Chapter 1
Trading in Options
This book explains the business of trading options. It is intended for an options trader, or a trader who needs to know more about options trading in order expand trading skills. To fully appreciate the book, you will need a basic grounding in the field, including mastery of options terminology, trading rules, nomenclature, and preferably some preliminary experience in trading options.
An options trader looks at a trade completely differently from a stock transaction. The value judgment in an options trade is limited to whether the trade can be made and if there is an ‘edge’ to the trade (we say a trade ‘has edge’). That is, that an options trader knows something about the trade that gives them an edge, or at least perceives a specific advantage based on underlying price movement, option premium levels, and current news (especially earnings surprises or announcements about product approvals, mergers, and other significant changes). If you trade a stock, you make a value judgment about the next direction of price movement; someone on the other end of the trade disagrees with you. The result is that the stock price is an amalgamation of all trading in that stock to arrive at an optimal price. People make trades based on these perceptions, and of course, they can be right or wrong.
Throughout this book, you may find yourself thinking of options trades as “good” or “bad” in the sense of the underlying asset and its current volatility and recent price movement. You might think that the value of the options trade is related directly to the attributes of the underlying security. This is only true to the extent that you know something about the underlying security that may give you an ‘edge’ in options trading. Throughout the book, this concept of ‘edge’ is a recurring theme.
The options trading business is about timing of transactions. Whether they are smart or not is a different story and, as you will learn, the more volatility in the market, the better it is for options traders. So wise trading may involve resisting the urge to think of options as related directly with whether a stock transaction is a sensible alternative trade. The process involves being able to capitalize on trades, packaging them in combinations, or recognizing hedging opportunities to minimize risk.
The framework for trading options comes from the concept of a TOMIC (the one-man insurance company). Traders should approach options just as a large insurance company approaches selling insurance policies to consumers and businesses. In buying and selling options as a TOMIC, you may turn options trading into a business rather than a side activity to investing. The TOMIC approach encourages strong skills in trade selection, risk management, strategy execution, and of course adapting to market conditions as they change. Every TOMIC trader need to understand the basics of this approach before moving into the nuances of trading options for edge.
The TOMIC
Insurance companies make money in two ways, by making a small amount of premium on the insurance they actually sell, and by selling overpriced policies due to greater risks. When selling a policy to a 38-year old male with a wife, children, and a job, the insurance company uses actuarial tables to predict how much it is going to cost to insure a life. While on an individual basis this might cost more than the actuarial table predicts, the insurance company can make money (because the insurance company can write thousands of policies to thousands of individuals and families). Even if the insurance company loses the gamble on a decent minority of those it insures, it will make money. Even outlier events have little to no effect on an insurance company when they write enough policies (generally). The profits are derived from the experience among the insured group at a particular age, as well as by investing reserves throughout a lifetime to earn investment income. While actuarial tables are used for life insurance, other forms of insurance, such as homeowners or automotive, are based on the history of claims in a particular region.
The TOMIC trader is going to take this same approach to writing option policies. For example, as a TOMIC trader, you might decide to sell option spreads at prices that you believe are too high and buy option spreads that are too cheap. This is what an insurance company does as a matter of risk evaluation to arrive at pricing. As a TOMIC trader, you set up a regular routine for trading and executing option trades.
As a TOMIC trader, you develop a process for picking trades while keeping a comprehension of risk and opportunity in mind, typically leaning toward selling option spreads following the guidelines described in later chapters. You set risk limits and capital allocations as a part of this process. Next, you manage the book of trades. This process is also described in coming chapters. Then you are able to evaluate the process for following your own trading guidelines (when to enter and exit and how much to place at risk) while constantly looking to improve the process. This requires developing a method for closing trades and taking profits (or accepting losses) systematically to keep dollars in hand. There are other pieces to the TOMIC philosophy that you will need to master. For example, you will need to manage many forms of risk, such as the risk that an outlier event that can occur. Even this risk can be managed if your trading book of policies is put together with risks in mind. In the remainder of this chapter we will discuss the important steps that are necessary to build a successful trading program:
–Build an infrastructure
–Build a trading plan
–Select trades based on articulated criteria
–Manage risks
–Learn all the essential elements of trading
Build an Infrastructure
Every trader, like every organization, has to develop or have access to key infrastructure capabilities that enable the trader to do due diligence. Those capabilities can be costly in both time invested and expense and therefore do not get proper credit. For example, some cost centers on the surface may appear to slow down or interfere with daily work, but upon further study, they are actually centers of efficiency and cost savings. This is the infrastructure of the TOMIC. They are important pieces of every trader’s infrastructure. The following infrastructure capabilities should be in place and in use continuously:
–The right clearing firm
–Proper margining
–The right execution platform and executing broker
–The proper analytic tools for volatility analysis
–Risk management tools
–News and information services
–The right hardware
–Proper reporting tools
–A sounding board/risk manager
–A good accountant
–Redundancy of all of the above
–The manager ‘got hit’ by a bus plan
Only once you have these capabilities in place are you are ready to set up a trading program (your trading business) and begin planning to trade options for edge. Infrastructure will save you thousands of dollars over the years. In addition, a risk manager—a necessary “luxury” many traders forgo, who has little to do with day to day operations, but is there to make sure you take on the correct risks— will most definitely make traders more money.
Build a Trading Plan
Trading options for a career, in the TOMIC approach, requires a trading plan. The first key to a TOMIC trading plan is to take the emotion out of trading. Every trading approach should have a written plan of action. Standard Operational Procedure (SOP) is important when you want to trade like a professional. The process helps manage things when the plan goes as expected, but it is equally important that processes are applied when things go wrong—or even slightly off the plan yet within the realm of possibility. A well-constructed plan prepares for the unexpected. Just as the Navy Seals know what to do when something occurs completely by surprise, a TOMIC trader might not know what to do at the onset of a crisis, but will know how to determine the proper course of action as the situation evolves. In all cases, when you deviate from a plan, things go wrong. Improvisation is wonderful . . . in comedy; but in trading and putting money at risk, what might seem like improvisation is actually derived from a plan. When a basketball team ‘plays on the fly’ against a talented, well-coached team, that team loses. When the team sticks to a plan and a process for evaluating the next play, assuming the team has sufficient talent, that team will win. Even in cases where a dynamic play happens that seems to come out of nowhere, like a fast break, it is likely the result of good planning on defense or offense. Many of the best traders know that improvisation is derived from processes and contingencies. Even improv actors that seem to be moving ‘on the fly’ have an SOP for evaluating what to do next in a scene, whether they know it or not. This is why the best comedians study comedy. An effective trading plan doesn’t have deviations; it has plans on how to develop deviations when needed.
A TOMIC plan answers the following:
–What is the normal approach to trading the TOMIC if all goes according to plan?
–What is the approach to trading the TOMIC when expected issues happen?
–What is the approach to trading the TOMIC when the unexpected happens?
–How do you analyze conditions when the unexpected happens? How do you improvise?
In checking off these questions with a basic approach to trading, you will be able to stick to a process. When you stick to a process and take emotion out of your trading, you improve your odds of success. Speaking of emotion, I have seen traders who believe they could do no wrong get burned badly. I have also seen traders who constantly ignore their process because something ‘feels’ right or wrong. Both typically end up costing the trader money. If you believe that a trade is a good or bad idea, that is one thing, but if you are trading on fear or hubris, the TOMIC approach will fail.
Select Trades Based on Articulated Criteria
Once you build a framework for trading options, you will begin the selection process. This can be tedious and taxing but is worth the investment of time. If you build the appropriate screening process, much like an insurance company screens applicants to fit them to the right risk profile, you can build a screening process for selecting trades. Your screening process of the overall market needs to include:
–Product awareness
–Conditional awareness
–Volatility analysis
–Term structure analysis
–Skew analysis
Once you have analyzed the markets, you next embark on a screening process to select options trades. This involves several steps:
- Evaluate the product to trade
- Evaluate other products
- Determine the viability of a trade
- Pick the trade to execute
- Execute the trade
- Enter the feedback loop
- Look for offsetting or complimentary trades
In combining these steps, you develop a pattern of finding trades that have ‘edge’ in them, executing them, and then taking profits. In addition, you will be able to build the trading plan using your SOPs.
Manage Risks
Risk management is nothing new. I had a risk manager in my fraternity in college. His job was to make sure our parties didn’t turn into unmitigated disasters. He usually failed, but did ensure that we never got into any real trouble. But that’s another story. My college itself had a multitude of risk managers. Most corporations have designated risk managers or risk departments. You cannot run a company without an eye on risk. I stress the importance of risk and the need for risk management.
Risk management, in fact, is the most important attribute of trading. It is derived in two ways:
- Executing good trades: If you do not execute profitable trades—those with edge—risk management is a waste of time. One school of options trading states that you can just go out and sell options and you will make money. In theory, over millions of trades, this might be true. However, in the real world, where capital is not limitless, nothing could be further from the truth. The first key to managing risk is to get into trades that have edge. Trades that are executed for edge require less risk management effort. There are typically more dollars per trade, less adjusting, and fewer catastrophic losses.
- Managing trades and dollars: While you can trade options for edge all day, much like an insurance company, some trades will go bad. How you deal with these trades is key. The first key is to have SOPs in place. Proper planning leads to good risk management. However, beyond a trading plan, there are some important considerations to also keep in mind. These include:
–Asset management
–Money management
–Trade allocation management
–Trade management
–Outlier risk protection and management
–Additional addressable risk management
A plan that addresses these considerations ensures your ability to ‘trade the next day.’ The ‘trade the next day’ rule means that no matter how bad things get, you will not run out of money to continue trading. Every trader will tell you that the key to longevity is the ability to trade the next day . . . no matter how crazy the market might be. This approach ensures that your trades are properly allocated across a larger portfolio.
Finally, you need to work with a risk manager or, at minimum, a sounding board. At Karman Line Capital, we rely on a risk manager to make sure that the fund stays within in its standard operation plan. In addition, when I choose to improvise it is the risk manager that I use as my sounding board. Giving someone veto power, even over your own money, potentially lowers your net return but dramatically increases your risk-adjusted net profit.
Learn All the Essential Elements of Trading
Every professional needs to undergo a learning process. When I was a floor trader I switched trading pits four times; once when I moved from the AMEX to the CBOE (Chicago Board Options Exchange) and then three different times in six years on the CBOE. In each case, I had to learn a new set of products and rules. When I first left the floor, there weren’t even weekly options to trade. Now the range includes weekly options, options on VIX (the CBOE volatility index), weekly options on VIX, you name it. In addition, multiple opportunities to trade in other markets have expanded to include much more, including commodities options on soybeans, even hog options. All of these take time to learn.
When I was hired out of college by Group One Trading, I spent a year learning to trade. Before I traded any products, I spend months observing. In the case of Karman Line, this took years. If you are unfamiliar with a product, consider hiring someone to coach you. At a minimum, find someone you trust to show you the ropes.
Be willing to accept that sometimes conditions change, and the things that made a trade successful can also change. In the late 90’s, you could sell any straddle to a customer and win just based on changes in implied volatility (IV) that options traders believed would occur going forward. This aspect of option pricing at times was so high that stocks could make wild moves and the options would still be overpriced. Then, in the following decade, this strategy was a net wash at best or a large loser at worst. In 2008, the best trade was the short time spread as volatility fell. Over the next 6 years, the opposite was almost always true; calendars (buying an option expiring in one month against selling another option in a different month) had a high success rate. Conditions change and you need to be aware of what is happening around you. At some point a trade might stop working for a time, or permanently. You will develop a sense of when a trade doesn’t work and when it might never work again. This can happen.
By constantly educating yourself on what is going on in the market, what other pros are trading, and new products coming on the market, you will be more likely to find yourself on the cutting edge of new trades and products that can make you a lot of money in short periods of time. This points out flaws and potential improvements to an existing strategy. The best traders are constantly learning and improving. Professionals need to have a feedback loop, either through their environment or via one they have created themselves. The purpose of this book is to address and re-address risk management for successful trading and the development of a professional approach to managing your book of options trades.