I’m sorry for anybody shorting this market

This is a difficult market to get a read on, that’s for sure.

Shorting the market right now is a fool’s errand. Whether you believe liquidity from the Fed is driving the market higher or not doesn’t matter.

The market wants to go higher. That’s where the path of least resistance continues to be at the moment.

Selloffs are very few and far between. You have to be tactical and quick with any shorts in this market. They can payoff, as they did for me on Thursday and part of Friday. But they stop working very quickly.

We are all waiting for the next big selloff. It may come. It may not. For that reason you have to be careful until we get there.

I learned my lesson last year

I got burned time after time shorting the market for the larger part of 2019.

I was focused on fundamentals, trade war headlines, and a seemingly deteriorating market.

So I shorted consistently all of last year. I came very close to blowing up actually. I was down 80% at one point.

It wasn’t until March of this year that my short positions paid of very handsomely and actually got me back to even despite the horrible 2019 year.

In recent weeks my trading has improved

I’m more focused on what VVIX and VIX are telling me in terms of volatility. If I believe these are trending higher, then I’m going to be biased to mix in long and short trades to capitalize on a move in either direction.

However, if VVIX and VIX are trending lower, them I’m biased to hold a majority of my positions long in the market, depending on what is moving on that given day. In recent weeks, I’ve been able to make good plays on the likes of XLF, GS, JPM, BA, UAL, RCL, CCL, F, TSLA, XOM, AMD, NVDA, VIAC just to name a few.

Take profits and cut losers

I like to play options that are 2-4 weeks away from their expiration date. Weekly options (5 or less days to expiration) are too risky for my style right now. I like to give my options a little breathing room.

I watch my positions like a hawk. When I begin getting down 20% I seriously have to consider cutting this position and taking a loss. Once I’m down 40% I cut it no questions asked.

I also try to take profits on 50% of the position around a 10% gain (or more if it’s there). Then I take off another 25% around a 20% gain (or more). The I leave the final 25% of my position to run to see how far it can go.

Last week I had a SPY put option that I let run, that went from $90 to $630 in a matter of days. In the past, I would have never let it go that far because I would’ve booked all of my profits too soon. But because I had already closed out 80% of the position at a gain, that last contract I was holding was essentially risk-free and I had no problems holding it for a little longer.

If you want to learn more about trading psychology, I highly recommend you check out my notes on Trading in the Zone by Mark Douglas.

I was wrong

A few weeks back I was dumb enough to think selling would return to this ridiculous stock market.

I want to catch the next downturn. I think we all do.

Downturns provide opportunities for large profits.

Volatility events have been some of my most profitable times. The hardest part with shorting any market is being patient and strategic.

My gauge to short flashed

I have a few different metrics I monitor to gauge when are better times to short than others.

They began flashing on May 11 and 12, and sirens were going off on the 13th and 14th.

On the morning of the 14th, the market miraculously recovered. I felt like OPEX and VIX expiration would loosen up this market. Alast I was wrong. But, I ended up minimizing my losses from this due to position management.

Position sizing and profit taking

This is why position sizing and profit taking are key to succeeding in overcoming your emotions in the face of an uncertain future.

On May 12, I put on 100 SPY July 17 puts at the $110 strike for $0.03 per contract, totaling $300 (small bet).

On May 13, I took off 20 contracts at $0.06, for a total of $120. That was a 100% profit from the previous days price. Now, my cost minus proceeds received from this sale is $180 ($300-$120).

On May 14, I took off 20 more contracts at $0.10, for a total of $200. That was a 233% profit from the previous days price. Now, if I take the $180 above, and take off the $200 here, my cost minus proceeds now equals -$20 ($300-$120-$200). This means my remaining position is risk-free.

Risk-free? No way…

Yes way. I had 60 contracts left that could literally expire worthless, and I would have still made a profit on the entire trade. This is why it’s important to take profits along the way on any position you’re playing

Turned out I was wrong. But I played my signals, managed around the situation, and came out with a small profit (which actually turned into a small loss because I later added to it…).

But…I ended up with a smaller loss because I managed around an unknown future. At times in the past, I would’ve ridden the entire trade from top to bottom and loss damn near my full investment.

Back to work here…

Hello friend!

I’m back to working on this blog starting this month.

This is what I’ve been up to

The months of February and March were crazy with the coronavirus and its impact on the market. I was busy most of the time in these months trading, documenting, programming, and continuing the improve and refine my trading processes.

2018 (with emphasis on the last three months of the year) was extremely rough for me. I fought the Fed multiple times on trades and I lost. I was actually looking for jobs in January and February because I wasn’t sure I’d be able to continue trading.

That changed, fast

Volatility in the market took off. I held short positions that profited insanely. Negative gamma had proven to be my ally. Convexity won out.

This extended my runway another 4-6 months at a minimum. It’s been a scary ride but I’m loving every minute of it.

What’s to come

Anything that I’m interested in. I’m currently interested in the following things, in no particular order.

Understanding gamma exposure deeper
Other options greeks and their effects on markets
Higher order options greeks (vanna and volma)
Game theory
Kelly criterion and position sizing
The rise of the carry trade
Federal Reserve operations
The current state of the economy
The current state of politics in the world
Python programming
Calculating gamma exposure from easy to obtain information
Building trading dashboards

That’s just a few I can think of off the top of my head.

Follow this blog to stay updated.

We are all at the mercy of news trading algos

It’s become commonplace for news stories to drastically and instantly influence the movement of stock prices. This has become more observable in the past two years, with China trade deal news dominating headlines seemingly every day.

According to Larry Harris (Trading & Exchanges) there are four kinds of informed traders, with news traders exhibiting the second most influence on the market. According to Harris:

News traders collect and act upon new information about instrument values. They try to predict out instrument values will change, given new information. News traders try very hard to discover material information before other traders to.

Unlike value traders, news traders do not estimate the value of an instrument from first principles and all available data. Instead, they implicitly assume that current prices accurately reflect all information except their news.

It’s difficult trying to day trade or swing trade around the drastic changes in stock prices that are triggered from a single headline.

Many algorithms are programmed as news traders, which read news headlines or tweets and have some pre-programmed objective-based method of interpreting the sentiment of those headlines.

Algorithmic trading has been of much chagrin of people in Wall Street such as Jim Cramer. Earlier this fall, Cramer said the following about machine trading

Cramer blamed the errant jumps in the transport stocks on machine trading, calling the buying “robotic.”

“Real human buyers wouldn’t pay up eight points for FedEx on no news, unless they think there’s going to be some sort of takeover, which there probably isn’t. Real buyers work an order. They wait for sellers to come to them,” he said. “Instead, these machine buyers they blitzed all the sellers all the way up, and you have to believe they didn’t even attempt to try to get a good price for their customers.”

The dreary truth

We have to accept the fact that algorithmic trading is a part of the market as we know it.

As a day trader you will always at the mercy of algorithms suddenly going against your positions which makes day trading harder than it already is.

If you’re a swing trader, you can ride out the waves because news headline trading tends to smooth out over time (unless it’s something dramatic like a President Trump tweet tantrum).

So we must deal with it, must learn from it, and must learn how to trade with or around it. It’s up to you what you do.

Why do options market makers take on short volatility positions?

Adapted from Options Volatility and Pricing Textbook by Sheldon Natenberg.

Option market makers typically profit when there is more options volume being traded. The reason for this is market makers profit from the difference in the bid-ask spread, and higher volume provides and opportunity for them to take in more profits on this spread.

When options trading volume is elevated, you also tend to see higher volatility in the market. This is because demand for options increases as volatility increases due to market participants purchasing protection for their portfolios and/or speculators looking to profit from large price swings.

Market makers have an indirect long volatility position

As a result of this, option market makers have what is known as an indirect long volatility position, because they profit when volatility is high as a result of increased volume. Market makers want an increase in the volume of options but not because they have long volatility positions per se.

To hedge against this indirect long volatility position, you will see market makers take short volatility positions in volatility contracts, most commonly the VIX.

The market maker takes a short volatility position because they want to hedge themselves against the possibility of there being low trading volume which would ultimately hurt their profits.

What I’m currently reading in January 2020

As of January 2020, here are the books at the top of my reading list. I’m currently flipping back and forth from these books on various topics.

Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris

I first heard of this book from squeezemetrics on Twitter. This individual said that this was one of the best books they found to gain a deeper understanding of the markets, and helped inspire the gamma exposure research that they have completed.

I got this a month ago and have to agree that this book is fantastic at helping you understand the inner workings of the stock market. If you are up for advanced knowledge on the markets, this book is for you.

From Amazon:

This book is about trading, the people who trade securities and contracts, the marketplaces where they trade, and the rules that govern it.

Readers will learn about investors, brokers, dealers, arbitrageurs, retail traders, day traders, rogue traders, and gamblers; exchanges, boards of trade, dealer networks, ECNs (electronic communications networks), crossing markets, and pink sheets.

Also covered in this text are single price auctions, open outcry auctions, and brokered markets limit orders, market orders, and stop orders.

Finally, the author covers the areas of program trades, block trades, and short trades, price priority, time precedence, public order precedence, and display precedence, insider trading, scalping, and bluffing, and investing, speculating, and gambling.

The Big Book of Dashboards: Visualizing Your Data Using Real-World Business Scenarios by Steve Wexler, Jeffrey Shaffer, and Andy Cotgreave

I got this book because I want to improve my data visualization abilities for this blog and for those charts I post on Twitter as well. I also want to improve my own record keeping process for my trades and create a more professional dashboard that will allow me to review past trades.

From Amazon:

Comprising dozens of examples that address different industries and departments (healthcare, transportation, finance, human resources, marketing, customer service, sports, etc.) and different platforms (print, desktop, tablet, smartphone, and conference room display) The Big Book of Dashboards is the only book that matches great dashboards with real-world business scenarios.

Option Volatility & Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg

I’ve had this book for a few months, and I’m constantly coming back to it for a deeper understanding on options and the options market.

This book is great for anyone looking to dive deeper into understanding options and options theory. If you trade options or just want to understand the options market better, this one is a must read.

From Amazon:

One of the most widely read books among active option traders around the world, Option Volatility & Pricing has been completely updated to reflect the most current developments and trends in option products and trading strategies.

Featuring:

Pricing models
Volatility considerations
Basic and advanced trading strategies
Risk management techniques
And more!

Written in a clear, easy-to-understand fashion, Option Volatility & Pricing points out the key concepts essential to successful trading. Drawing on his experience as a professional trader, author Sheldon Natenberg examines both the theory and reality of option trading. He presents the foundations of option theory explaining how this theory can be used to identify and exploit trading opportunities. Option Volatility & Pricing teaches you to use a wide variety of trading strategies and shows you how to select the strategy that best fits your view of market conditions and individual risk tolerance.

Links above are affiliate links. If you purchase any of those books through the link I posted, I’ll get a tiny cut of the sales proceeds. Your support is appreciated.

How the limit order book became abstracted into options and why gamma exposure matters

Information obtained from a thread courtesy of squeezemetrics via Twitter

You know how old-school traders talk about using the limit order book to know where supply and demand are? Basically what happened is that the limit order book got abstracted into options, and the actual buying and selling is now done by option dealers, on behalf of customers.

So what happens is, I sell a call because I want to collect some premium and give up some upside. This is largely equivalent to submitting a bunch of progressively larger limit sell orders above the market, except that those orders cannot be seen.

So what happens is that the option dealer takes the other side of those would-be limit orders by shorting the underlying and committing to, in this case, a schedule of buying the underlying when it goes down, and selling more when it goes up.

This means that there are, through the agency of the option dealer, a bunch of what are effectively limit orders sitting above and below the market, all of which will push against any move in the underlying itself. The more of these there are, the more stifling it gets.

So when GEX is really high, that’s when it’s super-stifling. BUT WAIT THERE’S MORE. As these call options lose value, the dealer slowly buys back some of the underlying that they shorted before, slowly supporting the market, ceteris paribus. Low volatility, upside drift.

(Hopefully it’s obvious why knowing where supply and demand will be is useful.)

Why do you trade?

For full-time income?

For extra income?

For fun?

Let me know with a comment below.

How to write trading rules

Do something.

Realize, oh shit I shouldn’t have done that.

Write down what you shouldn’t do.

Result: new trading rule.

Tip: Study those things that have ruined those who have come before you. Better to understand someone else’s big blunder to avoid one happening to yourself.

What are the options Greeks?

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

Greeks refer to dimension of risk that an options position entails. The Greeks are used by options traders and portfolio managers to hedge different risks to their positions.

Is simple terms, the Greeks are derived based off a pricing model, like Black-Scholes, using inputs: option price, underlying stock price, days to expiration, and risk free interest rate.

The most commonly used Greeks used are Delta, Gamma, Theta, Vega.

Delta

Delta is the amount an option price is expected to move based on a $1 change in the underlying stock.

Calls always have positive delta, between 0 and 1. If the underlying stock price goes up and no other variables change, the price for the call will go up.

If a call has a delta of 0.50 and the stock goes up $1, the price of the call will go up about $.50. If the stock goes down $1, the price of the call will go down about $.50.

Puts always have a negative delta, between 0 and -1.

Gamma

Gamma is the rate of change in delta for every $1 change in the stock price. If delta is the “speed” at which option prices change, you can think of gamma as the “acceleration.”

Options with the highest gamma are the most responsive to changes in the price of the underlying stock.

Gamma is highest for options with strike prices near the current underlying stock price. It is also highest for those options at the money that are closer to expiring vs. those options which are due to expire further out in the future.

Theta

Theta, aka time decay an option buyer’s biggest enemy, and option seller’s best friend. Theta is the amount the price of calls and puts will decrease theoretically for a one-day change in the time to expiration.

In the options market, the passage of time will erode an options value. Time value melts away and does so at an accelerated rate as expiration approaches.

Vega

Vega is the amount call and put prices will change, in theory, for a corresponding one-point change in implied volatility.

Vega does not have any effect on the intrinsic value of options, it only affects the “time value” of an option’s price.

Typically, as implied volatility increases, the value of options will increase. That’s because an increase in implied volatility suggests an increased range of potential movement for the stock.

Conclusion

If you’re trading options, you absolutely must understand those Greeks above and how they impact your trading strategies.