Pros Versus Regular Joes
You are a self proclaimed professional directional trader, using leverage in the form of derivatives in attempt to capture positive alpha. Stock picking, as difficult as it is to the average money manager, is no longer a challenge for you. It’s too easy and you have grown tired of winning all of the time. Always seeking the next challenge you set out to master the equity option markets. In doing so you have complicated matters tenfold for yourself, but let’s not worry about that now. This is the sure fire way to put yourself in position to double your account on a good year, and on a slower year maybe “only” grow your capital by 25%.
Now that we have our “trade plan” in place let’s take a look at a couple of examples of recent processes I have seen used by two different traders, both with the same goal: Use directional leveraged bets using equity options / ETFs.
Starts with a bird’s eye view of the market environment in which he finds himself. Understands the macro perspective at a high level, and uses relative strength analysis in the form of ratio charts and Relative Rotation Graphs to spot sectors which are primed to outperform overall. Once relative strength is found, he drills down into the appropriate sector or industry group and builds a scan to sort these stocks according to the following:
Average of 500k shares per day traded to help ensure liquidity and tight spreads
Beta over 1.5 to ensure it’s an underlying that will move more than the overall market
Price over $10 per share
Short as a percent of float over 15% so a short squeeze is possible
Now that the scan is complete Trader #1 has a list of 30 stocks from which he scans through, looking for very specific criterion which must be met in order to put on the trade:
Stock adheres to a price pattern known to exhibit a strong breakout
Stock is supported by underlying high volume nodes, a defined trendline, channel boundary, or moving average which has shown to be an area where price bounces.
There is no sign of overhead supply immediately above giving his trade room to work higher.
Trader #1 has located a stock that meets or exceeds all criterion above and begins to plan the trade itself. Because with options getting the timing right is as important as direction, he uses the most recent several swings highs to swing lows to estimate an average of how far and how fast the underlying can move over a specific time period. With an understanding of timing he now can look for an appropriate expiry for his option position. Next, the trader analyzes the risk/reward ratio using a Black Scholes calculator. He knows first what he is willing to lose on the trade and what he stands to gain in the event that the trade works out in his favor. Before even thinking about putting the trade on he decides what percentage of his total account he is willing to risk on this one trade, and understands how this specific trade impacts his overall account. He knows that he allows himself a maximum of 5 option positions at one time and this is number 5. He won’t add anything else until one position expires or is exited so he can manage each trade properly. He enters the order paying attention that he isn’t paying too much in premium and tries several times to get in as close to the bid as possible.
Now that the trade is working, he enters the position in a journal. Notes such as why he took the trade, risk capital, and where he will exit should the trade go against him are of paramount importance. He looks back at his journal often to see where he can improve, what he did right and what had gone wrong. At the end of each month or other specified time criterion, he has stats calculated such as Sharpe, Treynor and Calmar ratios for his account.
Scrolls through Twitter, Stocktwits, and other paid sites to find what the stock of the day is. Often follows other traders into positions without knowing why the trade was taken and has no exit plan. When the position goes against him, adds to it to double down on his already underwater position. Has no real rules as to how many positions to have on at any one time and neglects to check Black Scholes for anything. He sees blocks of option trades going off and chases those because “someone must have known something” if they bet that big. Holds all losers to expiry, never recouping any lost premium. Doesn’t own a trade journal and doesn’t understand spreadsheets well enough to calculate any financial ratios. Looks at account balances at the end of each month and assumes he “had a great month” if he had a big profit, never minding the big profit came from a trade which was pure luck due to a news event. Doesn’t understand the concepts of risk adjusted return and is oblivious to changing market environments and mechanics because his “system used to work so well.”
If you find yourself to have any of the traits of Trader #2, this is going to be a tough road for you in the long run. Sure you will go on streaks and have some success, but I can almost guarantee that in the long run you will under perform on a risk adjusted basis. Believe it or not, almost all traders start out much more like Trader #2. In time some find their way but most don’t. It’s a hell of a lot of work and most don’t have the attention or grit to run it like a business. If you are serious about this and I know many of my readers are, be as much like Trader #1 as possible and rid yourselves of any of the bad habits you see plaguing Trader #2. Your P&L will thank you for it.
Trent J. Smalley, CMT