Dunning Kruger Journal

[destriero]

You're making a point of buying vol when you're in the peak of the vol (term structure). You're paying 38-vol for gamma. As vol goes up, gamma (pos) goes down.

Further, there is no relative value on skew as the long leg of the vert is slightly higher vol. Yes, I agree that you should use theta as your risk measure and trade a flat-theta ratio. The 3:4 gets you to $0 thetas.

It's a solid trade--the logic (vol edge) was off. It's a distribution trade. It's dirty with the naked put, but you won't get killed.

 

[maximumpossiblesuffering]

destriero

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You're making a point of buying vol when you're in the peak of the vol (term structure). You're paying 38-vol for gamma. As vol goes up, gamma (pos) goes down.

Further, there is no relative value on skew as the long leg of the vert is slightly higher vol. Yes, I agree that you should use theta as your risk measure and trade a flat-theta ratio. The 3:4 gets you to $0 thetas.

It's a solid trade--the logic (vol edge) was off. It's a distribution trade. It's dirty with the naked put, but you won't get killed.

Given my outlook, what would be the optimal trade structure without exposing myself to (An extent) undefined risk?

 

[destriero]

The MAY3 185/195/205 put fly from 2.35. A similar payoff to the vertical, but a better distribution and no naked write involved. Neutral to 195.

 

[NQurious]

I read the title of this journal and thought that it was going to be about Trump, the example of Dunning Kruger par excellence.

 

[maximumpossiblesuffering]

The MAY3 185/195/205 put fly from 2.35. A similar payoff to the vertical, but a better distribution and no naked write involved. Neutral to 195.

Your idea is margin efficient and provides protection against an epic AAPL miss. I thought your post earlier showed a 190/195/205 put fly. That would also be interesting, especially if there seemed to be a greater chance of a big earnings miss or if there were greater uncertanty regarding the extent of a potential earning miss.

The cost of the deep out of the money leg seems high from an implied IV standpoint and would likely have a negative long term effect on expectancy, but it does protect one from being right on direction and still losing money, sometimes lots of money.

Thanks for your input.

 

[maximumpossiblesuffering]

I read the title of this journal and thought that it was going to be about Trump, the example of Dunning Kruger par excellence.

In this journal, opposed to ET’s political forum, I tend to talk about Goverment policy from a clincal, macro economic perspective. In the political forums, I tend to be more passionate while emphasizing social and micro economic impacts of Government policy.

In either case, when it seems that Trump has screwed up, I may note potential impact on trading in my journal or even lay into Trump in the politics forum.

I would like to keep politics that does not directly affect trading or is unlikely to have significant economic impact to be kept out of this journal.

 

[maximumpossiblesuffering]

Although GDP came in at a stronger than expected 3.2% rate for the first quarter, I have concerns whether that rate can be maintained. Maritime’s Dry Baltic Index of shipping rates is near five year lows. For US trucking, freight rates are declining, truck to load ratios are increasing, and the contract to spot rate ratio is wide and getting wider. Part of this is increasing capacity. Additionally, capital investment in transportation is likely to start tampering off if carrier profitability starts to fall. Bloomberg published an recent article showing world trade volumes declining at the fastest rate in a decade.

And yet in spite of my concerns above, I’m generally bullish on US equities in spite of seemingly high equity prices.

The Fed’s recent easing has encouraged homeowners to refinance as shown by a recent surge in mortgage applications. Historically this has led to increased consumer spending. Personally, I prefer economic growth based on plentiful jobs and wage increases over growth by financing. At least the US job market still seems strong.

Another driver of economic growth is energy exploration, especially in the US with many of the oil shale plays around the country. Relatively stable oil prices in the $70 to $80 per barrel range would likely accelerate exploration and the infrastructure spending that goes along with it. Even with energy prices at current levels, areas like Midland, Texas are seeing economic boomtimes and sub 3% unemployment rates. Many industries can benefit from this infrastructure spending such as steel, chemicals, and transportation. Additionally, support industries including services and homebuilding can benefit as well. Unfortunately, higher energy prices can curb consumer spending in other areas.

Another area of potential economic growth is infrastructure spending in the US for roads, bridges, and tunnels. I tend to cringe when hearing the words “highway infrastructure spending” because of widespread pork barrel spending and kickbacks. There is a proposal to raise Federal fuel taxes to fund additional infrastructure projects. Interestingly, the US Government fuel tax rates are only roughly 60% of what states charge for fuel tax, yet the Federal Government pays 90% of Federal Highway spending. Although the following is not necessarily justification for increasing Federal fuel taxes, unlike state fuel taxes, they have not been raised in decades and are a much lower percentage of fuel cost than in decades past. Admittedly, states have to take care of their local roads as well as their 10% share for Federal highway spending.

Another potential avenue for increased economic growth is increased trade. Right now, trade friction over trade treaty terms seem to be a bit of a drag and a disappoinment. Should the US reach agreements on trade with major trading partners, the could be a nice boost to global economic growth, especially if there is some pent up demand for foreign goods and this causes business confidence to improve which in turn may encourage increased capital expenditures and hiring.

The final potential growth economic factor is increased domestic and foreign business expansion in the US. If business leaders are confident the economy can sustain its growth and that the US regulatory environment is stable, they may be willing to build manufacturing facilities, build office buildings, and hire more people. Quite a few large corporations have a tremendous amount of liquidity on their balance sheets which is currently earning a very low return.

Should several of these potential economic growth drivers combine, the US may see actual boom times. 3.2% may ultimately be seen as an economy “limping along”.

Indications that some of these drivers are currently in play or are being addressed, it is likely the US stock market will hit new all time highs, making investment attractive for long term investors. The adage “Don’t fight the Fed” comes to mind. For day and swing trading, opportunities should present opportunities on both sides of the market, especially as investor sentiment moves towards short term extremes.

To sum up potential economic drivers going forward:

1. Easy Federal Reserve policy encourages homeowners to refinance and use their equity for consumer spending and encourages investment on new construction.

2. Stable crude oil prices above $70 per barrel will likely encourage increased infrastructure spending through energy exploration. However, higher energy prices will tend to dampen consumer spending in other areas.

3. Increasing infrastructure spending through increased fuel taxes tends to increase job creation, but higher fuel prices reduces consumer descretionary spending in other areas.

4. Increasing trade can increase foreign demand for US goods. It also increases US consumer demand for foreign goods. A balanced trade agreement may end up being a net benefit for US consumers and should result increased spending as well as encouraging business investment.

5. Extensive balance sheet liquidity of certain key US corporations and even some foreign companies creates the potential of increased capital investment in the US and the economic opportunities that go along with it.

The economic drivers in play also show which industries are likely to outperform. Additionally, the more economic drivers in play at the same time, the greater the chances of increased inflation rates taking hold.

 

[maximumpossiblesuffering]

The AAPL trade idea did not work out even though their earnings report seemed weak. Intel disappointing earnings report last week also supportted the orginal AAPL trade idea. Perhaps AAPL’s relatively lower valuation metrics versus other technology companies and enough traders anticipating a worse earnings report, caused the big short covering and fresh buying we see today.

In response to Destrieros’s new journal, I will post trade ideas as I think of them and post my executions and preliminary or expected trade management levels.

Most of my trade ideas will utilize various option strategies. The time frame for most of my strategies will last from intraday to swing. My money management levels are at .72% of account equity based on a ATR(12) of the expected timeframe my trade idea is expected to cover.

I will post trading results and select metrics such as Profit % and R:R weekly. As time allows, I will post pictures of marked charts that highlight the reasoning behind my ideas.

 

[maximumpossiblesuffering]

Been doing some research over the weekend on option strategies that generally meet the following criteria:

1. Requires little real time management.
2. Has defined risk.
3. Effectively addresses my scenario.
4. Likely has a positive expectation.

For day or even swing trading timeframe, I am looking at ratio backspreads on low implied volatility instruments such as ES. IB’s option strategy payoff diagram is fairly coarse, so I will do a few test trades before implimenting this strategy. The benefits of this strategy include being positive gamma to the point of my risk to reward ratio of being 2:1 on one week until expiration with the long options strike set close to the short option strike. Theta decay is substantial, but as most of my trading losses are taken within one hour of day or even swing trading and almost all of the balance of my losses are taken within 24 hours, this strategy appears to be a strong match for my overall trading plan.

Another area I looked at is option strategies around significant scheduled events, such as earnings. I focused on a strategy that takes advantage of volatility expansion as the event approaches. Basically this strategy involves buying a long calendar spread 2 to 3 weeks before the event. Using weekly options, My plan is to sell front month that expires before the event, and buy the first expiration series after the event. Below is a specific trade idea on LULU, which has an earnings report scheduled for May 30, 2019, according to zacks.com.

This is a daily chart of LULU with a history of IV shown in blue. Current volatility is at the low end of the range.

This shows recent implied volatility of both the front expiration of 5-24, and the back expiration of 5-31. As I understand it, the theta decay of the back month should slow as traders buy options in anticipation of the earnings event. The front expiration should see theta decay quicken as both time to expiration and LULU volatility decreases.

Above is a payoff diagram for a long calendar LULU calendar spread with strikes set at $185.00. Although the profitability range of this trade idea is currently tight, it should expand as the IV in the back expiration increases. My exit idea be when the underlying is near $185.00 after the IV increases.

 

[maximumpossiblesuffering]

Been thinking about option strike price selection based on delta versus my expectations. A delta of .25 on a option is considered to have a 25% chance of expiring in the money and 50% chance of a price touch by the underlying. If my perceptions are realized by more than 50% of the time, my trading performance may be improved by using deltas below .25. However, I need to consider the effect of using money management but the trade end up being ultimately profitable.

Below is a tentative table showing various market statuses as I may perceive them, my typical market expectation, default option strategy, and delta selection range for ES. Since the implied volatility of some stocks and futures contracts can respond differently to price changes than what is typical for ES, my strategy for those instruments are adjusted accordingly.

Several counter trend bars are observed. Trend resumption and range expansion expected. Whether bullish or bearish, buy .17 to .25 delta calls or puts respectively, with current week expiration on this well defined trade.

Narrow range bars at recent high or low (consolidation). Trend resumption expected. If bearish, buy calendar spread with a .17 to .25 delta, basis front expiration, or if bullish, buy a butterfly spread with body at .20 to .25 delta with wing selection based on the nuances of my expectations.

Wide range bar in direction of underlying trend after correction. Trend continuation expected. Bullish or bearish, buy near the money iron condor for crediit with long wings at about .16 delta depending on nuances of my expectations. Depending on age of the current trend, other strategies may be favored.

Wide range bar in direction of extended trend (Exhaustion). Short term reversal expected. If bearish, buy 1 week calendar spread with front month delta of .17 to .25 or if bullish, buy put vertical spread for credit with long option at .50 delta.

Although the above trade ideas have defined risk, I will still use stops based on how the ES appears to be closing during the current trading day or how price action develops after the open of regular trading hours during the next trading day. I believe my trade performance will be enhanced by staying within positive trade probabilities for longer and being able to safely increase my trade size somewhat.

My exit plan will depend on each particular option strategy, but long options will typically be closed on a wide range bar or turned into spreads as conditions may justify. Option spread exits will consider current risk to reward, especially if the underlying price reaches the optimum price, but at an unfavorable time as may be quantified by delta or perception changes.