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The Option Pit Method

The Option Pit Method. Option Pit Boot Camp The Option Pit Method For trading options. Option Pit. Option Boot Camp- The Option Pit Method. The Option Pit method uses Position Structure Efficient use of Capital Risk Management

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The Option Pit Method

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  1. The Option Pit Method Option Pit Boot Camp The Option Pit Method For trading options Option Pit

  2. Option Boot Camp- The Option Pit Method • The Option Pit method uses • Position Structure • Efficient use of Capital • Risk Management • Structure position that have “edge” but keep the risk relatively low. • To do that traders need to know the fundamentals to identify market conditions

  3. Boot Camp Quiz 2 • Explain what realized volatility is? • Backward looking volatility for the underlying over a set period of time • What does low IV mean? • Market thinks stock are flat, option are cheap • What is the chief advantage of a spread? • Takes IV out of the equation to large degree (delta) • Is there a low IV type of trade? • Buyer of option or don’t sell too many

  4. Boot Camp IV-What You Will Learn • A reminder on realized volatility • Thinking about positions in terms of Greeks • Planning for a change in Greeks using position • Modified Butterflies • Non-Directional trading • Portfolio Risk Management

  5. Think of realized volatility as potential energy Holding Back? Overflowing?

  6. Realized Volatility

  7. What is Edge? • Buying one volatility and selling another for a positive number. • This could be realized versus implied (delta neutral) • This could be in the skew (vertical spreads and flies) • This could be in the term structure (calendar)

  8. Option Pit’s Rule of Realized Volatility • Paraphrased from the great Sir Isaac Newton • A stock in motion tends to stay in motion • A stock at rest tends to stay at rest Corollary- “Unless there is a reason to change the motion”

  9. From our SL Aug 14th • Market Conditions: • Higher realized volatility • Very fast decline in implied volatility • A long straddle (a directionless position) requires 1 of too things: • A jump in implied volatility (Vega) • A jump in the price of the underlying (Gamma)

  10. Buying non-Directional trades

  11. SPY Aug 15th , 2014

  12. What is non-Directional Trading? • Non –Directional trading is a reliance on the other Greeks to generate P/L • Mostly Gamma, Theta and Vega • Our example used Vega as the P/L generator from the long side • Most retail trader hate the long option side but -at minimum a good long gamma trade makes a poor short gamma trade

  13. Non-directional trading Realized Volatility that is too High will leave traders burned If they sell options too early Just because IV is high does not Mean that it should not be sold Realized volatility matters

  14. Non-directional Time Spreads • The long time spreads are short gamma • Short realized vol • Long implied vol • On a properly produced calendar Theta will take care of itself • A good long time spread should have too much theta relative to gamma

  15. Non-Directional Time Spread • The long time spread is a classic short RV trade

  16. Non-Directional Time Spreads • Think about what has to work: • Vega has to remain firm • Underlying cannot move too much • But it is adjustable!

  17. The Iron Condor as a non-directional trade • Some Non-directional rules: • Has the IV run and started to move lower? • Is the realized volatility moving lower? • Is the trade manageable/adjustable? Remember Delta is not your friend here!

  18. Characteristics • A short iron condor is generally going to have the short calls closer to ATM than the puts • This is caused by SKEW • Will be short delta • Because the shorts are closer to the money than the longs it is • Long Theta

  19. Characteristics • The spread wants the underlying to stay in a tight range and not to move • Thus the spread is SHORT gamma • The spread is selling premium, • Thus the spread is SHORT VEGA

  20. Keys to Success • An iron condor will perform well when IV is elevated and falling • Do not try to catch a falling knife • Be fine with selling into falling IV • Try to catch the VIX falling from 20 to 15, do not try to sell this spread when the VIX is at 30 • Can perform great in a stable IV environment as well

  21. What Greeks Affect an IC • An Iron condor is • Flat delta, short gamma, long theta, short vega • However, the trade is meant to be a ‘vega’ trade • The trader should be looking at IV and time when trading • A successful IC will be most affected by Vega movement

  22. What Greeks Affect an IC • It is VERY bad for delta and gamma to become risk factors in an IC • As gamma increases, likelihood of success falls off considerably • It is important to manage delta and gamma to keep VEGA as the key greek • When gamma explodes traders must adjust or exit a trade

  23. Keys to Success • Generally speaking, a flat skew will help the odds of this spreads success, but it is not imperative • Trader wants HV to be falling as well as IV • One result of high IV is really high HV • Part of the reason that we don’t sell super high IV is because HV is so high

  24. The Iron Condor as a non-directional trade

  25. The Iron Condor as a non-directional trade

  26. Protected Fly • The trader wants Delta • Does not want to own the Vega on a rally • Wants protection in a meltdown • What does the trader do? • Buys Protection

  27. TSLA Protected Fly

  28. TSLA Protected Fly IV up 15%

  29. Understanding Risk • Before flying a plane, pilots must go through extensive training as to how the plane actually works • Then pilots must do extensive time in a simulator • Why? • So when they are flying they are prepared for what could happen and why it is happening

  30. Understanding Risk • What have we learned? • Managing is risk is about understanding the Greeks • Efficient Use of Capital- What is at risk? • Being short term wrong and long term right • Starting to identify trades with market “edge” • There is lots more to this in our Gold Class and Platinum Class

  31. Risk Control • What factors does the spread mitigate? • Name some other similar type of delta trades • Name some other similar type of vega trades • The type of position chosen matters even if the Greeks are the same

  32. Example 2 This is a bullish GLD Iron Butterfly • If IV falls, how will it affect the greeks of this trade?

  33. Results Before After (IV-2)

  34. Why Does this Matter? • Charts are nice, but they are built on models • If one doesn’t understand how the model works, one cannot accurately manage risk • This allows a trade to “respond” instead of “react”. • Understanding the cause of risk is key to managing risk

  35. The Greeks add up!

  36. Making Plan • Make a plan for how you want to build your trading business • The TOMIC (http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403) • We will briefly walk through our approach now

  37. Building a Plan • Learn the Product • Build a Money Management Plan • Money allocation • Build a Portfolio Trading Plan • Risk allocation • Build a Trade Plan for an approach • Managing individual trade • Test for Scalability

  38. The Option Pit Method • As a trader becomes more or less short premium the trader is willing to accept less edge to take the opposite trade • I am long a lot of premium I will sell premium at a discount • I am short a lot of premium, I will pay up a little for premium • Greeks are traded to offset each other

  39. The Retail Trader • The retail trader does not have trades coming at him or her. • But the retail trader does have an edge • The ability to initiate • EVERY trade should have perceived edge in it • These options are too cheap • These options are too expensive • Relative to the other!

  40. The Retail Trader • Each successive trade should be better than the last when it is adding to Greek risk • The problem with this approach is finite capital • Are there any counter trades before adding to short volatility/short gamma? • Take the case of IBB recently as to why

  41. Short Volatility in IBB (09/28/2015) Note some things about Risk Control here – 30 day IV at 51% is about 4% movement Day- the daily move on the 28th was closer to 6%. Short term IV is showing closer to the real risk of short gamma- around 73%

  42. IBB Sep 28, 2015

  43. Retail Trader • As a trader builds greeks, he or she is actively looking for trades that take the other side • I am long a lot of delta, I am going to look for trades that have edge that get me short delta • I am short a lot of vega, I am going to look for trades that have edge that will get me long vega • Or pre load the short side of risk by owning some protection

  44. The Method • If executed properly, the trader should be able to carry a NET portfolio that has little systemic risk • The portfolio will have low NET greeks • Each position will have greeks though • If we can limit risk to company risk and away from systemic risk, trading for edge will be profitable • Assuming you know how to find edge

  45. Using SPY put butterflies for insurance

  46. Things to Remember • You need to learn how to capture edge • You need to learn how to weight greeks • Use capital weighted • Use beta weighted as well • This can be commission intensive • Require slightly more active management • To be a ‘job’ requires several hours a day • Requires STRONG understanding of Option Fundamentals

  47. Most Important Thing • Gamma and Vega are the most important greeks to monitor in any approach • Theta and delta will handle themselves • Be aware of how the greeks change with underlying prices • A balanced portfolio can change on you • Learn to Trade VIX derivatives • They have the most edge • Vega without Gamma

  48. Managing the Book • How to manage a short side trade and a long side trade if both have some edge in them. • SPY IC longer term with SPY put butterflies shorter term • Let’s walk through this!

  49. In the End • The Option Pit Method is a trading plan, that isn't a trading plan. It states • Put on good trades for edge • As a portfolio takes on risk look for trades that take the other side • Manage each trade on its own • Practice EXTREMELY tight risk control • Manage the portfolio greeks • ABC: Always Be Closing

  50. Summary • Start to think about fitting positions to conditions • What is the realized volatility? • Is there a spread that fits what you think will happen? • Structure the position and the exit

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