The Reward of Profit and the Risk of Losses needs to be managed at 2
related levels of performance: Portfolio and Trade Specific.
Protecting Your Portfolio to Stay in Business
Your portfolio contains the entire available capital to risk for returns, as a home business. Any business – regardless of scale – runs the risk of ruin the moment it becomes undercapitalized.
Guarding against not being able to start up again becomes more critical,
the lower the amount of capital you have to risk. Unlike institutional
trading firms, retail traders are likely to face more difficulties in
securing bank loans to fund the home trading business. There is no alternative source of
funds, other than cash balance in the trading account.
Especially for a home business, there is a clear responsibility to optimize the capital entrusted to you. Let's say your immediate family/relatives helped fund part of the start up capital of your home trading business. Why would family members give you more of their hard earned money, if you continue losing? You should be increasingly protective of the assets under your charge, be it your own money or funds from family or relatives.
Treat the capital of your home business with strict discipline from the onset. Target the expected outcomes for the portfolio.
Maximum Return Target: complete achievement of the “ideal” measure. Dream of the “ideal” that stretches you beyond what is practical. For example, earn 2-3 times your monthly living expenses with the monthly trading profit. This is to stretch your imagination well beyond mediocrity. Even if you fail, you just might end up with more than your original target.
❑ In absence of shareholders demanding accountability for the
treatment of their capital, being the sole owner-operator of a business, you
must stretch beyond the goal of making enough to pay for a one-off yearly event
(e.g. family holiday). Otherwise, your learning stagnates and
the search for insights stalls – there is no edge in being dulled into
complacency. Inspire yourself with a harder Maximum Return goal.
For e.g. education fees the kids will need for 3-4 years of university;
or, sufficient financial support for your spouse to be independent, in the
event something unfortunate should happen to you.
❑ Or your "ideal" goal is to replace a salaried job with trading from home. Considerations to think through when linking the home budget with Portfolio Metrics, see "Budget for Home Trading".
Minimum Return Target: the lowest acceptable measure, achievable under most conditions, excluding a catastrophic market event. Use the historical annualized return of the S&P 500 between 10%-12% (prior to the financial pandemic), as the lowest acceptable boundary. The S&P 500 being a widely accepted benchmark for trading equities is adequate to base the minimum target off, though your portfolio needs to be profitable – being ahead of the $SPX in negative territory does not count. Below the historical annualized return range of 10%–12%, is the 3 Month T-Bill, presently near zero. While the T-bill theoretically represents an “absolutely” zero risk investment, even the safest investments will still carry a residual amount of risk no matter how small that risk is. The point is this. You got into options and all that Greek terminology, not to make salads; but to beat the performance of equities as an asset class. If your portfolio's return is between what is near zero-risk and 10%–12% per annum, you are just delaying reaching a point of pain that marks failure in grasping the base-line ability, to control risks. If the returns of your portfolio are between 0%–12% and you plan to continue trading options, processes within your trading process will need to be re–engineered. Want more on how to start the diagnosis?
❑ Few achieve their ideals. Still, as you learn to earn, you should
progressively achieve a level of return near the Minimum, then move past the Minimum towards the Maximum Return. It’s rare to exceed the Maximum, unless you
set it very low to start with.
There needs to be a discernable difference between Maximum and Minimum
Return targets. Otherwise, there is no point in setting a Maximum to stretch
your performance.
"Halt Trade" Target: cumulative losses reach an absolute amount below the Minimum Return, making it necessary to stop trading altogether for a stated period. 10% of [(60% x Cash Balance at the start of the year); or Net Liquidating Value]. For eg. for a $50,000 trading account, 10% x (60% x $50,000) = $3,000 of losses in total, is the absolute amount to halt trading. Why 10%? Blowing up your account is final. There is no bail out package.
❑ “Halt Trade” means a conscious break away from the markets, for eg. 3–4 months (not too long that you lose the rhythm), focused on activities totally unrelated to the markets. Reignite your start–up business with the remaining capital of $40+K with fresh insights, once you’ve recomposed yourself.
Before the Time Out Target is reached, there is likely to be a period of Drawdown which requires you to work out your time to recovery.
Drawdown: is any loss that lowers the account’s P/L from its most recent highest profit number. Reality is trading accounts spend more time in a nominal drawdown mode, because you cannot keep making a higher profit number every single day. Though, it’s not a realized P/L until you unwind the positions but your account spends much time in drawdown mode. An account remains in drawdown as long as a new profit high is not made.
Average Holding Period
To trade through a period of drawdown requires much patience and persistence. Do not stop simply when the account goes into drawdown mode. Trade less and trade in smaller sizes.
Other than setting tighter alerts on the value of your live trades,
analyze the dates of historical Winners separate of Losers
❑ What is the Average number of days a Winner takes to make profit? Give yourself twice the length of the average holding period a historical winner takes to make profit; and, during a drawdown period, trade 1/2 to 1/3rd the normal contract size [normal = 2%–5% per trade, that's 2%–5% x 60% of the Cash Balance at the start of the year); or Net Liquidating Value].
❑ What is the Average number of days a Loser reaches 50% of its Maximum Loss? Halve the length of time (days) of a historical loser to cut losses; and, during a drawdown period and trade 1/2 to 1/3rd the normal contract size [2%–5% per trade, 2%–5% x 60% of the Cash Balance at the start of the year); or Net Liquidating Value].
The analysis helps you work out your Trade Turnover which answers 2 questions: do you do more/less trades given the Average Holding Period of Profit versus the Average Holding Period of Losses; or, do you stay in the Winner longer with more days to ride the Winner Higher and exit the Loser in fewer days to reduce the losses quicker?
Portfolio measures enforce the top-down discipline of performance. Now, to build the blocks of performance bottom–up needs Trade Specific management.
Consistent Logic for Repeatable Performance at the Trade
Specific Level
Recognizing Profit/Loss (P/L)
Behaviour – Measuring the Risks of Your Trading Habits
We all have our natural
tendencies which will translate into our trading habits. Few reach an emotionless state to be
completely mechanical in their trading.
Still, before breaking a habit, force yourself to isolate that specific
tendency as a strength to fortify; or, a weakness to substitute with a newly
learnt skill to overcome the undesirable habitual pattern. Regardless of the size of one’s
business, you cannot grow it counter–intuitively. Trading is no different – build the performance recognizing
what you are already naturally strong at.
At the trade specific level, this requires understanding a single position that can be established and liquidated without impacting other remaining positions in the portfolio.
❑ It is estimating the independent effect of a single spread (e.g. a vertical or calendar, etc.) constructed on a single underlying product. Be clear in the logic used for independent measures (mutually exclusive), before combining measures to analyze more complex dependant (correlated) positions.
Directional bias in market orientation
❑ Calculate the Average P/L
value of Short versus Long positions specific to the Upside/Downside and
Neutral spreads you have traded. Also, record the Total dollars spent on buying Debit Spreads
versus Total dollars collected from selling Credit Spreads and the respective
ROI percentages of spread types traded. The P/L trends of these sets of data
will identify your strength and relative weakness.
❑ For e.g. recognizing that
you trade Short Upside Verticals more profitably than Long Neutral Calendars isolates this as the core competency to generate income. While losses in another type of trade suggests
limiting or abstaining from that trading style, until you are able to replace
losses with profits from the trade style you are most capable of. There is no point forcing yourself into
a trade style for the sake of diversifying the use of strategies. Especially,
if it is counter intuitive for you.
❑ Retain your strength in
the type of spread you trade profitably; but, diversify the risks of that spread type across Asset Classes. Do not exchange your
strength for something “new” that your trading buddies “discovered”. There is nothing “new” in the trading
business, other than the technology that continues to bridge the functional gap
of trading platforms between retailers and institutions. Stay true to your
orientation based on your core competency and add to your strength – do not
displace it. Like any other firm, build your home business on clearly
identified competencies. With limited capital, avoid experimentation.
Individual Position Sizing: position size and portfolio exposure is linear.
Volatility within retail
portfolios has a 1:1 direct relationship with the size of individual positions.
For retail traders with account sizes below USD 0.5 Million, the typical amount
of money to allocate per trade is between 2%–5% out of the Cash Balance at the start of the year; or, Net Liquidating Value
in the trading account.
❑ For any given position in your portfolio, an amount twice the size is double the risk, whereas a position half the size produces half the exposure. Want more about the Linearity of the Greeks and positing sizing?
❑ Products like the series of
UltraShort ProShares enables retailers to double the risk or halve their
contract sizes with the same amount of exposure to price action (though, on an
inverse basis), compared to trading conventional Index products.
ROI Testing of an Individual Position’s IV sensitivity. While it is a complex relationship, it is imperative to address the total portfolio’s correlation with an individual position’s IV within a portfolio. The most practical way to adjust the entire portfolio’s volatility without damaging the combined favourable probabilities of all positions, is to add individual positions with increasingly higher incremental returns for the same amount of incremental IV risk of all other positions in the portfolio.
❑ How do you test if an identified
opportunity can add ROI value without increasing overall portfolio Risk?
Use a +/– 10% IV change (depending if the position is be long/short) in the individual product but keep the Theoretical Price of the option/spread at zero – do not change price, to analyze if its ROI and Maximum Profit
potential are both higher than the Average ROI and Average Value of Winners in
the portfolio to date. Obviously,
construct the position’s probability of this candidate to be within the same
probability range chosen for prior winning trades. Only if the individual position’s ROI and Maximum Profit
potential passes this test, the identified opportunity is likely to be a viable
candidate to trade. Failure means testing another opportunity.
This test includes so called “adjustments” to existing trades. Some option training firms teach adjustments to salvage the scrap value of a trade, more often than not to hook you into another module of their proprietary software; or, upgrade to yet another seminar. Treat “adjustments” as a new individual trade with the same stringent ROI Testing, as Skew and IV levels in the same underlying you are trying to “adjust” can change materially, especially from week to week. Especially after 5 trading days (1 week), you are effectively dealing with a different risk profile, in looking for an “adjustment” in the same underlying. The Home Options Trading techniques emphasize robust pre–selection of opportunities and stringent risk management while the trade is in In–play to avoid fiddling with the trade after it is filled.
Duality
of Diversification. The more diverse the products are in the portfolio, the
lower the portfolio’s risk. Diversification is made up of 2 separate parts:
(1) Number of underlying
products included in the portfolio and (2) Commonality of pricing
characteristics of these products.
❑ To increase risk of asset
concentration in the portfolio, have fewer products in it; or, for a given
number of products, select products with more common price characteristics
(higher correlation amongst products); or, a combination of the two.
❑ To reduce risk of asset
concentration in the portfolio, add more products in it; or, for a given number
of products, select products with less common price characteristics (lower
correlation amongst products); or, a combination of the two.
For retail portfolios, it is
more prudent to choose products with less common price characteristics – i.e.
diversify across asset classes, than use multiple strategies in more products
within the same asset class.
❑ Case in point, the China sell–off and sub–prime woes in 2007, caused the equities as an entire asset class to take a dive. Regardless, if you were trading multiple broad–based Indexes across multiple sectors and you were doing a mix of Verticals/Calendars/Iron Condors across these Indexes, a portfolio concentrated in equities was impacted hard. You cannot afford to have a home business absorb shocks to a limited capital base that will not be refinanced, unlike an institution that can access commercial loans to recover losses.
The higher the correlation of
individual products in the portfolio, the lower the benefits of
diversification. For e.g. in terms of price traits, wheat is a substitute of
corn –
both are commodities. Choose one to trade not both in the
same expiration cycle. For
Indexes, the highest correlation is between the Dow Jones and S&P 500,
which also means the DIA (or DJX) is highly correlated with the SPY (or XSP). Choose one
to trade, not both at the same time. For currencies, the tightest correlations
with Commodities are the Australian Dollar, the Canadian Dollar and the New
Zealand Dollar. Choose one currency ETF to trade, not all 3 at the same
time. The risk to avoid is the
economic overlap of substitutable products.
While diversification in
itself has an intuitive merit, it also carries the risk of diminishing benefits
with over-diversification. Adding more products within an asset class; or,
choosing one product but adding more asset classes; or, a combination of the
two entails increasing effort in risk analysis and position management.
❑ From a retail viewpoint, as a guide for each trading month, allocate 2%–5% per trade for 10–15 trades at maximum per expiration cycle, across a minimum of 3 Asset Classes. That translates into 3–5 trades per asset class and within these 3–5 trades, further diversify the directional/non-directional bias of the trades. That is the base guideline for adequate diversification.
Key Portfolio Metrics: Accuracy, Responsiveness and Performance Ratio
Win / Loss Probability: Measures Accuracy.
This measures your portfolio's % of profitable trades against the total number of trades for a given period. There are several ways to calculate this %, it can be measured using the:
❑ Number of trades weighted or not
weighted by the amount of dollars invested per trade.
❑ Number of products in your
portfolio with further sub-categorization of trades by Sector and Asset
Class.
In any case, the Win/Loss Probability = Winners / Total Trades per
given period.
The higher the Win/Loss Probability (between 70%–90%), indicates your successful edge in accurately identifying opportunities prior to trading – a strength to nurture to your advantage.
A lower Win/Loss Probability (below
50%) suggests the need to deconstruct the portfolio to evaluate the risk
characteristics of products traded and re-examine if ROI testing of IV
for each individual trade was done consistently with judicious discipline.
Average Value of Winners / Average Value of Losers: Measures Responsiveness.
This measures how efficient you are at risk management – judgement around timing (impatient/too fast or slow) in taking profits and propensity to cut losses at levels below which material damage hurts overall returns.
Here's how to calculate it:
1. Categorize trades into a group of winners separate from a
group of losers.
2. Count the number of individual trades and aggregate the
total dollar value of the group of winners. Separately, do the same for the
group of losers.
3. Specific to each group:
Divide the Total Value of
Wins by the Number of Winners = Average Value of Winners.
Divide the Total Value of
Losers by the Number of Losers = Average Value of Losers.
4. Average Value of Winners / Average Value of Losers = How much profit is won per $1 dollar lost.
Take note that the Numerator
is the Average Value of Winners, while the Denominator is the Average Value of Losers.
The goal is to have the Average Value of Winners exceed the Average Value of Losers, i.e. the Numerator is greater than the Loser. It reasonable to aim for a ratio of $2 Average Value of Winners : $1 Average Value of Losers.
When the Average Value of Losers (Denominator) is larger than the Average Value of Winners (Numerator), this signals holding on to losers longer than necessary. This problem typically arises from misreading the volatility levels of asset classes, trading in illiquid products impeding profitable exits; or, often, it is related to one’s personality (being headstrong, etc.). Problems in the denominator point towards the combined issues of unsystematic product selection in the associated asset classes and lax risk controls.
The Average Value of Winners and Losers is effectively determined by the Theoretical Price you entered and exited the option/spread.
Theoretical Price Entry & Exit. The Theoretical Price of an option becomes equal to its market value, as IV is entered into the equation of an options pricing model. Do remember IV converges to zero at expiration.
❑ When you trade Implied Volatility, especially at ATM/OTM strikes where Extrinsic value dominates the pricing of these options, you are buying Theta as decay (for IV to rise) at a % point below; or, selling Theta as premium (for IV to fall) at a % point above the theoretical price of market value that participants are willing to pay/sell for. A difference of getting filled – / + 0.10 to that of the Theoretical Price of an option/spread translates into a much larger percentage than the absolute for the Average Win or Average Loss.
Combining Accuracy with Responsiveness for Sustainable Performance.
The Performance Ratio
combines all the required reward and risk elements of managing a portfolio, bringing together 2 finite but related objectives:
1. To be correct on more trades than you are wrong AND
2. To make a higher value on
winners than you give back to the market on the losers.
Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss).
E.g. 0.70 x 1.5 = 1.05
❑ Where 0.70 means you win 7 out of
10 trades, losing only 3.
❑ And 1.5 means the Average Win is 1.5 times higher than the Average Loss.
The lowest measure of
successful performance is 0.5. Meaning your judgement on market direction (be
it Up/Down/Sideways) and IV is working for half your trades, while you are
making as much on winners as you are giving away on losers.
If your portfolio’s performance is above 1.00, your judgement on market direction (be it Up/Down/Sideways) and IV is working for more than 50% of your trades, while you are making measurably more on winners as you are giving away on losers. Sustaining the ratio above 1.00; or, failing to sustain the ratio above 1.00 is used as the metric to adjust the allocation of capital within the money management rule of 2%–5%. That's how you get the step–function progression in the profits, as seen in the 2009 Model Portfolio's Performance. Want more details on the techniques used?
In essence, every trading activity you do MUST contribute to both the measure of Accuracy and Responsiveness. A home business has no chance of becoming successful, if you do not set it up to consistently support your living expenses month– after–month and sustain in for year–after–year.
Profitability
Concentration Ratio: Can you stomach a high % of Losers to get
to a small % of Winners?
In breaking down your portfolio’s P/L, you may notice that profits are being generated from 10%–20% of large winners, while 70%-80% are break-even trades (not losers); or, near break–even trades (between +$1–$10 of insignificant profit), while the remaining ~10% in the portfolio are real losers (negative dollar values).
The Expectancy Measure = (Probability x Average Win) – (Probability x Average Loss), suffers considerably. You may end up with a Negative Expectancy, i.e. your trading system in loss–making the more trades you do. In engineering the mechanics of your trading system, it is Positive Expectancy that is and must be the sustainable outcome.
In practical terms, do you have the emotional fortitude to go through 6–8 trades with no material profit, to get to the 1–3 trades which will generate the entire income needed to meet the return target set for that trading cycle?
If the answer is “Yes”, you
are deliberately planning to have your Accuracy measure suffer, for a huge score
on your Responsiveness measure, in order to create a profitable portfolio.
❑ In planning to trade this way,
it also means you are likely to trade frequently. As you need to get through a
set number of break–even trades to get to the winners. Trading this way is psychologically
much more demanding versus improving your Accuracy first.
Bear in mind, if it is profitability
concentration that you seek, you will habitually construct positions with large skews in your chosen products. And you will look for “home run
hitting” subscriptions/services to feed this trading habit.
❑ The Home Trading Process does not
promote profitability concentration methods. This site will not help you with a
trading style centred on hitting home runs.
Retail traders who insist on making home runs their core trades in the first 1–2 years of their trading careers are accelerating the odds of blowing up their accounts. It’s more sensible after your second year with reasonable profits from consistent winners, to set aside a small amount to look for the infrequent “big” hit. Your capital and business = your decision, ultimately.
RE–Balancing Cash Flow Cycles in Alignment with IV Ranges
Debit spreads means cash
flows out of the account, while Credit spreads means cash flows into the
account (albeit margined). Both use cash ultimately. There is no advantage of only trading credit spreads, or only trading debit spreads. Obviously, depending on the prevailing IV range of a
given product, you would decide if buying decay in anticipation for IV to rise; or, selling premium in anticipation for IV to fall would make
sense.
❑ Even if you have analyzed the P/L of Debit spreads versus Credit spreads and found trading Debit spreads to be your strength, consider subsidizing the Theta decay in making profits with long positions using Credit Spreads. With Debit spreads you need to wait for IV to rise to make money. Cash flow balancing of Debit spreads (entry on Low IV, exit on Higher IV) typically traded between 60-90 days can benefit from the funding of Credit spreads (entry on High IV, exit on Lower IV) typically traded between 30-45 days. The cash cycle of outflows for buying decay and inflows for selling premium should be synchronized and netted off to arrive at a Net IV position that you budget for your portfolio to end up with, for a given expiration cycle.
❑ As a side note, if you are a US resident with a 401K account, which is by definition always long stock, it would make sense to sell more premium in the options account (short Deltas) versus adding more Deltas (directional risk to an already stock-laden 401K account). Those without a 401K account (Non-US residents) can still apply this logic, if the set–up of your retirement account is long stock/long equity–based funds because of the regulatory rules of the country you are a tax resident of, limits you to long positions.
Price Scout: Work the
Entry Hard
Simply stated, the value in which the trade is entered and exited determines the P/L of Winners and Losers. Nothing else.
Use one contract as a scout
to check out the elasticity of the bid/ask range of a particular product for
that day.
❑ For e.g., within the allocation rule of 2%–5% per trade, that translates into 6 contracts for that given trade, do not execute all 6 orders at once.
❑ Shoot one contract in first at mid–price (the trading platform of your chosen broker should already middle orders automatically by default) and see how fast it gets filled. If the order is filled between instantaneously up to 5 minutes, you are too lenient on pricing the trade. Be more aggressive, work the order harder for –/+ 0.10-0.15 below/above the mid price, depending if it's a debit spread or credit spread that you are trying to fill.
Recall: It is the IV (not HV)
of an option that is the required standard deviation input when entered into a
pricing model that makes an option's current Theoretical Price equal to the
current market price.
❑ To work the entry
hard, it makes sense to value the option/spread as close to its Theoretical
Price, to fill it slightly above/below market value. Get every decimal of edge
on your side. How?
❑ For a given option/spread, set the contract size to one. Then, set the limit price to zero, removing any market value from the option/spread. The Profit/Loss Open field or Profit/Loss Day field in your trading platform should effectively only show the Theoretical Price. Once you know this Theoretical Price, depending if you plan to buy/sell you do so +/– 0.05 to +/– 0.10 to gain from the higher/lower purchase/sell price of the option at Entry. Depending on the product and the volatility conditions of the day, you may get away with up to +/– 0.15 of Theoretical Price.
If the order is filled only after 2 hours, you have been sufficiently aggressive in pricing the order. Never feel sorry for the counter–party filling your order – make them sweat over it.
In most cases, it is an electronic eye of an investment bank/broker linked into an algorithmic trading system resizing ranges acceptable to the bank/broker to trade at, with a server calculating every microsecond the required adjustments to the pricing bands to match intra–day volatility changes. All institutions have an electronic eye that scans for incremental trades within the Bid–Ask range. Bid–Ask data of a liquid product is publicly available. What is not revealed is how far away from the Mid price an institution will settle at. Institutions often load in block trades in 1,000s to hedge equities which they already own and sell (to retailers/fund managers/asset management firms, insurance companies, etc.) as part of their proprietary funds or customized portfolios. They have already collected hefty fees from their wealth advisory services and order flow, sufficient to give up a few basis points per trade up to an allowable limit. Do not feel sorry for these fat cats. Always, nickel and dime every entry. If you do not get filled today, work the order as hard or harder the next day, up to 3 days at maximum. Failing which, choose another product, or reconfigure the position with a different spread construction. On the exit you can be more lenient in accepting the mid as it is.
Sequencing Alerts:
Automating the P/L Monitoring of Positions
Given the multi-dimensional
nature of an option’s value, it makes sense to move past relying on the
rigidity of standard order types (e.g. Trailing Stop, 1st Triggers Sequence,
etc.) especially for exiting a trade.
You may not wish to trade every day. Automating alerts removes the drudgery of monitoring your positions daily.
As part of automating your daily monitoring, set increment-based Alerts on the Mark value of the position in play; but, do not link the Alerts to actual orders. You may be exiting the position pre–maturely on a sporadically wild trading day affecting the position's Delta and Gamma, just as IV is about to begin working favorably for the option/spread. Give yourself the flexibility of assessing the context of the position’s P/L vis-à-vis Probability, IV and Skew, once the Alert signals a Profit or Loss event, before you decide to execute an order.
Go beyond just setting up price alerts, specific to each spread type set up a combination of Alerts to track the
❑ Rise/Fall of the price of the associated option/spread’s Debit paid/Credit received at specific +/– % changes.
❑ Rise/Fall of Implied Volatility of the associated Debit/Credit spread at specific +/– % changes.
❑ Price movement based on pre-identified P&F trading ranges for the Upside/Downside or Range-bound levels.
❑ With Alerts, as part of ensuring consistent risk controls, set the increments/reductions to be equal; or, set the limits for losses tighter but be more liberal with the profit increments. You do want to lock–profits with the adequate number of contracts, to allow the remaining contracts to ride higher.
❑ Obviously, do not set the alerts for a negative increment in losses higher than the alert for a positive increment in profits. Repeating this mistake hurts the ratio of the Average Win/Average Loss in the longer run.
A Technical Twist for
Managing at the Trade Specific Level
For most retail traders,
Technical Analysis (TA) has a seductive lure (for some) to obsess over patterns and indicators.
The Home Trading Process
selectively uses technicals in the form of P&F charting techniques focused
specifically on Range, Reversals and Retesting.
❑ Why limit TA to these 3 areas? If you have visited the trading floor of one of the exchanges, it is obvious
traders in the pits do not obsess over charts. There is barely enough standing room in
the pits. Though, floor traders
are highly attentive to major Support/Resistance levels, seasonal/cyclical Ranges
specific to the pits they trade in and seek confirmation in raising/lowering IV
vis-à-vis other asset classes (Bonds, Commodities, etc.). There’s simply limited hours in their trading day to
pour over hours of technical studies, floor traders either make a market or they don't, at a pre–determined price they have planned to get in/out, not because price traded X times near the top/bottom of an inside bar.
Many retail–oriented training firms like to popularize the myth that TA works because “everyone” is watching the same pattern/indicator. Do realize that the collective retail trading community (“everyone”) looking at chart patterns only makes up ~15% (at most) of trading volume on the exchanges, possibly less, depending on which exchange. While there are many eyes looking at the “same” patterns, it represents limited volume. So, where is the remaining 85+% of the other “eyes”? Institutional floor traders. Not “everyone” is looking at the patterns retail traders fuss over – eyes responsible for 85+% of traded volume have no time to play with Dojis, MACDs, Oscillators, etc. When you have truck loads of Calls/Puts to get or offload, you respond to only one thing – price. They could care less how many times price traded intra–day near the tail of a dragonfly doji.
Reversals at Resistance/Support as both Entry and Exit
With price dispersion, it means price is prone to sporadic bursts within the day. For e.g. long candlesticks/bars or gaps intra-day. Yet, time–based charts tell you very little if price has actually reversed. Some retailer traders like to “fade the gap”, only to be caught in price drifting in the valley of the gap for an extended period longer than planned. Or, to have an earlier than expected reversal where the gap fails to be filled but price pulls back/rallies in the opposite direction.
P&F charts eliminate gaps
by virtue of their construction, recording only true reversals to identify
unmistakable Resistance/Support levels.
Prior
Resistance – once broken – forms new Support and vice-versa.
❑ If you are already in an upside winning trade, where price is approaching a prior Resistance level, which was unbroken or was tested twice and price failed to break through, it makes sense to scale–off 2/3 to 3/4 of a winner to lock–in profit. Do not scale–off 1/2 of the winner just to break–even. If the plan is to ride the winner higher, risk only 1/3–1/4 of the remaining contracts, as price may fail yet again to break through Resistance to create the new Support level. It is not prudent to initiate a new upside position as price approaches a prior unbroken Resistance level; or, a strong Resistance level that has forced price down twice. There is no “third time lucky” phenomenon with Resistance/Support lines.
❑ If prior Resistance is broken, forming one of the P&F Buy Confirmation Patterns, depending on the IV forecast, this presents an opportunity to open a new upside trade; or roll up the strikes of the remaining contracts of the prior position. It is at a Breakout to the upside and Breakdown to the downside near Resistance/Support levels that the pricing for Calls/Puts is sharpest. Especially, if the Resistance/Support level is at the product's 52 week High/Low.
So, once price is confirmed what else is needed to validate the candidate as a potential trade? It is not looking for another “special” P&F pattern to confirm the first P&F pattern. P&F charting does not need one pattern to confirm another. Confirmation is outside the realm of charts. Forget Oscillators, no TA Indicator can give you a forward view of what the expected values are in the back month. Instead, establish if there is an anticipated IV rise for an Upside Debit spread and an anticipated IV drop in a Upside Credit spread. Here's how.
Apply the same logic to
Support levels for down-trending positions to Enter/Exit.
Of note, when a product’s
price reaches its 52 Week High or 52 Week Low – levels at which price can drift
within a small range and become Resistance/Support, exit your the position altogether.
❑ Prices at their All Time High/Low can go into unprecedented Overbought/Oversold conditions compared to prior Overbought/Oversold conditions. Do not open new positions under such extreme conditions. It’s more sensible to choose another product; or rotate into an Asset Class other than Equities to choose a product to trade in.
In and Out Ranges – Hone
into the Zone
Even under normal conditions,
price is prone to jumping around in a dispersed manner. Price becomes
increasingly erratic when it is OverBought/OverSold. Especially, when price is
at its outer IV extremes, the energy built up within price to breakout of the OverBought/OverSold area is amplified.
By any measure, the area representing OverBought/OverSold conditions is
much smaller compared to the Zone that is not OverBought/OverSold. Meaning,
there are much more opportunities in the zone, than out of the zone.
Stay out of
Overbought/Oversold conditions. Trade IN the Zone. So, how do you work out where the “Zone” is? It requires the use of the Bullish
Percent Index. The following comments are specific to trading equity-based
Sector Indexes. Bonds, Commodities, Currency ETFs and REITs do not have a BPI
equivalent.
Unique
to P&F charting is the Bullish Percent Index (BPI). A widely accepted and
contrarian market breadth indicator that identifies bullish price levels as
prices bottom out and bearish price levels as prices approach their tops.
❑ It is calculated by dividing the
number of stocks in a given group (typically a Sector) that are currently
trading with Point and Figure Buy signals, by the total number of stocks in
that group. BPI is used to determine Overbought/Oversold conditions. It is important to note that the BPI is
not applicable to a single stock; but, rather an Index that is calculated for a
group of stocks. Which makes the BPI an indispensable tool for trading Sector
Indexes/ETFs.
❑ Do note that the BPI, as a
market breadth indicator is assessing risk, not performance. This is the main
difference between the BPI and the P&F chart of the associated Sector. For price performance, you will still
need to look at the P&F chart specific to the Sector being traded. At the
same time, also look at the specific BPI of that particular Sector Index. With
both charts, there is a complete view of risk and performance of the Sector.
For the exact % criteria of trading in the zone, see "Sweet Spot" for Sector Indexes in the Point&Figure and Relative Strength section.
For an underlying that does
not have a related BPI, it makes sense to use a P&F charting service that
identifies Overbought/Oversold conditions specific to that product – be it an
individual equity or Index/ETF. Dorsey Wright & Associates does this precisely, in
addition to its Relative Strength services.
Confirmation
Confirmation requires more
than using a single representation of price to validate the authenticity of the
state price is in.
❑ For example, overlaying one chart pattern or risk graph over another fails to confirm. This is merely reinforcement of one isolated dimension of price. Being an option trader necessitates delving into multiple dimensions of price. It is only when you trade the product directly by itself that Gamma, Theta and Vega equal zero, leaving you only Delta to deal with. Once you touch an option, get ready for Zorba and gang to turn up.
Confirmation entails continual alignment of both the Macro and Micro logic of Price ranges, expected Greeks by design, worst-case Probability and Implied Volatility range forecasting. The topics above have emphasized the Micro trade specifics, below are the Macro elements of managing the portfolio.
Macro Outlook
Asset Classes alternate between Relative Strength (and Weakness) at different periods of the Business Cycle. It’s difficult for Equities or any asset class to remain in a state of consecutive multi–year trends. Some asset classes are not only prone to cyclicality but are compounded by changes in seasonality within the cycle (e.g. Commodities and similar “fast” markets).
❑ Much of option trading
emphasizes methods of visualizing the traits of the underlying’s price even
before moving onto its derivatives. It’s sensible to watch as a distinctly
strong asset class begins to drift away from strength, prior to it moving
towards a state of weakness and vice–versa.
How do you consistently relate trades to macro–economic conditions without being an economist?
Revaluate the Relative Strength of Asset Classes with each option expiration cycle. Especially for buyers of premium who plan to be long options between 60-120 days, reassess the Relative Strength of the product for which you have a trade on, once a week. Weekly, because Asset Classes rarely shift between Strength/Weakness intra–day. For example, Currencies do not just strengthen/weaken overnight, neither do their associated optionable Currency ETFs.
Are the original trades you
have on in equities/commodities still distinctly strong; or, are they becoming increasingly weak; or, are
they starting to drift undecidedly?
❑ Debit spreads need time for IV to rise, to become valuable. For example, arguing a Debit Vertical in– play has 60–90 days remaining for price to rise is not sufficient. A Debit Vertical is both a negative Theta, at the same time, it is a positive Vega trade. If the Relative Strength of an Asset Class has changed it's IV profile unfavourably – which may not be obvious on the specific product’s price chart – subject to the Skew of the product, adjust the exposure of your trade to that Asset Class by 1/3 to 1/2. With Theta decaying at the square root of time in a debit spread, you are restricting the trade’s probability to bank exclusively on IV to behave as planned. While IV may turn out as forecasted, the magnitude may not be sufficient for the trade to become adequately profitable.
❑ Credit spreads in play for 30-45 days need to be
assessed using the same consistent method. Remember, Credit spreads are not only positive Theta; but, at the same time negative Vega trades. You may have unknowingly initiated a position, at the very
cusp of a cyclical/seasonal change in Relative Strength between Asset Classes. Despite the period of Credit spreads typically being shorter than Debit spreads, with Theta decaying
in your favour, being caught in cyclical/seasonal changes
can flip the IV of short premium positions 180 degrees, causing IV to rise and wipe out the premium collected by positive Theta. This may leave the spread with insufficient days to collect enough premium to lower the credit to turn the spread back into a profitable trade. More so, when Skew becomes inverted to that of the original position (+ Skew becomes –
Skew and conversely), the position has effectively been flipped beyond repair.
Switches in Relative Strength
occur, not because Equities got tired of leading the business cycle and
delegated it to the nearest asset class.
❑ With displacement of Relative
Strength/Weakness between Asset Classes, watch what is happening with the Yield
Curve in Treasuries, in tandem with revisions in GDP estimates.
Vigilant monitoring of Relative Strength, Yield Curves and GDP forward estimates is sufficient as the macro parameters to watch for managing home–based portfolios.
With one eye on the macro,
the other needs to watch the micro mechanics of the trade.
Market Ranges: Futures Pre-sage the
Price’s Pulse of the Day.
On any given day, a +/– 1% change in the 3 Major Indices (Dow:$INDU, Nasdaq:NDX & S&P:SPX) is considered a big move and the closer it gets to 2% is deemed huge. How “Big” is a Big Day versus what is a Normal Day, compared to a Dull Day? Why bother categorizing the type of day? The Theoretical Pricing is dramatically different dependent on what type of day it is. If price has already moved 1 Standard Deviation on Big Day, why chase to price it that day? It makes more sense to price within 1 Standard Deviation on Normal and Dull Days. Take profit/reduce exposure to losses on Big Days.
A Big Day (Up + / Down –) is characterised by the trading ranges of Futures
❑ Mini Dow Jones Industrial Average Futures. Net Change is +/– 90 to 100.
❑ E–Mini Nasdaq Futures. Net Change is +/– 15 to 20.
❑ E–Mini Russel Futures. Net Change is +/– 10 to 15.
❑ E–Mini S&P 500 Index Futures. Net Change is +/– 15 to 20.
– Any bigger Net Change number than the above guidelines is considered Extreme. Your trading platform should have a function for you switch on to see the Net Change number of the Futures.
A Normal Day (Up + / Down –) is characterised by the trading ranges of Futures
❑ Mini Dow
Jones Industrial Average Futures. Net change* is +/– 40 to 60.
❑ E–Mini Nasdaq Futures. Net change* is +/– 10 to below 15.
❑ E–Mini Russel Futures. Net change* is +/– 5 to below 10.
❑ E–Mini S&P 500 Index Futures. Net change* is +/– 10 to below 15.
*1: A Net change number
larger than that stated is abnormal behaviour, signalling a build up into a
possible Big Day, in subsequent days ahead.
*2: A Net change number
smaller than that stated is a Dull Day.
For examples of Big versus
Normal Days, see thumbnails on the right (above).
Using Futures as market gauges coupled with VIX readings holds practical implications for Short and Long positions. You do not need to trade Futures to use them as barometers for trade Entries and Exits. Want more about how to relate Bonds to Equity Futures, to Theoretically Price spreads within reason?
Conclusion. The Discipline of Portfolio Management is about working the Macro and Micro elements, every day before/during and after market hours. It takes conviction to repeat an unexciting routine. There is no easy (i.e. "simple" = lazy) way to build reliability into a home trading process. No Chief Trader/Head of Desk is looking out to guide your next step. Self–directed trading = Self–responsibility, that’s it.
