Contents

Part I: Professional Lessons Every Trader Needs to Know

Chapter 1: Trading in Options

The TOMIC

Build an Infrastructure

Build a Trading Plan

Select Trades Based on Articulated Criteria

Manage Risks

Learn All the Essential Elements of Trading

Chapter 2: Risk Management

The Pricing Model

Delta

Change in Underlying Price

Change in Strike Price

Time to Expiration

Volatility

Gamma

Price of the Underlying

Strike Price

Time to Expiration

Volatility

Vega

Price of the Underlying

Strike Price

Time to Expiration

Volatility

Theta

Price of the Underlying

Strike Price

Time to Expiration

Chapter 3: Market Makers, Risk, and the Individual Trader

How Market Makers Make Money

Skew

Term Structure

Market Maker Size

Market Maker Global Risk

Chapter 4: Volatility

Realized Volatility

Zone 1 Ultralow Volatility

Zone 2

Zone 3

Zone 4

Implied Volatility

Zone 1

Zone 2

Zone 3

Zone 4

Chapter 5: What Is Edge?

Edge

10 Day HV

20 Day HV

60 Day HV

Review the IV of the Product

IV30

Term Structure

Skew

Know the Zone of the Market

Select the Trade

Chapter 6: Locking in Edge

The Retail Trader

Establish the Option You Want to Execute

Establish the Offsetting Contract

The Hard and Soft Side of a Trade

Execute, Manage, Exit

Part II: Using Spreads

Chapter 7: A Quick Review of Spreads

The Call Spread

The Put Spread

The Straddle

Short Straddle

The Strangle

The Iron Butterfly

The Short Iron Butterfly

The Long Iron Butterfly

Standard Butterfly

The Iron Condor

The Short Iron Condor

The Calendar Spread

The Long Calendar

Short Calendar

Front and Back Spreads

Back Spreads

The Front Spread

Chapter 8: Adding Edge to Spreads

Credit/Debit Spreads

Volatility

Skew

Management

A Few Words on Adjusting

Chapter 9: Butterflies and Condors

The Butterfly

Trading a Butterfly

Targeting Profit in a Butterfly

Condors

Strangle

IV and HV

Skew

Set Up and Management

Chapter 10: The Front Spread

What Is a Front Spread?

Creating a Front Spread

IV

Skew

HV

The Broken Wing Butterfly

Trade Management

Aggressive Management

Passive Management

Beginning of Front Spread in TSLA

Target Profit

Broken Wing Butterfly Variation

Chapter 11: Calendar Spreads

Creating a Calendar

Evaluate Overall Implied Volatility

Evaluate Term Structure

Evaluate Event Risk

Evaluate Realized Volatility

Choose the Right Strikes

Execute the Trade

Manage the Trade

Exit

Part III: Gobal Risk

Chapter 12: How a Market Maker Trades

Market Making

The Trader

Step 1

Step 2

Step 3

Step 4

Chapter 13: Portfolio Greeks

Delta

Gamma

Theta and Vega

Theta

Vega

Managing a Book

Chapter 14: Crisis Alpha

Defining a Market Crisis

Lehman Brothers Bankruptcy

VIX Term Structure Determines ‘Value’ for VIX Derivatives

Crisis Alpha Approaches

Approach 1: Tactical Long VIX

Approach 2: Low Cost-of-Carry Options Structures

Exit Strategy

Part IV: Appendices

Appendix A: Important Terms

Historical Volatility (HV)

Short-Term Historical Volatility

Intermediate-Term Historical Volatility

Long-Term Historical Volatility

Realized Volatility (RV)

Forward Volatility

Implied Volatility (IV)

Calls and Puts

Skew

Term Structure

Volatility Index (VIX)

Delta

Gamma

Theta

Vega

Appendix B: Best Blogs

Index

Preface

Why am I writing this book? That is the question that my wife, my co-workers, and my friends have asked me. The answer: There are many great books that explain what an option is, how they function, and what the P&L payoffs are for options both bought and sold. There are many books that then take this a step further and walk through what each type of spread is and how to build each of the spreads. These books tend to walk through the P&L payout and may delve into the basic reasons why a trader would put one of the spreads on. Yet there are no books that I have found that adequately explain how these spreads can fit together and the optimal conditions that each of these spreads should be executed under. Essentially, there are a lot of books that can tell you what each option position is and how it makes money. But there are very few, if any, books that explain why a trade should be entered and the optimal conditions for each spread. Even more so, I am not sure there is a book that puts these spreads together so that a trader can tell when to pick a spread. My goal is to fill that void and teach traders how each position works and more importantly how to put several positions together to build a portfolio.

Now that we established why I am writing this book, let me discuss what I want you to learn by reading this book. In short, the answer is conditional trading. But what is conditional trading? Conditional trading is the art of understanding what the market looks like right now and how to trade that market. In essence, while most books are happy to teach you the ‘how to build’ portions of individual trades, there are no books (that I am aware of) that teach the why of executing a trade, when to enter that trade, and most importantly how to piece all of these trades together.

In this book I am going to show you why you would enter one trade over another. What are the exact conditions when you should trade a butterfly? What are the conditions that make a condor or straddle a great trade? When do you buy premium and when do you sell premium? If you want to buy or sell, what is the best trade for the market right now given the market conditions and the conditions in the stock, ETF, or index itself?

Then I am going to take things one step further by explaining how to piece a portfolio of trades together. If you already have on a butterfly and conditions are ripe for another butterfly, what should you do? As the market changes on a portfolio of trades, how do you add to a portfolio? Can you build a portfolio that can make money most of the time and not get completely run over in the event of a major market collapse like the ones we saw in 2008, 2011, and in August of 2015?

Once a portfolio is built, how should each of the trades and the portfolio be managed? What adjustments make sense in order to minimize losses while ensuring that good money isn’t just dumped after bad? How do you make sure that the dollars being spent to manage trades are being implemented in the best way possible?

Finally, I’ll discuss the right way to manage and hedge a portfolio for both active traders and for those looking to hedge a portfolio of trades. I’ll discuss how constant hedging and ‘crisis alpha’ are different and how to implement both.

At the conclusion of the book, readers should have a clear idea of not only how the Option Pit Strategy Letter is written and managed by our pros, but how Karman Line Capital, my hedge fund, also manages risk on our trades.

When you have finished this book, my hope is that you will have a clear idea not only what each trade should look like, but what a portfolio of trades should look like.

A small but needed disclaimer, this book is meant for educational purposes only. While I may discuss in general how Option Pit and Karman Line Capital build and enter trades, due to regulatory restrictions this book will not share our performance. Karman Line Capital is offered to qualified investors only on a one-on-one basis. If you have interest, you can contact our CFO directly [email protected].

I want to thank you in advance for reading this book. I hope you find the time well spent.

Mark S. Sebastian

Introduction

If this is your first options book, you picked up the wrong book. This should be read after you have read books that explain options theory. This book is meant for experienced options traders. Have you been through a ‘mentoring’ program and been disappointed by your preparedness? Then this is the right book for you. Have you read books by Sheldon Natenberg, Larry McMillian, etc.? Then this book is for you. Have you been trading options for a year or more and understand the Greeks . . . for the most part? Then this book is for you. If your answer was no to any of these, I suggest you go read books that will get you to this point. Then you will be ready to pick up this book. If you still want to buy it, okay, just know that it was written for people with backgrounds in the area. I assume the basics are understood. Once you are ready, here is what you will read:

This book is divided into four main sections:

Part I: Professional Lessons Every Trader Needs to Know

Chapter 1: This chapter will articulate the business side of trading. It then talks through how running a good trading business leads to good risk management. Good books (as in a book of trades) mean good understanding of risk. This chapter will explain why.

Chapter 2: This chapter covers the Greeks as they apply to risk management. An in-depth discussion of the Greeks as they pertain to market conditions will be covered. Instead of just knowing what the Greeks are, you should understand why the Greeks act the way they do. I will spend LOTS of time on how the Greeks move as market conditions change. Instead of what delta, gamma and vega are, I’ll discuss what causes a Greek to change.

Chapter 3. This chapter will cover how market makers manage risk on a position-by-position basis when trading. How do market makers stop themselves from taking on too big of a position for not enough money in a stock or index? This will be your introduction to how I want you to trade.

Chapter 4: This chapter discusses how to evaluate edge trades in terms of volatility. Learn to understand volatility as it relates to realized and implied volatility. Understand the zones that stocks might trade in for a period of time as well as the zones that implied volatility might trade in. Finally, this chapter discusses how the zones relate to one another.

Chapter 5: Here I discuss how to evaluate edge in long and short premium trades. What makes a trade a winner or loser? How do you recognize a good trade from a bad one given market conditions? What part do volatility, term structure and skew play in understanding the particular trade?

Chapter 6: It is not enough to spot edge, you must also capture edge. This chapter is about strategies you can use to capture edge and therefore effectively capture the value. It points out some of the risks that may be associated with a trade that looks too good to be true. It points out how to use a series of trades to lock in edge. It also points out the issues you may have as a retail trader that large houses do not in terms of information and how to actually make the trade to make sure you lock in the value.

Part II: Using Spreads

Chapter 7: This chapter is a survey of the basics of various spreads and conditions where they may be successful. Calls and puts, straddles, strangles, iron butterflys, butterflys, iron condors, calendar spreads and front and back spreads are covered in this chapter.

Chapter 8: Chapter 8 looks in detail at call and put spreads and how volatility, skew and management of the trade (as in when to get out) enable you to gain edge.

Chapter 9: Similarly to calls and puts, butterflys and condors can be made to gain edge through volatility, skew and management. In this chapter, I present short checklists which point to the best conditions for utilizing these spreads.

Chapter 10: I discuss trading front spreads and broken wing butterflies for edge in this chapter. This will cover how traders manage front spreads, and naked options in a non-directional manner.

Chapter 11: Here I talk about calendar spreads: when to buy them, when to sell them, and when to trade something else. I also discuss how weighted vega affects calendars and where shorts and longs fit within a portfolio.

Part III: Global Risk

Chapter 12: In this chapter I discuss market makers, their role and how they manage risk. Their processes are compared with small traders. Steps taken for rating a trade are presented that should be useful to all traders.

Chapter 13: This chapter discusses book management for the retail and professional customer. I’ll show how to engage in net portfolio weighting and how to hold rate trades against a total portfolio. As a portfolio builds into a full set of trades, how do you manage the risk? We examine weighted vega, vol vega, and beta weighting as it relates to a portfolio of trades as well as how to rank a position and how to rank trades.

Chapter 14: This chapter will finish with how a trader can manage catastrophic risk on both long positions and a book of long and short positions—Crisis Alpha. Finally, I’ll close with how crashes form, what to look for, and how to manage this risk.

Part IV: Appendices

Appendix A consists of important terms you should be well-versed in for options trading.

Appendix B is a group of blog posts I have written over the years—in real time— as events unfolded. Hopefully by reading what I was thinking during these events (since 2010), right or wrong (I’ll note that), you’ll understand how a pro might think given a situation of trades.

When you finish reading, I hope many questions have been answered and you are armed with knowledge to help you build a portfolio of trades and how to manage global risk across your book of trades.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.91.203.238