyourportfolio’sequity?Whatdoyoudoifyourportfoliolosesmorethan6%inamonth?

•Tradingjournal:Whatinformationwillyoubekeepinginyourtradingjournal?Istheinformationthathasbeenrecordedenough

toprovideinsightsintothetradingdecisionswhendoinganafteractionreview?Willyoubeusinganyspecialsoftwaretokeepyourtradingjournal?

Answeringthesequestionswillhelpyouconstructyourtradingplan.Createyourplan,useit,andreviseitasyougrow.Notradingplanissetinstone,butitisthefirst

“stone”thatyouwillneedtobuildasuccessfulTOMIC.InChapter10,“OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZ,”wewalkyouthroughasampletradingplan.

Endnotes1.KevinB.O’Reilly,March8,2010,“InfectionRatesDropasMichiganHospitalsTurnto

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.

6.TradingInfrastructureThetradinginfrastructureconsistsofthebackofficeelementsneededtoimplementTOMIC.Thisincludesbutisnotlimitedtoriskcapital,thebroker,tradingplatform,analyticalsoftware,portfoliomargin,informationsources,

dedicatedspace,andbackupplans.

RiskCapitalTOMIC’stradinginfrastructurebeginsbydefininghowmuchmoneyyouwillneedtostartthebusiness.TOMICisascalablebusiness.Itcouldstartasasmalloperationandgrowintoalargeronewithoutyourhavingto

changemuch.Whatreallychangesaretheskillsoftheoperator.Everybusinessstartsoffwithsomecapital,whetheritisalemonadestand,whichhastohavesomecapitaltobuythelemons,sugar,andice,orTheOneManInsuranceCompany,whichneedscapitaltocoveritsmarginrequirements.Themarginrequirementsarethe

equivalentofthereservesofaninsurancecompany.Foraninsurancecompanytobeallowedtowriteinsurance,ithastohavereservessoitisabletocoveranyclaimsagainsttheinsuranceitwrites.Whatistherightamountofriskcapitaltostartwith?Dependingonyourplan,youcouldstartTOMICwithaslittleas$5,000.Ifyouarejust

startingout,planforasmallaccount,andaddtoitasyougainexperienceandconsistentprofits.DependingonyouastheoperatorofTOMIC,thelevelsofriskcapitalwhichyoucouldstartoutinTOMICarethese:

Level0—Beginner:A

beginnerisanoperatorjuststartingthejourneyintotradingoptions.Youarelearningthebasicsontradingoptions,sendingorderstothebroker,andyouknowenoughtoplaceandtakeoffatrade.Beginnersshouldstartwithasmallaccountallowingthemtotradesmalllotsandgainexperience.Somebrokersoffer“paperaccounts”thatallowyoutopapertrade,meaningyoucansimulate

yourtraderswithfake(paper)money.TheCBOEalsohassuchavirtualsite.Thepaperaccountsarehelpfulforlearninghowtousethetradingplatform.However,theyarenothelpfulforlearninghowtooperateTOMIC.Thestressfromdecisionsmadewithrealmoneyisverydifferentfromthestressyougetwithpapermoney.Asabeginner,youshouldstartwitharealmoney

account.Level1—Intermediate:Theintermediateoperatorisonewhohasagoodunderstandingofoptionsbasicsandknowstheanatomyofthedifferenttradestrategies(butterflies,condors,calendars,anddiagonals,forexample).Youunderstandtheusesofthestrategiesandhavesomeideaoftradeselectionandhowto

applytradesindifferentenvironments.Youknowenoughtogetintrouble,andenoughtogetoutoftroublemostofthetime.Level2—Semiprofessional:Semiprofessionaloperatorshavemoreexperienceundertheirbelt.Youhavegoodmasteryofoptionstrategiesandknowwhentoapplyeach.Youknowwhattradesgivethebestrisk/reward

ratio.Youknowhowtotradeandmakeadjustments.Youareatapointwhereyouknowhowtomakemoney.YoumanageTOMIConapart-timebasisandhaveanotherjoborareretired.AgoodportionofyourincomeisderivedfromoperatingTOMIC.Youareamasteratmanagingtrades.Level3—Professional:Theprofessionaloperatoroperates

TOMICforaliving.AllormostofyourincomeisderivedfromoperatingTOMIC.YoumighthaveTOMICfundedpersonallyormightbemanagingotherpeople’smoneyinTOMIC.Youmanagetheentireportfolio.Thatmeansthatinadditiontomanagingtheindividualtrades,youmanagetheriskoftheentireportfolio.YoumanagetheGreeksnotonlyofindividualpositions,

butoftheentireportfolio.YouknowhowatradeimpactstheGreeks.Youarelikeageneralinabattle;youmanagetheentirebattlefield.Usually,yourportfoliosarelargerandtheyhavemoretradesonthantheLevel0toLevel2.Onemorething:Yourreturnsarenotnecessarilyhigherthanthoseofthesemiprotraders,buttheyaremoreconsistent.YouknowhowtooperateTOMIC

toalevelthatdeliversconsistentreturns.Bymanagingtheportfolio,youcansmoothoutthepeaksandvalleys,allowingformoreconsistentreturns.

TheTradingPlatform(Broker)Agoodtradingplatformisessential,especiallywhenyouaretradingoptions.The

OneManInsuranceCompanydependsalotonthetradingplatform.Theeaseofenteringandexecutinganorderisofparamountimportancegiventhatthereisonlyonepersonatthehelm.TheOneManInsuranceCompanydoesnothaveatradingdeskstaffedwithtraderswhotakeyourordersandmakesuretheygetdone.Youarethetraderatthetradingdesk.Youarealsotheunderwriter,thechief

executive,andthejanitoroftheentirecompany.Havingagoodtradingplatformwillsaveyoutimeandpreventcostlytradingerrors.Beforewereviewtheplatform,awordaboutbrokers.Herearesomeofthecharacteristicsyoushouldlookforinanoptionsbroker:

1.Optionspecialist:Alotofbrokersallowyoutotradeoptions;however,

youshouldlookforabrokerspecializinginoptions.Thisisimportantbecauseitimpactsthetoolsthattheyofferandthemarginstheyprovide.

2.Understandingofcomplexordermargin:Ifbrokersspecializeinoptions,theyofferbettermarginterms.Forexample,somebrokers

requiremarginforbothsides(verticalcreditspreads)ofanironcondor.Goodbrokerswillrequiremarginforonlyoneoftheverticalspreadsoftheironcondor.Iftheyknowaboutoptions,theyknowthatinanironcondoryoucanloseononlyoneside.Therefore,theyneedthemarginequivalentfor

onlyonesideoftheironcondor.

3.Customerservice:Thisissomethingweallwant,expect,anddeserve.

4.Reputation:Useabrokerwhogivesyouconfidencethatthefirmisnotgoingtogooutofbusiness.MakesurebrokersaremembersofFINRAandSIPC.

5.Tradingplatform:Thebrokershouldhaveagoodonlinetradingplatformthatallowsyoutotradeoptionseasily.

6.Tradingdesk:Inadditiontothetradingplatformsoftware,thebrokershouldhaveatradingdesk.Thisisforthetimeswhentheplatformisdown,ortheInternetisdown,oryou

needtocallarealpersonforhelp.

Afteryouhaveselectedasetofbrokers,you’llneedtoseewhichplatformworksbestforyou.Theplatforminfluencesthebrokeryouchoose,unlessyouhavealargeraccountandcanaffordtohaveathird-partyplatformtointerfacewithyourbroker.Whatisimportanttohaveinatradingplatform?Thereare

subjectiveelementslike“easeofuse”thatarelefttoyourdiscretion.Hereisthechecklistofwhatagoodplatformshouldhave:

1.Tradeanalysistools:Thisconsistsofgraphiccapabilitiestoplotriskgraphstoanalyzeanoptiontrade.

2.Charts:Theplatformshouldhavesomebasicchartingcapabilitiesthat

willallowyoutoanalyzetheunderlyingmarket.

3.Easytouse:Theplatformneedstohaveaneasy-to-useinterface.Mostbrokershaveapapertradingplatformthatyoucantryoutbeforesigningup.

4.Customizablelayouts:Everyoneisdifferentandseesthings

differently.Youshouldbeabletocustomizethelayoutsoftheinformation,whichhelpsyouspeedupyourdatagatheringanddecisionmaking.

5.ExternallinkstoExcel:Thisisnota“musthave”feature,butitisveryuseful.YoucanprogramspreadsheetsinExcelandgetreal-time

datafromtheplatform.ThisgivesyoutheflexibilityofrunningcalculationsinExcelandisusefulwhenyou’relookingfortradesandmonitoringyourpositionsinrealtime.

Inmostcasestheplatformisbroker-related.However,ifyoustartmanagingasignificantamountofmoney,

sayover$1million,thenthird-partytradingplatformsthatarebrokeragnosticmaybepreferable.Examplesofthird-partyplatformsareObsidian,Derivix,Microhedge,andRealTick.

PortfolioMarginAlmostalloptionbrokerageaccountsofferReg-Tmargin.Therefore,ifyouhaveanaccountthatallowsoptions

trading,youshouldbefamiliarwithReg-Tmargin.Reg-Twastheonlychoiceavailabletoretailcustomersupuntil2007.After2007,somebrokersbeganofferingportfoliomargin(PM)toretailcustomers.Eachbrokerhashisorherownaccountminimumrequirementsforportfoliomarginaccounts.Portfoliomarginisanotherwaytocalculatethemargin

requirement.InsteadofcalculatingthemarginoneachindividualpositionlikeReg-Tandthenaddingupthenumbers,portfoliomargincalculatesthemarginrequirementsovertheentireportfolio.Tocalculateportfoliomargin,thebrokerstress-teststheportfolioandcalculatesthemarginrequiredbasedontheoutcomeofthestresstest.

WhatdoeshavingportfoliomarginmeanforTOMIC?Itmeansthatithasaccesstomuchmoreleverage.Here’sanexampleofReg-TversusPMonamarriedput:

SamplePosition:Long100SharesAAPL@$330Long1PutAAPLOCT320@$18Reg-Trequirement:

50%ofEquityPurchaseCost($33,000)=$16,500+100%ofPutPremium=$1,800TotalReg-TMargin=$17,300PMRequirement:Maximumlossdown15%instock=$4,950–Equitylossoffsetby

theoreticalgaininputoptionsof$3,950Netloss=$1,000TotalPM=$1,000

ThedifferencebetweenhavingPMandhavingReg-Twas$16,300.This$16,300iscapitalliberatedifyourTOMIChadPMwithnochangewhatsoeverintheriskprofileoftheaccount.Noteverypositionexperiencessuchdramaticsavingsin

margin.However,thisexampleshowsthesignificantdifferenceyoucouldhavewithPMversusReg-Tmargin.Ifyourbrokerismoreconservative,thatwilladdadditional“haircuts”tothestandardportfoliomarginrequirement.Forexample,abrokercouldincreasetherequirementiftheportfolioistooconcentratedinone

industrysector.So,whenlookingforabrokerwhooffersPM,makesureyouunderstandthebroker’sPMrequirements.Onecautionarynote:JustbecauseyouhavePMdoesnotmeanthatyouhavetouseittothemaximum.HavingPMgivesyoumoreflexibility,however.WhenmanagingTOMIC,youshouldalwaysbeawareof

howmuchexposureyouhaveandactivelymanageyourrisk.Ifyouareabeginner,usethemoreconservativeReg-Tstandardsuntilyouaremoreadeptatmanagingriskforyourentireportfolio.

InformationResourcesandOtherAnalyticalToolsInthisInternetage,itiseasy

togetoverloadedwithinformation.TherearemanyhundredsofWebsitesthathelpyougainperspectiveaboutwhatisgoingonintheworldasyoutradeandmanageTOMIC.Hereisalistofsitesthathavebeenusefultous:

www.bloomberg.comfinance.yahoo.comwww.seekingalpha.comwww.stocktwits.com

www.thestreet.comwww.theflyonthewall.comwww.tradethenews.comwww.livevol.comwww.cboe.comwww.ivolatility.com

Somesitesarefree,somecharge.Exploreandfindtheonesmostusefultoyou.Thisdecisiondependsonthekindoftraderyouareandtheproductsandmarketsyou

trade.Inadditiontogeneralmarketinformationandthetoolsprovidedbythebroker,youcanopttousethird-partyprovidersfordataandotheranalyticaltoolstohelpyouimproveyourtradeselectionandriskmanagement.Insomecasesanalyticaldataprovidedbyyourbrokermightnotbeasgoodorreliableasyouwant.For

example,theGreeksprovidedarebasedonthemodeldefinedbythebroker.Somebrokerssimplify(orbecomelazy)anddon’tincludeallthevariablestocalculatetheGreeks.TheymightnotusedividendsintheircalculationoftheGreeks.Thismightnotseemtobeabigdeal,butforsomeprofessionalsitis.Hence,youmayopttobuydatafromaproviderwhodoescalculatetheGreeks

usingmodelswithwhichyouaremorecomfortable.Otherusefultoolsareprogramstoviewandanalyzevolatilityskewsandtermstructures.Toolssimilartolivevolpro.comorivolatility.comareusefulforselectingtrades.Anotherusefultoolisasimulator,orbacktrader.Thistooltriesoutnewstrategiesandsimulatesthe

behaviorandriskmanagementadjustmenttobeusedinyourtrades.Thisisgoodfortraderstryingtocreatesystems;theyarelessusefulfordiscretionarytraders.BrokerslikeThinkorSwimhavebacktradingtoolsintegratedintheirtradingplatform.Also,youmaypurchasesoftwarepackageslikeOptionvue,whichhasbeenapopularoptionbacktrading

DedicatedSpaceNowadays,youprobablydonotthinkthathavingadedicatedspacefortradingisimportant.SomepeopleclaimthattheycantradefromanywhereintheworldgivenanotebookcomputerandanInternetconnection.Thatmightbetrue,butitdoesnotworkthatwellifyouare

tradingforaliving.Itishelpfultohaveadedicatedworkspacewhereyoucanrunyouroptiontradingbusiness.Itcouldbeanofficeoutsideofyourhome,orahomeoffice,orevenadeskinyourbasement.Itshouldbesetwhereyoucanconcentrateandfocuswithoutdistractions.Yourtradingspaceshouldbeaplacethat

•Isquietandallowsyoutoconcentrate

•Isfreeofinterruptions,suchasscreamingchildrenorvacuumcleanernoises

•Hashigh-speedInternet•Iscomfortable•Providesacalmandsereneenvironment

BackupPlans

Whentradingforaliving,makesurethatyouhavebackupplans.Youneedredundantsystemsbuiltintoyourinfrastructure.Hereisalistofthingstoconsiderinyourbackupplan:

•HaveredundantInternetconnections,fromyourcableprovider,cellphoneprovider,orphoneprovider.

•Haveabatterybackup

foryourcomputer.•Useatleasttwobrokers.

•Useatleasttwocomputers,aprimarydesktopandabackupnotebook.

•Haveyourbroker’stradedeskprogrammedonyourspeeddialorcellphoneincaseyourtradingplatformfails.

•Haveafuturesaccount

tobeabletobuyorshortS&P500futures.KnowhowmanyS&P500deltasyouownintheportfoliosoyoucangoflatbysellingorbuyingthesefutures.

•Haveabackuplocationtogoincaseyourofficebecomesunavailable(duetoburstpipes,gasleaks,poweroutages,orairconditioning

failures,forexample).ItcouldbeaStarbucks,Barnes&Noble,alibrary,ahotel,anairportlounge,oranyplacewithInternetconnectivity.

Havingabackupplanisimportanteventhoughyouprobablywon’tneedtouseit,butoccasionallyyouwillbegladyouhaveone.

7.LearningProcesses“Itisnotthestrongestofthespeciesthatsurvives,northemostintelligentthatsurvives.Itistheonethatisthemost

adaptabletochange.”—CharlesDarwin

AsasuccessfulTOMIC

manager,youhavetobeabletolearnandadaptasthebusinessenvironmentchanges.Everysuccessfulbusinessreceivesfeedback.Thefeedbackisfromcustomers,employees,competitors,andsuppliers.Thetrulysuccessfulbusinessesusethisfeedbacktocontinuouslyimprove.Tocreatecontinuousimprovementinyourbusiness,youneedtoembed

alearningprocessintoyourbusinessDNA.Thereareseveralelementsyoucanusetoinstillalearningprocess.AsTOMIC’smanager,youneedatradingjournal,asoundingboard,andacontinuingeducationplan.

TheTradingJournalEverysuccessfulbusinesshasgoodrecords.Everygoodtraderalsohasgoodrecords.

ThisisaprerequisitetooperatingTOMICsuccessfully.Whyaregoodrecordsimportant?Becausetheyprovidefeedback;theyhelpyourbusinesskeepscore.Youhaveheardcommentslike,“Atradingjournal?Seriously,isn’tthatawasteoftime?”Atradingjournalisagooduseoftime.InAmericanfootballdothe

teamskeepscore?Dotheircoachestapethegamestoanalyzewhattheteamdoeswellanddoeswrong?HowdotheDallasCowboysprepareforagameiftheydon’tknowwhattheycanimprovefromthepriorgame?Anybodycantradeforashorttime.Butnotanyonecantradeoveralongperiodandbeconsistentlyprofitablewithoutfeedback.Whydo

mostgoodcompanieskeepgoingandgoingandgoing?WhyhavegoodcompanieslikeCoca-Cola,GE,andApplesurvivedandflourishedoverthelonghaul?Itisbecausetheyadapttotheirmarketplace;theychangetheirstrategiesandadapt.DoyourememberwhenCoca-ColalaunchedNewCoke?Itwasadisaster;theychangedtheformulaandgotridoftheoriginal.Their

salesplummeted,andtheircompetitorsgainedmarketshare.Whathappened?TheyhadtobringbackCokeClassic.Theywereabletodothisbecausetheylistenedtofeedback.TheconsumeroftheoriginalCokedidnotlikeNewCokeandstoppedbuyingit.Cokenoticedthedropinsalesandquicklyfiguredoutthattheyhadaproblem.

Whydoairplaneshave“blackboxes?”TorecordeventsleadingtoacrashsothattheycanbereportedonCNN?No,itisforfeedback.Theonlywaytheairplanemanufacturersandairlinecompaniescancorrectaproblemonfutureairplanesisbyknowingwhathappenedinacrash.Hence,comingbacktoTheOneManInsuranceCompany

(TOMIC),thetradingdiaryisyourblackboxrecorder.Itisdesignedtogiveyoufeedbackandtoimproveyourbusiness.Allthebesttraders,whetherinstocks,options,orfutures,keepatradingdiary.AgoodexampleofkeepingatradingjournalisgivenbyDr.AlexanderElderinhisbookComeintoMyTradingRoom:ACompleteGuidetoTrading.

Whatinformationiscapturedinthetradingdiary?Table7.1showsthedatawesuggestyoushouldcaptureforeachtrade.YoumayaddtothislistanydatathatmaybeusefulforyoutomeasureyoureffectivenessasamanagerofTOMIC.Table7.1.DatatoCapture

inYourTradingLog

Thesearevariablesthatyouneedtomonitorconstantly.ItisusefultosetupanExcelspreadsheettomonitorthepositionsyouhaveinTOMIC.TheExcel

spreadsheetshouldincludeareal-timedatalinksoyoucanmonitoryourpositions.Oncethetradesareclosed,keeptheinformationinyourtradingjournal.Analyzeyourcumulativeresultsmonthly,quarterly,andannually.Thisgivesyouasenseofhowyouaredoing.Also,pickabenchmarkindextocompareyourselfagainstsoyoucantellwhetheryouaredoing

wellrelativetotheenvironmentyouareworkingin.Forexample,answerthefollowingquestions:

1.Howmanytradesdidyouenterthismonth,quarter,andyear?

2.Howmanytradeswereprofitable?

3.Howmanywerelosingtrades?

4.Whatwasyourwinrate?

5.Whatwereyouraveragedaysinthetrade?

6.Howmuchwasyouraveragewin?

7.Howmuchwasyouraverageloss?

8.Howmuchdidyouwinorloseonaveragepertrade?

9.Whatisyouraverageyield(realizedprofit/marginused)pertrade?

Table7.2isanexampleofasummarytablewiththeanalysisofthemonthlytradesdoneatTOMIC.ThetableshowstherelevantdatafortrackingtheperformanceoftheTOMICmanager.Thefirstrowshowsthenumberoflosses,nine,thetotalvalueof

thelosses,$(15,445),andtheaveragesizeofaloss,$(1,716).Thesecondrowshowstheinformationforthewins,andthethirdrowshowsinformationforthetotaltransactions.Thewinratio(percentageofwinningtrades)is94%,andthetotalcapitalriskedwas$1,833,878.Theaveragedaysintrade(DIT)was26,andtheaverageyieldwas3.6%,whichresultsfromdividing

$66,417/$1,833,878.Ifyouannualizetheyield,yougeta63.8%return.1

Table7.2.ExampleoftheMonthlyTradeAnalysisat

Keepingtrackofyour

performanceeverymonth,quarter,andyearwillhelpyouknowifyouaredoingwellorifyouneedtomakeadjustmentstoyourtrading.Forexample,let’ssaythatyourwinratefellto90%—wouldyouthinkyouhaveaproblem?Maybe,maybenot.Ifyoucheckyouraveragelossandyouseeitis$(500)andyouraveragewinis$500,youcouldsaythatyouareactuallybetter.Becauseeven

thoughyourwinratehasfallenfrom94%to90%,your$loss/$winratiohasalsofallenfrom3.2to1.0,andyouractualexpectedpayoutincreasedfrom$0.75to$0.80.CompareTables7.3and7.4.Table7.3.WinRatio94%and$loss/$winRatio3.2

Table7.4.WinRatio90%and$loss/$winRatio1.0

Thetradingjournalallowsyoutocheckyourperformanceagainstthetargetsyoudefinedinyourtradingplan.Inthisexample,Table7.2,thegoalofTOMICwastoearnbetween2%and4%permonth.Hence,

assumingthatmostofthecapitalwasinvested,knowingthatTOMICearned3.6%thismonthletsyouknowthatyouarehittingyourgoals.ThisfeedbackisimportanttoyouasthemanagerofTOMICbecauseyougainconfidenceandknowthatyouaremakinggooddecisions.However,ifyouhadnotbeenhittingyourgoals,thefeedbackwouldhavealertedyoutomakecorrectionsto

youtrading.

SoundingBoardTradingisalonelyprofession.Itisimportantthatyou,asthemanagerofTOMIC,begroundedinreality.OneofthekeysuccessfactorsofTOMICistheunderwritingskillsofyouasmanager.Toimproveyourunderwritingskills,meaningtradeselection,youhaveto

beopentofeedback.Awaytoobtainfeedbackonyourtradesistohaveotherpeoplehelp.HavingasetofpeoplewhounderstandwhatTOMICisdoingandwhocangivefeedbackandadviceisusefulandadvancesyourskillsgreatly.Thereareseveralchoicesforhowyoucansetupafeedbacksystem.Thetwoeasiestwaysare(1)joiningatradinggroupand(2)hiringatradingcoach.

JoiningaTradingGroup

SomepeopleclaimthattheybelongtotheCNBCtradinggroup.Thatistotallywrong;watchingTVtalkingheadsisnotbeingpartofatradinggroup.Beingamemberofatradinggroupgivesyouasoundingboardfortryingoutnewideas.Thegroupalsohelpswithaccountability.Eventhoughyouareultimately

heldresponsibleforallofyourtrades,thegrouphelpsremindyouofyourtradingplanandkeepsyouonthereservation.Findagroupwithtradingstylesandbackgroundsimilartoyours.Somequestionsyoushouldaskyourselfwhenchoosingatradinggroupincludethefollowing:

•Whatarethegoalsofthetradinggroup?

•Howwilltheinteractionsbe?Inperson,online,byphone?Willyoubeusingachatroomonline(forexample,Skype,AIM,GoogleTalk,andsoon)?

•Howoftenwillyoubemeeting?

•Howmanymembers?•Whataretheexperiencelevelsofthemembers?

•Ifeveryoneisanovice,willitbeacaseoftheblindleadingtheblind?

•Iftherearedifferentexperiencelevelsinthegroup,willthemoreexperiencedmembersbewillingtosharewiththelessexperienced?

•Whatdoyoubringtothegroup?

•Doesthegroupkeepameetinglog?Iftheydo,

reviewittoseewhattheyhavebeenworkingon.

•Doyoupoolresources?•Doesthegrouphaveacoach?

HiringaTradingCoachAtradingcoachissomeoneyouhiretolistentoyourtradingstrategies.Thecoachhelpsholdyouaccountableandhelpsyouconstantly

improveonyourtrades.Thecoachissomeonewhoismoreexperiencedandhasawealthofknowledgeandexperiencetosharewithyou.Somequestionsyoushouldaskwhenhiringatradingcoachincludethefollowing:

•WhatcanIlearnfromthiscoach?

•Canthecoachprovidereferences?Talktothepeoplethathaveused

hisorhercoachingservices.

•Howavailableisthecoach?Howeasyisittocontactthecoachifyougetintrouble?

•Howmuchtimewillyoubeinteractingwiththecoachperweek?

•Whatisthecommunicationmediumthatyouwillbeusing?Nowadays,usingan

onlinemeetingservicelikeWebexorGoto-meetingiscommon.

•Doesyourcoachknowenoughtochallengeyou?Willheconstantlychallengeyoutoimprove?

•Isyourcoachanindividualorpartofalargercoachingorganization?

•Doesthecoachhave

“student”tradinggroupsthatyoucouldparticipatein?

•Doesthecoachstillactivelytraderealmoney?Howishisperformance?

•Howgoodarehis/hercommunicationskills?

ContinuingEducationNomatterwhatprofessionyouarein,thereisalways

somethingyoucanlearntoimproveyourbusiness.Allhighlyskilledprofessionals—medicaldoctors,dentists,lawyers,computerengineers—havetokeepupwiththeirfields.Theydosobyattendingseminars,goingtoclasses,andpursuingcontinuingeducation.AsthemanagerofTOMIC,youtooshouldfollowacontinuingeducationplanto

stayatthecuttingedgeofoptionstrading.Continuingyoureducationandimprovingyourskillsetsarenecessarytosurviveintheoptionstradingprofession.Youshouldalwaysbelearningnewthingsinordertobepreparedforanyevent.Itislikeakaratepractitionerwhoknowshowtoblockandpunchreallywell.Hecouldprobablydefendhimselfwithjustblockingandpunching;

however,learninghowtokickhelpshimhavealternativestocausedamagetoanopponent.ThesameprincipleappliestothemanagerofTOMIC.Youshouldbeskilledandfluentinallthedifferentoptionstrategies.Youshouldknowhowtoreadtheenvironmenttousethebestavailablestrategyforthemarketconditions.Youshouldalwaysbelearning.

Youreducationplanshouldincludereadingbooks,attendingseminars,takingspecialclasses,orjoiningcoachingserviceslikeOptionPit.com.SeeAppendixA,“RecommendedReading,”foralistofrecommendedbookstocontinueyoureducation.Also,youmayfindinformationonOptionPit.comservicesinAppendixC,“OptionPit.com.”

Endnote1.Toannualizetheyield,mostpeoplemakethemistakeofdividingtheyieldbythenumberofdaysandthenmultiplyingby365.Thisisnotcorrect.Toannualizetheyieldcorrectly,usethefollowingExcelformula:(1+yield)^(365.25/numberofdays)-1.

PartII:ImplementingtheBusiness

8.UnderstandingVolatilityYouareprobablyawareofhowthepricingmodelworks.Tofullyunderstandhowtotradeoptions,potentialhedgefundtradersneedastrongunderstandingofhowoptionsfunction.

Alloptionpricingmodelsareverydifferent.TheolderoneslikeBlack-ScholesandtheWhaleymodelaresomewhatantiquated,butmuchlikeautomobilesorhouses,eventhemostadvancedmodelsrelyonacertainamountoffundamentalinformation.Allmodelsneedfivefactors:underlyingprice,strikeprice,timetoexpiration,costofcarry,andforwardvolatility.Fourofthefivearepretty

simple...andthenthereisvolatility.Toahedgefundtrader(andalltraders,forthatmatter),volatilityisbyfarthenumberonedeterminantofsuccess.Forwardvolatilityistheonlyfactorthattradersdonotknow.Anyeducator,coach,book,software,orservicethatignoresvolatility,ordoesnotemphasizevolatilityastheprimaryandfundamentalkey

tosuccess,islikelynotworthmuch.Ifyouareunfamiliarwiththeconceptofvolatility,stopreadingthisbookandgrababookonoursuggestedreadinglist.Evenwithafundamentalknowledgeofwhatvolatilityrepresents,itspracticalapplicationinandofitselfisnotaneasysubject.Thischapterexplainsthefactorsofvolatilityandwhatcausesvolatilitytooccur.

WhatCausesVolatility?Themodelhastouseforwardvolatility,butamajorityoftradersdonotknowwhatforwardvolatilityisgoingtobe.Ifyoudidknowwhatforwardvolatilitywasgoingtobe,therewouldbelittlereasontotrade.Infact,theuncertaintyofvolatilityisyourbestfriend.Traderswho

haveamasteryofthesubjectwillfindthattheroadtosuccessinanoptionhedgefundwillbesmoother.Masteringvolatilitydoesnotmeanthatyouneedasixthsenseofsomesort,butratheranunderstandingofhowhighorlowimpliedvolatilityismoving.Impliedvolatilityisthemeasureofvolatilitythatmostretailandinstitutional

traderstrack,butitisalmostuniversallymisunderstood.Forstarters,mosttradersdonotunderstandwhatdrivesimpliedvolatility.Commonly,theretailpublicthinksthereissomesortofboilerroomofmarketmakersinwhichthetradingpriceoftheoptionisdetermined.Thegeneralassumptionisthatmarketmakerssettheoptionpriceandthusvolatility.Thiscouldnotbefurtherfromthe

truth.Marketmakersmaydeterminethemarket,andthusimpliedvolatility,atanygivenmomentinthemarketstheypost.However,theydonot,inthelongrun,determinethepriceofoptions.Thatissetthroughpricediscovery.Ifmarketmakersplaceabidtoohighforanoption,themarketwillbegintosellthese

unmercifullytomarketmakers.Tradershavechoices:eatalotofoptionsorlowerthebidprice.Oncemarketmakershavetakenonacertainamountofriskatagivenvolatilitylevel,theydropthebidpriceandlowertheiroffer.Thisisdoneasawaytomanageinventory,andvolatilityfallsasasideeffect.Ifmarketmakersovercompensateforadeluge

ofsalesinanattempttomanageinventory,itwillnotbelongbeforetheystarttoseebidsforthoseoptions.Prettysoon,marketmakerswillbeforcedtoraisetheofferpriceinanefforttonotselltoomanyoptionsattoocheapapricerelativetowheretheyjustpurchased.Tradersraisetheiroffersandimpliedvolatilityincreasesalongwithit.

Table8.1showsanexampleofhowthishappensinastreamedmarket.Table8.1.SampleofHowaMarketMakerMightMoveMarketsasCustomerPaper

Noticethatmarketmakersmovetheirbidlowerand

lower.Thenoncethepriceoftheofferdropsto1.00,tradersfindbidsontheothersideoftheirtrade.Thisisthemarketmakers’signthatthebid/offerhasdroppedtoomuchbymovingto26%impliedvolatility.Realizingthatthemarketistellingthemthatvolatilityisoversold,marketmakersquicklyraisethebidprice.Thedeterminantofimplied

volatilityisnotmarketmakers,butsupplyanddemandforoptions.Marketmakerstaketheothersideofpublicorders,andthoseordersdeterminethemarket.Thesmarthedgefundmanagercantakeadvantageofmarketmakersmuchthewaythebuyerdidinthepreviousexample,orbetteryet,takeadvantageofvolatilitythewaythesellerdidintheexample,inwhich

thebesttradeacrosstheboardwasthefirstsaleof100at1.10.SinceTOMIChastheabilitytoinitiate,itshouldlookforopportunitiestoselltheovervaluedcontract.Impliedvolatilityisdeterminedbythemarket,notthemarketmakers.Sellingwhenothersarebuyingandbuyingwhenothersaresellingisthekeytosuccess.Smarthedgefundstakethe

riskawayfromthosewhoarepanicking,orthosewhoareoverlycomplacent.

Three-DimensionalVolatilitymightseemsimple,butitisnot,because“vol”isnotaone-dimensionalconcept.Itisactuallythree-dimensional.Tradersusingvolatilitytodeterminepricehavetolookatallfacetsofoptions:theATMoptions

priceinthenearterm,volatilityskew,andtermstructure.

ATMOptions

ThemostactiveoptionstradedatanygiventimearealmostuniversallyfrontmonthATMoptions.Tradingintheseoptionsdeterminestheoverallstructureofvolatilityinaproduct.ThinkofATMoptionsassails

poweringaboat.Whileotherpartsoftheboataffectspeed,theeffectofwindonthesailmeansmore,nottomentionthesizeofthesailanditsangleagainstthewind.MovementsinATMoptionsaffectthepriceofOTMputs,OTMcalls,andtheentiretermstructure.IffrontmonthATMoptionIVisdropping,sowillmonthsfurtherout.Onthe

flipside,ifIVisrallying,sowillallotherpartsoftheproduct’sstructure.Frontmonthdoesnothavethemost“vega.”However,frontmonthoptionsarefarmoresensitivetochangesinimpliedvolatility.TheTOMICmanagerwillfindthatthissensitivityiswhyfrontmonthoptionsarethenumberonedeterminantinthesuccessofatrade,evenifyoudon’tholdATMoptions.

Becauseithaswhatissometimescalled“vomma”—thegreatestsensitivitytochangesinimpliedvolatility—youwillfindthatwatchingATMfrontmonthoptionswillindicatehowIVonanyoptionwillmove.

Skew,sometimescalled“kurtosis,”representshowdifferentoptions’volatilities

relatetoeachotherinanygivencontract.Thereareseveraltypesofskew;however,withinequityandequityindexoptions,optionsusuallyhavean“investmentskew,”whereOTMputshaveahigherimpliedvolatilitythanATMoptions,andOTMcallshavealowerimpliedvolatilitythanATMoptions.Althoughthereareoccurrencesinwhichthisisnotthecase,mostnotablyin

dealstocks,FDAannouncementstocks,andVIXoptions,equityoptionshaveaninvestmentskew.Themainreasonforthisskewisfoundinthedriversintheequitymarketplace:naturallongs.Whatdomost401(k)’sinvestin?Mutualfundsareforthemostpartlongstocks.Whatdomostpeoplehaveintheirpersonalaccounts?Mostindividualsholdlongstock.

Infact,ifyouwanttogetshortinapersonalaccount,thereareallkindsofextraforms,questionnaires,andmarginrequirementsyouhavetomeet.Theentirestructureofthemarketissetuptomakeiteasiertobuystock,andhardertoshortstock.Sowhatdoesthishavetodowithoptions?Therearetwomainwaysthegeneralpublic

hedgeslongstockpositions:1.Theybuyputs.2.Theysellcalls.

Ifalargeportionofthemarkethasthesametrade,andeveryoneistryingtobuyputsandsellcalls,itcausesademandshift.Putswillgetbidupandcallswillgetdepressed.Thisphenomenonhastobepricedinsomehow,anditshowsupinvolume.Sothemainreasonforskewis

actionsbythegeneralpublic.

UsingSkew

LikeATMoptions,orderflowdetermineshowskewmovesupanddown.Iftherearetoomanytradersbuyingorsellingrelativelylow-pricedOTMputsorlow-pricedOTMcalls,IVcango“outofwhack.”Thisallowstraderstosetuptradesthatarestatisticallyfavorable.Anoverlyflatskewmaybethe

biggestdeterminantofsuccessofabutterfly.Italsowilltypicallyleadtomoresuccessfulbackspreadsandfrontspreadtrades.OnamorebasictradeyoumayonlywanttosellOTMputorcallspreads.Bybuyinganoversoldoptionorsellinganoverboughtoptionina“creditspread,”youwillbeabletosqueezeuptoanextra.02to.10in

andoutofthespread.Ifyoucansave.10onevery10trades,youwouldsave100ineverytrade.Thatmorethanpaysforthetypicalcommissioncost,andinanactiveaccountanextra100pertradequicklyaddsup.Doingthemath,afundtrading500contractspermonthsavesupto$5,000.Therelationshipofskewisacomplexone,andhasamajor

effectonyoursuccess;youneedtomonitorskew.Onastrike-by-strike,trade-by-tradebasis,youshouldexaminethecurvebeforetrading.Findthemispricedoptionifthereisone.Forindextraders,thesolutionismorecomplex.Youneedtodotwothings:OnaglobalscalepickafewOTMputsandOTMcallsusingeitherpercentageOTMor,better

yet,delta,andmonitorhowtheseoptionsarerelatedtoeachother.Forinstance,ifa10deltaputtrades30%andtheATMoptiontrades20%,the10deltaputtradesat150%ofATM.Asthe10deltaIVputmovesupanddown,youwillbeabletoseehowtherelationshipofthetwoalsomoves.CombinedwithmonitoringATMIV,youshouldhaveagoodgriponhowthecurveappears.

Forthosetradingindexcreditspreads,monitortherelationshipoftheentirecurve.Youwillbeabletosqueezeafewpenniesoutofeverytrade.Althoughthisisimpossibletodobylookingatatradingplatform,programsthatmapthecurvepayforthemselvesandareworththeinvestment.

Youneedtobeawareofthe

wayOTMoptionspriceintermsofvolatility.Atacertainpointanoptionstopsbehavingwithvolatilityandbeginstotradefora“price.”Inotherwords,anoptionthatcosts.10ontheSPXdoesnothavevolatility;ithasalotteryticketprice.Althoughthechanceof.05to.10optionsbecomingworthanythingisslight,theriskoftheseoptionscannotbeoverstressed.A.10option

thatmovesto15.00returns1,500%,andthereisnowaytopricethatdegreeofmovementinanoption.Optionpricingmodelswerenotdesignedtopricethe“humanrisk.”Wecall“humanrisk”theconceptthattradersarenotwillingtosellextremelycheapoptionsnakedbecauseoftheriskofcatastrophicloss.Althoughthefirstandsecondstandarddeviationsarefairlypriced,

onceastockoranindexmovespastatwostandarddeviation,whichismorethanthepricingmodelpredicts,optionswillmovetothatfourthorfifthstandarddeviation.Therefore,

1.Nevershortoptionsworth.10orless.

2.Ifyouareshortanoptionworthlessthan.10,itisprobablyworthbuyingtocloseevenif

thereisacommissionforthatclosingpurchase.

3.Ahedgefundthatsellspremiumshouldalwaysbenetlongthese“units.”

Byfollowingthesethreerules,youavoidatotalcatastrophiclossandmayfindyourselfsittingonasurpriseprofitintheeventofamajorupwardordownward

move.Aninvestmentin5%to10%ofthefundinoptioninsurancewillinthelongrunpayout.

TermStructure

MuchlikeskewandATMoptions,variouscontractmonthswillseedifferentamountsofpaper.Thefurtheryougofromthenearterm,thelessliquidcontractmonthsbecome.Thus,abig

ordercanmoveonemonthsubstantiallyrelativetoanothermonth.Althoughoverallvolatilityisimportanttothesuccessofacalendarspread,youwillfindthatbymonitoringtherelationshipofdifferentexpiries,youopenupanopportunity.Ifacontractmonthseesaninordinateamountofpaperflow,youshouldbeabletotakeadvantageofthe

movementintherelationships.Iftheneartermisunderpriced,itwillmakesensetobuyneartermandselllong-termoptionsagainstit.Theretailpublicshouldavoidthistrade,butbeawarethatwhenthisconditionoccurs,alongcalendarisalosingproposition.Whentheneartermisoverpriced,itmakessensetoselltheneartermandbuythebackmonthsagainstit.

FrontmonthoptionshavemuchmoresensitivitytoIVchangesthanbackmonths.Thebestopportunitiestotradecalendarspreadsarewhenthefrontmonthbecomesoverpricedorunderpricedinaquickmove.Sometradersmakealivingbysimplytrading“vomma”actionoffrontmonthoptionsagainstlong-termoptions.Thepriceactioninfront

monthscanalsobeusedinamoregeneralsense.Ifyouwouldliketosimplysellironcondors,butterflies,andstrangles,monitorvolatilityrelationshipsagainsteachother.WhentheIVofonemonthbecomesoverbought,itmakessensetomoveacondororstrangletradeintothatoverboughtcontractmonth.Itcanalsobeahintthatyoucanavoidbuyingorsellingadifferentcontract

month.Thereareafewpitfallsyouneedtobeawareofwhen“volatilityswapping”ormovingcontractmonths,especiallyinindividualequities.Beonthelookoutforthefollowing:

•Earnings•FDAannouncements•Corporateactions•Dividends

Everyonelikessellingexpensiveandbuyingcheap,butaspreadcausedbyanyoftheprecedingactionscanbeagoodreasontoleavethatcontractmonthalone.Inaddition,ifaspreadisexorbitantlywide,eveniftheTOMICmanagerthinksthereisnoreasonforthespread,thereprobablyisareason.Doadditionalresearch,makephonecalls,anddigintothemessageboards.Ifaswap

seemstoogoodtobetrue,itprobablyis.Don’tbeafraidtotradeswapsanddifferentcontractmonthsagainsteachother.Themonthsarecorrelatedbutnottied.Ifyoutakeadvantageofthesemovementsbetweenmonths,youwillseethattherearehigheroddsofsuccessthanthepricingmodelpredicts.

VolatilityandtheModelIVisanoutputofthemodel,notaninput.TheGreeksareanoutputofthemodelandsoisIV;sotraderssittinginfrontofascreenhavelittlepowertocontroltheriskoutputs.Ifyouarenotmanagingyourownvolatilities,youcannotseeyourriskparameters.To

properlymanagerisk,oneshouldmodelhowtheGreeksandprofitandlosswillmoveacrossawidevarietyofsituations.YoushouldalsoknowwhattheIVsareofeverycontractyouown.Byknowingthis,youcancircumventmanyofthepitfallsofretailtradingplatforms.Tomonitorvolatility,keeptrackofthefollowingin

everystocktraded:ATMIVSkewThree-monthtermstructure

Forpositionsheld,keeptrackofthefollowing:

TheIVofeverycontractheldTheGreeksoftheentirepositionsExpectedGreeks

ProfitandlossbasedonadeclineorincreaseinIVof5%,10%,and25%.

9.MostUsedStrategiesInthischapteryou’llfindthefivemostusedstrategiesforTOMIC.Thisgivesyouanoverviewandanexampleofeachstrategy.Howshouldyousetupeachofthemajorshortpremiumspreads?Whatistheexactcriterionforevaluatinga

decentsaleofinsurance?Clearly,notallsalesareequalandthekeytoanykindofsuccessistosellinsurancepremiumwhenitisata“goodprice.”Inthissectionyou’llfindfiveofthemajorspreads,fromconstructiontomanagementtoexit.Althougheverytraderhasadifferentapproachtotrading,youhavespenttimestudyingeachspread,tryingtofindwhatyoubelieveisthebest

approachtotradingthem.Theissueisthateverytraderhasdifferentrisktolerancesandtradinggoals,soyouneedtothinkofthefollowingasguidelines,notrules.Asyoubuildyourinsurancebusiness,planontweakingandadjustingtheseguidelines.Youareconstantlyattemptingtoimproveandtweakyourapproach.Asconditionschange,partsofyouroverall

strategywillhavetobeadjusted.

TheVerticalSpreadVerticalspreadisthegeneraltermforabullcallspread,bullputspread,bearcallspread,orabearputspread.Thenameverticalspreadreallyderivesfromtraderslookingatanoptionmontageandseeingthatthespreadismadeupofthedifferent

strikesthatarelaidoutvertically.Theverticalspreadisoneofthebuildingblocksofothermorecomplexspreadsliketheironcondorandthebutterfly.Ifyouweretogetstrandedonadesertislandandcouldtradeonlyonestrategy,theverticalspreadwouldprobablybeyourchoice.Itisaspreadthatmanybeginnersusebecause

itisfamiliartothem.Manybeginnersstartoutwiththecoveredcallornakedputs.Theverticalspreadmightconsistofashortputcombinedwithinsuranceorashortcallcombinedwithinsurance.Mosttradersuseitfordirectionalplays,eitherbullishorbearish.Bydefinition,averticalspreadiscomposedofalongandashortoptionatdifferent

strikesinthesameexpiration.Verticalspreadscanbebullishorbearishandcanbeboughtforadebitorsoldforacredit:

Herearethesituationsinwhichtousethedifferentverticalspreads:

Bullish(1)Verticalcalldebitspread:Usewhenpartiallybullishanddon’tmindthetadecay.

(3)Verticalputcreditspread:Usewhenpartiallybullishandwantpositivetheta.

Bearish(2)Verticalputdebitspread:Usewhenpartiallybearishand

don’tmindthetadecay.(4)Verticalcallcreditspread:Usewhenpartiallybearishandwantpositivetheta.

Focusonthecreditspreads:theverticalputcreditspread(bullish)andtheverticalcallcreditspread(bearish).Thesespreadsarethetapositive.Assumingthatthereisnomovementintheunderlying,thetradeearnsmoneyastime

goeson.

Conditions

Theverticalspreadisbestwhenyouhaveanopiniononthedirectionofthemarket.Volatilityrule:Useverticalcreditspreadsintimesofstableordecliningmarketvolatility.Thewidthofthespreaddependsonthesteepnessoftheskew.Insteepcurves,narrower

spreadsarerecommendedsothelongoptionvolatilityhaslessofagapwithrespecttothevolatilityoftheshortoption.Iftheskewislesssteep,youmayusewiderspreadstosaveoncommissions.Time:Usuallyplaceverticalspreadtradeswith30to60daystoexpiration.Thisdependsonhowfarout-of-the-moneythespreadis

placed.OnfarOTMspreadsthethetadecayismorelinear,sowhenyou’redoinglongertrades,asinanironcondor,startingatrade30to60daysfromexpirationisoptimal.

VerticalSpreadExample

HereisaverticalputcreditspreadonAAPL(Apple).OnOctober13,2011,30-dayimpliedvolatilityand10-dayhistoricalvolatilitywere38

and37.IVwasgreaterthanHV,whichiswithinnormalparametersforthistrade.Next,checkIV,whichwastrendingdownfrom51onOctober4,2011.AfallingIVisagoodenvironmentforthisverticalspread.YouplacedtheverticalspreadonOctober13,2011,at10a.m.,whenAAPLwastradingat$405,shorted10AAPLNOV360,andbought

the10AAPLNOV350foracreditof1.55perspread,net$1,550forthetrade.SeeFigure9.2forthedetails.TheriskprofileofthetradecanbeseeninFigure9.1.

Figure9.1.Riskprofileofthe10NOV360/350verticalputcreditspread.(Source:

OptionVue6)

Figure9.2.Openingdetailsofthe10NOV360/350

verticalputcreditspread.(Source:OptionVue6)

OnNovember4,AAPLwasat$401orbelowthepricewhenyousoldthespread.However,IVwasdown.ImpliedvolatilityoftheAAPLNOV360putwasat41.7%whenyousold,andonNovember4,2011,theIVoftheAAPLNOV360putwas

at34.1%(seeFigure9.3).Thespreadatthispointwasworth$0.25.Youhadcaptured83%ofthecreditreceivedsoyouclosedthetradeandbookedtheprofit.Youboughttoclosethespreadfor$250.Yousoldthespreadfor$1,550andboughtittoclosefor$250,resultingina$1,300profitforthistrade.

Figure9.3.Closingdetailsofthetrade10NOV

360/350verticalputcreditspread.(Source:OptionVue6)

TheReg-Tmarginforthis

tradewas$8,450andtheprofitwas$1,300.Thisgaveyouareturnonmarginof15.4%inaspanof22days.

TheIronCondorTheironcondorconsistsoftwoverticalspreads,bothsetupout-of-the-money:ashortcallspreadsetabovethecurrentpriceoftheunderlyingandashortputspreadsetbelowthemoney.

Thegoaloftheironcondoristosetuptheshortsatadistancetheunderlyingisunlikelytogettooverthelifeofthespread.Foraprimeronironcondors,youcanrefertoJaredWoodard’se-bookIronCondorSpreadStrategies.

Conditions

Volatility:Foranironcondor,impliedvolatilitydoesnotneedtobehigh,butonly

higherthantheaveragetruerange(ATR)1oftheunderlying.Thus,anironcondorcanbetradedinjustaboutanytypeofvolatilitycondition.ItonlymattersthatexpectationsofimpliedvolatilityarehigherthanATR.Essentially,youthinkimpliedvolatilityistoohigh.Ironcondorsaremosteffectiveinlowervolatility.Inhighervolatilityyouare

gettingahigherpremiumorsettinguptheironcondorwider,butoftenATRishigh.Thekeytotradingironcondorsinhighvolatilityistotrytosellwhenvolatilityisstableorfalling,notwhenimpliedvolatilityissimply“high.”Forexample,onAugust5,2011,theCBOEvolatilityindexwastradingover25%,historicallyelevated.

However,thatvolatilitywasactuallylowrelativetowhatthemarketwasabouttodo.Ifyousoldanironcondorinthoseconditions,youmighthavebeenconsideredselling“highvol”butyouwerenotsellingvolatilitythatwastoohigh.Thereisamajordifference.InthecaseofAugust2011,volatilitywashigh,butitwasonanuptrend,notadowntrend.AnironcondorsoldonAugust5

wouldhavehadsomemajorproblems.Anironcondorsoldonlyonemonthearlierwouldhavebeenadifferentstory.TheVIXwasnotnearlyashighasitreachedonAugust5,yetbecausevolatilitywasdeclining,anironcondorwouldlikelyhavebeenaquickexitforatraderwhoenteredaspread.Volatilityrule:Stableor

decliningmarketvolatilityarekeytoasuccessfulcondor.Skew:Ifyouweresimplysellingstrangles,theskewcurvemightbethemostimportantpartofthetradeequation.Becauseyouaresellinganironcondor,thussellingashortandbuyingalongagainstit,skewseemstomatterless.Still,itcanhelpthetraderrecognizeredflags.Inlowvolatility,typically,

youwouldpreferaslightlysteeperskew.BelowATM,anelevatedskewwillpushtheshortslightlyfurtherawayfromATM.AboveATM,theshortcallspreadwillreceiveslightlymorecredit.Thisisnotofmajorsignificance,butitdoesmatter.Anoverlysteepcurveshouldbeconsideredamajorwarningsign.Whenimpliedvolatilityhasyettorally,but

thecurvehascaughtabid,thiscanbeasignofanimpendingvolatilityspike.Sellinganironcondorintorisingvolatilityisarecipefordisaster.Skewtendstobeverysteepintwoinstances:risingvolatilityandfallingvolatility.IfIVisreallylowandskewissteep,eitherdon’tenteranironcondororbackupthetruckoninsurance.

Time:InJimBittman’sbookTradingOptionsasaProfessional(agreatprimerforthisbook,bytheway),oneofthemostcompellingpointsinthewholebookhastodowithdecay.Thereisaflawedbeliefthatoptiontimepremiumdecaysexponentiallyacrossallstrikesinthefinal30daysofanoption’slife.Thisiscompletelyflawed;inthefinal30days,studiesshow,

onlyATMoptionsdecayexponentially.Aspricemovesfurtherawayfromat-the-money,optionsdecaymuchmorelinearly.Jimpointsoutthatforanoption10%out-of-the-money,theoptionlosesmorevaluefromday60today30thanitdoesday30today1.Uponfurtherstudy,optionsseemtohavea“coneoffeasibility”thatrelatesto

whenandhowtheydecay.Asanoptionmovesfrombeinglogicallyin-the-moneytoanoptionthatcannotendupin-the-money,thisiswhenoptionsgiveupthebulkoftheirvalue.Thus,whentradinganironcondor,youshouldsetupthetradewhenitwilllogicallylosethebulkofitsvalue.Youwillprefertosetupinthe10–15deltarangewhencreating

yourironcondor.Thus,underalmosteverycircumstance,rightaround60daysseemstobetheoptimaltimetosellanironcondor.Insuring:Thegreatestdangertoanironcondorisnotfoundwhenvolatilityislow.Thegreatestdangerisnotwhenvolatilityishigh.ItisduringthetransitionfromlowtohighwhenironcondorscancompletelydestroyaTOMIC.

Theproperimplementationofunitputscansaveaportfolio.ThetransitionfromlowtohighcanrampupthevalueofOTMputs.Thus,ifvolatilityisinthelower25%ofitshistoricalrange,youshouldalwaysspendafewdollarsoninsuringthevalueoftheopenironcondor.Althoughtradersvaryinhowmuchtheybuy,nomorethan10%ofthecreditreceivedonasaleis

necessarytoensurethattheironcondorisproperlyinsured.Ontheotherhand,whenvolatilityisatitshighestlevelsanddeclining,insuringmaybeunnecessary;itislikelythatthetradewasenteredwhenyouhadafullviewoftheriskassociatedwiththetrade.Itisalsolikelythatanyinsuranceboughtwouldbeineffective,asthe

farOTMputswillalreadyhavealargeportionofriskpremiumbuiltintotheirprice.Thesetup:Onceyouhavedeterminedthatvolatilityis“toohigh,”youshouldlooktosella10–11deltacallandbuythenextcallstrike.However,thisisnotsetinstone.Asmarttraderexaminesstrikesaroundthe10–11deltastoseewhetherthereareanystrikesthatare

mispriced.IhaveseensituationsinwhichanSPX1350–1360callspreadnettedmorethananSPX1340–1350callspread.Thisisgenerallyduetoa“publicorder”beinginthe“book.”Thenyoushouldlooktosellthe10–12deltaputagainstthecallspread.Youmaycheatupatouchontheputsideofthecurvetoincreasecreditandhelpflattendelta.Skewnaturallycausestheshortput

spreadtobefurtherawayfromthecurrenttradingpricethantheshortcallspread.Althoughstocksdo“creepupandcrashdown,”cheatingputsinastrikeortwodoesnotmakeaprofounddifferenceintheoutcomeofthespread,especiallyifyouinsuretheironcondor.Thereturnshouldbeassuchthatyouaregettinggood“odds”beforeensuring.For

instance,ifyoucanget2.00ona10-pointspread,thatequatestoarisk/rewardof200over800,or25%returnonrisk.Ifthetradehasan85%chanceofsuccessaccordingtoprobabilities,youareinaveryfavorableposition.Ifthetradehasonlya70%chanceofsuccess,youareinafarlessfavorabletrade.Althoughprobabilitiesandpayoutsareonlyafunctionofvolatility,itis

importanttobeawareoftheserisk/rewardcomparisons.Bylookingforthebestspotstobuyandsellinanironcondor,youmightbeabletosqueezeafewpointsofprobabilityoutofthetrade.Intrading,every.05counts;anextra.05inaspreadmightbeenoughtocoverinsuringtheportfolioorpayforacommission.Goals:Aspreadwillalmost

neverfullydecay,anditalmostnevermakessensetoallowaspreadtofullydecay.Thegoalshouldbetocapturethepremiumsoldasthetradeleftthe“coneoffeasibility.”Thatamountisslightlyover50%ofthevalueoftheironcondor.Thus,youshouldtrytocollectabout55%ofthevalueoftheironcondoryousold.Theintentistobeoutofthecondorby30daysuntilexpiration.

Ifthetradepicksup25%ofthecreditsoldinunderfivetradingdays,youcaught“edge”inthesale.Youshouldexitthetrade,stop,reevaluatecurrentconditions,andthendecidetoenteranewtradeifyouaresoinclined.Profitmadequicklymeanstherewasedgeinthetrade,andedgeshouldalwaysbecapturedinatimelymanner.

Risk:Inmanagingrisk,youneedawarenessoftwotypesoflosses:maximumlossandabsolutemaximumloss.Maximumlossisanumberatwhich,onceit’shit,youexitthetrade.Setthisnumbertoequalyourprofittarget,forexample.Inagivenyearyoumayexpecttohitthismaximumlossononeortwooccasions.Itispartofthebusiness.However,ifyoumanagethetrade,thenetof

hittingseveralprofittargetsshouldresultinapositiveoverallreturn.InmanagingthetradeaThirdThirdThirdRuleisinvoked:firstadjustmentatone-thirdofmaximumloss,secondadjustmentattwo-thirdsofmaximumloss,andexituponhittingthefinalthirdofmaximumloss.Thisiswhereabsolutemaximumlossisimportant.Absolute

maximumlossisanumberthatyoushouldneverallowatradetoexceed.Setthisnumberatthevalueofthecreditreceivedinthetrade,forexample.Ifatanypointa1.5standarddeviationmoveinonedirectionwouldputthetradebeyondtheabsolutemaximumloss,thetradeshouldbeadjustedorexitedevenifthetradeisnotyetatmaximumloss.

Inmanagingtherisk,wearenotfansof“rolling”outatrade.Thekitespread,theratiospread,theverticalspread,andthebackratiospreadaremuchbetteradjustments.YouwillfindexamplesofthekitespreadadjustmentsinAppendixD,“KiteSpread.”Anironcondorissetwithsuchawideareathatmanagingtheunderlyingwithinthatareaisnotthatdifficult.Theideaof

rollingoutandincreasingsizecanbecostly,difficult,andrisky.Inmoregeneraltermsthegoalshouldbetogetthemosteffectivehedgeandspendaslittleaspossible.Liketradesthemselves,eachadjustmentisrightforaspecificcircumstance.Forquickreferencehereareafewguidelinesforeachadjustment:Upside:

Kitespread:Thisistheprimaryadjustmentforupsidemovement.Thistradereducesgammaandcoststypicallyverylittle.Theonetimethistradeisnottheoptimalspreadiswhenimpliedvolatilityisespeciallylow.Injustabouteveryothercircumstancethistradeworks.Backratio:Thisisthesecondaryadjustmentontheupside.Thistradealso

reducesgammaandcostsverylittle.However,becauseofthestructureofthetrade,thisshouldbeusedonlyincaseswheretheimpliedvolatilityisatverydepressedlevels.Callspread:Thisisthetradeoflastresortwhenyouneedalotofdeltainahurry.Thismakessenseonlyifyouthinkthemarketisgoingto“roar”higherandimpliedvolatility

isextremelydepressed.Itisthequickestandeasiestwaytogetalotofdelta.However,becauseofthecost,itshouldbeavoidedunlessyouareinatruepinch.Themargintrade:Thetimecallspreadisagreatspreadforthosethathaveportfoliomargin.Itinvolvesbuyingafrontmonthcallandsellingahigherbackmonthcallagainstit.Thisisagreat

spreadinmanyconditionsandmaybecomethepreferredadjustmentforTOMIC.However,becauseitissomewhatcomplextotrade,youshouldfullyunderstandtermstructurebeforeenteringthetrade.Theone-by-twocallspreadmayalsobeagoodtrade,althoughtypicallyitwillcreateadebitontheupside.Iftradedproperly,itcanmake

moneyevenifthemarketturnsback.Downside:Ratiospread:Whenyouexpectvolatilitytorallyasthemarketfalls,theshort1long2ratiospreadcanbeagreatwaytomanagethisrisk.Itwillnotexpandthetradeout;however,itwillquicklyflattenthecurve.Thisshouldbeconsideredtheprimaryadjustmentforthedownside

ifvolatilityisnormal.Theputspread:Becauseofputskew,aputspreadisamuchcheaperoptionforanindextradethanacallspread.Thistradeisaversatile,ifstillsomewhatexpensive,adjustmentforthedownsideofthecurve.Thisshouldbeconsideredthesecondaryadjustment.Themargintrade:Ifyouhavemargin,aone-by-two

frontspreadmakesalotofsense.Thetradeisinexpensive,itsetsaverywidetent,andunliketheothertrades,whenthemarketturnsaround,ifenteredproperly,thistradeaddstoprofitandloss.Exit:Whenagoalishit,goodorbad,itistimetocallthetradeaday.Itcanbetemptingtostayinatradebeyondyourgoal;however,

disciplinemusttrump“gut.”Wehaveseenmoredollarslostongutfeelingthanjustaboutanyothertypeofloss.Whenexiting,makesuretoexittheentiretradeincludinginsurance.Thosedollarsandcentsmatter.Ifthelongputpurchasedforprotectionisworthlessthan.10,keepit.Thesale,aftercommission,islikeawaste.Wewouldalsonotethatalthoughadjustingmaychangemargin,the

trade’sgoalssetfromtheoriginalonsetshouldnotchange.Addingorremovingcapitalfromthetradeshouldhavelittletonoeffectonthenettargets.

IronCondorExample

OnOctober19,2011,youevaluatedtheJanuarycontractmonthforapossiblecondor.YounoticedthatIVwastradingatapremiumto

realizedvolatility,andyoualsonotedthatIVwastrendinglower.Skewwaselevatedbutnotoff-the-chartshigh.Yousetthetradesothatyouweretradingasmuchasyoucouldalongliquidstrikes.Youalsoreceivedafavorablepayoutrelativetotheoddsofsuccessonthecondor.Collectingabout2.50,yourgoalwastomakeatleast

1,250andtobeoutofthetradeby30daystoexpiration.SeetheironcondordetailsinFigure9.4.TheinitialprofitandlossriskgraphoftheironcondortradeisillustratedinFigure9.5.

Figure9.4.OpeningdetailsoftheSPX

990/1000/1340/1350ironcondor.(Source:OptionVue6)

Figure9.5.RiskProfileoftheSPX990/1000/1340/1350ironcondoratthestartof

thetrade.(Source:OptionVue6)

Obviously,aslowgrinddownisthebestscenario,butifIVcameinandSPXrallied,youwouldhavebeenpleasedaswell.Overthenext30daysthereweretimeswhenthistradegotthreatened.However,it

neveractuallytouchedtheThirdThirdThirdRule.After30days,yourcondorwasupabout1,000(seeFigure9.6).Notquiteyourgoal.However,thiswasprobablyworththeexitconsideringtheproximitytothetopofthechartandyourdesiretobeoutofthetradebyday30.

Figure9.6.RiskprofileandcurrentP&Lline(T-0)of

theSPX990/1000/1340/1350ironcondoratthecloseofthetrade.(Source:OptionVue6)

Again,thesetupmadethetrade.Adjustingcanbe

tempting,butaswithmosttrades,thekeytoriskmanagementistradeentry.

TheATMIronButterflyTheironbutterflyconsistsoftwoverticalspreads,bothat-the-money,ashortcallspreadwiththeshortATM,andashortputspreadsetATM.Thegoaloftheironbutterfly

isfortheunderlyingnottomoveasthedecayfromtheshortATMstraddleoutpacesthedecayfromtheprotectivestranglesetaroundtheshortstraddle.

Conditions

Volatility:Muchlikeanironcondor,foranironbutterflyimpliedvolatilitydoesnotneedtobehigh,butonlyhigherthantheaveragetrue

rangeoftheunderlying.Thus,anironbutterflycanbetradedinjustaboutanytypeofvolatilitycondition.ItonlymattersthatexpectationsarethatimpliedvolatilityishigherthanATR.Essentially,foryourironbutterflyyouthinkimpliedvolatilityistoohigh.Youwillfindthatironbutterfliesaremucheasiertomanageinlow-volatilityenvironmentsthaninhigh-volatilityenvironments.

AnironcondorisaplayonhowhighimpliedvolatilityisrelativetoATR,whereasanironbutterflyisaplayonhowhighATRisrelativetohowhighATRisgoingtobeoverthetimeperiodinvolved,alongwithhighrelativeIV.ThisisbecausetheironbutterflyisATMandhasanarrowerwingspan.EvenifATRislowrelativetoIV,theflycanstillloseiftheunderlyingmovestoofarorif

theunderlyingmakes“gappingmoves.”However,unlikewithacondor,thefinaldeterminantofsuccessforanironbutterflyistheoverallrelationshipofthewingsrelativetothevalueofthestraddle.Morethananyotherfactor,thefinaldeterminantofsuccessforanironbutterflyistheskew.Skew:Anironbutterflyis

basicallyashortstraddleandalongstrangle.Thekeytoitssuccessisgoingtobethepriceyoupayforthestrangle.Thismakesironbutterfliesmoresuccessfulinalow-volatilityenvironment,aslongastherelativerelationshipofthewingsisinexpensivecomparedtothethoraxor“meat”oftheironbutterfly.Forequityfliestheputoften

iseitheroverpricedorunderpriced.Yourironbutterflycontainsa“normalskew”andyouneedtoknowwhatthatis.Whentheputtradesovera6%discountinIVterms,thisisafavorabletimetoenteranironbutterfly.Ifittradesata10%discounttoIV,thisisanexcellenttimetoenterthetrade.Whentheputskewisflat,thetradewillbeashortandverylikelyprofitabletrade.

Whentheputistoolow,ifIVrises,theOTMputwillskyrocketnotonlytoamorenormalskewbutpossiblyevenhigherasthedepressedputoverreactstomarketIVmovement.Thisprovidesthetradeadditionalpaddingonaspike.Solosingtradeswilltypicallyloseless.Ontheflipside,ifIVdoescomein,theOTMputwillprobablynotseeitsIVmoveasmuchinrelativetermsasthesinking

ATMIV.WhenIVisfalling,skewwillrise,allowingtheflytooutperformthepricingmodel’sexpectationsinfallingIVmarkets.Forexample,intheSPXnormallythe10deltaputtradesat140%premiumtoATMIV.SoifATMIVis20%,the10deltaputwilltradeatabout28%.Ifthat10deltaputistradingat26%,theskewoftheputistooflat

at130%ofATM.Oneofthreescenarioscouldoccur:

1.IfATMincreasesto22%andskewnormalizes,the10deltaputincreasesfrom26%toabout30.8%,oralmost5%,asopposedtolessthan3%itwouldnormallyincrease.ThisshouldmutemuchoftheIVspikefromtheATMs.

2.IfATMIVdeclinesto18%,thereisagoodchancethattheskewwillnormalize.Thiscausestheputtodropfrom26to25.2,almostnothing.YouwillbeabletocapturealargerportionoftheIVmovedownwardthanthemodelpredicts.Thisreducesthetimeyouareinthemarketandletsyoucloseoutthespread

onanydownwardIVmove.

3.IfATMIVstaysstable,thereisahighchancethattheputwillincreaseinIVby1%to2%regardless.Thisplaces1%to2%ofIVintoyourpocket.Itwillpushyoutowardaprofittargetmuchmorequickly.

Theout-of-the-moneycallis

typicallylessimportantthantheputasittendstomovearoundless.Thecheaperthelongcall,thebetter,forthesamereason.Ontopofthis,whenyoupurchasethecallcheapenough,iftheunderlyingralliesandIVcomesin,youwillfindthatthepositionactsthewayyouexpected;thisisadistinctadvantage.Skewrule:Youwantaflat

putcurveandasteepcallcurve,whichisnotasrareasyoumightexpect.Time:AsthetradeisplacedATM,itdoesmakesensetoputtradesoninsideof30daysinanattempttocaptureexponentiallydecayinginsurancevalues.Thereisno“tooclosetoexpiration”rule,althoughthemostexperiencedtraderswillnottrytoholdanironbutterfly

intothefinalthreeorfourdaysuntilexpiration.AlthoughthesameIVandskewrulesapply,theexplodinggammathatcomeswithdecayinginsurancepremiumscanbearealchallenge.Withtheintroductionofweeklyoptions,thereisconsiderableopportunityforyoutosmoothoutreturnsbysellingshort-termiron

butterfliesinweeklyissues.Insuring:Typicallyanironbutterflyhasaverytightlydefinedrisk.Insuranceshouldbeapartoftheoverallportfolio.WhenIVislow,andespeciallyifskewisflat,itpaysoffinthelongertermtoownonetotwounitputsforevery10ironbutterfliessold.Thesetup:Insideof30days,onceyouhavefounda

productwithstableorfallingATR,astableorfallingATMIV,andaflatputcurveandsteepcallcurve,youprobablyhaveagoodcandidate.Settinguptheironbutterflyissimple:SellthatATMstraddle.Buythewingsataonestandarddeviationforthemaximumnumberofdaysyouwanttobeinthetrade.Foranironbutterflywith30daystoexpiration,thismightbe15to20days.Oncethe

wingshavebeenplaced,youwillbeshortdelta;thatdeltashouldbeflattened.Flatteningthedeltamakesyourtradesvolatilityplaysandnotdirectionaltrades.Toflattendelta,buyacallortwoinsidethetentoftheironbutterfly.Buyingfewercallsclosertothemoneyisabetterwaytoflattendeltathanbuyingmanycallsout-of-the-money,duetothe

predictabilityofreturnsforcallsclosertothemoney.Youmightalsoflattendeltawithstockorfutures.Oncethedeltahasbeenflattened,ifyouaregoingtobuyafewunits(whichisadvisable),thisshouldbedonenow.Thetradewillendupflatdelta,althoughtheunitsboughtmightmakethetradenominallyshort.Goals:Thegoalofaniron

butterflyistogetinandoutasquicklyaspossible.Awell-constructedironbutterflymakes5%to10%inonlyafewdaysiftradedproperly.Beyond10%youareprobablygivingupyour“edge”inthetrade.Althoughitmightbetemptingtoshootfor15%to20%returnonanironbutterflyandhopethatdayspasswithnothinggoingwrong,thisapproachisnotalong-termwaytomakea

profit.Thus,at10%startlockinginaprofit.Youcandothisbyemployingastrangle-tighteningtechnique.Risk:Well-constructedironbutterfliesareveryeasytomanage.Typically,ifthetradegetsoutsideofthetent,itshouldbeaboutawash.Exitthetradeatthatpoint.Thekeyistocutironbutterfliesforascratchwhentheybreakoutsideandkeep

winnersprofitable.Onceanironbutterflyhasreachedtheprofittargetagain,takethetradeoff,oratleasttightenupthestrangle.Figure9.7showsanexampleoftighteningthebutterfly.

Figure9.7.Riskprofilecomparingtheoriginal

butterflyandthebutterflyafterthetighteningadjustment.(Source:

OptionVue6)

Onceatradeisup10%,typicallythewingswillhavelostmuchofthelonggammatheyofferasprotection;thecurrentprofit-and-losscurvewilldevelopsomeshapeandbegintolookmorelikethe

ironbutterflyatexpiration.Ifyousellthefar-outwingsandbuywingsinside,ineffectbuyinganironcondor,youwillfindthatyouhavecompletelyflattenedtheprofitandlosscurveagain.Thisisanexcellentwaytostayinthetradeyetensurethatprofitsarelocked.Oncethestrangleistightened,iftheday’sprofit-and-losscurvebreakstheexpirationtent,closeupthetradeand

takethemoneyout.Beyondtighteningthestrangle,therearenotalotofgreatavailableadjustments.However,afewareeffectiveifyouchoosetoactivelymanageriskaggressively.Upside:Oneapproachfornonmargintradingnotinvolvingbuyingorsellingtheunderlyingsecurityisbuyingacalltocleanupsomeofthedeltaswhileat

thesametimetighteningthespreadonthedownsideoftheironbutterfly.Ifthestockhasralliedenoughtothreatenthetoppartoftheironbutterfly,itmakesalotofsensetotightenuphalfofthestrangleandbuyacall.Youmightalsousecallspreadstoachievethesameresult.Formarginedtraders,muchlikewiththecondor,thecalltimespreadandtheone-by-

tworatiospreadworkwondersinrepairinganironbutterfly.Undernocircumstancesshouldaddingabutterflybeusedasanadjustmentunlessyouwouldexecutethatironbutterflyonitsown.Althoughitwillextendthetrade,theseironbutterfliesarenotadd-ondevicesinthebestofconditionsandaddalargeamountofmargin.

Everymajorlossinironbutterflytradingthatwehaveseeninvolved“tranchingflies.”Ingeneralwehavefoundthatthrowingcapitalatatradeisnotalong-termsolutiontomakingmoneyinoptions.Downside:Awell-constructedironbutterflywillnotloseifitbreaksthetenttothedownside.Yourfirstchoiceshouldnormallybeto

shutdownthetradeinthosecircumstances.Intheeventthatyouinsistonstayinginthetrade,anironbutterflywilladjustverymuchlikeanironcondor.Ratiospread:Whenyouexpectvolatilitytorallyasthemarketfalls,theshortone-long,two-ratiospreadisagreatwaytomanagerisk.Itwillnotexpandthetradeout;however,itwillquickly

flattenthecurve.Thisistheprimaryadjustmentforthedownsidewhenvolatilityisnormal.Putspread:Becauseofputskew,aputspreadisamuchcheaperselectionforanindextradethanacallspread.Thistradeisaversatile,ifsomewhatexpensiveadjustmentforthedownsideofthecurve.Thisisasecondaryadjustment.

Themargintrade:Ifyouhavemargin,aone-by-twofrontspreadmakesalotofsense.Thetradeisinexpensive,itsetsaverywidetent,andunliketheothertrades,whenthemarketturnsaround,ifenteredproperly,thistradeaddstoprofits.Exit:Ironbutterfliesshouldmakeorlose10%orless.Ifthetrade“breaksout,”itis

probablyaclose.Ifthetradehitsthat10%,theedgeisgoneandit’stimetocloseortighten.

ATMButterflyExample

AfterChristmas,younoticethatSPXskewisespeciallyflat.Thisisnotunusualduringholidayweeksasfewopenpositionsequatestolessinsurancebought.Thiscanflattenskew,especiallywhen

overallIVisaverageorhigh.YoulookupthedeltasoftheputsinFigure9.8.Thenyoucalculatetheskewbetweenthe10deltaputsandtheATM.Next,yourefertoFigure9.9andlookatthecallsandnoticethe25deltacallisalsotradingwithinrange.Youdeterminethatnowisthetimetoenteranironbutterfly.Noticetherelationshipofthe1270sandthe1170s.

Figure9.8.OptionmontagewithSPXputinformation.(Source:OptionVue6)

Figure9.9.OptionmontagewithSPXcallinformation.(Source:OptionVue6)

Callsarealsoingoodshape.NoticetherelationshipbetweenOTMcallsandATMoptions(seeFigure9.9).Nextyoucalculatea17-daystandarddeviationbasedonthe1270strike(Figure9.81270puts)andanATMIVof18.5%:0.185*SQRT(17/365)*

1270=51Youroundto50,settingupthetradeat1220/1270/1270/1320(seeFigure9.10fordetails).Withadeltaof–28youbuyacalltoflattenthedelta.Then,likeallsmarttraders,especiallythosetradingfliesinaflatskewenvironment,youbuyafar-out-of-the-moneyunitput,asshownatthebottomofFigure9.10.Thetraderisk

graphisillustratedinFigure9.11.

Figure9.10.1220/1270/1270/1320SPXbutterflydetails.(Source:

OptionVue6)

Figure9.11.1220/1270/1270/1320SPXbutterflyriskprofileatthestartofthetrade.(Source:

OptionVue6)

Sellingtheironbutterflyat41.35(beforeaddinginthewingandtheunit),yourgoalistoreturn5%to10%inafewdays.Recallthatyoumarginoffthefly,notthehedges.Thisshouldnotbethatdifficultbecausethetrade

isatafavorableprice.Whilethestockdoesmoveupanddownoverthenextfewdays,atnopointisthiswell-constructedtradeeverinanyrealtrouble.OnJanuary5youareupalmost900,morethanyour10%goal(seeFigure9.12).

Figure9.12.1220/1270/1270/1320SPXbutterflyriskprofileatthecloseofthetrade.(Source:

OptionVue6)

Ifyouhadheldoneortwomoredays,youwouldhavemadeatotalkillingwiththe

trade,butyoushouldnevercomplainabouttakingasmartanddisciplinedprofit.Asmartsetupwithproperscreeningcreatedaneasytrade.Youmayhavenoticedamajorpatternhere.Well-constructedtradesareeasytomanage.

TheCalendarSpreadorTimeSpread

Thecalendarspread,eithershortorlong,canbethebesttradeahedgefundcanuse.Ifyouaresaying,“Ican’tsellcalendars!”rememberhowsimilartheS&P500futuresoptionsaretoSPXoptions.Theycanofferanalternativewhenyouwanttoselltimespreads.Unlikebutterfliesandcondors,thisspreadreliesontherelationshipbetweenoptionswithdifferenttermdatestradedoffoneanother.

Whileacalendarspreadcanbeaneffectivetradeandiseasytoexplain,itisalsothemostsensitivetoproperexecution.Bothlongandshorttradesareexcellentforanyfund.Tounderstandcalendars,youneedtounderstandtheconceptofweightedvega,theideathatthedifferentmonthshavedifferentvegasbutalsohavedifferentsensitivitiestochangesinrealizedvolatility.

Inaperfectworldyouwouldhaveabookofcalendars,bothlongandshort,withlittletonopositiveornegativethetaandwithallthetradesputontheperfectconditions.Thiswouldproduceaportfoliooffavorabletradesinwhichtheoverallweightedvegawasnotoverlyhighorlowandprotectedyourportfoliofromhugeswings.

ConditionsVolatility:

Long:Forthelongcalendarspread,youusuallypreferbelow-averageimpliedvolatilityandverylowrealizedvolatility.Inaperfectworldyouwouldseelittletonomovementbutanincreaseinimpliedvolatilityatthesametime.Althoughthatmightsoundgreat,itneverhappens.Infact,ifimplied

volatilityistoolow,thelongcalendarspreadislikelytogetbeatenuponapopinrealizedvolatility.Itdoesn’tmatterwhatIVyoubuy;iftheunderlyingmarketmovesaround,thecalendarisgoingtolose.Therefore,youwillfindyourselfinamuchhappierplaceifyoubuynormalvolatility,notthebottom15%ofIVrange.Short:Fortheshortcalendar

youwillfindtherearetwotimeswhentheseworkbest:whenIVissuperdepressed,andwhenIVisveryhigh.Inbothcasesthebreakoutoftheextremesmakestheshortcalendarworksowell.Thekeytotheshortcalendaristoputitonwhengammaismosteffective.InthecaseofhighIV,thecombooflonggammaandIVcominginatthesametimemakestheshortcalendarabigwinnercomingoffof

highvolatility.Thelonggammainthetradeoffersyousomeprotectionagainstthemarketmovinghard.Onthelowend,termstructurecomesintoplayonacalendar.BecausefrontmonthoptionsaresosensitivetochangeinrealizedIV,frontmonthIVcanmoveandthegammacanworkwithoutbackmonthoptionsmoving.ThisislikelytohappenwhenIVisextremelylow.

Skew:Becausebothoptionsareboughtorsold,skewisnotamajorfactor.Termstructure:Acalendarspread,eithershortorlong,isreallyatermswapinwhichyousellonemonthagainstanother.Overallimpliedvolatility,thespreadbetweenfrontmonthoptionsandbackmonthoptions,isgoingtobethenumberonedeterminantofsuccess.Thecombination

oftherightIVandtherighttermstructuremakestradingbothshortandlongcalendarsalayup.Longcalendar:Thekeytothelongcalendaristoselltheshortatahigherlevelrelativetothebackmonthoptions.TakealookatanindividualproductmonitorinwhichtheIVrelationshipisbetweenwherefrontandbackmonthoptionsnormallytrade.Begin

tosellthefrontmonthwhenittradesatasignificantpremiumtothenormalspread.Asignificantpremiumisatleast10%offrontmonthIV(thus,iffrontmonthIVis20,youwantthatfrontmonthtradingata2%premiumtothenormalrelationship).Atthesametime,makesurethatIVisnotout-of-controlhigh.Ifitishighacrosstheboard,thatcanbeasignthatthereisan

eventcoming.Anothersignthatthereissomethingwrongiswhenthemonthsaretradingattoohighapremium.Generally,ifthefrontmonthistradingatapremiumofmorethan25%overthefrontmonthIV,lookatwhytherelationshipisoutofwhack(infact,alwaysbewaryofacalendarifthemonthsareoutofwhack).Thekeywithalongcalendaristoselloverbought

volatility,notvolatilitythatishighforareason.Shortcalendar:IVconditionsthatmakealongcalendarbadaretheexactconditionsthatmakeashortcalendargreat.Thecontractmonthboughtshouldtradeata10%discountofnormalATMIV.Alsobewaryofanoverlywidespread.ThekeywithashortcalendaristobuyoversoldIV,notsellhighIV.

Time:Theruleappliedtobutterfliesalsoappliestocalendars:Tradethemwithin30daysofexpiration.Therearetwoexceptions.IfIVsareoutofwhack,anycontractmonthcanbetradedagainstanother.Soacontractwithfivemonthstoexpirationcanswapagainstonewithsix,seven,oreightmonths,especiallyinETFsorindexfunds.Ifonemonthisoutofwhackinthefar-outmonths,

itislikelycausedbyliquidity,notanevent.Tradingacalendarinthefinaldaysofexpirationismuchmoredifficulttohandlethanabutterflybecauseofthewaythegammaexplodesagainstthebackmonthoptions.Also,theIVrelationshipsloserelevanceinthelastcoupleofdaysoftrading.Inthefinalfewdaysofacontract’slife,thishaslesstodowithIVand

moretodowithabsolutestraddleprice.Anythingwithinoneweektoexpirationisstraddleprice,notanIVtrade.Thesetup:Forthelong,sellanATMcallorputandbuyanATMinthenextmonthoutwhentherelationshipisthat10%outofline.Oncetheyareinline,unwindthetrade.Itisthatsimple.Pickthemonthsandpickthe

strikes.BuyrelativemidrangeIVandthetradeislikelytosucceed.MakesureIVhasbeenstable.Youdonotwanttotrytocatchafallingknife,butifIVisinthemidrangeandstable,thatisagoodlongsetup.Fortheshort,lookforultra-lowoverallIVorultra-highIVandaspreadinwhichthemonthboughtischeaperthanthemonthsold.Oncethe

spreadmovesintolineagain,closethetrade.ThereareoccasionswhenyoucantradeoverallhighIVandignoretheIVspreadtosomedegree;however,thisapproachisforonlythemostexperiencedhedgefundtrader.Goals:Thegoalofthecalendarspreadistomake5%to10%inafewdays.Goingforanymoreimpliesyouareclosingyoureyesand

hopingthattheunderlyingdoesn’tmove,orthatIVdoesn’tmoveagainstyou.Hedgefundtraderstradevolatility,notthetadecayofcalendars.Getin,takethe5%to10%,andgetout.Ifthetradetouchesthebreakevenatexpiration,killthetrade.Itistemptingtoaddtothetrade,butyouwilllikelybeflattoslightlydown.Withabookofcalendars,taking10%andgivinguplessthan

5%willleadtoaprofitablebookoftrades.Risk:Italmostneverpaystoaddtoawell-constructedcalendarspread.Mostbigcalendarspreadlossesareincurredwhentheyareoutofthetentandyouaddabunchoftimespreadstothetrade.However,therearesomechancestoaddtocalendarsoradjust,especiallyontheshortcalendarspreadside.

Ifthelongspreadisstilloutofwhack,youmightaddtothecalendaraslongasyouflattenupthedeltaatthesametime.Toputanadditionalcalendarspreadon,conditionsmustbeasgoodasorbetterthantheoriginaltrade.Ifnot,donotadjustusingacalendarspread.Inthatcase,youmightbuyanoptiontocutdeltadown,butmakesureyoubuythecontractinthelessexpensive

month.Ontheshortsideofthetrade,anymoveintheunderlyingshouldallowyoutoprofit.However,astheunderlyingmovesaround,thereisachancethatconditionswillnotchange.Ifthatisthecase,youmighthavethechancetoscalplonggamma.Considerusinga“paythedecay”approachinscalping,butdothisonlyinsmallincremental

moves.Ifthemarketismovinglessthanaone-daystandarddeviation,oncetheunderlyingmakesarun,unwindthetrade;donotattempttoscalpgammabackandforth.Scalpinggammawascreatedtodefendagainsttimedecay,notasawaytoactuallymakemoney.Ifthetradehits10%,takethemoneyandrun.Exit:Neverlosemorethan

10%onthemarginoftheoriginalcalendarspread.Exitifthathappens,andshootfornomorethan10%returnonacalendar.If5%happensinlessthanaday,consideritagiftandkillthetrade.

LongCalendarSpreadExample

Hereisanexampleofalongcalendarspread.OnNovember16,2010,at3

p.m.,younoticedthattheOEXDecember-Januarycallspreadprovidedagreatsetupforacalendarspread.Overallvolatilitywasrelativelylowataround19%(seeFigure9.13).Atthesametime,theDecemberIVwas,duetoaminormarketshock,increasedinIVtothepointthatittradedatanIVpremiumtoJanuary.

Figure9.13.OEXDecandJanATMimpliedvolatility.

(Source:OptionVue6)

YouenteredcontractssellingDecemberandbuyingJanuaryfor4.80.TheATMcalendarhadGreeks,asshowninFigure9.14.

Figure9.14.ATMcalendarGreeks.(Source:OptionVue6)

YourhopewasthatthespreadwouldcollapseandDecemberwouldfallbelowJanuary.OrthatthespreadwouldholdandJanuarywouldcreepslightlyhigher.Thenextday(Figure9.15),yourluckwasevenbetter.By3p.m.,notonlywasDecemberlower,butJanuary

wasslightlyhigher.

Figure9.15.NextdayOEXDecandJanATMIV.(Source:OptionVue6)

Overnightyourtrademadeover5%.Thisisexactlywhatyouarelookingforinacalendarspread.Thepointoftheswapisnottoholdfordecay,itistomakemoneyoffmispricedvolatility.TheblackdotinFigure9.16

showswhereyourprofitwasasyouunwound.

Figure9.16.ProfitandlossoftheOECcalendaratclosingdate.(Source:

OptionVue6)Calendarspreadssetuplikethisallthetime.Theymight

notalwaysmake5%overnight,butifdoneconsistentlyintherightconditions,overtime,thebankededgewillpayout.

ShortCalendarSpreadExample

Whenalongcalendarspreadlooksbad,ashortcalendarspreadcanlookgreat.OnDecember16,Januaryoptionsbecamegreatly

oversoldrelativetoFebruaryoptions.Atthesametime,overallvolatilitywaselevated.YouenteredaSPXDec-JanShort1220callspreadtakinga1.6%volumecreditandsellingFebat24.4%IV.Thenetsalewas14.10(seeFigure9.17).

Figure9.17.SPXDec-JanShort1220callcalendaratstartofthetrade.(Source:

OptionVue6)

Youwerehopingforthefrontmonthtotightenuprelativetothebackmonth.Fortherelationshiptoholdsteady,theunderlyinghastomoveandIVshavetohold,orsomecombinationofthese.ByDecember20,thetradewasawinner.Whilethefront

monthdidfallmore,theunderlyingmovedandthebackmonthoptionssoldoffmuchharderthantheJanuary(seeFigure9.18).

Figure9.18.SPXDec-JanShort1220callcalendaratcloseofthetrade.(Source:

OptionVue6)Thetradecanbeboughttoclosefor$13.40,aprofitofabout$0.80in4days.You

mademorethan5%injustamatterofdays(seeFigure9.19).

Figure9.19.ProfitandlossoftheSPXshortcalendarspreadatclose.(Source:

OptionVue6)Whenyouarepatient,youdo

evenbetterastheunderlyingkeepsrallying.Youcouldhavemade20%onthiscalendarspreadjustbyowningoversoldoptions.

TheRatioBackandFrontSpreadTheratiospreadcanbeoneofthebesttradesahedgefundcanapply.Forthosewithoutportfoliomargin,

buyingtwoandsellingoneisnormallytheonlyspreadtouse.Ifyouhaveportfoliomargin,lookatbuyingoneandsellingtwo(oftencalledafrontspread).Thekeystotheonebytwo,muchlikethebutterfly,areskewandvolatility.However,thisspreadaddsathirdcomponent:direction.Tosucceedintradingratiospreads,youneedtoberight

onskewandvolatility.Forthespreadtobewildlysuccessful,youneedtoberightondirectionaswell,althoughyouwillfindthatthisdoesnotalwayshavetobethecase.

Conditions

Volatility:Theratiobackspreadisalmostalwaysalongvegaspreadatonset.Thetwolongpositionshavea

highernetvegaweightedorunweightedthantheoneshort,atleastatonset.However,astimepasses,thatgoesawayifallothermattersareequal.Thisiswhywhenyou’reputtingonaratiobackspread,thelowertheimpliedvolatility,thebetter.NeverputonaratiospreadunlesstheIVisinthelower40%ofthecurrentIV.UnlessthistradeisinapositionwhereIVcangoup,thetradeis

likelytonotsucceedwithoutabigdirectionalmove.Skew:BecauseyousellanATMIVandbuytwoOTMputsorcalls,theskewisgoingtomatter.Basedonthediscussioninbutterflies,theflattertheskew,thebetter.Youhopetobuythecurveatanextracheapprice.Thecheaperthebetter,especiallyifIVisalsolow.Youhopethegeneralpublicrecognizes

thattheOTMoptionsarethecheapestandbidsthemup,evenifIVdoesn’talsomove.IfIVgoesup,theskewnormalizesandthetwoOTMputscandowell.ApopinIV,skew,orbothcangetyououtofatradewithoutthestockevenmoving.Addinbeingrightdirectionallyandyoucanmakeakillingonthesespreads.BeontopofIVandskew

whentradingratios.Nottakingthisintoaccountisthrowingmoneydownthedrainonaratiobackspread.Asteepskewandhighvolatilitywillcausethesetradestoloseevenifyouarerightondirection.Time:Aratiospreadcanbeexecutedinanytimeframe.Thekeyistopicktherightmonth,whichhasthelowestrelativeIV(at60daysto

expiration,comparethetwo-monthoptiontothe60-dayIVinthepast).Addinginskew,thiscanmakeanymonthawinner.Thereareimportantissuestonote:Tradesexecutedclosetoexpirationrelyontheunderlyingmoving,andtradesexecutedfurthertoexpirationrelymoreonmovementsinvolatility.Ifyoumakeadirectionalbetandaratiospreadsetsup

nicely,useit.IfyouwanttosetuparatiospreadasaportfoliohedgeorasalongIVplay,usemonthswithatleast60daystoexpiration.Thesetup:Ifthegoalistoplayvolatility,thekeyistogetthatsameflatskewyouwantedinabutterfly.Youwanttheskewtotrade7%to10%underpricedandIVtobeinthelower40percentileofhistoricalrange.Selloneat-

ornear-the-moneyputorcall,thenbuytwoOTMcallsorputsagainst,andthenetpremiumpaidforthetwoshouldbelessthanthevalueoftheonesold.Youwantacreditorwantatleastzerocost.Thisway,ifyouarewrongondirection,youcanstillwinfromvolatility.Donotgofora“bigcredit”butacceptaslittlecreditaspossible.Thiswillallowthetwolongpositionstohangin

foraslongaspossible.Goals:Whenyou’retradingvolatility,thegoalistogetin,takethemoney,andgetout.Ratiospreadsarejustlikeanyvolatilityplay.Yourgoalisabout10%,andyouwillnevertakemorethan10%.Risk:Therearefewadjustmentsthatmakesenseforratiospread.Ifthetradedoesnotworkout,closeit.Ifconditionschangeforthe

betterandthetradeislosing,closethetrade.Ifthetradeislosingandconditionshavemadethetradepotentiallyevenbetter,addtoit,assumingyouhavenotovercommittedcapital.Exit:At10%takethewinor,ataminimum,lockitup.Neverallowatradetolosemorethan10%oforiginalmargin.Ifthetradewasaddedto,youmightusethat

margin.Theone-by-twoorone-long-twoshorts:Theone-by-twocallspreadismuchlikeacalendar.Theconditionsthatareawfulforabackratioaregreatfortheonebytwo.Oneimportantdifference:Makesurethatthetradegeneratesacredit.Unlikearatioinwhichyouwantthetradetomoveinyourdirection,aone-by-twocallspreadisbasedonthe

underlyingmovingintheoppositedirection.Onceitmovesawayfromthetwoshorts,theskewshouldflattenandIVshouldcomein.Atthatpointitislikelythattheonebytwosoldatacreditcanbeboughttocloseforacreditaswell.Thisisasuresignthatitistimetokilltheone-by-twospread.Aswithanytrade,youarenotgoingforahomerun,youaretryingtomakeyour10%.

RatioSpreadExample

Theratiospreadmaybetheeasiestspreadofall.OnJune6,2011,withtheVIXnearall-timelows,youdeterminedthatnotonlywasIVlow,buttheskewwasrelativelyflatwiththe10deltaputtradingat135%ofATM.Realizingthatskewisrelative,youboughtputscheap.Youwerenotsurethemarketwasgoingtodrop.Thus,youentereda

ratiobackspreadsellingtheJulyATMSPX1280putsandbuyingtwiceasmanyoftheJuly1230puts(seeFigure9.20).

Figure9.20.JulyATMSPXratiobackspread.(Source:

OptionVue6)

Thetradewaslonggamma,longvega,andslightlyshortdelta.ItalsowouldnotlosemuchifyouwerewrongandtheSPXrallied(seeFigure9.21).

Figure9.21.JulySPXrationbackspreadGreeks.(Source:OptionVue6)

ThepayoutisshowninthegraphinFigure9.22.YourgoalwasforIVtorallyandtheunderlyingtofallatthesametime.Becausethecurvewasflat,yourhopewasthatskewwouldalsosteepen,causingthe1290stogainevenmorethanthemodelpredicted.

Figure9.22.6/6SPXratiobackspreadprofitandloss

graph.(Source:OptionVue6)

OnJune15,thetradestartedtomakesomedecentmoney.TheIVwentupandSPXdroppedasskewincreased

incrementally(seeFigure9.23).

Figure9.23.6/15SPXratiobackspreadprofitandloss

graph.(Source:OptionVue6)

Youhityourgoal,abletosellyourspreadatadecentcredit

(seeFigure9.24).YouflipoutofthepositiononJune16upquitesignificantly.Youdidn’thaveanymajorproblemsbecauseyousetupyourtradeproperly.Skew,time,andvolumewereallonyourside.

Figure9.24.6/16SPXratiobackspreadexitthetrade.(Source:OptionVue6)

Thedirectionhelpedbutwastheleastimportantpartofthetrade.

Endnote1.Averagetruerange(ATR):AmeasureofvolatilityintroducedbyWellesWilderinhisbook

NewConceptsinTechnicalTradingSystems.ATRisamovingaverageoftrueranges(generally14daysofthetrueranges).Truerangeisthegreatestof:1)currenthighlesscurrentlow,2)absolutevalueofthemostrecentperiod’shighlessthepreviousclose,3)absolutevalueofthemostrecentperiod’slowlessthepreviousclose.

10.OperatingtheBusiness:PuttingTogetherTOMIC1.0fromAtoZIsthereasecretsauceformakingasuccessfuloptiontradingbusiness?Thereis.Oneofthebestbookson

learningtobeasalesmanisYouCan’tTeachaKidtoRideaBikeataSeminar,byDavidSandler.Asthetitleofhisbookconveys,youprobablywillnotlearneverythingthatyouneedifyoudon’ttrade.Youwillneedtotrademanytimesuntilyoulearnhowtobeconsistentandmakemoney.Inthischapteryou’llfindguidelinesforoperating

TOMIC.TosucceedatTOMIC,ittakescommitment,dedication,andpractice.Sofar,youhavereviewedtheingredients.Youhaveexaminedthemostusedtrades:verticalspreads,calendarspreads,ironcondors,butterflies,andratiospreads.Thequestionishowtomixalltheingredientstoobtainasucculentmeal.ReviewtherecipetobesuccessfulatTOMIC.Recall

thatthekeysuccessfactorsofaninsurancecompanyarethese:

•Tradeselection•Riskmanagement•Tradeexecution

Todoallthreefunctionseffectively,youalsoneedtohaveyoursupportstructuresinplace:

•Atradingplan•Tradinginfrastructure

•AprocessforlearningInthischapteryouwillexamineasampleportfolioforTOMIC1.0.Youwillfollowthedecisionswetake.Therearemanywaystocookameal.Likewise,everyportfolioisuniqueandeveryTOMICisunique.Therearemanyvariablesthatdependonyourcomfortlevelandstyleoftrading.Thefollowingisanexampleof

TOMICcalledTOMIC1.0.Asyourskillsprogress,yourportfolioevolvesandbecomesuniquetoyourstyleoftradingandcomfortlevel.

TradingPlanEveryTOMICbeginswithatradingplan.Youshouldbeabletoanswerthesequestions:

•WhatisthegoalofTOMIC1.0?

•WhichmarketsamIgoingtotrade?

•WhatarethestrategiesIwillemployforeachmarket?

•Whataremyriskmanagementparameters?

•Whatisthebestwaytoefficientlyexecutethetrade?

Goals:TOMIC1.0isaportfoliousedtolearnand

conditionyouasanoptiontrader,intotheframeworkofmanaginganoptionportfoliolikeaninsurancecompany.Theprofitabilitygoalistonotlosemoneyoverany12-monthperiodandtohaveanannualabsolutereturngreaterthan10%.Themonthlygoalistomakearound1%returnontotalcapital.Markets:Youwillfollowatotalof10markets,including

indexes,ETFs,andequities.ThemarketsyouwillfollowareSPX,RUT,NDX,RTH,OIH,AAPL,CAT,EXC,MCD,andWMT.Strategies:AsyouprogressinproficiencyasamanagerofTOMIC,youwillhavemoreandmorestrategiesinyourarsenal.Youwillusedifferentstrategiesfordifferentmarketsetups.However,forthisexample

youwillusejustahandfulofmostusedstrategies.Youwillusethefollowingstrategies:

•Verticalspreads(creditanddebit)

•Ironbutterflies(andtheirvariations,broken-wingbutterflies)

•Ironcondors(andtheirvariations,unbalancedcondors)

•Calendarspreads

•RatiospreadsTable10.1showsthefivestrategiesusedinTOMIC1.0andtheconditionsinwhichtousethem.Table10.1.StrategyCheat

RiskManagementParametersforTOMIC1.0:

Maximumlossallowedpertrade:2%.Maximumportfoliolossallowedpermonth:6%.Portfolioconcentrationlimits:Nomorethan20%inanyoneindustrysector.Stayincashifconditionsarenotfavorableforanytrade.Tradeduration:Lessthan90days.

Execution:

Youwillbeusinganonlinebrokerwhospecializesinoptions.Thebrokershouldhaveaneasytouseinterfaceforsubmittingcomplextrades(suchasverticalspreads,condors,butterflies,orcalendars).Youwon’trequireportfoliomarginforTOMIC1.0;aReg-Tmarginaccountwillsuffice.

Setup:

•StartTOMIC1.0with$100,000.

•KeepatradingloginExcel.

•UseanInternetconnectionprovidedbyyourphoneorcableoperatorandusetheInternetconnectionfromyourcellphoneasabackup.

•Usealaptopcomputertotrade,incaseofa

powerfailure.•Programthebroker’sphonenumberintoyourcellphonewithouraccountnumberinhand.Ifonlineaccessisdown,youcancallthebrokerbyphoneinanemergency.

Figure10.1showsanexampleofhowyourtradingloglooksforaverticalspread.

Figure10.1.ExampleofanentryinthetradelogofanAAPLverticalspread.

ExecutingtheTradingPlanYoustartoutwith$100,000,andmonitorthemarketsyou

wanttotrade:SPX,RUT,NDX,RTH,OIH,AAPL,CAT,EXC,MCD,andWMT.Youknowthatyoucanriskupto2%ineachtrade.Thismeansthateachtradeshouldnotriskmorethan$2,000(2%of$100,000).Youwilltrytodoatleastthreetradespermonthaslongasmarketconditionspermit.Assumethatconditionsare

righttodoaverticalspreadinAAPL.Let’swalkthrutheexampleinFigure10.1.AnAAPLverticalputspreadconsistsinthisexampleoftenpoints.TheReg-Tmarginis$9,010.IsthiswithintheriskparametersofTOMIC1.0?Yes.The$9,010isthepotentialmaximumlossthetradewouldhaveifnoadjustmentsoractionsweretakenwhileinthetrade.However,TOMIC1.0isan

activelymanagedbusiness,andpartofriskmanagementisadjustmentsyoumakeduringthetrade.Inthistradeyouplacea“maximumloss”pointat150%ofthecreditreceived.Inthisexamplethecreditreceivedwas$990(includingcommissions),soyour“maximumloss”is($1,485).Thismeansthatifthetradegottothepointoflosing($1,485),youwouldcloseandtaketheloss.This

wouldrepresent1.49%ofthe$100,000fund,withinyour2%riskpertradeallowed.Makesurethatwhenyouenteratradeconditionsareright.Alsomakesureyouknowyourexits.Knowwhentoexitwhetheryouaremakingmoneyorlosingmoney.NoticethatintheAAPLexampleyouhadanexitof($1,485)ifyouwerelosingmoneyandanexitat

$693ifyouweremakingmoney.Thistradewasclosedmaking$710becauseyouhityourtarget.Haveamixoftradesintheportfolio.Followyourmarketseverydayanddeterminethebesttradesavailablegiventheconditionsofeachmarket.Haveanopinionofthedirectionofthemarket.Followtheimpliedandhistoricalvolatilitiesof

eachmarket.Thishelpsyoudeterminethebesttradesavailable.Keeptrackofthebestavailabletradesonatable.Table10.2showsanexample.

Table10.2.ListofBestAvailableTrades

Fromyouravailabletrades,selectthebesttocreatea

portfoliooftrades.Trytocreateabalancedportfoliobasedontheoverallmarketenvironment.Table10.3givesanexample.Table10.3.TOMIC1.0PortfolioExample

Noticethatnotradehada

“maximumloss”greaterthan$2,000or2%oftheassetsundermanagement.Iftheportfoliolostmorethan6%inthemonth,youshouldcloseallthetradesintheportfolioandgoflat.Thenreassessyourstrategiesandstartfreshthefollowingmonth.Yourtotaltargetwinfortheportfoliowas$3,530,whichrepresents4%returnonAUM(assetsundermanagement),andyour

averageofdaystoexpirationwas36ifeverythingwenttoexpiration.Inreality,tradeswouldbeclosedbeforeexpiration.Inourexperiencethistypeofportfoliowouldhaveaveragedaysintradebetween25and30days.Oncetheportfolioisworkingandyouhitexittargetsonatrade,youshouldclosethetradewhetheryouaremakingmoneyorlosingmoney.

Whenyouhityourprofittarget,closethetrade.Itlocksinprofitsandreducesyourexposure.Onceyoutakeoffatrade,gobacktotheavailabletradeslist,andselectthebestavailableatthattimeandplaceit.Thus,youreplacethetradeyouclosedandkeepTOMIC1.0makingmoney.However,iftheenvironmentishostileandthereareno

goodtradesavailabletoplace,donotplaceatrade.Waituntilconditionsarefavorablebeforeenteringareplacementtrade.TobecomeaproficientTOMICmanager,youmustmaketrades.Itislikebeingaheartsurgeon:Themoreoperationsyouperform,thebetteryoubecome.Makesuretowriteyourtradingplanwithasmuchdetailas

possible.Defineyourgoals,riskparameters,strategies,andentryandexitsparameters.Goaheadandexecutethetradingplan.Createafeedbackloop.Keepatradinglogwithdetailednotestolearnfromeachtradeyoumake.Attheendofeachmonth,checkyourperformanceandseewhatyoucanimproveonthefollowingmonth.Repeatthiscyclecontinuously,andyou

willbecomeabetterTOMICmanager.

PartIII:LessonsfromtheTrading

11.LessonsfromtheTradingFlooronVolatility

UnderstandingWeightedVegasinSPXIndexOptionsMarkSebastianwrotethe

followinginhisOptionPit.comblogon12/06/2010:Somepeoplecallacalendaragoodwaytohedgetheshortvegafromincomespreads.Thismightbetrueinsomecasesbutnotinallcases.Itisbettertounderstandthemovementsofimpliedvolatilityacrossoptions.Oneshouldunderstandhowvolatilityspikesaffect

volatility.Thechartbelowisagraphof30-dayimpliedvolatility(higherline)comparedto90-dayimpliedvolatility(lowerline).Whatdoyounotice?

(Source:Livevol©www.livevol.com)

Noticehowthe30-dayismuchmorefreneticthanthe90-dayvolatility.Icallthistheveganeutralizer.Itistruethatcalendarsarelong,whatweonthefloorwouldcallrawvega.However,tradersneedtorememberthatthemovementinthefrontmonthcanneutralizeanymovementinthebackmonthoptions.Thisextramovementinthefrontmonthisinmanyways

causedbythegammaofthespread.Whilethebackmonthvolatilityisincreasing,becauseofthelongtimetoexpiration,thusthepricemovementsmatterless.Meanwhile,inthefrontmonth,thesecrazypricemovementscanhaveamorepermanenteffectandcanreallymovedeltasofthespreadaround.Thiscanmakebeingshortalotoffrontmonthoptionsadangerous

game.Tradersneedtocompensateforthispricemovement.Onthefloortheonlywaytodothiswastojackupthefrontmonthimpliedvolatilitymorethaninthebackmonth.Sincebackmonthoptionshavemoretimetorelax,weraisedthevol,notwantingmarkettogettoooutofwhack.But,ifoneremembershowmuchvegaareinback

monthoptions,ifthingsgetreallyexpensive,owningthosesuckerscanbeaverydangerousgame.WewerealwaysafraidtoownexpensivebackmonthpremiumbecausetheIVcomingincouldbedeadly,sowedidn’traisetheIVthatquickly.Thesamemusthappenonthewaydown;tradersonlyhavealimitedtimetogetoutofa

losingvolatilityposition,orapositionwheretheunderlyinghasstoppedmoving,especiallywhendealingwithATMoptions(wehaveallseenwhy;ifnot,seethefollowinggraph).Theactionofthemarkethaltingcausesthewholeworld(retailtradersincluded)tosellpremiumprettyquickly.Tradersonthefloorwhodonotwanttohaveto

chokeonpremiumkilltheIVofthefrontmonthinordertoavoidgainingtoomuchinventoryoflongoptions.Withmoretimeforbackmonthoptionstotakeadvantageofanotherspikeinmarketvolatility,tradersarenotasquicktokillthebackmonthoptions.Wecanclearlyseethishappeningbetweenthegraphsbelow,whichisthewaythetermstructurelookedon11/30:

Thefollowingistoday’sclosingvol.NoticehowDecemberandJanuaryimpliedvolatilitywassoldoff

farharderthanFeb:

Thistypeofunderstandingcanhelptradersnotonlytradecalendars,butdouble

diagonals,butterflies,andcondorsaswell.

TakingontheSkewMarkSebastianwrotethefollowinginhisOptionPit.comblogon5/13/2010:

Themarketcontinuestohaveaniceintradayandinterdayrange.Evenifitisgoingupanddowntonowhere.Withimplied

volatilityatcurrentlevels,though,Ithinksellingvolmakessomesense.TheproblemformosttradersisthattheywanttoselltheATMvol,whichwhilethejuiciestalsoisthemostfairlypriced.Theskew,whichstillissomewhatelevated(althoughnottothelevelitwas),islikelythebettersale.Theproblemisitishardtodothiswithoutgettinglong

premium,butitcanbedone,inafewways:1.RatioSpread.Thisisnotabadtrade,exceptthatifthemarketreallyfallsout,thetradercouldloseonthisone.Iftradingaratio,IthinkthebestmoneywouldbeinbuyinganATMputandsellingOTMputs.Atthesametime,makesuretobuysome

extraprotectiononthewaydownside(that’srighttraders,units).

2.Condor/Strangle.Ilikethestranglebetter,butbecauseofmargin,tradersmighthavetosettleforcondors.Thekeyistosellattheinflectionpointwherethevegaoftheoptionreallyfallsoff.Thiswaythetradercantake

thebestadvantageoftheelevatedimpliedvolatility.Still,thetraderhastobuyvolatilityevenlowerandhigheronthecurve.

3.Finally,themostunderutilizedandpossiblythebestplayforthemoneyrightnow,inmyopinion,isthedoublediagonal.Iwouldbelookingtosell

thefrontmoneyOTMcallandput,andbuythebackmonthOTMevenfurtherout.HereisoneplayIamlookingat:Mayisdone,itisallgamma,Iwouldstayaway.ThisleavesJune,which,whilenotsky-highintheskewlikeMay,isstillveryelevatedinitsputsandcalls.JulyandAugustareelevatedbutnot

nearlythewaythatJuneis.NowIneedtodecidewhatstrikestotrade.Iamgoingtosetupthetradevegapositive,butafterIweightthevega,Ishouldbenegative.HereisoneexampleintheOEX.

Atfirstglancethespreadhasavegaofabout82.Forthesizeoftheposition,Iamgoingtocallthatprettyflat.

However,onceIweightthevegaIfindthatIamshortabout170.00weightedvega.

Thisspreadwillmakemoneyiftheskewflattens,ifthespreadbetweentheJuneandJulytightens,orevenifIVingeneralfallsrelativetohowit

ranup.Ifatraderwantstotradethefrontmonthsmile,withoutahugeoutlayofcapital(relativetoastrangle),Ithinkthisisadecenttrade.

FourTipsWhentheVIXCashIsDepressedMarkSebastianwrotethefollowinginhisOptionPit.comblogon

3/23/2010:ItisallovertheblogospherethattheVIXfuturesarefarexceedingthecashVIX.“Sowhat?”thetradermayask.“Howisthisofanyusetome?”Itisprettysimple:tradingapproach.WhentheVIXfuturesarefaraheadoftheVIXcash,itbecomesvisibleintheoptionsviathetermrisk.Thefront

monthischeaprelativetothebackmonth.OnthefloorIwouldhavetriedtobuygammaandsellvega.Aprettyeasytask;allthetraderhastodoisselltimespreads.Fortheretailtraderthisprocessisalittleharder.Thisisbecausemostretailtradersdonotsitonatonofmargin.Thisdoesnotmeanthatthetraderneedn’theedtheVIX-

Futuresspread.Herearefourthingsretailtraderscandowithoptionswhenthetermspreadiswide.1.Avoidlongterm-riskplays—Thismeanscalendars,doublediagonals,younameit.Ifatraderinsistsonputtingonacalendar,tryoverlayingalittleextrabackmonthIV,orbuyingsomecheap

frontmonthstranglesagainsttheposition.

2.Don’tfearthefrontmonth—NoticeIdidn’tsay,“Don’tsellthefrontmonth.”ItcanbeokaytotradebutterflieswhenIVislow,aslongasthetradersetshisorherwingsusingastandarddeviationcalculation.WhatIliketodoisassumeIwillbe

inthetradefor18.5days.ThensetmywingwidthbasedontheATMstrikeimpliedvolatility.ThiswillcausemywingstobewiderinhighIVmonthsandtighterinlowIVmonths.ThisisagreatwaytomitigateriskintheinstanceofabreakoutoflowIVs(postacommentortwoifyoutraderswouldlike

amoredetailedexample;thismightbeagreattopicforthenextarticle).

3.Ifthebackmonthisstillelevatedoverthefront,thenwhyfearthecondor?—TheIVtermstructureofoptionsiscurrentlyverysimilartowhatitwasinJanuary.Traders,condorsdidFINEin

thatcycle.Thisisbecausecondortradersweresellingthemonththatwasrelativelyhigh.

4.Asstatedinnumber1,don’tbeafraidtospendalittlebitofcashonsomecheapputs—Nothingwillcostsolittleandletthetradersleepsowell.AsmyfriendandSevenTimeBrokerofthe

YearKevinKennedyusedtosay:“Buy’emwhenyoucan,notwhenyouhaveto!Becausewhenyouhavetobuythem,youcan’t!!!”

HowtoFindandTrackVolatilitySkewMarkSebastianwrotethefollowinginhis

OptionPit.comblogon4/02/2009:

Howdoesonefindvolatilityskew?IsthisaccomplishedbystudyingthematrixwithimpliedvolatilityandcomparingdailyIV?Byfindingrichercondors?Everystockhasvolatilityskew.Somewillbesteeperthanothers.Thebestwaytotrackskewisbylooking

atthevolatilityofseveraloptionswithaspecificdelta.Youkeeptrackoftheskewbychartingthechangesinthevolatilityofthesespecificdeltaoptionsandthespreadsbetweenthem.Forinstance,onemightwanttokeeptrackofthe5deltaput,the20deltaput,the50deltacall,the25deltacall,andthe10deltacall.Whytheseoptions?I

thinkusingtheseoptionscangiveafairlyaccuraterepresentationoftheskewcurve.Afterpickingyouroptions,keeptrackofthevolatility,butmoreimportantly,thevolatilityspreadsfromstriketostrikeandoptiontooption.PutthemintoExcel,andfillitineveryday.Runagraphoverthevolsandyouwillreallybeabletoseetheskewcurve.

Runasecondgraphoverthedifferencesinthevolspread,andyouwillreallybeabletoseehowthecurveismoving.Generally,whenwegettoabout15daystoexpiration,Iliketoswitchtothenextmonthout.Here’saniceremindertoswitch:Whenyouhitthefirstofthemonth,youshouldnolongerbeusingthatmonthtochartskew.

Inyourcharts,makesuretonotewhenyouswitchmonths.Youwillactuallybegintonoticepatternsinhowtheskewcurvemoves.Asfarascondors,thoseareagoodindicatorthatsomethingishappening,andmaybeaveryquickshortcut.However,it’snotawonderfulwaytoreallytrackskew.

SPXSkew:It’sAllRelativeMark’sstudentsconstantlyreviewhowimportantthevolatilitysurfaceis.Theyallknowthedifferencebetweenahighskewandalowskew.However,theysometimesfailtograsponeimportantfactor:SkewisapercentageofATMIVandonlyarelativenumber.ATMimplied

volatilitymatters.Hereisanexample:Youhavetwotradesyoucouldenter:Trade1:SPXironcondorsoldat15deltaDownsideskewissomewhatsteep—thetendeltaputtradesat140%ofATMIV.ATMIVis19%,andmedianIVofthestockis23%.Upsidecallskewisflat,and

25deltacallistradingat90%ofATMIV.Trade2:SPXironcondorsoldat15deltaDownsideskewissomewhatnormal—thetendeltaputtradesat135%ofATMIV.ATMIVis25%,andmedianIVofthestockis23%.Upsidecallskewisnormal,and25deltacallistradingat85%ofATMIV.

Conclusion:Whichtradeisbetter?Notethat140%of19isIVof26.6%,whereas135%of25is33.75%.Onthecallendofthetrade,85%of25is21.25%,whereas90%of19is17.1%.Eventhoughtheskewislow,thefactthattheIVitselfwassomewhatelevatedmakesabigdifference.ThePoint:

Volumesgoupanddown.Thelowerthevolume,themoreyouneedskewtomakeupforit.Thehigherthevolume,thelessskewmatters,althoughacomboofhighskewandhighATMIVisthebestsetup.

UnderstandingImpliedVolatilityinIronCondors

Markhadaninterestingdiscussionwithoneofhisoptionmentoringstudents.Hewasinthemiddleofcommentingonhowhedidnotlikethewayironcondorslookedatthemoment.Markhadgoodreasons:

•Impliedvolatilitywasrelativelylowintermsofwhereithadbeenoverthelastfewmonths(notintermsof

realizedvolatility).•PutskewwasflatnotjustinDecember,butalsoinJanuary.

•TherewasnotabigvolatilitypremiuminsellingtheDecemberorJanuaryrelativefrontmonthvolatilityorrealizedvolatility.

Theoptionmentoringstudentrespondedbysayingthathecouldstillget.60whenhe

soldhisshortputandcallstenpointswideatthe10deltastrike.Didn’tthatmeanthatthetradewasstillokay?No.ExaminetheputsideofanSPXironcondorsold36daysoutatthe10deltastrike,asshowninFigure11.1.

Figure11.1.SPX1115/1105DEC10putspread

information.(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrative

purposesonly.TDAmeritrade,Inc.,andOptionPitLLCareseparateunaffiliatedcompaniesandarenot

responsibleforeachother’sservicesorpolicies.)

SPXtradesat1218andthe

tradecollects.60.Itplacesatthe1115/1105strike,about8.5%out-of-the-money.Lookatthecondoronlyonemonthprior,asshowninFigure11.2.

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-

the-money.Inabsolutetermsthespreadisanextra15pointswideonthedownside.Thesamewouldholdtrueifyoudidtheupsideofthespreadaswell(althoughthetwowouldlikelybeasmallerdifferenceinabsoluteterms).Allcreditsarenotcreatedequal.Justbecauseyoucollect.60froma10deltaspreaddoesn’tmeanit’sagoodtrade.Volatilityand

volatilityskewwillpullinthewingsofanironcondor.Unlikeabutterfly,inwhichthiscanmitigaterisk,thismakestheironcondormorevulnerabletotroubleintheeventthatimpliedvolatilityblowsup.

TheStagesofSkewMarkSebastianwrotethefollowinginhisOptionPit.comblogon

8/29/2011:AstudentaskedmewhytheSPXhadsuchasteepvolatilityskew(sometimescalledsmile)inSeptemberandOctober.TheVIXwascomingin;shouldn’tskewflattenasimpliedvolatilitiesdrop?SPXskewissteep,moresoinOctoberthaninSeptember(althoughit’selevatedtheretoo),where

the10deltaputistradingatavolatilityofabout152%oftheATMstraddle.Whileit’sclearthatIViscomingdownandfearhassubsidedsubstantiallyintheshorttermwiththeFedmeetingoverand[Hurricane]Irenepassing,wearecertainlynotinastageofcalmeither.AVIXofover32is

historicallyastronomicallyhigh,asitismorethan50%elevatedrelativetothelong-termmeanoftheVIX.OnethingtorememberiswhenIViscomingin,themarkettypicallywillwanttokeepbiddingupthosebabyputsforalongtime,becauseofoverallfearofIVgoinghigherinsteadofbacktowardthemean.Thisbringsustothe5

majorphasesofvolatilityskew:

Phase1:Calm

Inthisphase,impliedvolatilityislowandskewisnormaltoflattish.Thisphaseiswhatwewouldcall“normaltimes,”wheretheVIXisbetween16%and18%.Themarketmayhave

upsanddowns,butthereislittlefearofa“majorevent”oramulti-standarddeviationoutlierday.Phase2:CalmBeforetheStorm

Inthisphase,IVisstill

somewhatlow,butmaybeslightlyelevatedornot15-20intheVIX.However,thereissomedevelopingfearofamajorstandarddeviationevent.ItcanalsooccurwhenIVis“oversold”andthereissomepent-upselling.Thisphasecanleadtothenextphaseorrightbacktocalm(Phases2and4canmoveineitherdirection).Basically,themarketisstartingtobuyprotection,butdoesn’twant

toownATMoptions,thusbuyingof“unitputs”pushesupskew.Phase3:TheTyphoon

Inthisphase,thereisextremefearinthemarketandtheVIXisat30%to40%or

greater.Wewerejustinthisphaseaslateaslastweek.IVonthedownsideofthecurveisstillhigh,butATMIVisupsomuchthatskewactuallyflattens.Thisisaconditionofborderlinepanic.Phase4:TheCalmingStorm

IVisstillquitehighinthisphase,butitisfalling.Themarketthinksthingsmightbegettingbetterbutisafraidthatthingscouldgetbadagain.ATMIVisbeingsoldoff,butmanyofthosesellingATMvolatilityarebuyingout-of-

the-moneyputs.Unitprotectionisatitsmostexpensiveinthisphase,asATMIViselevatedandskewissteep.TheVIXcanbeanywherefrom20%to35%inthisphase.LikePhase2,theCalmingStormcanblowupintoaTyphoonagain,oritcanmovetowardPhase5.Phase5

Alliswell,inthisphase,asIVreturnstonormal,butskewstaysslightlyelevatedforaperiodoftimeasthemarketlicksitswoundsfromrecentlosses.TheonlydifferencebetweenthisphaseandPhase1isthatskew

mightbeslightlysteeper,andIVmaymovealittlemorequicklyoffoflows.ThisphasecanjumptoPhase1orPhase2.Itcantakeupto6monthsforPhase5toturnintoafullycalmsituation.Inbetweenthe5mainphasestherearemanysmallphasesandtransitions,butIthoughtitmightinterestyoutraderswhowatchskewtoseeaclearexampleofhowskew

cangofromcalmtocrazytocalm.

12.LessonsfromtheTradingFlooronRiskManagement

CashIsaPositionCashisapositionyoucantake.Beingincashhassomeseriousadvantages,yetmanyareafraidoftheposition.

Table12.1showstwoannualreturnsinwhich$10,000tradedinironcondors.Table12.1.TwoScenariosforIronCondorReturns

Thenetsimplereturnonthedatasetwas$700or7%,notbadatall.

Nowexaminethisseconddataset.Thenetsimplereturnonthedatasetwas$1,300or13%,almostdouble.TheonlydifferencebetweenthetwosetswasinSeptember.Youdecidedtostayincash.Believeitornot,youmademoremoneynottrading.Youmightknowthisurgetotrade,thisneedorwant.Itshouldberesisted

whenyoudon’tseeanythingthatyoulike.Ifyoudonotlikewhatyousee,skiptradinganddrinkaDietCoke.Youwillbefarmorerelaxedandwilllikelyhavemoremoney.Itmaynotbesexy,butintheendI’dratherberichthansexy.Betteryet,thereisanoldsayingthatthereisalwayssomethingworthtrading.Ifyoudonotlikewhatyousee,

startexpandingyourknowledgebasesothatyoucanrecognizeopportunities.Itcanmakeahugedifferenceinyourtradinglife.

TheCardGameValueOneofthemostlovedtradesbytheretailpublicisthe“creditspread.”Oneofthebiggestmistakestheretail

publicmakesisfailingtoexitcreditspreadswhentheshortoptionbecomesinexpensive.Thisisnotbecausetheywanttoholdthetradetoexpiration.Itisbecausemostdonotunderstandthatthereisasecondcomponentinthevalueofoptionsthatmostoptionpricingmodelscannotcalculate.Thiscomponentwillcausethefinalportionofthevalueofanoptiontotakemuchlongertodecaythanthe

modelpredicts.Thisvalueexistsbecauseofthepayoutdisparityiftheoptiongoessour(unitrisk).ThisisTheCardGameValue.Understandingthisallowsyoutoexittradesatanearlierdateandmovemoneyintotradesthatfollowthestandardoptionmodel.TheCardGame:Twomenaregoingtoplayacardgame;theywillplayitonly

once.Thereare100cards.Ninety-nineofthecardshaveavalueof0andonecardhasavalueof1,000.Oneofthemenwillpaytheotherforthechancetodrawonecard.Ifhedrawsthe0,hegetsnothing;ifhedrawsthe1,000,theothermanmustpayhim$1,000.Theoretically,thecardgameisworth$10(1,000×1/100).Butwhatdoyouthinktheonemanshouldchargetheothertoplaythe

game?Ifthisgamewereplayedoverandover,themanwouldprobablychargeaverylownumber,say$11.Hewouldknowthatovertimeprobabilitiesareinhisfavorandhewillcomeoutahead(thisishowLasVegaspaysforallthosenicehotels).However,thisgamewillbeplayedonlyonce.Theoddsarethesame,butifthe$1000cardisdrawn,themanonthehookwillhaveno

opportunitytomakethemoneyback.Myguessisthatitwouldtakealotmorethan$11togetsomeonetoplaythisgame.Thisthoughtprocessisexactlywhatthrowsoffthevalueofcheapoptions.Theprobabilitiessaythattheoptionshouldbeworthnothing,buttheoptionwillmaintainavalueof.10to.25foranexceptionallylong

time.Thatisbecausethepersonwhosellsthecheapoptionisthesameasthemanwhoissellingthedrawinourcardgame.ThepersonwouldmakemoneyovertimeinaVegasworld,butoptionmonthshavealimitedlife.Ifthesellerofthecheapoptionhasthetradegobad,hewillneverseethatmoneyagain.Thetraderwillnothaveanunlimitednumberofchancestoplaythisgame.Themajor

movehashappened;thetraderhaslost.Tomakemattersworse,unlikeinthecardgame,thetraderhasanundefinedrisk,meaningthathehasnoideahowmuchhewillloseifthetradegoesagainsthim.Thefinal0.25ofanoptiontakesmuchlongertodecayout.Whatdoesthismeantoyouasacreditspreadtrader?Takeoffcreditspreadswhen

theynolongerfollowthemodelandonlyhaveCardGameValue.Thisimprovesyourperformancebecauseyoufreeupcapitalearliertomoveintoothertrades,whichpricingmodelsandGreekscanvalue,andcanbeoutofyourtradesearlier(alwaysagoodthing).Creditspreadsareagreatwaytomakemoney,butittakesonlyonebaddrawtowipeyouout.Don’tgetcaughtplaying

cards.

WhyAreOptionTradingHandsSoHardtoSitOn?MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/28/2010:

OnceIhavebeenworkingwithanoptionsmentoringstudentforalittlewhile,

theycanusuallyfigureouthowtoproperlysetupatrade.Thatisabouthalfofthebattle;thenextstepismanagingandadjusting.ThisiswhereIcanrunintoproblems.Mostofmystudentsgetthewaytoadjust,andcanevenunderstandthewhen;it’sthewhennottothatseemstokillthem.HereisaDIApositionthatwearecurrentlyworkingonin

theAMPitReport:

(Source:TDAmeritrade,Inc.Usedwithpermission.Forillustrativepurposes

only.)

Lookingattheposition,doesitneedadjusting?Ifso,whatshouldIdotofix

thisposition?

IfyouranswerwasanythingbesidesNOandNOTHING,youmayhaveacaseofover-adjustingdisease.Iamnotsurewhypeoplegetthisdiseasebutitisrampantinthetradingworld.Themainsymptomisthatatradermakestradesinapositionthatisnotintroublebutisnearapointwherethepositionmightstarttogetinto

trouble.Thisdiseasekillsmoretradesthanthemarket,andhereiswhy.Everytimeyoumakeanadjustmentonaposition,itputsthetraderinthetradelongerandcoststhetradercommissions.Thelongeroneisinatrade,thelongeroneislikelytogetamajormulti-standarddeviationmove.Itisthebighugemovesthatkillatrade,nottheslowcreepsup

ordown.Wecanadjustapositiontosmallupsanddowns.Thesmallmovescanalsoturnaroundwithoutushavingtoadjust;remember,justbecauseapositionisNEARtroubledoesn’tmeanit’sgoingtogetintrouble.Underlyingsecuritiesdoturnaroundorstopmovingsometimes.Ontheotherhand,multi-standarddeviationmoveswilllikelyhurtanytradeevenifitis

adjusted.Youcanprotectapositionfromalotofmoves,butnotall.SohowcanItellifIshouldadjustaposition?Thatishardtosay.However,hereisatestIliketouse:Pushyourcurrentpositionforward3days,thenlookattheposition.Askyourself,IfIdonothing,amIlikelytomakemoney/breakevenifwestayhere,rallyastandard

deviation,orfallastandarddeviation?Iftheanswerisyestoatleast2outof3ofthose,donothing,ifitisnot,thenconsiderlookingatadjusting.Tradingisn’taneasyjob;thelastthingtradersshouldbedoingismakingitmoredifficultbyaddingcommissionandtimetotheirincometrade.

HowOptionTimeValuePremiumDecaysovertheWeekendThefollowingisfromMarkSebastian’sOptionPitBlogon10/29/2009(atthetimeitwascalledOption911):

Aretailtraderhadonacalendarspread(longtimespread)thatwasgoing

verywell.OnaFriday,hiscalendarpositionwasup18%.Hewasexcitedbecauseifhecouldjustholdonthroughtheweekend,hewasgoingtocollectanother4%returnonhiscapital.

OnMondayhewasquitedespondent.Hehadheldhispositionovertheweekend,andafterthemarketmovementthatMonday

morning,hewasdownfromFriday.Thestudentsaid,“Mark,Idon’tgetit.Ididmyanalysis.IshouldbeupatleastafewhundreddollarsfromlastFriday.HowcomeIdidn’tmakeanythingovertheweekend?”

Hereistheshortanswer:WeekendthetaisdecayedoutofapositionbyFridayafternoonat4:00p.m.Mostretailtradersassumethatthetadecayislinear.Over

time,thetadecaysattheratethatyourtradesoftwaresaysitdoes.Forinstance,ifcertaintradingsoftwaresaidapositionhadapositivedecayof10,mostretailtraderswouldassumetheywouldhaveanextra10dollarsbythefollowingtradingmorning.Butwhatabouttheweekend?Marketmakersarenotstupid(well,someare).Theydon’t

likegivingawayfreemoney.Ifthepositiondidn’tdecayoutbeforeFriday’sclose,othertraderswouldcomein,sellalargeamountofpremiumattheendofthedayonFriday,andthenbuytoclosefirstthingonMondaymorning.Traderswhosoldthepremiumwouldbehappy.Theywouldhavegottentheentireweekend’sdecay,21/2days(Friday4p.m.toMonday9:30a.m.),forthe

priceofonewake-up(Sunday4:00p.m.tillMondaymorning).Sowhatdomarketmakersdo?It’sprettysimple.Webegintodecaytheentireweekendasearlyaspossible.Althougheverymarketmakermanagesweekenddecaydifferently,Markmighthavedonethis:OnThursdayaboutmiddayMarkwouldturnoffallofhisquotes.Hewouldgo

intohisoptionsquotingsoftwareandbeginmovinghissoftware’stheoreticaldayforwardFriday(thisisverysimilartousingthedatefunctioninTOS,OV,orTradeStation).Markwouldnoticethatothertradersbegansellingpremium.Hewouldnotwanttobuypremiumthatwoulddecayfortwodayswhilethemarketisclosed.Sohehad

twochoices.Hecouldlowerthetheoreticalvolatility.Thiswouldreducehisoptionpricesbasedonpremiumsellers’activity.Orhecouldmovethetheoreticaldateforward.Thiswouldreducethetheoreticalvalueoftheoptionsusingdaystoexpirationinsteadofloweringtheimpliedvolatility(thisistheonetimewherethedaystoexpirationportionofthefivefunctionsofapricing

modelcanmatterasmuchasvolatility).OnFridaymorning,MarkwouldalreadyhavethetheoreticaldatetosetSaturday’sdate.Thislethimstayaheadofthegame.Oncehesawpremiumsellersacting,hewouldmovethetheoreticaldateforwardtoSunday.AtthecloseofthedayonFriday,Markwouldhavehissystemsetto4p.m.

ESTonSunday.Thesystemwouldhaveonewake-up(Sunday4p.m.toMonday9:30a.m.)oftheoreticaldecayleftpricedintotheoptionshetraded.Therewasno“free”premium.Sohowdoesthisknowledgeaffectyouasaretailoptionstrader?Youmaynotethatcurrentsoftwaredoesnottakeweekenddecayintoaccount.

You,asasavvyoptiontrader,can.IfyouareinanoptiontradeonthecuspofexitonaFridayafternoon,getoutoftheposition.Thereisnot21/2daysofpremiumtobemadeovertheweekend,andyouhavealreadymadeachunkoftheta.Afewpeoplemaythinkthattheycanmakemoneybybuyingpremium;thisisalsonotthecasebecauseyoustillhavetopaythewake-updecay(Sundayat

4p.m.tillMondayat9:30a.m.).Thereisno“weekendedge.”Thereisonlythetrader’sedge—yourabilitytoperformbetterthanothertraders.

WhenIstheTimetoDe-riskYourPortfolio?Theterm“de-risk”meanstoexecuteanactivityoraseries

ofactivitiestolowertheriskstoyourportfolio.Formostpeoplede-riskingaportfoliomeansreducingpositions,whichinturnreducesexposure.Sowhenshouldyoutakeoffrisk?Inthesesituations:

•Theportfolioissovolatilethatyoucan’tsleepatnight.

•Themarketenvironmenthas

changedandyoudon’thaveareadonthenewenvironment.

•Youhavehityourportfoliotradinglosslimits.

•Yourtradingmodelisnotworkinginthecurrentmarketenvironment.

•Youneedtorebalancetheportfolio.

•Yourpositionshavehit

theirtargetprofits.De-riskingisaveryimportantpartofsuccessfullymanagingTOMIC.Makesureyouknowwhentopulltheparachutechord.Don’thesitateinpullingit.Itisbettertobesafethansorry.

HowtoTradeWhenYouGoonVacationHowatradershouldtrade

whengoingonvacationissimple:Goflat.Don’tleavetradeson.Ifyoudo,theyshouldbelong-term.Assumethatyouwon’thaveaccesstotheInternet,andthatyourtravelingpartnerwillnotbehappywithyouifyouareconstantlycheckingyouraccount.Itisnofuntobeonvacationandtradeatthesametime.Thatiswhyitiscalledavacation.

YoumightfindyourselfonacruiseshipclaimingtohaveInternetavailable.However,whenyouarecruisinginAlaskainthemiddleofglacierterritory,thatInternetconnectiondoesnotwork.Youmightbeunabletocheckyouraccountforseveraldays.Befullyengagedwhenyouaremanagingyourportfolio,butletgowhenyouareonvacation.Ifyoudon’thavetheluxuryofgoingflatwhen

yougoonvacation,youshouldgetatradingpartnertotakecareoftheportfoliowhileyouareaway.

13.LessonsfromtheTradingFlooronTradingandExecution

WhatEverybodyShouldKnowAboutPaymentforOrder

FlowMarkSebastianwrotethefollowinginhisOptionPit.comblogon12/20/2009:WhenIfirstbegantradingin2001,amarketmakingfirm,let’scallitFirmXYZ,cameupwithanewandinnovativeideatobringoptionvolumetothePitswheretheycontrolledthemostvolume,

thePitswheretheyweretheSpecialist,ortheDesignatedPrimaryMarket-MakerorDPM.Thiswascalledpaymentfororderflow.Theexchangescallthem“marketingfees”andyourbrokermaycallitoneofmanynames.Whatseemedlikeabrightideaatthetimehasblossomedintoasituationthatis

•Badforthecustomer•Badfortheliquidityprovider

•GREATforyouronlinebroker

Inthefollowingyears,thesystemwouldslowlybecomeintegratedbytheexchangesandtakenoutoftheindividualfirm’shands.Thesystemhasessentiallymorphedintoahierarchythatputstradingfirmswhoare

willingtopaytoseelargerordersinthedriver’sseat,andthepublicinthetrunk.Iwillnotbroachthehierarchysubjectforlargeorders,butIwillexplainwhyitisimportantthatonetakesthetimetoreviewthestatusoftheirorder.

GettingtheFirstLook

BacktoFirmXYZ,thewell-meaningmarketmakingfirm

thatopenedPandora’sbox.(IwillbepickingonFirmXYZduringthisarticle,butthisisindustrypractice.Idonotwantthereadertothinktheyaretheonlyfirmthatdoesthis.Asstatedabove,mostEXCHANGESnowengageinthispractice.)Theymadeagreementswithmanytradingfirmstogeta“firstlook”atallofthepaperthatacertainfirmhas.Butwhatdoesthat“firstlook”really

mean?•IfFirmXYZismatchingtheNBBO,andtheorderishittingtheNBBO,theorderwillroutetoFirmXYZ’spit.

•IfFirmXYZwasn’tthebestbidoroffer,dependingontheorder,FirmXYZmightstillgetfirstlookattheorder.Byrouting

throughlinkage,theorderwouldgetsenttotheexchangewiththebestbidoroffer.

•IfFirmXYZwasmatchingtheNBBO,andanorderdidnothittheNBBO,theorderwouldstillroutetoFirmXYZ.Asaretailtrader,onemightlookatthatdealandthinkthatitisn’tsobad.That

traderwouldbesorelymistaken.

ThefirstpartofthedeallikelyhaslittleeffectonretailtradersastheyarehittingtheNBBO.Likelytheirorderwillgetfilled.Theonlytimethiswouldbeaproblemisifthetraderissendingalargetradeandtheorderisbeingsenttotheexchangewiththesmallestbidoroffer.Itispossiblethatasmallportion

ofthetrader’sordercouldgetfilled,andwhilebeinglinkedtoanotherexchangethemarketchangesonthetrader.Thiswouldleavethetraderopenonaportionofhisorhertrade.Thesecondsituation,wherethemarketmakingfirmisn’tmatchingtheNBBO,yetseestheorderfirst,thenroutestheorderthroughlinkage,isslightlymoreproblematic.If

thereisonlyoneexchangebidatacertainlevel,thesecondsittakestheordertomovefromtheFirmXYZthroughlinkagetotheexchange,amarketcancertainlymove(actuallyIbelievemanyfirmsthatacceptpaymentfororderflowhavesomesortofmatchingguaranteetoprotecttheircustomersfromthisoccurrence).

Finally,therealculprit,anon-marketableordergetssenttothemarketmakingpit.TheexampleIamabouttorunthroughactuallyhappenedtomeinIBM.ImaginethattheISEiswillingtopay50centsforanoptionupto5,000timesandthePHLXiswillingtopay50centsupto30times.Ifatraderhadanordertosellanoptionfor55cents10times,

wouldthetraderexpectittobesenttotheISEorthePHLX?ThetraderwouldexpectittogototheISE;thefirmacceptingPaymentforOrderFlowwouldsendittothePHLX.Thisisbadnewsforthetraderbecausetheorderisbeingsenttoaplacewiththefewestnumberofeyesonit.Thismatters!!IhaveseenofferssittingonthePHLXwhilethatpriceistradingontheCBOE.AsI

havestatedbefore,theonlythingsmartaboutasmartrouteristhatitissmartforyourbrokertomakethemostmoney.

WhenShouldYouWorryAboutAssignment?MarkSebastianwrotethefollowinginhisOptionPit.comblogon

2/07/2010:Iwanttodiscusssomethingsomewhatbasicthatseemstohoundmeconstantly:retailtradersaskingmeifIamworriedaboutbeingassignedonashortputposition.TheveryneophytetraderswillsometimesgosofarastoaskifIamworriedaboutcallassignment.Iam

goingtogivetheshortansweronassignment,andthenIamgoingtoproveit.ThenIwilldiscusswhenitisokaytoconsiderassignment.Veryquickly,astradersbeingassignedshouldbeoneofthelastthingsweworryabout.Thereasonbeing,itisn’tsomethingthathappensveryoften.Thecircumstanceswhena

traderwillbeassignedareactuallysomewhatrare.Thisisespeciallytruenowwithinterestratessolow.Hereiswhy:Iamgoingtostartwiththisstatement,anditwasoneofthefirstthingsIlearnedasatrader.Aputisacallandacallisaput.Almosteverytradeprotradersmakeisconvertingcallstoputsandviceversa.Forinstance,theprotective

put:Ifonechartsthegraphofaprotectiveput(longput+longstock),whatdoesthetradernotice?Itlooksexactlylikeacall.Thepositionhasalimitedloss,andunlimitedupside.

Anothercommontrade,thecoveredcall(longstock+shortcall)looksexactlylikeashortput.Thepositionhasalimitedupsideandanunlimiteddownside.

Ifallcombinationsofstocksandoptionscanbeconvertedintootherpositions,thentheremustbesomesortofforceholdingthesecombinationstogether.SimilartoE=MC2,theoption

worldhasaformulathatholdsittogethercalledput-callparity.Put-callparityistheformulathatensuresthattraderscannotmakemoremoneybuyingcallsthantheycanbuyingputsandstock.Whenoptionsareoutofparity,arbitragebegins;thisquicklybringsoptionsbacktoparity.ThisFormulaisCall−Put=StockPrice−StrikePrice+(Interest−Dividends).TheshortequationisC−P=S

−X+(I−D);theI−DisoftenreplacedwithaKforcostofcarry.Usingthisformula,ifacustomerwantstoselltheFebruary50callat9dollars,withthestocktrading55.00andacostofcarryof0.20,whatwouldtheputbetrading?9−P=55−50+.20.Theputshouldbetradingaround3.80.Iftheputhadabidof4.00,themarket

makerswouldbuyasmanycallsastheycouldfor9dollars,sellthestockagainstthecalls(convertingthemintoputs),thenselltheputs.Thiswouldallowthemtosyntheticallybuytheputandthenselltheactualput.Let’sthinkaboutput-callparityandassignment.IfIamlongaput,andlongtheunderlyingagainstthatput,whatpositiondoIreally

have?Iamlongacall.IfIreallyhaveonacall,thentheonlywayIwouldexercisemyputwasifthevalueofthecallwaslessthanthevalueoftheput,stock,andcostofcarrycombinationorC.IfIhadboughtanATMbutterflyinOEXonJanuary19th,ImayhaveenteredintotheOEX500/530/560putfly.OnFebruary5th,theOEXis40pointslowertradingat

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

downswing,itisnotinmycounterparties’bestinteresttoexercisetheput.Withinterestratesthislow,assignmentsarefewandfarbetween.TheMarketMakerratewillhavetoincreasebyatleast1%beforethispositionbecomesasomewhatattractiveexercisecandidate,evenwithan8%downmove.Hopefullybynowonecanseetherearefewscenarios

wheretheputshouldgetassignedtoseller.Callsareaslightlydifferentstory;nondividendpayingcallsshouldneverbeearlyexercised.However,tradersareatriskofassignmentiftheunderlyingpaysadividend.TakeEXCforinstance:OnFebruary11th,EXCgoesex-dividendpaying52.5centspershare.IfIamshortthe40calls,shouldIworryaboutgettingassigned?

Icanfigureitoutbypluggingthenumbersintoputcallparity.Thecallistradingaround4.25,theputaround.05.Thestockistrading44.25andthecostofcarryendsupbeing(.01–.525).Pluggingthesenumbers,4.25–.05=44.25–40+(.01+.525),the40callshaveaproblem;theC–PdoesnotequaltheS–X+K.Thosecallswilllikelygetassignedtome.

Nowthatwehaverunthroughthemath,tradersshouldcertainlybeclearabouthowtotelliftheywillbeassigned,usingslowlonghand.IwillgiveyouwhatIamcallingthe“TradersShortHand”tofigureoutassignment:

1.Ifthe(i−d)isgreaterthanthevalueofthecalloppositethetrader’sshortput,the

tradermaygetassignedontheposition.Generally,Idonotpayattentiontothisuntilthecallisworthlessthan.25orso.Withratesaslowastheyare,itiscloserto.05.

2.Ifthedividendisgreaterthanthevalueoftheputoppositethetrader’sshortcallposition,thetraderis

likelytogetassignedonhisorhershortcallposition.Ifthecalldoesnothaveadividend,tradersshouldneverbeassignedontheshortposition.

Tradershavemanyrisksassociatedwithaposition.Itisimportanttoconcentrateonthemostimportantrisks,whileignoringtheinsignificantrisks.Inalmost

everycase,savedividends,assignmentriskisatornearthebottomoftraders’risks.

ASuccessfulShortSPXCalendarMarkSebastianreviewedanexampleofashortcalendartradeinhisblogentryof8/24/10:

YesterdayduringtheMid-DayPitReportIwas

pointingouthowwidetheIVspreadwasbetweenSeptemberandOctober.WiththemarketuponthedayIpointedoutthattheimpliedvolatilityspreadbetweentheat-the-moneySeptembercallsandtheat-the-moneyOctobercallswasalmost2points.Thisdrovethepriceover14.00atonepointyesterday.

Thistraderdidnotgetthebestexecution,butIwantedtorelaytheactualtrade.ThetradesoldtheSep-Oct1085callspreadwiththeSPXaround1080

foracreditof13.25.

only.)

Thatvolatilityspreadwas

stillover1.5pointsonthistimespread.Thetraderthenputinabidtobuythespreadbackfor12.20.Thiswouldhavebeenareturnof8%onastandardlongcalendar.However,thefillontheopenthismorningwasgoodandittradedat11.75.Thatisareturnof150.00inaday,or11.3%.ThisisinasingleDAY.

only.)Thislayupofatradeisnolongerthere,butwilllikelyreappeartotraders

whounderstandhowoptionsfunction.Traders,thisisthepowerofunderstandingvolatilityandtermstructure.Yes,itisveryimportanttounderstandhowtosellpremium.Butforanytraderthereisalotmoretolearnthansimply“sellacondor.”Onethingtoremember,theothersideofthiscalendarhaslostwhatmytraderhasmade.

Thatiswhywedonotsimplyslapthesametradeoneverymonth.

ButterflyTradingChecklistMarkSebastianwrotethefollowinginhisOptionPit.comblogon9/13/2010:

Optionmentoringisnotaneasybusiness.Weare

alwayslookingforeasy,simpleanswerstoverycomplicatedquestions.Onesubjectthatoneshouldreallyconcentrateonistradeselection.Therearementorsouttherewhosuggestthatthesametradeeverymonthworks;thesepeopleareprobablynottrading.Theysaytradethesametradeeverymonthbecauseitissimple.Tradingisnot

simple,tradingishard.However,wewanttohelp.Thus,wedevelopedathree-partchecklisttotellwhetheritissafetoenterabutterflytrade.Thereisalotmoretothesuccessofaflythanthesethreethings,butthisisagoodplacetostart.1.MakesurethatatraderpaysattentiontotheIVofthebutterfly.Believe

itornot,thetraderdoesnotwanttoentertheflywhenimpliedvolatilityissky-high.WhenIVsaresky-high,thereislikelytobeasnapbackrally.IfIVsaretoolow,thatisbadtoobecausethetradeislikelytohaveIVpop.Ifindthatmiddle-of-the-roadimpliedvolatilityisactuallythebestplacetoenterbutterflies.If

theIVsareinbetween25%-75%ofthe90-daymeanimpliedvolatility,feelfreetochecknumberoneoff.Iftoohighortoolow,nocheckbox.

2.Makesurethattheinter-monthskewisn’ttoowide.Ifinter-monthskewistoowide,thisisanotherwarningsignofabreakout.Wheninter-

monthskewistoonegative,itcanmeanthatinrelativetermsthefrontmonthistoohigh.Butterfliesareafrontmonthtrade,thuswewanttoavoidthisproblem.Iftheskewistoopositive,thatlikelymeansthemarketismovingaroundalotinrelativeterms.Consideringthatbutterfliesareagamma

trade,thisisalsobadnews.Therearesomereallygreatwaystotrackthisskew;onequickwayistocompareVIXtoVXV.Thiscangiveaprettygoodideaofhow30-dayvolatilityisbehavingrelativeto90-dayvol.Ifthetermspreadisnottoohighortoolow,putacheckinthebox;otherwise,weareanogo.

While90-dayvolisusuallyhigherthan30-dayvol,Ithinktraderscanseehowpointsofwideningcoincidewithmajormoves:

3.WatchIntra-Month

skew.Whenskewishigh,butterfliesareaverytoughtrade(seeMay,June,andJulyfordetails).Whenskewislow,butterfliesareaneasytradeandcheaptoensure(seeAugust).Whatdoesthisskewlooklike?Let’stakealook.

Again,thisisnottheanswertoalltradingquestions.Wedidnotattachanynumericguidelines,asshouldbedone,forcheckboxes2

and3.Also,therearemorethingstolookatthanjustthesethree.Butthisisastartingpoint.Thatsaid,ifallthreeofthesecanbecheckedoff,thebutterflyisprobablyafavorabletradetoenteratthatgiventime.Inthisexample,wedon’tthinkwecancheckoffanyofthesethreeitems.

WhatIstheProperWidthforanIndexButterfly’sWings?MarkSebastianwrotethefollowinginhisOptionPit.comblogon11/29/2009:

IwasrecentlymentoringastudentwhohadasplitstrikebutterflyinMNX,orsohethought.Ilookedatthetradeforasecond;I

quicklynoticedthathiswingswerespacedREALLYwide.Icalmlyspoke:“Thisisnotabutterfly,thisisanunhedgedstrangle.”Thestudentwasflabbergasted.(BTW,isthereacoolerwordthanflabbergasted?IthinkIhavelovedthewordeversinceDonMusicwroteasongaboutthewordon

SesameStreet.)“WHAT!”hesaid.“Ihavelongsee,andI’mlongthiscallandthisput!”“Yes,”Istated,“butthosearen’tahedgeagainstthisposition.Thoseoptionswillhavenoeffectonprofitandloss.Whenyouboughtthoseoptions,youhedgedNOTHING!”TheaboveconversationwasnotthefirstI’vehad

concerningwingplacement,norwillitbethelast.Mosttraderscanfigureoutwhichoptionstheywanttosell.It’stheoptionstobuythatcanturnintoabignightmare.Whilesomestudentssettheirlongstoclose,themorecommonproblemissettinglongsfartoodistantfromtheat-the-moneystrikes.

Thepurposeofthelongoptionsinaspreadistoreducemargin,reducetheriskoftheposition,andmaximizeefficiencyofcapital.Ifatradersetsupabutterflywherethelongsdonotsignificantlyreducethemarginofthetrade,itisawarningsignthatthetradehaswingstoodistantfromtheat-the-moneystrikes.Whenabutterfly’sriskis

significantlygreaterthanthereward,thisisanotherwarningsignthatthelongoptionsaretoofarfromatthemoney.Iftheunderlyingcanmoveonestandarddeviationwithouthavingasignificantimpactonthepriceofthelong,thewingissetouttoofar.Thisisabigproblembecauseitcannotonlyputtoomuchcapitalatrisk;itcanmesswith

thetrader’scalculatedreturnoncapital.Thiscantrickthetraderintostayinginatradetoolong,openupthetradertosubstantialunnecessaryloss,orboth.Withtheseinmind,herearesomeguidelinestraderscanfollowtosetupbutterflywings:1.Optionsthatareworthlessthan$0.25donot

hedgeanything.Ifatraderissettingupabutterflythathashimorherbuyingawingunder.25,thetradershouldnotbuythatoptionforahedge(noteIamnottalkingaboutunitswhicharetobeusedasblackswaninsurance;thisisacaseinwhichtheoptionisactuallyapartofthespreadbeing

entered).Hereiswhy:IfIbuyacalloptionfor.25asapartofabutterfly,theunderlyingralliesthreedollars,myshortcallsareprobablylosingasignificantamountofmoney,mylongstrikethatIboughtfor.25isprobablystillworthabout.25.Traderswillfindthatbuyingoptionsworthmorethan.25when

settinguptradeswillperformbetterandactuallycostless.

2.Lookforatleastaone-to-oneriskreward.Ifthetradersetsupabutterflywheretheriskismorethanthemaximumpotentialprofit,thetradercanlikelyreducethemargineasilyatlittleornocosttothetrade.

3.Alwayscheckthenextcloseststrike.Whensettingupatrade,ifatradercanpushthecalldownastrike,ortheputuponestrikeanditcoststhetradelessthanonetofivemargintoprofitpotential,itisprobablyworthstrikesin.Forinstance,ifatradercanmakeaonelot

butterfly’swingsfivepointscloseranditcoststhetraderlessthanonehundreddollars,thetraderlikelyhashislongwingssettoofarfromhisshortstrikes.

4.Ifatradersetsuplongsproperly,whenthatdecaygetsdowntounder$0.25,thetradershouldconsidereitherpullingoutofthetrade

andtakinghisorhermoney,orkickingthewingsintoreducethemarginonthetrade.

Traderswhokeeptheseguidelinesinmindwhentradingwillfindthattheyareusingtheircapitalmoreefficiently,puttinglessatrisk,andmostlikelymakingmoremoney.

TheImportanceof

GoodExitsHavingtherightconditionsbeforeenteringatradeisprobablythemostimportantfactorinordertoconsistentlymakemoney.However,exitingatradeisthesecond-most-importantcondition.Infact,itisprobablythemostimportantconditioninordertonotlosemuchmoney.Itislikehavingabalancedfootballteam,agoodoffense

andagooddefense.Thegoodtradingoffenseisknowingyourentrypoints.Thatmeansplacingtradeswhenconditionsareinyourfavorandyouhaveanedge.Thegoodtradingdefenseisknowingwhentoexit.Thatmeansclosingatradewhenyouhavewonenoughorbeforeyoulosetoomuch.Whenyouboardanairplane,thefirstthingtheflight

attendantspointoutistheemergencyexits.Thisknowledgeofthepositionoftheemergencyexitsmaysaveyourlifesomeday.IntradingoptionsforTOMIC,youneedtoknowwhatyourexitconditionsareforthetrades.Whenthingsstarttogowrong,andwhentheydotheygoveryquickly,youneedtoknowwheretheemergencyexitis.

AtTOMIC,beforeyouenteratrade,youneedtoknowexactlywhentoexit.Therearealwaysatleasttwoexitpointsforatrade:

1.Theexitwhenthetradeisgoingagainstyou.

2.Theexitwhenthetradeisgoinginyourfavor.

Whenthetradeisgoingagainstyou,whenitisnotworkingout,youshouldexitwithouthesitation.Likethat

emergencyexit,itmustbeused.Thispreventsmajorlossesintheportfolio.Youmighthesitateintakingtheexitbecauseyoudon’twanttheloss.Youcouldbelievethatthemarketcouldchangedirectioninthenextminutesorhoursandthingswillimprove.Thisthinkingmightormightnotwork.Butifyouarenotdisciplined,asmalllosscouldbecomeagiantloss.Thatgiantlossmightbe

unrecoverable.Thisisthesamethinkingthatmakesgamblersgobroke.Thelosinggamblerskeepplayinguntiltheylosealltheirmoneybecausetheyalwaysthinkthattheirluckmustturnaroundinthenextbet.Takingthelossatapredeterminedpointhelpscontrolthisimpulseandlimitsthelosses.Thebestlossisthefirstloss.Whenatradeisgoinginyour

favor,youneedtoknowwhentoexitthetradeandtakeprofits.Youmightkeepthetradeonbecauseyouthinkthattherearemoreprofitstobemade,whensuddenlythemarketreversesandwipesouttheentireprofit.Considerusingapercentageofmarginastheparametertotriggertheexit.Hereisanexample.Whenenteringanironcondortrade,

youmightsettheexitatalossof20%ofmarginoratagainof15%ofmargin.Ifthetradegoesagainstyou,youmightmakeadjustmentstotrytomanagethedeltas.However,whenthetradehitsalossof20%,youneedtoexit.Thesameholdsifthetradehitsaprofitof15%.Therearevariationsonthis.Sometradersmanaginglargepositionsmightdecidetoexit

usingscales.Soifatradeisgoinginyourfavor,insteadofwaitingforthe15%gain,youmightsellpartofthepositiongaining10%,andthensellanotherpart,gaining15%.Theexitpointsarejustexamples.Inreallifeyoushoulddefineyourownexitparameters,butitisimperativebeforeenteringthetrade.Bedisciplinedandfollowyourpredefinedexitcriteria.Havingpredefined

exitsforyourtradessavesyoumoneyandmakesyourtradesmoreprofitable.

PreparingtoTradeforaLiving,HowMuchCapitalIsNeeded?Totradeforalivingasaprofessional,youneedtobeprepared.Youneedknowledge,mentaldiscipline,

andfinancialmeans.Peoplewhotradeforalivingarethosewhotradeontheirownhook.Theyarethemastersoftheirowndestinies.Theyreporttothemselves,andtheyknowwhethertheyarewinningorlosinginthegameoftradingbylookingatthebalanceintheirtradingaccounts.Beforeyoubegintotradeforaliving,youneedtoknow

yourannualexpenses.Howmuchdoyouneedtoliveon?Thenmakesureyouhaveatleasttwoyears’worthofsavings.Soifyourannuallivingexpensesare$60,000,youshouldhave$120,000savedliquid.Next,youneedtoknowthereturnsyouhavebeenaveragingonyourpart-timetrades.Beforeyouembarkontradingforaliving,youneedtofirstexperiencetrading.Soifyou

havebeenaveraginga2%profit(returnonReg-Tmargin)permonthoverthepasttwoyears,youhavemorethan500tradesunderyourbelt.Hence,ifyouaverage2%permonth,youareabletoproduce24%returnperyear,assumingthatyouarefullyinvestedallthetime.Inreality,youprobablywon’thaveallyourcapitalinvested.Mostlikelyyouwillhavebetween40%and60%

onanormalbasis.Onaverage,assumeyouwillbe50%invested.Now,dothemathtofigureouthowmuchmoneyyouwillneedtohavebeforestartingyourtrading-for-a-livingventure.Hereisthecalculationtostartyourventure.First,youwillneedenoughsavingstocovertwoyears’worthoflivingexpenses,whichis$120,000.Next,youneedenough

investmentcapitaltoearnenoughtocoveryourlivingexpenses.Soifyoucanconsistentlyearn2%permonthoneachtradeandyouneed$60,000peryearor$5,000amonth,youwillneed$5,000/0.02=$250,000.Butwait—ifyouareinvestingonaverageonly50%ofyourcapital,thenyouwillneed$500,000ofinvestmentcapital.

Sotostarttotradeforaliving,youneedtohave$120,000(savings)+$500,000(workingcapital)=$620,000.Bepreparedpsychologicallytorunyouroptiontradingasabusiness,likeTOMIC.Ifintwoyearsyouhavebeenabletocoveryourexpensesandincreaseyoursavings,youaredoingverywell.Ifintwoyearsyouhaveearnedyourlivingandmaintainedyoursavingsat

thesamelevelatwhichyoustarted,youaredoingwell.However,ifintwoyearsyouhavedepletedyoursavingsandhavenotbeenabletocoveryourexpensesbytrading,considerthepossibilitythattradingforalivingisnotforyou.Ifthisisthecaseandyoustillwishtocontinue,hireacoachandrereadthisbook!

TheImportanceofFocusHaveyouever...

•Feltoverwhelmedbytoomuchinformation?

•WantedtotradeeverymarketthatatalkingheadonTVrecommended?

•Tradedmultiplemarketswithdifferentstrategiesatthesame

time?Andlostoneverytrade?

•Frozenlikeadeerintheheadlightsduringaflashcrash?

•Analyzedatradeoverandoveragainwithoutplacingit,onlytoplaceitwhenthetradehadalreadyplayedout?

•Feltlikeswitchingstrategieseveryday?

•Boughtanew

investmentnewslettereverytimeyougotane-mailabouthowgreatthenewsletterwas?

•Wantedtochangeprofessionsafterthemarketmovedagainstyou?

•Tradedwhenyouwereupset,andmadealotofcostlymistakes?

•Lostmoneywhentradingafteraclose

friendorrelativedied?Ifyouansweredyestoanyofthesequestions,youmighthaveproblemsfocusing.BeingabletofocusisakeyabilitytobesuccessfulasamanagerofTOMICorinanyotherendeavor.Whenasurgeonoperates,hehastoconcentrateondoingeverythingcorrectlytosavethepatient’slife.Hemustnotbethinkingabouthisdinner

datewithhisnewgirlfriend.Heshouldbefocusedongettingthesurgerydonesuccessfully.Wouldyoubecomfortablegoingintoaneyesurgerywhenyourdoctortellsyouthathismotherjustdied,butnottoworrybecausehecandoyoursurgeryinhissleep?Ofcoursenot.ThesameappliestothepersonrunningTOMIC.You

havetobefocusedonwhatyouaredoingwhenyouaretrading.IfyouarerunningTOMIC,youarerunningabusiness.Thewell-beingoftheshareholders(youandyourinvestors)dependsonyourdecisions.WhenMichaelJordanhadtheballwithonlyacoupleofsecondsleftinthegame,whatwashethinking?Didhehearthecrowdcheering?Did

helistentotheopponentplayers’trashtalk?No,hewasinthezone;hewastotallyfocusedononethingandonethingonly:scoringtowinthegame.WhenyouaremanagingTOMIC,yourfocusmustbelikealaser.Youneedtobealertandmaintainyourdisciplineinordertomanagerisksandbookprofits.SteveJobs,Apple

Computer’sinnovator,wasverygoodatwhathedid.Hefocusedoncreatingelegantandsimpledevicesfortheconsumer.Becauseofhisfocus,hewasabletorevealtheneedsthatpeopledidn’tknowtheyhadandthattechnologycouldsolve.ThemanyusesoftheiPadwerenotimaginedbyconsumersuntiltheyhadaniPad.Daniel(RalphMacchio),in

themovieKarateKidII(1986),wasabletobreaksixslabsoficewithoneknife-handstrikebecausehewasabletofocusandconcentratealltheforceofhisbodyintoonesmallareaofimpact.Whatdoesallthismeantoyou,asTOMICmanager?Itmeansthatyouneedtodefinewhoyouare.Knowyourinvestmentstrategyandhowyouaregoingtoimplement

it.Onceyoudo,don’tgetsidetrackedbyotherinvestors,markets,strategies,orproducts.Stayfocusedonwhatyouaredoing.

14.LessonsfromtheTradingFloorontheOtherGreeks

WhatHappenstotheGammaofITMorOTMOptionsWhenIVIncreases?

MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/29/2010:WhenIamworkingwithoptionmentoringstudents,forthemostparttheycanfigureoutat-the-moneyoptions.TheygetthatasthestrikebecomesmoreATM,thedeltachangefrom50deltatothenextstrikeineitherdirectionhasdecreased

becauseofvolatility.Butwhataboutout-of-the-moneyoptions?Doout-of-the-moneyoptionslosegamma,orgainwithanincreaseinIV?Theanswerisboth!Foroptionsthatarewelloutofthemoney(belowa15delta),ingeneralanyincreaseinimpliedvolatilityisgoingtoincreasegamma.Thisisverysignificantforcondorandstrangletradersto

understand.Theyneedtoknowthatinitially,whentheIVincreasesontheircondor,thecondorisgoingtohavemoredeltasensitivityinadownturnthanthemodelpredicts.Takealook;hereisanMNXcondorwithstrikesthatare10%outofthemoney.

(Source:TDAmeritrade,

Inc.Usedwithpermission.Forillustrativepurposes

only.)

NowweraiseIV5%.Noticethatinfactthepositiondoesgetshortergamma,andformosttradersthisisalltheywillneedtoknow.

(Source:TDAmeritrade,Inc.Usedwithpermission.

Forillustrativepurposesonly.)

However,thecrazythingwithOTMoptionsrearsitsheadifweincreaseIVsignificantly,inthiscase15%.NoticethenthatthegammaactuallyFALLS!!!

(Source:TDAmeritrade,Inc.Usedwithpermission.

Forillustrativepurposesonly.)

Whydoesthishappen?WhenIVincreases,OTMoptionsgothroughaprogression.AsIVincreases,atfirstOTMoptionsgaingammaastheybecomemorelikeanATMoption(rememberATMoptionshavethemostgamma).OncetheseoptionsgainenoughIVthattheyactuallyBECOMEsosimilar

toATMoptions,theybeginlosinggammawithincreasesinvolatility.Whilethiscanseemconfusing,thinkaboutitthisway.Way-out-of-the-moneyoptionsgaingammawithincreasesinvolatility,untiltheyarenolongerway-out-of-the-moneyoptions.

WhyDoINeedtoWeightMyOption

Portfolio?MarkSebastianwrotethefollowinginhisOptionPit.comblogon12/29/2010:

DeepdownIamafloortraderatheart.ThisiswhyIgetsofiredupwhenIseetraderstradingwithoutunderstandingtheconceptofweightingthatIamabouttorunthrough.

WhenIwasafloortrader,thegroupIworkedfortradedSPX,SPZ,ES,DJX,DIA,andmanyotherindexoptionsagainsteachother.Needlesstosay,thiswasacomplexprocess.Inordertoreallymakethesetradesworkproperly,wehadto“weight”thedeltaandthegamma.Meanwhile,withvegaandthetawehadtodoverylittlewhen

combiningtheGreeksofseveralproducts(therewerealotofotherthingstomanagewithvega,butpracticallynothingfortheta).Whywouldweneedtodoabunchofworkfordeltaandgammaandpracticallynothingforvegaandtheta?Theanswerliesinthedefinitionofadelta.Adeltarepresentsthe

correlationtotheunderlyingproductfora1-pointmove.The1-pointmoveistheimportantwordinthatstatement.A1-pointmovecanmeandifferentthingstodifferentunderlyingproducts.IfIBMgoesuponedollar,wouldatradernoticethatitwasup?Probablynot!IfFordralliesonedollar,wouldatradernoticethat?Yes,of

coursethetraderwould.ForIBM$1.00isbarelymorethan.5%;inForditiscloserto6%!!Aone-dollarmoveinIBMmeansalotlesstotheshareholderthana1-pointrallyinFord.Whydoesthismatter?Itmattersbecausemosttradersaretaughttothinkinpercentages(andmoststrategiesaredesigned

thatway).WhatifIhadaportfoliowhereIthoughtFordwasgoingtooutperformIBM(Iknow,itwouldbeaweirdportfolio).IfIsold100sharesofIBMandbought100sharesofFordinmy“pairs”trade,thenFordrallied5%andIBMrallied2%,wouldImakemoney?NO,Iwouldbeahugeloser:

FReturn:100*16.75*.05=+83.75IBMReturn:−100*146.52*.02=−293.04Congratstomeonbeingright;bootomefornotunderstandinghowtoweightthesestocksaccordingtoprice.IfIwantedthistradetoreallywork,Iwouldhaveneededtobuyaboutnine

sharesofFforeveryoneIsoldinIBM(thatstrategywouldmake$460.00).ThisconceptisevenmoreapparentinwhatweweredoingwhenconvertingSPYtoSPX.WhentheSPXrallies1.00,howmuchofaneffectontheindexisit,basedonthereactionfromtraderstoday,whentheSPXralliedlessthan

2.00?NOTHING!IntheSPY,though,1.00isnotaninsignificantmoveintheunderlying,amountingtoabout.8%(toabout.08%intheSPX).Becauseofthese,weknewthatifIsold1000SPYcallsthathadadeltaof30,therewasnoneedtopanic;itwastheequivalentofselling100callsintheSPX.

SowhenwewereconvertingOEXandSPX,wewouldbetradingabout2.23OEXforeverySPX;inDIAitwasmorelike11,inSPYalittleunder10,andsoon.Regardlessofriskbeta,understandingthesizeofthecontract’sunderlyingwasakeytohavingabalancedportfolio.Sotraders,remember,intrading,sizedoesmatter!!

GammaScalpingMarkSebastianwrotethefollowinginhisOptionPit.comblogon10/27/2010:

Igetaskedallthetime,“HowshouldIscalpgamma?”Itisasurprisinglydifficultquestiontoanswer.AsamarketmakerIhadveryfewconstraintsonmy

tradingactivity.IcouldhedgeabackspreadanywayIwanted.IfIwantedtohedgebysellingstock,thatwassimple.Ipulledupmystockexecutionsystemandunloadedtheunderlying.IfIwantedtotradeoptionsagainstthegamma,Icouldtradejustaboutanyoptioninthespectrum.IfIthoughttherewasmoreedgeintradingtheJanuary2012

monthtohedgeafrontmonthbackspread,Iwould.

IfIwantedtohedgecallswithputs,orputswithcalls,thatwasalsonotaproblem.Retailtraderslacktheabilitytotradeandexecutemanyhedgingstrategies.Isoonrealizeditreallydoesn’tmatterwhatthetraderusestohedge.Itmattershowthetraderhedges.Whilethereare

endlessoptionstoscalpgamma,therearetwowaysIteachstudents.OnemethodisforveryactivetradersthatIcall“paythedecay,”andtheotherisforlessactivetradersthatIcall“delta/gammaratiohedging.”

PaytheDecay

WhenIfirststartedteachinggammascalping,theonlymethodItaughtwas“paythe

decay.”Thisisanintenseandinvolvedformofscalpingandisprobablymoreusefulforfull-timetradersthanretailtraders.Alltradersshouldunderstandthetechnique.Thetraderusesthetaofthepositiontocalculatehisdaily“nut.”Thetraderusestheformulaforchangeinslopetocalculatehowmovementisneededintheunderlyingto“paythedecay.”

Lookingattheblindstraddleon10/16/09,thepositionislong8.25gammaandshort6.09theta.Thetraderwouldplugin7/5*6.09asthesolution(7/5totaketheweekenddecaysomewhatintoaccount),andusethegammaasthechangeinslopeforthecurve.Thevariablethetraderissolvingforisthechangeinprice.Theformulaendsuplookinglikethis:

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

TheSPYneedstomove$1.44inordertocoverthethetadecayforthatday.Thisformulahastobereruneverymorningasdecayandgammachange(bothgetlargereveryday).Amajorcomplaintisthatanyonewhohasa“realjob”maynotfeellikedoingthiscalculationdaily.Thereisamuchbiggerproblemwiththisformulathough:Itdoesn’tanswerwhento

adjust.Mostofmystudentsassumethattheyshouldsetthescalp$1.43fromthepreviousday’sclosingprice.Notthecase!Settingthescalpthatfarwillonlygethitaboutonceevery3days.Personally,Isetmyscalpsat50%oftherequiredmove,andsellallofmydeltasatthatpoint.ThenIbuythembackwhenthestockmoves

backtounchanged.Thiscreatestwoscalpsthatequal72centsofmovement.Ihavetomakethistypeofscalptwice,eitherroundtrippingtheunderlyingmoving72centstwice,orgettingacomboofroundtripstotheupsideandthedownside.Atday’send,Ialwayszerooutdeltas.Iftheunderlying“gaps”pasttherequiredmove,Iwould

sellalloftheposition’sdeltas(oratleast75%ifIthinkthemovecouldcontinue).Iftheunderlyinghitsascalpandcontinuestoruninthatdirection,Iusethescalpingpointasmynewstartingpoint.Thismethodrequiresalotofworkandcanbeveryfrustratingwhentheunderlyingreallyruns(I’llbehonest,ifIsensemomentumIwilllettheunderlyingrun

andsettrailingstopordersinstead).Thistypeofscalpingwillcertainlycoveraportionofmydecayandsurprisinglyisfarmorelikelytocovermydecaythensettingthescalps$1.43apart.Why?Volatilitypredictspricemovement,notdirection.Scalpinggammaatcloserintervals,Iendupmakingfar

morescalpsthansettingthescalpsfurtherapart.WhenIwasonthefloor,tradingSunMicrosystems,thereweretimeswhenIwouldscalp10to30timesinaday.BytheendofthedayIcouldhavethousandsofdollarsinmypocket,evenifSUNW(theoldsymbol)didn’tmove.Oneoftheneatthingsaboutlonggammaisthatthetraderwantstogetinasmanyscalpsaspossible.This

methodallowsforthat.The“paythedecay”methodisveryinvolvedbecauseofthelargenumberoftrades.Ontopofthat,gammaandthetaareconstantlychanging.Traderswhocan’tsitinfrontofacomputeralldayhaveaseriousproblem.AsamentorIwantedtobeabletohelpmystudentstradestraddlesandscalpgammaiftheywantedto.Iasked

myself,“Howcanaretailtradertradeastraddle?”Thisbroughtmebacktomyfloortradingdays.Atanygiventime,Icouldbemanagingasmanyas60positions.Ihadabouttenstocksthatweremybread-and-butterstocks.Thesewereconsistentlybusy.Thentherewereusuallyaboutfivetotenotherstocksthatwouldheat

upfromtimetotime(theserotated).Fortheslowerfortystocks,Ididnothavethetimetositthereandscalpgammabackandforthbasedonthe“paythedecay”formula.Iactuallyhadadifferentmethodforverysmallpositions.Dependingonhowhecticthemarketwas,andtheindividualstockwas,Iwouldtradethesecurityona

delta/gammaratio.For,moststocks,Iwouldtradethemonetoone.Essentially,whenmydeltaequaledmygamma,Iwouldflattenmydeltas.Atfirstthismayseemalittlearbitrary,butonceyouthinkaboutit,maybeit’snot.TheGreeksareallinterrelated.WhenoneGreek,inthiscasedelta,clearlybecomesthedominantGreek,itintuitively

makessensetocutthatriskdown.(ItworksoutinthemodelbutIwillspareyouguystheproof.)Tradingthedelta/gammaratioaccomplishesthis,withoutforcingthetradertositandstareatthetrader’scomputer.Inthemorning,youcanmovethepriceupuntilthedeltaequalsthegamma,thensetapricealertthere,andthendo

thesameonthedownside(ifthetraderisusingstockinsteadofoptions,heorshemayconsiderrestingasmallstockorderthere).Forsmallerpositionsorstocksthattendtotradewithamomentum,Isuggestthatyouuseasomewhatlargerratio,becauseofcommissionsortotakeadvantageofthestocks’momentum.Gammascalpingisreallynot

formostretailtradersunlesstheyhaveaVERYstrongunderstandingofthemechanicsandthetraderhasclearreasonswhyheorshewantstogetlongpremiuminthatunderlying.However,properimplementationcan:

•ReduceP&Lvolatility•Reducethepainofthetadecay.Thisallowsyoutostayintheposition

longerwhileyouwaitforyourpositiontowork.

ObviouslyIambacktrading,butIdidmybestnottoMonday-morningquarterbackandputthescalpsinwheretheygo.Becauseofthesizeofthisposition,Iwentwitharatiooftwotoone.Istillendedupmakingseveralscalpsusingputsandcalls.Onethingyoushouldnote:

Ifyouareusingoptionstoscalpgamma,nomatterwhatmonththestraddleisplaced,thefrontmonthoptionsshouldbeusedtohedge.Why?Becausetheyhavethemost“pure”deltas(basically,theseoptionshavetheleastvega).Ifthepositionislarger,deepcallsandputscanbeaseffectiveasstock.Inthis

case,thepositionwassosmallIhadtousefrontmonthout-of-the-moneyoptionstotradeinandoutofmydeltas.Thisisnotaverydesirablewaytomanagedeltas,butIhadtodealwiththecardsIwasdealt.So,Iendeduptradinginandoutofdiagonals.WhenIexitedthetrade,Imadeslightlylessthanthatnakedstraddle;however,mypositionhadfarlessP&Lvolatilityandwas

neverdownasmuchasthenakedstraddle.

TradeSummary

(Source:OptionVue6)TradeDetails

(Source:OptionVue6)16Oct2009at11:00AM

(Source:OptionVue6)28Oct2009at3:00PM

(Source:OptionVue6)5Nov2009at3:00PM

(Source:OptionVue6)

WhyDoOptionTradesBetaWeightGamma,andnotThetaandVega?

Mostoptiontraderscangetdelta,andeventheweightingfactor.Gammaseemstobedifferent;Ioftenhavenewoptionmentoringstudentswhodonothaveafullgraspofhowgammaworks,especiallywhencomparingsomethinglikeSPYandSPX.However,nowthatIhavewalkedthroughdeltaweighting,gammaweightingshouldbeabreeze.

GoingbacktoSPYandSPX,wecanclearlyseewhygammamattersintheseverityofthepercentmovements.IfSPYdrops3dollarsfrom126to123,whatpercentageofadropisthat?Well,3/126isalmost2.5%.Thatisamassiveone-daydropinastock.The126strikewouldlikelydropfroma50deltatosomewhereinthe30–40deltarange.Thatwouldbeachangeindeltaofabout15

deltasacontract.Thus,thegammawouldbeabout5.InSPXadropof3dollarswouldbetheSPXgoingfrom1260to1257,notexactlyexciting.Inthatprocessthedeltaofthe1260mightdropfrom50to48.5.Thatwouldbeagammaofabout.3.Samepointmove,verydifferentdeltaeffect.Thereasonisthepercentchangeintheunderlying.Three

pointsintheSPXisabout.25%vs.2.5%intheSPY.Gammaisalwayssetfora1-pointmoveintheunderlyingregardlessofthesizeofthecontract.Itmightbeconfusingbutitworks,becauseiftheSPYwasdown3.00theSPXwouldneverbedown3,itwouldbedown30!Thenthechangeindeltasactuallymatchup:ForSPY:3*5=15deltas

ForSPX:30*.5=15deltasThegammaisn’tweightedbecausethepricemovementoftheunderlyingproductsis!

VegaandThetaThiswillbeaquickandeasyone.Thetaandvegaaredirectlytiedtotheamountofpremiuminthecontract,nottheunderlyingproduct.Itisthisfunctionthatallowsustocrosshedge.IfIsell$3,000

ofpremiuminSPYorSPXwith30daystodecay,thenthat$3,000needstogoawayin30daysregardlessofwhatproductitwassoldin.ItmaytakemorecontractsinSPY,butifthepremiumsarethesame,soshouldthethetasbe(savetheextradayoftradinginSPY).Thus,thetaistheta,regardlessofwhatproductitissoldin.Becauseofthisfunction,ifI

amshort$3,000inpremiumIwillbeshortthesameamountofvegaorvolatilityexposure.Thus,ifIVgoesup1pointinSPYor1pointinSPXIwillhavethesameloss.Thus,vegaisvega,regardlessoftheproduct.Hopefullythismakesthingsalittleclearer.

15.TheBeginningWe’vegotnewsforyou.Thisissupposedtobethefinalchapter,butitisn’t.AsBuzzLightyearfromDisney’sToyStorymoviewouldsay,“Toinfinityandbeyond!”Itisonlythefinalchapterofthebook,butnotthefinalchapterinyourquesttobuildThe

OneManInsuranceCompany.Whenyoudecidetostartbuildingyourownoptionportfolioorhedgefund,youwillneverstoplearning.Thisbookisonlyoneofmanyyouwillreadonyourpathtobecomingasuccessfulmanagerinyouroptiontradingbusiness.Tobuildyourfundyoumustmasteralltheprimaryandsupportfunctionsofthe

OptionTrader’sHedgeFundvaluechain.Makesureyouunderstandandareabletodothefollowing:

•Tradeselection•Riskmanagement•Tradeexecution

Also,makesurethatyouhaveinplacethesupportingfunctions:

•Tradingplan•Tradinginfrastructure

•AprocessforlearningUnderstandvolatilityandusethisunderstandingtoobtainanedgeinyourtrades.Youshouldbeascomfortablereadingvolatilityasyouarereadingthespeedometerinacar.Learnallthedifferentoptionstrategies.Thenselectandusethestrategiesyouarecomfortableusing.Intime,likeakaratemaster,youwillmasterallthestrategies.

However,asyoulearnandgrow,youwillfigureoutthat80%ofthetimeyouwilluse20%ofyourstrategyarsenal.Wesuggestthatyouuseverticalspreads,ironcondors,butterflies,calendar(ortime)spreads,andratiospreads.ThesearetheonesthatweusethemostattheOptionsTrader’sHedgeFund.InFigure15.1,wehavegivenyoutheframeworktosetup

theOptionTrader’sHedgeFundasTheOneManInsuranceCompany(TOMIC).Manyofyouwouldsaythatitseemstobesimpleenoughandthatitisnotrocketscience.Butthemajoritywouldputtheideasasideandnotfollowthrough.Thisbusinessisnotforeveryone.Weappreciatethatyoutookthetimetoreadourbookandweappreciateyoursupportifyoupurchasedit.If

youwouldliketoinvestlikeTOMICanddonotwanttodothework,youcanlookforfundsthathavesimilarinvestmentphilosophiesandoutsourceyourinvestmentdutiestothem.ForthoseofyouwhochoosetodevelopTOMIC,congratulationsinadvancefortakingthepathlesstraveled.

Figure15.1.TheOptionTrader’sHedgeFundvalue

chain.

BuildingtheOptionTrader’sHedgeFundisabigendeavor.Dennisstartedand

continuestogrowSmartIncomePartners,Ltd.,withalotofsmartwork,discipline,andcommitment.Markconstantlypushestheenvelopeinunderstandingandusingvolatilitytogainatradingedge.Bedisciplined.Usetheguidelinessetforthinthisbook.Usethebookasacollectionofsignpostsmarkingapath.However,rememberthatthepathneverendsandthatyourpathmight

notbethesameasthepathforothers.Everyreadercouldhaveauniquepathbecauseeveryonehasadifferentwayofseeingtheworld.Soyourwaytomakingmoneytradingoptionsmightbedifferentfromours.Infact,evenwe(DennisandMark)havedifferenttradingstyles.Butourgoalisthesame,tomakemoneyconsistently.Thisisthebeginningofyour

journey,ofyourquesttobecomeaTOMICtrader.Congratulationsagain.Neverstoplearningandimprovingyourskills.Followthepathtoconsistentprofits.

A.RecommendedReadingOneofthequestionsMarkgetsfromhisoptionmentoringstudentsis,“Whatarethebestbookstolearnoptionstrading?”It’sagoodquestionbecausetherearehundredsofbooksoutthere

allclaimingtobethebestoptionsbooks.Thetruthis,foreverygreatoptionsbooktherearenineortenthataretotaljunk.SohereareMark’srecommendedbooks,thosethatprovideenoughtheoreticalknowledgetobeatthelevelofadvancedoptionstrader.

Category1:TheStarter

TheRookie’sGuidetoOptions,byMarkD.Wolfinger:Yesheisalittleirritablesometimes,butintheendthemancaresaboutpeople.Hewantstohelpnewtraders,andhewroteaprettygoodbeginner’sbook.Thereareotherdecentrookiesbooksoutthereaswell.OptionSpreadTrading,byRussellRhoads,andOptionsfortheStockInvestor,byJimBittman,arebothgreatbooks

aswell.However,ifyouwanttopickone,MarkWolfingerismychoice.

Category2:GettingReadytoStartPaperTradingTradingOptionsasaProfessional,byJimBittman:Moremathematicalthanabeginnerbook,butlessmathematicalthanan

advancedbook,butintheendbeautifullywritten,highlyeducational,andonefinebook.Wehaveyettofindanintermediate-levelbookthatisashigh-qualityasthisone.Hedidamasterfuljob.OneotherbookthatwelikeinthisclassisOptionsVolatilityTrading,byAdamWarner.Thisisprobablyoneofthehardestareastowriteinandbothoftheseauthorsdiditwell.

Category3:ReadytoTradeOptionVolatilityandPricing,bySheldonNatenberg:Consideredbymostprofessionalstobethebibleoftheindustry,thisisthebest-writtenupper-levelintermediatebookavailableinthemarketplace.Thisshouldbeoneverytrader’sshelfandistheclosestthing

toatextbookthatisactuallynotatextbook.TheothergreatbookisLarryMcMillan’sOptionsasaStrategicInvestment.Iftradersbuyonlyoneotherbook,Iwouldmakeitoneofthese.

Category4:AdvancedandMathematical

DynamicHedging,byNassimTaleb:Muchmorenuts-and-bolts,andlesspreachythanhislaterbooks.Ifyouwanttounderstandadvancedconceptsofvolatility,thisisthesource.Togetanydeepermeansyouarereadingamathbook.WewouldalsosuggestJeffAugen’sTheOptionTrader’sWorkbookatthislevel.Itwillhelpyouapplyallthatyouhavelearned.

Thereareseveralbooksthatdon’tfitintoanyofthesecategoriesthatareinterestingreads;however,theymakesenseassupplements.AnythingbyJeffAugeniswortharead.WhenJaredWoodardpublishes,wearesurethatitwillbegood,andpartsofCharlesCottle’slatestbookhavetremendousvalue.However,wewouldskiptheseuntilyouatleastgetthoughMcMillanor

Natenberg.

OtherBooksThatMightBeUsefulThefollowingaresuggestionsmadebyDennistogiveyouawiderperspectiveoftheinvestmentworld:

AgainsttheGods:TheRemarkableStoryofRisk,byPeterBernstein.Thehistoryofrisk

managementfromitsbeginningstotoday.OneUponWallStreet,byPeterLynch.Aninvestmentclassiconinvestinginequities.ReminiscencesofaStockOperator,byEdwinLefevre.Amustreadforanyprofessionaltrader.Itisaclassic.TheInnerVoiceofTrading,byMichael

MartinTheTaxGuideforTraders,byRobertA.Green.AgoodreadforoptionandfuturetraderswhopayU.S.taxes.TradingforaLiving,byDr.AlexanderElderComeintoMyTradingRoom,byDr.AlexanderElder.Goodexamplesoftradingjournals.MoreMoneyThanGod,

bySebastianMallaby.Ahistoryofhedgefunds.TheDailyTradingCoach,byBrettN.Steenbarger.Agoodbookontradingpsychology.TheCMEGroupRiskManagementHandbook,byJohnW.Labuszewski,JohnE.Nyhoff,RichardCo,andPaulE.Peterson.Thisisagoodreferencebook.

TradingintheZone,byMarkDouglasTheSnowball:WarrenBuffettandtheBusinessofLife,byAliceSchroederTheParadoxofChoice:WhyMoreisLess,byBarrySchwartzTheDhandhoInvestor,byMohnishPrabaiTrendFollowing,byMichaelW.Covel

TheIntelligentInvestor:TheDefinitiveBookonValueInvesting,byBenjaminGrahamDeepSurvival:WhoLives,WhoDies,andWhy,byLaurenceGonzales

B.StrategyLearningSequenceTableB.1showsarecommendedsequenceforlearningthedifferentstrategies.

TableB.1StrategyDevelopment:P=

Proficient,E=Expert

Youcanlearnallthedifferentstrategiesinanyorder,butthisisasuggestedguideline

ofthesequencetofollowbasedonthelevelofcomplexityofthetrade.Itisjustlikelearningkarate.Youbeginwithzeroskillsasawhitebelt.Then,asyougainskills,youarepromotedtodifferent-coloredbeltsuntilyouobtainablackbelt.However,youarenotdoneatthispointandyouwillneverbedone.Therearemanylevelsofblackbelts;youhavejustbegunyourtraining.

ForadetaileddescriptionofeachspreadyoucanrefertoOptionSpreadTradingbyRussellRhodes.

C.OptionPit.com

OptionPitprovidestop-to-bottomoptiontradereducationconcentratingontraderswhowanttobecomefull-timeprofessionaltradersandtraderswhoarealready

tradinglargeamountsofcapital.Wearefocusedonhelpingoptiontradersunderstandkeytradingskillsandtechniques,whilenotemptyingthetraders’accountstopayforeducation.Studentswhoenrollinanyofourserviceswillemergefromourprogramwithmoreconfidenceintheirabilitytotradeoptions.Weofferanarrayofcost-

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D.KiteSpreadAkitespreadinvolvesthebuyingofalongoptionbelowwheretheshortspreadiscurrentlyplacedandthensellingmoreoftheoriginalspreads(nowatahighercredit)againstthelongpositioninanattempttopayformuchofthecostofthelongoption.Generally,thetrader’sgoalshouldbetopay

foratleasthalfofthelongoptioninordertoreducecost.Ithassimilarcharacteristicstoaratiospread,buthaslessvegaandexplosivegamma.FigureD.1showscallcreditspreadandoverlaysthekitespreadadjustment(theonethathasapointlikeakiteatthe1390price).

FigureD.1Riskprofileoftheverticalcallcredit

spreadoverlaidbythekitespreadadjustment.(Source:

OptionVue6)

Benefits:

Thetradeislonggamma,andastheunderlyingralliesshortvega,itinmanywaysactslikearatiospread.Astimepasses,thetradewillbecomelongergammaandwillcontinuetohedgetheposition.Thetradeisrelativelyinexpensive,hedgeseffectively,andhassomewhatpredictable

returns.Itdoesnotaddnearlyasmuchriskasrollingbackandrampingupsize.

Detractions:Thereisa“sourspot”wherethistradecanlosemoney.Itaddstomargin.Itdoesnotaddalotofgamma.

Isalmostimpossibletoexecuteonthedownsideofacondorasthespreadreliesonverticalskewtomakethecallspreadsproduceenoughcredit.

Execution:Buy1callbelowthespread.Sell2-3callspreadsaddingtothespread.InFigureD.2,weboughtone

1370andsoldthree1390/1400callspreads.

FigureD.2Kitespreadtradeexecution.(Source:

OptionVue6)Oncethetradeison,leaveitonuntiltheentiretradeisunwound.Itisacheap

enoughadjustment;itisworthkeepingonthroughthetrade.

Numerics2008financialcrisis(UnitedStates),38401(k)plans,47

Aaccess

leverage,67redundantInternet

connections,71accounts

futures,71trades.Seetrades

acquisitioncustomers,6,7risks,14

actions,corporate,87actuarialtables,11addressablerisks,37-38adjusting.SeemodifyingAFLAC,21

AgainsttheGods:TheRemarkableStoryofRisk,196AIG,20

bailouts,13systemicrisk,37

Allstate,21analysis

results,75tools,69-70trades,66

Apple,38,74

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

comparisons,9averages,76

records,75avoidinglong-termriskplays,136

Bbackmonths,136backtraders,70,97backupplans,70-71badtrades,34,36bailouts,AIG,13

basketofequities,22.SeealsoETFs(exchange-tradedfunds)batterybackups,71bearmarkets,verticalspreads,90benchmarkindexes,75benefitsofkitespreads,204BerkshireHathaway,8,39.SeealsoBuffett,WarrenBernstein,Peter,196bestavailabletrades,126Bittman,Jim,95,195

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

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

Ccalculations

Greeks,69livingexpenses,170portfoliomargins,67

calendarspreads,52,64,108-114,123

SPXindexoptions,161-163weekendtimevalue

premiumdecays,149-152calls

assignments,157buying,159parity,160selling,85VIXoptions,45

capitalgains,21risk,63-65

CardGameValue,146-147cashpositions,145-146catastrophes

events,44

relatedlosses,20,38CaymanIslands,29-30CBOE(ChicagoBoardOptionsExchange),23,28,51

volatility,94CDSs(creditdefaultswaps),13,20characteristicsofbrokers,65charts,66checklists

butterflytrading,163-

165functions,60

Chevron,35ChicagoBoardOptionsExchange.SeeCBOEclaimsprocessing,6-7CMEGroupRiskManagementHandbook,The,197CNBC,78Co,Richard,197coaches,hiring,79Coca-Cola,74

companyrisk,37-38comparisons

autoinsurancetooptions,9valuechains,14

computers,backup,71conditions

ATMironbutterflies,100-105calendarspreads,109ironcondors,93-98markets,43-44

ratiospreads,115verticalspreads,91

condors,41,64iron,52,66,90,93-100,

122cashpositions,145impliedvolatility,

138-140RUT,35strangles,134

confidence,management,56-58connections,Internet,71

ConocoPhilips,35consistency,65.Seealsodisciplinecontinuingeducation,79-80contracts

insurance,9.Seealsoinsurancestrikes,43termstructures,87-88

convertingOEX/SPX,176corporateactions,87costofcarry,81,160

Cottle,Charles,196Covel,MichaelW.,197crashes,flash,39,45creditdefaultswaps,13,20.Seealsoswappingcustomers

acquisition,6-7service,66

customizinglayouts,67

DDailyTradingCoach,The,

197daysintrade(DIT),76decay,95

gammascalping,179weekendtimevalue

premium,149-152decision-makingskills,57dedicatedspace,70dedication,57definingtradingstyles,60-62deltas,103,175

delta-neutraltrades,52management,169spreads,140

de-riskingportfolios,152designingtrades,48-49detractionsofkitespreads,204DhandhoInvestor,The,197diagonals,64

double,52discipline,56

exercising,58-60

marketconditions,43-44DIT(daysintrade),76diversification,portfolios,35-36dividends,87doublediagonals,52,134Douglas,Mark,197durationoftrades,29.SeealsotimeDynamicHedging,196

earnings,87easy-to-useinterfaces,66education

continuing,79OptionPit.com,201-202

Elder,Alexander,33,197emotions,conquering,56Enron,38enteringorders,49-54entryparameters,62equities,21

optionson,24-25

ETFs(exchange-tradedfunds),21-24evaluating

months,46products,47skews,47

eventsblackswan,38-41catastrophic,44macro,38

Excelexternallinksto,67

tradingjournalsas,73-77

exchange-tradedfunds(ETFs),21-24execution

kitespreads,204trades,15-16,43,126-

129designing,48-49evaluatingmonths,

46impliedvolatility,

maintainingdiscipline,58-60

marketconditions,43-44

orderentry,49-54product

evaluations,47skews,47TOMIC(TheOne

ManInsuranceCompany),122

volatility,44exits

calendarspreads,112parameters,62ratiospreads,116strategies,168-169

expectationsmarkets,46payouts,76

expirationcalendarspreads,110timeto,81

exposure,portfoliodiversification,35-36

externallinkstoExcel,67Exxon-Mobil,35

FFDA(FederalDrugAdministration)announcements,87feedback,74,77findingvolatilityskews,137firstlook,definitionof,156fixedpricing,30flashcrashes,39,45

flatteningdeltas,103flexibility,57,68Florida,29-30focus,importanceof,170-172forwardvolatility,81.Seealsovolatilityframeworks,5frontmonths,87,136frontspreads,115-119functions.Seealsoprocesses

checklists,60

ofinsurancecompanies,6TOMIC(TheOneMan

InsuranceCompany),17ofvaluechains,15

futures,21accounts,71VIXoptions,136

Ggammas,40,102,132

scalping,176-190

GE(GeneralElectric),74GEICO,8,21GeneralRe,8,39goals,61

ATMironbutterflies,103calendarspreads,111ironcondors,96ratiospreads,116TOMIC(TheOneMan

InsuranceCompany),122Greeks,173-174

calculations,69gammascalping,176-

190management,64portfolios,weighting,

175-176Green,RobertA.,197groups,joining,78guidelines.Seealsorules

butterflywings,165-167discipline,market

conditions,43-44positionsizing,34-35

Hhedgefunds,1-2,5,47highskews,137.Seealsoskewshiringcoaches,79historicalvolatility(HV),44holdingpositions,147-149humility,57HurricaneKatrina,19hurricanes,29

pricing,30HV(historicalvolatility),44

Iimpliedvolatility,44-46,81,131.Seealsovolatility

ironcondors,138-140indexes,21-23

benchmark,75skew,86SPXindexoptions,

weightedvegas,131-134individualretirementaccounts(IRAs),47informationresources,69-

70infrastructure,trades,17-18,63

analytictools,69-70backupplans,70-71dedicatedspace,70platforms(brokers),65-

67portfoliomargins,67-68riskcapital,63-65

InnerVoiceofTrading,The,197insurance

ATMironbutterflies,102autotooptions

comparisons,9blackswanevents,38-

41howmoneyis

lost,12-14made,8-12

hurricanes,29operations,8-12overviewof,5-8portfolios,38

pricing,44success,driversof,14-

18interfaces,easy-to-use,66intermediateoperators,64InternalRevenuecode,21Internetconnections,71in-the-moneyoption.SeeITMoptionIntra-Monthskews,165investments

operations,6,8,14

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

ITM(in-the-money)option,12,45

ATMironbutterflies,89

JJobs,Steve,38JohnsHopkinsHospital,59joininggroups,78Jordan,Michael,57journals,trades,73-77

KKatrina(Hurricane),19Kennedy,Kevin,136King,Rawle,19kitespreads,97,203-204kurtosis,84.Seealsoskews

LLabuszewski,JohnW.,197layouts,customizing,67learningprocesses,73

sequencestrategies,199-200soundingboards,77-80tradingjournals,73-77

Lefevre,Edwin,196leverage,access,67links

toExcel,67real-timedata,74

liquidETFs(exchange-tradedfunds),22Livevol,133

livingexpensecalculations,170locations,backup,71logs,trading,73-77longcalendars,110.Seealsocalendarspreadslongoptions,kitespreads,203-204longterm-riskplays,avoiding,136losses,127.Seealsoprofits

catastrophe-related,20insurancecompanies,

12-14ironcondors,97ratios,76reducing,36

lowskews,137.Seealsoskewsluck,58Lynch,Peter,196

Mmacroevents,38maintainingrecords,73-77

makertakermodelexchanges,51Mallaby,Sebastian,197management,5

deltas,169Greeks,64importanceoffocus,

170-172risk,14-16,31-32,62,

68addressablerisks,

37-38blackswanevents,

38-41cashpositions,145-

146modifyingtrades,

36money

management,33-34overviewof,32-33portfolios,35-36,

152positionsizing,34-

35TOMIC(TheOne

ManInsuranceCompany),122styles,60-62TOMIC(TheOneMan

InsuranceCompany),56-58tradingjournals,73-77

margins,66portfolios,67-68trades,98

marketingfees,155marketmakers,82,151markets

conditions,43-44expectations,46risks,37selection,20-25TOMIC(TheOneMan

InsuranceCompany),122verticalspreads,90

Martin,Michael,197maximumlosses,127McMillan,Larry,196measuringoutcomes,59mentaltoughness,57

modelsBlack-Scholes,81pricing,81volatility,88Whaley,81

modifyingpositions,148trades,36

moneymanagement,33-34monitoring.Seealsojournals

variables,75

volatility,88months

back,136evaluating,46front,136

MoreMoneyThanGod,197mortgage-backedsecurities,13,20multiplebrokers,71multiplestrikes,51

Natenberg,Sheldon,196neutralizers,132nontraditionalspreads,52Nyhoff,JohnE.,197

Oofficespace,70one-by-twocallspreads,98one-to-oneriskrewards,167OneUponWallStreet,196operations

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

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

portfolios,weighting,175-176primarytaxadvantaged

index,22SPXindex,Weighted

Vegas,131-134VIX,45,94weekly,28

OptionsasaStrategicInvestment,196OptionsfortheStockInvestor,195OptionSpreadTrading,195

OptionsVolatilityTrading,195OptionTrader’sWorkbook,The,196OptionVolatilityandPricing,196Optionvue,70orderflow,payments,155-157orders

entries,49-54trades,sizing,53working,53-54

OTM(out-of-the-money)option,10,12,39,84

gammascalping,181outcomes,measuring,59out-of-the-moneyoption.SeeOTMoption

Ppanics,40ParadoxofChoice,The:WhyMoreisLess,197parameters

entry,62exit,62tradingplans,61

parity,put-call,160payments,orderflow,155-157payouts,expectations,76pensionfunds,47Peterson,PaulE.,197Petrobras,35piranhathreats,33planning

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

blackswanevents,38-41diversification,35-36exitstrategies,168-169insurance,38management,56-58,64margins,67-68riskmanagement,152units,39-41weighting,175-176

positionsassignment,157-161

cash,145-146holding,147-149monitoring,74risk,161short,40sizing,34-35volatility,monitoring,88

Prabai,Mohnish,197predictions,volatility,40premiums,8.Seealsoinsurancepreparingtotradefora

living,169-170pricing,6,48-49

ATMironbutterflies,101insurance,44models,81tradeselection,29-30VIXoptions,45

primarytaxadvantagedindexoptions,22processes

discipline,maintaining,58-60

learning.Seelearningprocesses

products,evaluating,47professionaloperators,64profiles,risk,103.SeealsoriskProfitandLosssummaries,8profits,76

insurancecompanies,8-12monitoring,75successdrivers,15

Pronovost,Peter,59protectionagainstblackswanevents,39.Seealsoblackswaneventsputs

buying,85,159parity,160spreads,98

Rrates,taxes,21ratios

loss,13spreads,98,115-119,

123strangles,134win/loss,76

rawvegas,132real-timedatalinks,74recommendedreading,195records,maintaining,73-77reducing

losses,36volatility,180

redundantInternetconnections,71Reg-T,67

portfoliomargins,68reinsurance,6-7,38relationships,volatility,87ReminiscencesofaStockOperator,196reputations,66reserves,13-14resources

information,69-70

recommendedreading,195

results,analysis,75reversion,46Rhoads,Russell,195risk,5.Seealsolosses;profits

acquisition,14ATMironbutterflies,

103butterflies,165-167calendarspreads,111capital,63-65

cashpositions,145-146long-termriskplays,

avoiding,136management,14-16,31-

32,62,68addressablerisks,

37-38blackswanevents,

38-41modifyingtrades,

36money

management,33-34

overviewof,32-33portfolios,35-36,

152positionsizing,34-

35TOMIC(TheOne

ManInsuranceCompany),122one-to-oneriskrewards,

167positions,161ratiospreads,116selection,14

subprimemortgages,14typesof,37underwriting,6

Rookie’sGuidetoOptions,The,195rules

positionsizing,34-35riskmanagement,33sharkthreats,34styles,defining,60-62ThirdThirdThirdRule,

trades,43.Seealsotrades

RUTcondors,35

SSalomonBrothers,57scalpinggammas,176-190Schroeder,Alice,197Schwartz,Barry,197Sebastian,Mark,131,134-135,140,147,155,157,161,175

Section1256oftheInternalRevenueCode,21sectors,risks,37securities,mortgage-backed,13selection

brokers,49-50market,20-25risks,14strikes,48trades,15,19-20

ETFs(exchange-tradedfunds),22-24

indexes,21-23optionsonequities,

24-25pricing,29-30strategies,25-28timeframes,28-29volatility,29

sellingcalls,85semiprofessionaloperators,64September11,2001,attacks,38services,customers,66

sharkthreats,33shortpositions,40simulators,70singleoptiontrades,52sizing

positions,34-35tradeorders,53

skews,84-86ATMironbutterflies,

101-102calendarspreads,109evaluating,47

Intra-Month,165ratiospreads,115SPXindexoptions,137-

138viewing,70volatility,134-135

stagesof,140-144tracking,137

skills,decision-making,57smallorders,filling,51Snowball,The:WarrenBuffettandtheBusinessofLife,197

soundingboards,77-80specialists,options,65speeddial,71spreads,51

calendar,52,64,108-114,123

SPXindexoptions,161-163

weekendtimevaluepremiumdecays,149-152delta,140front,115-119

ironcondors.Seeironcondorskite,97,203-204one-by-twocall,98puts,98ratios,98,115-119,123time,41vegas,135vertical,28,52,89-93

SPXindexoptionscalendarspreads,161-

skews,137-138weightedvegas,131-134

stagesofvolatilityskews,140-144StateFarm,21Steenbarger,BrettN.,197straddles,52

ATM(at-the-money)options,140

strangles,52,104condors,134ratios,134

strategies,61,89ATMironbutterflies,

100-108calendarspreads,108-

114CardGameValue,146-

147cashpositions,145-146discipline,market

conditions,43-44exits,168-169frontmonths,136frontspreads,115-119

holdingpositions,147-149ironcondors,93-100learningsequences,199-

200ratiospreads,115-119riskmanagement,37.

Seealsomanagement;risksimulators,70TOMIC(TheOneMan

InsuranceCompany),122-123trades,25-28,48-49

vacations,152-153verticalspreads,89-93weekendtimevalue

premiumdecays,149-152stresstests,67strikes

butterflywings,167contracts,43multiple,51price,81selection,48

structures,term,87-88

styles,trading,60-62subprimemortgages,13-14successdriversofinsurance,14-18Sullenberger,ChesleyB.,58swapping

trades,88volatility,87

systemicrisk,37

Ttables,actuarial,11

Taleb,Nassim,196TaxGuideforTraders,The,197taxrates,21TDAmeritrade,Inc.,139termstructures

viewing,70volatility,87-88

terroristattacks,38tests,stresstests,67TheOneManInsuranceCompany.SeeTOMIC

thetas,gammascalping,190ThinkorSwim,70ThirdThirdThirdRule,97three-dimensionalvolatility,83-88time

toexpiration,81frames,tradeselection,

28-29ratiospreads,116spreads,41,108-114

TOMIC(TheOneManInsuranceCompany),2,5.

Seealsotradesde-risking,152exitstrategies,168-169functions,17ironcondors,95learningprocesses,73management,confidence

of,56-58operations,121-122portfoliodiversification,

35-36riskmanagement,31,

38.Seealsomanagement;

risktrades.Seealsotrades

execution,43,126-129

planning,122-124timeframes,28

tradingplatforms,65-67valuechains,14,17

tools,analysis,69-70trackingvolatility,76,88,137.Seealsomonitoringtrades

analysis,66ATMironbutterflies,

104bad,34,36bestavailable,126butterflychecklists,163-

165CardGameValue,146-

147coaches,hiring,79delta-neutral,52execution,15-16,43,

126-129

designing,48-49evaluatingmonths,

46impliedvolatility,

44-46marketconditions,

43-44orderentry,49-54product

evaluations,47skews,47volatility,44

exitstrategies,168-169

gammascalping,176-190groups,joining,78holdingpositions,147-

149infrastructure,18,63

analytictools,69-70

backupplans,70-71

dedicatedspace,70platforms(brokers),

portfoliomargins,67-68

riskcapital,63-65journals,73-77margins,98modifying,36orders,sizing,53planning,55,122-124

confidenceofmanagement,56-58

definingstyles,60-62

exercising

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

timeframes,28-29volatility,29

singleoption,52swapping,88tradingdesks,66typesof,52vacations,152-153

TradingforaLiving,197TradingintheZone,197TradingOptionsasaProfessional,95,195transitions,ironcondors,95

TrendFollowing,197types

ofrisks,37-38oftrades,52

Uunderlyingprice,81

ironcondors,93underwriting,6,8,20-25

profits/losses,13unemployment,20units,86

portfolios,39-41USAirways,57

Vvacations,152-153valuechains,TOMIC(TheOneManInsuranceCompany),14,17variables,monitoring,75vegas,40

gammascalping,190spreads,135

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

ironcondors,93,138-140marketconditions,43-44models,88monitoring,88portfolios,152.Seealso

portfoliospredictions,40pricing,29.Seealso

pricingreducing,180skews,84-86,134-135

SPXindexoptions,

137-138stagesof,140-144tracking,137

SPXindexoptions,131-134termstructures,87-88three-dimensional,83-88trades

execution,44selection,29

VIXoptions,135-136volume,skews,138.Seealso

skewsvomma,84,87

WWarner,Adam,195Websites,resourcesandanalytictools,69-70weekendtimevaluepremiumdecays,149-152weeklyoptions,28weightedvegas,SPXindexoptions,131-134

weightingportfolios,175-176Whaleymodel,81wings,butterflies,165-167.Seealsobutterflieswinratios,76Wolfinger,MarkD.,195Woodard,Jared,93,196Woods,Tiger,57workingorders,53-54workspace,70WorldTradeCenter,9/11attacks,38

Inanincreasinglycompetitiveworld,itis

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Itisourgoaltocreateworld-classprintpublications

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