Synopsis: Gary discusses how he purchases out of the money calls and why he decided to take call options last week instead of buying Es outright. We also talk about how sometimes it’s better to buy an instrument that is correlated to what you want to buy or short rather than buying the instrument outright.
Gary on Trading Out of the Money Calls and Risk Management
Good morning SizeTraders. This is Amos here with Gary, Head Trader at SizeTrade. Gary, thanks for being here with us today.
Hey Amos. How is it going?
Good good. Gary, we got a lot of interest last week about your option strategies that we discussed. Particularly, you were buying out of the money calls and I know you did really well on them. So first, since most of our guys are trading futures, I want to ask you to just quickly go over options and maybe we can go a little more into the specifics regarding your strategy.
Sure no problem. Yeah, I saw some of those emails. I’m glad to see some of our traders doing really well on that. (Inaudible) are a derivative of the underlining. So in this case, the underlining is ES so we’re buying options on the 75 hundred futures. We’re trading options, you have to understand it’s not about just being right on the price movement, it’s also being right on the time frame.
So, if you remember when we spoke last week, I had a lot of Wednesday calls that I basically broke even on and I was able to roll over a lot on them on the Friday calls. Now, it wasn’t necessarily that I was wrong on the direction since the market never went down. It’s that the timing took a little longer than expected and that’s part of trading options. You have to understand that. That’s why I like to take off my Premium whenever I’m up in it. So on Wednesday, I think I had 5000$ or 6000$ worth of premium that was expiring. So when I was up that much money, the morning the market was actually reacting in money at 2285 on 5000$ worth of premium and let the rest of it go. It wasn’t necessarily that I didn’t feel comfortable with the direction hat I had the calls on, it’s just the timing is hard especially on the day of an expiration.
So I’m bringing that all back to options. Options are mainly priced on two facts. There’s more but the majority of the pricing on options is based on two facts. The first is applied volatility, which basically is a fancy way to say what to traders think is the percentage that the market is going to move. So when we’re more volatile and the VIX (volatility index) in higher, the implied vol. is higher and thus, the premium that you pay for your calls inputs goes up because the traders are looking for a bigger move so they don’t want to give that up for free so they’re pricing it in and making you pay extra for it.
The second part of the option price is how close you are to being in the money. The closer you are to being in the money, the higher priced the option is because you have to pay for the privilege of having limited downside risk. The reason why I like to risk with the outside of the money calls especially when the implied vol. is low, is because you can get really cheap calls and get paid on something that has 0.5% to 1% move. Now a lot of the questions that I saw from last week were why didn’t I get some of the more longer dated call options? Well, the reason why is because the VIX is at an all time low here or near historical lows so it’s better to buy short term options because it implies that the volatility is already degraded; time decay is dreaded so you can get in very cheaply and when you do get 1% move in your direction, you can get paid, like last week on some of my calls, I made a 1000% on the ones that expired on Friday with the big move on Friday. There were relatively cheap. I look to buy the puts that are around 20-30 cents up to 1.10$, 1.20$ maximum.
So Gary, let me just interrupt you for a second. As far as when a trader would look to trade the option instead of the underlining, it’s when the VIX is low and there’s low volatility?
So there’s a couple of time when you’d want to trade an option rather than an underlining. The first time is when the volatility’s low. So what’s happening in the market is that it’s going side ways. So there are a lot of strategies and some of our strategies aren’t working and that’s fine, it’s normal. There’s an old saying in Wall Street: ‘’Bulls and bears make money, pigs get slaughtered.’’ So when the market is actually moving, there’s opportunity and we make money. The problem is that a lot of times when the market is sideways, a lot of traders aren’t able to realize that. The hardest part of trading is to sit on your hands, traders say. So they continuously trade the way that they expect them to trade and be profitable, but the market is just not giving them the opportunity and they get shopped up and loose money a little bit everyday. Sometimes, it’s a little more than just a little bit every day.
So part of it is, when you have a low vol. time frame like we do now when the market is stuck in a range, there are other options. The first way I like to trade with call and puts depending on which way I think the market is going to go because the low vol. is attractive because the premiums are lower. So that’s the first reason why someone would trader his or her options. Second reason is if you’re not 100% certain is your technical pattern or whatever it is in the moment, it’s a cheaper way to play in because you have limited downside risk. So in this case, and I spoke about this, I saw the bull flag and I wasn’t necessarily crazy about it. So based on that and some other things (we’re entering the weakest part of this bullish season in February, we had a Doji and some reversal candles etc.), I fell it was prudent to take the risk, because you want to get paid if your pattern plays out, but in the most efficient way and I took advantage of the low vol. opportunities to buys really cheap calls.
So Gary let me ask you a question. At the risk of some of our listeners tuning out because we get a little more mathematical with some more numbers, could you give us some specific examples as far as the risk is concerned of why you went with options and how it would have planned out if you were trading futures? How you entered in with options? What were you risking? Why you wouldn’t of traded the futures because the risk would have been XYZ?
It’s hard to say because you don’t know exactly where you would have put your stop and how you would have got in it. Here’s an example: If you were buying the ES in the 2280, which is the break out levels, without waiting for the confirmation like I spoke about last week. The low ES last week was in the 2260, maybe mid 2263, 2264. So you’d have to take around 15 to 20 points depending of where you get in of pain. So depending where your stop is, you could have potentially got stopped out, maybe even shorted if you thought it was a real breakdown. And, that’s what I talk about the choppiness is that you see the bull flag, we start breaking out of the bull flag, you jump in because the technical and all the stuff you read is telling you that we’re going higher, your gut is telling you we’re going higher although your gut is not a good reason to trade, you get long in 2280s on the breakout, it’s goes to the high 2280 so it’s you’re only looking for a small bounce, fine you got out. But, if you’re looking for a small bounce, you should also be looking for having a small stop. In that case you might have also got stopped out because I don’t’ know if it just exploded higher, I don’t remember.
So ultimately, basically, you weren’t confident that the pattern was going to play out and in the technical so you preferred to do the options rather than the futures?
I step back and I take a look at the overalls. Every time you do a trade, you have to look at the best way to set up a trade. There’s always different ways to play a certain outcome. To give an example, just because you have a bull breakout, doesn’t necessarily mean that you want to trade. Yes, if you’ve seen correlations that you think are lower risk. So a lot of times instead of playing the ES outright, although in this case I did because there wasn’t much correlation, but there was a lot of correlation when the oil and the market was going down. So I looked into it and if I saw the opportunity to short oil, but oil was risky because it was so volatile after dropping 80% from he highs, I would just play that via shorting ES because ES was following the oil markets and I felt that even if the oil bounced a few dollars, the ES percentage wise would bounce a little bit less because there was other negatives in the beginning of last year form China and so on that would have pressure on the ES. So there are always correlations between assets and you always have to try and find the best way with the lowest risk to trade your correlations. Sometimes it doesn’t workout, you think the ES is going higher but I think that that will affect the dollar a certain way and I get the long the dollar or short the dollar instead and it doesn’t workout yes. But, majority of the time, there’s always different ways to trade what you think the outcome is going to be.
So that brings me back to the options. Sometimes I look at options, especially when the volatility is so low, because I know I can get really cheap calls or puts that are expiring this week or next week. So when I see a pattern, I have to play the pattern. If you believe in patterns and technical analysis, you have to always trade it even though your gut is telling you that it’s not a perfect set up. You just have to figure out how to minimize the risk to your favour.
See in this case with low vol., I jumped on it and took advantage of it. If the vol. was high, I would have had to figure out another way maybe using treasuries or gold that I would have seen correlations. I would have said to myself: ‘’hey, if the market goes higher, I think it’s going to trap yields XYZ, or gold higher because inflation is more prevalent’’. I think that even if I’m wrong and the market comes in, gold will have a bit on their end because people are pricing in inflation regardless. And I’m not saying this was the right way to play in last week, I’m just saying this is an example of how sometimes you could correlate different asset classes but take the least amount of risk.
In this case, I decided that options with low implied vol. is the best way to play it and I did much better and had a lot less risk than with buying ES directly. Yes I was buying ES and the calls in the lows 2270s to the mid 2260s of the bull flag; that’s where I got the majority of my calls. Last Wednesday expired worthless. Since the market opened at 2285, I was able to get off 20% of my possession at a nice set of profit to breakeven for the entire premiums and then the rest of the premium expired worthless so I think I broke even; I lost a little on commissions. But, I was able to take that money, 4-5 thousand that I got back in premiums and I was able to put into the Friday calls. I didn’t do that as much on Wednesday because I was waiting for the close, but I did that Thursday morning, afternoon and evening. I was able to put the 4000$ and I added a little more. I ended up having 30 000$ worth of premium expiring of Friday. I had some 23 hundreds that ended up expiring out of the money. Although they expired out of the money, I did really well on 2295s because I was buying them between 10 and 30 cents because when the market was trading between 2275 and 2280 in the morning on Friday or the close on Thursday, I saw that’s It’s only a 20 points move on the ES to get the money and there was less than 1% move because 1% move, I was still expecting a bullish outcome. We had the employment job number Friday morning so I was able to buy a lot of contracts for very cheap between 15 and 25 cents (let’s call it an average of 20 cents). Then when the market was (inaudible) between 2290 and 2295, a lot of those calls were trading at 2$ so I started slowly selling that at 2$. The 2285s, which I had a lot of, were into the money around 5 or 6 points when the ES was trading 2260 so I took those off for 6 points. I got involved in those when the price was around 70 cents so I made a little less than a tenth on those. So it’s a pretty decent day. They could have expired totally worthless and I would have taken a hit, but it would have been riskier for me to buy ES in the normal size that I do and wait for a move. If the move never happened, I would have been stuck at 2290.
We always talk about probabilities of being right on certain trades. When we talk about our eagle strategy, we have a historical data that we’re between 60 to 70% right on out strategy. Here, when you took these option trades, you had some sort of idea of what the result would be, but there’s never any guarantee on anything in trading, so what did you feel your probability was of being right on these trades?
It’s difficult to say, it’s not only about direction, it’s also about timing. Based on the bull flag, I felt confident 70% chance, something in that scenario, that we’d go higher. With options, you have to do it within a certain amount of time. So I don’t have a probability on that, but what I do have is that I tend to make between 5 and 10 to a 1 on options. Typically, (inaudible) I’ll take it. Let’s say my average out in 7 to 1. The chances of you being right are so small for you to make money or break even. So at 10 to 1, that means you have to be right 10% of the time. So if you’re right 10% of the time, you break even. So when I trade options, I look more at what my breakeven point is and I ask myself if I think that I have a higher probability than a 10 to 20% chance of this move happening this week.
I think that’s the type of information that is really helpful for traders because we always talk about trading with some sort of mathematical model and having an idea of what your risk reward ratio is. I think that’s pretty clear that if you’re looking to make 10 to 1 and you only have be 10 to 20% right on your strategy, that’s a pretty good bet.
Right. It comes down to understanding the time frame of the market and what is going down in the market. Not every strategy is going to work 100% of the time. Pushing the strategy and trying to make it work when the market is not contusive to that, (inaudible) .A lot of personal messages that I got, is: ’’hey my personal trading is not going great because I’m getting shopped up. Is there anything you can help me with?’’ I usually tell them that it’s not necessarily that the strategy is wrong or you’re going something wrong. You have to understand that right now, we’re going side ways and you’re better off sitting on your hands. I know it’s painful for a trader. Trust me, I feel it. It’s one of the things that took me the longest to understand. But, sitting on your hands is sometimes the best trade you could do.
This is a more advanced theory of that, because, just because you’re sitting on the sidelines on your strategy, it does not mean there aren’t other opportunities on the market.
We’ve talked about before that you build a strategy that could be built for 80 to 90% of the time when the market is doing something, but then there’s a 10 to 20% of the time that it’s simply not going to work because it wasn’t built for that.
Exactly. That’s why we say: ‘’Bulls and bears make money, pigs get slaughtered’’. It’s because you can’t be greedy. Greed is what kills a trader. Because, if you have a good 10 months and 2 months out of the year your strategy is not working, not because it’s bad but because of the market, and you push yourself in those to months, you could give back 5 or 6 months of profit. At the end of the year you end up with 4 months of profits instead of 10 months because you pushed yourself on the 2 months. You have to really understand how your strategy is set up and if your environment is not right, as tough as it is, you have to sit on your hands. The goal of trading is to make money at the end of the year, not to make money of each trade or on a daily basis. It’s not a game. It’s about living a certain lifestyle that you want and making a career.
At the end of the year, you have to look at the total number and make a decision. Is it something that you could do profitably? Is this the environment that’s good for these strategies? Maybe trading is not for me; maybe it’s not something I want. But, you can’t look at a daily or monthly basis and overtrade. That’s what makes a profitable trader negative and a really good trader be an OK trader. If you have the ability to sit on the sidelines, it can make a strategy that’s flawed, a decent one because you’re missing on the loosing times.
That’s super interesting. Can you go a little more into detail about how you use correlations in other assets to make money on the instrument that you’re interested in trading?
One of the things that I learned early on is that there’s a lot of different ways to make money; markets are correlated. Sometimes they are correlated in a positive way, meaning they go up in the same direction, and sometimes they’re correlated in a negative way. That changes based on the time and what the market is focusing on. A lot of the time, there’s better ways to get the profits that you want by trading it in different ways.
Let me give you an example; last year, the market was trading with oil. Oil was leading. The first thing you have to figure out is what’s leading the marker? What’s making the market go up? Is the oil leading the ES or is the ES leading the oil market? Once you figure out that correlation, you can start figuring out; ‘’Ok they’re correlated is the same direction so, as oil is going down, the ES market was going down with oil at a smaller paste, but it was the same direction because the banks had a lot of oil, and if the oil kept going down, you’d see a lot of bankruptcies and that would affect the banks negatively which would affect the overall ES negatively’’. So that was the whole thesis of why oil was leading the market down.
There are also other things going on in the markets that were negative in the beginning of last year, particularly China. People were getting really worried because Chinas’ growth rate was slowing down pretty fast. Didn’t seem like the Chinese banks were ready to push stimulus in, fiscally they weren’t pushing stimulus in at the time. On top of that, you added the oil concerns that were affect emerging markets. Even if oil stabilized at those low levels, because that means that countries that would typically consume would have lower employment because oil prices were low, meaning there would be less jobs and that they would buy less US products.
There are all of these things coming together. At that time, oil was becoming very volatile and it could move 4 to 5% easily in a few hours either way. It just wasn’t the best way for me to trade oil, because the risk was too high for the reward. So I traded the ES based off of expecting the oil to keep going lower because the technical analysis was saying the oil was going lower. It was trading at about 40 and I thought it would go at the low 30s, but it ended up going to the high 20s. I also didn’t put beyond reasonable doubt that oil could bounce to the 60s in a quick amount of time. I decide that the better way to trade it is ES. I looked at the options because when the market goes down, the volatility spikes so the implied vol. was too high so it didn’t make sense to trade it with options. I decided to trade the ES. I shorted ES. I ended up making good money because I was right on the direction of oil. I probably would have done better if I just stayed short oil, but, in my opinion, I felt the risk was less by shorting ES that a 20 points bounce would have led not to a equally painfully bounce in ES because there are other underlining factors such as China, if oil bounced from 40 to 55 or whatever it could have been. It still wouldn’t have been high enough for emerging markets to turn around and survive recession. So, I felt ES was a safer play.
These correlations and divergences exist in the market all the time. One that has been here for a long time is when the yang goes down, the market benefits from it because a lot of cash comes into the market and vice versa. A lot of times in the past years, that’s what I was trading. I saw maybe low pattern on the ES but I saw patterns on the yang that was telling me that it was going from 100 to 120. A better way to play that than to take a risky bet on the yang is to trade the market. Or vice versa. Sometimes I saw that the market wanted to go higher or lower and I thought that the safer way to play that was to bet on the yang because it’s over extended and I doubt it could push any higher. I’m always looking for these correlations and a better way to trade the signal that I get. If I’m getting a longer-term swing signal that’s telling me the market is going higher, I’m trying to figure out exactly the best way to play it. Right now with the low implied vol. the best way to play it in my opinion, is with options.
Now, if the VIX were trading at 13-14-15-16 at a higher level, I would be looking for other coincidences in the market to take advantage of that. Maybe I would go something with interest rates, but right now, we have an easy correlation, which the derivative of the ES is so cheap, that I like playing it and I think there’s a lot of opportunity in that. Even though a lot of people are suffering, sitting on the sidelines and getting chopped up, there’s always opportunities in this market, or usually at least.
I really like what you said earlier that you might have done better if you shorted on oil but you felt that the risk was too high. That really resonated with me and with a lot of traders out there. A lot of times, they’re in a trade and they get out of it early and they feel that if they stayed in it they could have made more money but you have to look at a long-term profitable strategy. When you look at your trading as not just a day or a weekly trade but as long spectrum over the course of a year, how much are you risking and at what point do your realize that the risk is too high and you have to get out of this and look for something else?
It comes down to what you’re risking; how much money. Once you take a look at how much money you’re risking, you have to take a look at how high the probability of that happening is. If would have bought ES straight out and I don’t know how many contracts I would have bought because that’s not what I ended up doing, but I have a certain number in my mind and I would have said:’’ Ok, I’m buying it at 2280, I think if it breaks at under 2260, I’m going to get stopped out and I’ll want out of the trade’’. So I would have been risking 20 points. Based on 20 points, I know exactly if I want to risk 30 000 of this position, I know how many contracts I need to take knowing that. That said, for me to make that trade happen, I need to look at least to make 20 points. The way that I set up my strategies, it’s at least 1 to 1, sometimes 3-1,4-1,5-1 depending on how many different indicators, which indicators, overall breathe of the market. I take a look at that and I set up my strategies differently. But I almost never take a trade that has less than 1 to 1 risk reward. So in this case, I would have been stolen a trade, ended up making less money, would have had a big unrealized loss when the market was turning in the low 2260, fearing to be stopped out and you get unlucky sometimes by getting stopped out at the lows and then the market turns around on the back at 2290.
So in my opinion, you’re always looking at the risk and the reward. The benefits that outweigh the risk, which was that if it stays in the rage bound scenario for another week or two, I might loose a lot of premiums. I get that, it makes a lot of sense and I understand traders who fear that the market stays sideways a week and a half. That’s something that you have to weigh on a personal level. That takes experience and knowledge of the market. You have to weigh different scenarios and have to say:’’ I’m really confident that the market will go higher, I’m really confident that the market is not going to stop me out, but I don’t want to have this time affecting me’’. What I like to do is that whenever I’m up the amount of premium that I have, 2 to 1 usually, I take it. You don’t’ have to be in the money to take that. Because when you’re buying your call, I mentioned earlier I was buying 2295s at an average price of 20 cents let’s say, once it goes to 40 cents, I’ve double dup on that portion of the money. Obviously, I would have to get out of the entire amount if I wanted to just double up there so what I do is, I let go to 3 times so when it turns into 60 cents, I start slowly taking it off. And, because I have different time frames and different strike prices, I see which ones I like better, I price them out depending on how much time I have left and how big the move is and I come up with an answer as to which ones I should sell and how much risk I should leave on the books.
I like to take it off because, in this case, I had 30 000$ worth of premium and even if I was wrong and the market turned around for 2287 and ends up under 2280, which was a possibility since the market was so range bound, I at least got my premiums back. Yeah, I lost on commissions, which sucks, but at least I have the 30 000$ to put into this week’s Wednesday calls.
I’m kind of always rolling it. As long as it doesn’t go one direction straight down, typically, you have an opportunity if the market goes in your direction just a little bit, you’re able to take off some premiums to capture back your initial premium. Now, you’re leaving money on the table like I did on Friday, I took back my 30 000$, which if I had kept until the end of the day, would have probably been closer to 80 000$ so I left 50 000$ on the table. But, if I was wrong on the timing, now I have that 30 000$ to put back on the Wednesday and Friday calls and I have a couple extra day to find it again.
Sometimes, the expiry is totally worthless and you never had that opportunity but most of the time when that would have happened, I would have gotten stopped out because I was wrong on the direction.