Chapter 6
Locking in Edge

We just spent the last chapter explaining how to spot edge. However, given the market, edge in a trade can account for nothing. A trade is not a winner until the value is locked in. In this chapter, we will talk edge and locking in trades.

When I started trading, Scott Kaplan, my trading mentor, asked me, “Where is the edge?” What he meant was: Is there a way to lock and/or protect that value? Because if the value of a trade isn’t locked in, the trade might not hold value. If the trade doesn’t hold value, it doesn’t have edge. Thus, the only way to trade with edge is to buy something against a sale or to sell something against a buy. Let me give you an example from a market maker’s perspective.

When I was a floor trader, I made markets in ETF trading as EEM, the iShares MSCI Emerging Markets Index. At one point near the close, a broker came in looking to buy a near-term strangle, as I recall the strangle had about 60 days to expire. What made the strangle so interesting was that I had it worth about 0.10 less than what the broker was willing to pay. The set-up was great and on its surface the strangle looked like a winner. However, it was late in the day, and you never know when customers will pay because they think the stock is about to move. Basically, a strangle with 0.10 in it looks great until the next day when the underlying moves dramatically (something that happens if the trade is left alone). Therefore, on its own, I would have done this trade in small size. However, if I could ‘lock in the value’ I wanted as much of this trade as possible. (For more information on strangles and other spreads mentioned in this chapter, see Chapter 7).

Here is how I ‘locked it in’: Another broker, at the exact same time, was trying to sell a call tied to the stock that had about a 90-day duration, while at the same time that one broker was trying to buy the strangle, I had an option to sell. The option sale (by the customer to me), was just a touch better than fair value. I had about a penny or two of edge in the trade.

On its own, I would have never bought the calls, but with the strangle available, that trade went from marginal to crucial to me making money. I called broker B, asked if he still had his calls to sell, and bought 1,000 contracts. Once I had secured a purchase of the calls, I sold the other broker 750 of the strangles. Using one broker’s trade against another, I managed to lock in value in the trade. I was long, what amounted to a cheap longer-term straddle (calls plus short stock sold at delta neutral, creating a synthetic straddle). This combined long calls with long synthetic puts, along with long calls and long stock, against a short near-term strangle. With the whole thing at delta neutral, the trade amounted to a long calendar spread for 0.07 (0.05 in each option from the strangle and 0.02 in the calls). Even market makers do not expect that kind of value in a calendar spread, which priced on its own, might have 0.03 in it.

You may wonder how I determined the right number of contracts I needed to offset the trade, and how I knew that the two would ‘lock in’ value. The answer lies in dynamic vega management. In Chapter 12, we will dig into dynamic vega and how to quantify offsetting spreads. I used these techniques to piece together the trade. For now, think of the edge I captured as more than twice what I would normally get from two different brokers. Knowing that this wasn’t one customer with an agenda, but two customers with offsetting agendas, made me more confident in the trade. If I saw a calendar with 0.07 I might try to do 200, but because I pieced this together, I could do more, knowing that it wasn’t a trader that was too “smart” (a trader that knows something I don’t).

The Retail Trader

The retail trader does not have the advantage of having the ability to trade directly with brokers to generate offsetting trades like the one above. However, the power to initiate trades means that the retail trader can create their own edge. The key is finding edge via the spread trade.

As a retail trader, you must accept that one leg of the trade will be executed at a fair value price. However, if the other leg of the trade is too cheap or overpriced, you should not mind executing it because any edge to a retail trader is a win. The key is to follow the right steps:

  1. Establish the option you want to trade
  2. Establish the offsetting contract that is the cheapest to hedge the trade
  3. Execute the hard side of the trade
  4. Execute the easy side of the trade
  5. Manage the position
  6. Exit or hold to expiration

Establish the Option You Want to Execute

This is an option that is typically over- or underpriced. Its pricing is often driven by a large block order, or a group of large block orders. Institutions hedging or speculating typically have enough information in their decision tree that moving IVs by a point is not going to affect their decision. Paying 0.05 over fair value is the cost of business when you want exposure to the underlying, equaling 5 million shares of stock. However, one thing many retail traders do not know is that when a large trade pushes markets out of whack, market makers keep things that way until someone notices, then the market maker trades the minimum they can to move things back in line and avoid giving up edge. The average retail or prop trader (a proprietary trader who trades their own assets), is going to trade fewer than 100 contracts at a time. This is too small to move things for most market makers. Prop traders set up their trades to take advantage of being small and are prepared to trade inexpensive options.

Establish the Offsetting Contract

Before executing the trade that has edge, make sure that it actually has edge. How is this done? By quickly finding an option to buy or sell, you reduce the risk of the edge trade dramatically. This can be a calendar spread if term structure is off; this can be a credit, debit, or butterfly spread if there is a long strike out of whack. In determining the option to buy, one must spend the time to evaluate the curve (skew) and term structure. If going with term structure, make sure that overall IV matches with the trade. In determining a spread within the same contract month, the vol curve is key. We will dig into setting up these spreads on an individual basis in an upcoming chapter. The key is to be aware that in order for a trade to actually be a good trade, there must be something to buy or sell at the wrong price, and, on the other side of the trade, that the same thing is bought or sold at a fair price at a minimum (or in a perfect world, at a price that is too high or low depending on what you are hedging, so that you could make money on both sides of the trade).

The Hard and Soft Side of a Trade

Just because a contract is out of whack doesn’t mean it’s easy to buy or sell. When a strike or contract month is thrown out of whack, it won’t necessarily be easy to trade. That all depends on the order flow (customer orders). If strike was thrown out of whack by one large trade, what is done might be done and it likely will be ignored by order flow; an offer could sit there and never trade. Market makers are not stupid and will not simply execute the trade that you want at the current mid-price. They will only fill it if they think they will be able to trade something against it. This is especially true if the trade was put up as a cross or facilitated by a firm (a cross is when a broker finds both sides of a trade and meets prices in the middle). Facilitating a trade means the brokerage firm takes down the whole trade and the customer pays a high commission.

Let’s take a look at how a big trade in SCHW can be traded in the market:

A firm clearly was out to sell the December 30 calls as 20,000 of them were sold (the equivalent of 2,000,000 shares); this trade moved vol pretty hard. If you wanted to trade off of the order flow above, you could repeat the trade above. In setting up a trade, you might sit back on the bid on the December 30 calls and then go after the December 31 calls or the December 29 calls, depending on the direction of the underlying.

Another scenario occurs if there is a term or strike on the asset that is being actively ‘swept’ by the market (chased by customer order flow). In this case, multiple traders or one large trader is aggressively attacking a strike or term. In the example below, RR Donnelley trades met this description. The December 18 calls were aggressively purchased with the trader paying up to 0.30 on a market that started out at 0.15–0.20 and traded as low as 0.15 and up to 0.30. The point is that someone, or more than one, wanted to own the December 18s. There is no rush to own these as it will not be difficult to fill a sale in this case if you are looking to sell the 18s at 0.25.

Figure 6.1: Shows large orders in RRD that traded on a specific day.

The key is to understand what is harder to fill and what is easier to fill. When edge is created by one block trader, expect that there will not be a lot of follow-up. Traders in this case should work to execute the side of the trade that has edge to it first. Thus, in this case, the hard side of the trade was executing the option with edge. After the option with edge is filled, then you should execute the hedge. The worst case in this scenario is usually a trade executed for fair value (if you can’t fill the hedge).

Alternatively, when there are lot of sweepers and it is not hard to sell a strike or contract month, traders should assume that getting filled on the side of the trade with edge will be easy. The hedge on the other hand, with market makers knowing there are many contracts to be laid off, will not be as easy to fill. In this case, execute the hedge, then let the trade with edge come to you. Again, going with this route, the worst the trader will end up with is fair value, and more likely with edge as an order will come along eventually. When a spread with edge is being set up where the hard side of the trade is the hedge, it is much more likely to end up having edge than the other way around. Use speed to get a hedge in this scenario, then be patient in letting a trade come to you. More often than not, these spreads will produce.

Execute, Manage, Exit

Once a trade can be made, execute the hard side to fill and then the easy side to execute the trade with edge. Stick to the plan of the trade. If the trade does not have value, does not have edge, don’t execute the trade. Assuming the trade is done properly, it should be managed professionally. While we are going to spend lots of time discussing how to manage trades, I want this to be a clear point, we are going to hit on this many times: edge matters. If you put on a trade that you believe has edge, and that is proven to be incorrect, you should kill the trade by closing it quickly. If a trade is executed with edge and the assumptions change, kill the trade. Alternatively, if the trade is great and makes quick money, more than you were expecting, kill the trade. The point is, if the trade goes as unexpected, win or lose, get out. Finally, if the trade hits an adjustment point (which we will discuss in later chapters), make the adjustment. If the trade gets away, kill the trade. If the trade wins, kill the trade and take the money. Adjusting and managing are huge pieces of success, but they are determined by the edge in the trade. If the edge changes, take the money or take the licks. Take the time to be aware of how your position is changing and how you lose or make money. We are about to dig into each trade and then put a portfolio together in coming chapters.

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