I was watching a few tastytrade videos on YouTube while working on other stuff, and came across two sets of interesting videos that showcased how things are managed when a bet goes bad.
As a quick background, tastytrade was set up by Tom Sosnoff, the founder of thinkofswim (TOS). As Tom Sosnoff and the other presenter, Tony Battista are both options traders, the content does have a more options bent to it.
Karen the SuperTrader
Tom and Tony interviewed Karen the SuperTrader who made millions of dollars trading index (SPX, NDX, RUT) options (something like $100 million). SPX options are her main instruments.
There were two interviews conducted:
- http://www.youtube.com/watch?v=cXy9HoWX0es (May 31, 2012)
- http://www.youtube.com/watch?v=BquDGE9KxZQ (October 16, 2012)
- Attended a $22K Investools PhD course that took 1.5 years.
- Traded stocks using technical analysis from 2002 to 2007 with $10K capital.
- Start non-directional trading using options from 2007 with ~$100K capital, and made 50%.
- Friends put in money to start 2008 off with $700K.
- Made $41M profits by 2011, fund size was ~$80M.
- As of May 2012, was managing around ~$160M.
- Basic Strategy
- Theta trader, tries to pull as much time value out as possible. Theta starts decaying around 45 days.
- When volatility is high, she keeps on selling and buying back the options to capture the value.
- Trading index options allow for non-directional play, as well as being able to not be impacted by stocks’ earnings season.
- Sells the options that expire around 56 days, or 8 weeks away. Usually like to let the options expire when the month comes by.
- Sells Put options (on a market downswing) that have probability of being in-the-money of ~5% (TOS estimates that by looking at the one-year standard deviation of the underlying and assumes a Normal distribution, so 5% in-the-money is 1.64 standard deviations away)
- Sells Call options (on a market upswing) that have probability of being in-the-money of ~10%. Tries to sell the Call options above strong market resistance levels.
- Reason behind the 5% vs. 10% probabilities is that “the market crashes down, not up”, then down moves are quicker, so to be safe the Puts need to be further out.
- The positions are legged-in, i.e. the Puts and Calls are not sold at the same time.
- Sells more Puts than Calls.
- Usually commits 50%-70% of net liquidity so as to leave ammo to manage positions.
- Problem Management
- If an option gets to 30% probability of being in-the-money, the position needs to be actively managed.
- Any costs associated with fixing the problem (e.g. losses due to closing the position), will be made up by selling more options to get the premiums to cover the losses.
- For example, if the market moves up, she may sell more Call options that are further out (i.e. higher strikes), or sell more Put options at higher strikes (higher compared to the previously sold puts).
- When the market drops and volatility spikes (i.e. she is losing money on the Puts she sold), the fact that the strikes were far away (5% probability of being ITM) gives her time to assess and adjust her positions.
- When the Flash Crash of May 2010 happened, she closed her profitable positions and sold options further away (October, November months) to get more time to assess the situation.
- Other Tools
- Watch price and volume, and use bollinger bands.
- Karen’s strategy is pretty interesting. Essentially the strategy sells strangles with far OTM strikes, which makes money on the assumption that the market will be range-bound, at least until expiration.
- What is more interesting is how the trade is managed when the position goes bad. In the example, if the index goes up, there are two choices: 1) Sell more Calls, or 2) Sell more Puts. In the first choice, the bet is essentially that the index would not go up further, i.e. it is a counter-trend bet, whereas in the second choice, the bet is a trend-following bet that the index would not go down, i.e., that it will continue to go up.
- It is not clear from the interview how Karen decides whether to sell more Calls, sell more Puts, or to do both (i.e. bet that the market will still be range-bound, albeit at a higher range), and it is a pity that it wasn’t asked during the interview.
- I would think though that it will be a decision made based on the read of the market at that point in time, how the market is situated compared to the support and resistance levels, how the price / volume action has been, and at what position is the market relative to the bollinger bands that Karen said she uses.
- The first time I viewed the video my impression was that she would sell Puts in this case, and thought that it was interesting that the default position is a range-bound market, and as the market starts to trend, then switch strategy to take a trending bet.
- In any case, what I think is the important bit in this case is the fact that she commits around 50% of her capital, and leaves the remaining 50% for trade management purposes, which seems prudent.
How to Trade When Things Go Horribly Wrong
In the second video, Tom and Tony showed how they adjusted a huge losing position to break-even.
- Trade Rationale
- Sold PCLN August 2012 $565 / $785 strangle for $2.10 as an earnings play.
- Each strike was 2 standard deviations out (i.e. 95% probability of finishing out-of-the-money) to account for a large expected move.
- Trade Anatomy
- August 7, 2012
- Stock price: $678.64
- Sold $565 / $785 Strangle (i.e. Sell 565 Put / Sell 785 Call) for $2.10
- Earnings announced after Close
- August 8, 2012
- Stock price: $578 (8.31am)
- The short strangle position had opened at $11 – $12, representing a huge loss.
- Sold $590 / $785 Call Spread (i.e. Sell 590 Call / Buy 785 Call) for $9.95
- Stock price: $564.48 (2.11pm)
- Sold $575 / $590 Call Spread (i.e. Sell 575 Call / Buy 590 Call) for $4.50
- August 9, 2012
- Stock price: $559.76 (9.15am)
- Sold $565 / $575 Call Spread (i.e. Sell 565 Call / Buy 575 Call) for $4.00
- August 10, 2012
- Stock price: $563.67 (9.50am)
- Net result thus far is a short $565 Straddle (i.e. Short 565 Put and a Short 565 Call) with total premium collected of $20.55
- Bought $565 Straddle for $20.50 to close position.
- August 7, 2012
- Mitigation Logic
- Implied volatility gets crushed after earnings because all the speculative volume in options is gone.
- In the case of PCLN, volatility remained high (but still lower) as the stock tanked a lot.
- Tom and Tony’s views are that the stock will continue to tank.
- Hence they took advantage of the still-high volatility to sell more options to collect more premium to mitigate the loss.
- The $785 Call was bought back so as not to tie up any more capital.
- While they did not expect the stock to have a large bounce after the bad news, they expect that the volatility will go down if there is a bounce, hence they sold the first Call Spread quickly at 8.31am on August 8 to capture that premium while volatility was still high.
- The Call Spread values were chosen so that the stock price lies in the middle of the resulting short Strangle.
- It is not true that the first loss is the best loss, you need to look at the situation.
- If you maintain a small enough position, you can calmly maneuver and adjust to mitigate the loss. If your position is too large, you will not be in a right state of mind to manage the trade.
- Essentially the position was “saved” by taking a directional bet that the stock will continue to tank down, and continuing to increase the bet and capture previous profits by rolling the strikes of the short Calls down.
- Of course if the stock bounced, there will be some mitigation with a lower volatility but the trade will likely not work out well.
References on Margin Requirements for Options Positions
- https://scs.fidelity.com/webxpress/help/topics/learn_trading_options.shtml#sellingcallsrequirements (look under Naked Requirements)