In honor of the Chicago Cubs and Ernie Banks, today was not just one, but two episodes about being a tastytrader. In the first episode, Dylan was joined by Tom, Bat, Jared and Kai to discuss the concept of fear.
To be fair, as Kai pointed out, the concept of volatility is hard to grasp. Fear is hard to understand. Look at insurance for an example of how fear affects us, financially.
Most of us have insurance. Maybe it is life insurance, homeowners, rental, car, health, etc. We carry it just in case. If something happens, we have insurance to help with any financial repercussions. But how many times do we actually collect on those policies? Not often. We pay a monthly premium because we fear something may happen. Options act similarly.
Investors, as Bat put it, have “idears” (idears are like ideas, but better). Those idears usually involve sort of catastrophic move in equity prices, up or down. Options are seen as an insurance policy, just in case. And, like that insurance policy they’re overpaying for, they will overpay for an option. Tastytraders can measure that fear through volatility.
Understanding how volatility affects the price of an option gives us an advantage. We know volatility overstates actual price moves. Under normal circumstances, volatility overstates by 700 - 1000 basis points. We can sell those options. Or, we can look for opportunities where volatility, relative to itself, is very high. We identify those opportunities through IV rank.
Using IV rank, we can spot assets where volatility, relative to itself, is high; places where there is panic. That means option premium is more expensive than normal. If we are willing to remain calm when everyone else is afraid, we can sell that inflated option premium.
Panic passes. Jared talked about the math we have showing IV reverts to its mean. When that happens, option prices will come down, allowing us to buy back the same options we sold, but at a lower price.
If this worked every time, everyone would be doing it. It does not work every time. When it does, we need to know when to take profits. When it does not work, we have to know what to do.
For episode two, James, Nick and Pete joined Dylan to talk more about what to do when things do not work, than when they do.
Traditional finance tells us, “cut your losers and let your winners run.” Turns out, that works about as well as, “buy low, sell high.” Sounds simple but it does not work out so well for most.
We manage winning trades. When trades reach a certain profit percent, we close them. We do not give winning trades have a chance to turn against us. At the same time, we do not “cut our losses.”
When trades go bad, and they will go bad, we give them time. We roll them out further in time so they have a chance to recover. Nick talked about his experience with GDXJ and having to roll his trade multiple times before bringing it back to a scratch.
James brought up the idea that one of the keys to being able to roll trades is how much capital we initially use. Pete followed up with an important point when talking about how much capital to use. Options are leveraged products. Using 30% of your trading capital does not mean you may not need more, especially when a trade goes bad. Rolling a trade may require using more capital. That gets us back to the idea of trading small.
Staying small in terms of capital used in a trade means we can place more trades but it also means we have capital available if we need to “nurse” a bad trade. We feed those bad trades with more time and give them a chance to heal.
Just as we feed on that panic by selling option premium when everyone is most afraid, we have to control our own panic when trades do not work.
This past week’s market has been difficult. In one day many of us saw the market move too high, too low and then again too high. I personally have taken a hit. I’m no different from any of you. I have bills. I have kids. I work hard. I even have emotions, like panic. Being a tastytrader is not just about following mechanics. It is also about understanding fear and how we can use it to our advantage. So despite the urge I have to panic right now, I know in time things will normalize. Bad trades may need rolling so they can recover. Okay trades will turn into good trades. In the meantime, remaining mechanical, selling high IV, managing winners and rolling losers is what keeps us moving forward.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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