Riding the Inflection Point

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Account value down .5% on negative AH scalps and my inaccurate hedging strategy. IB shows my option spread as having delta and theta decay, but there is little price movement in either direction versus the underlying and I have yet to see the effects of theta decay. I will have to deconstruct and reanalyze this trade.

Attached below is a doctoral dissertation that contains option strategy backtesting results for straddles and calendar spreads using different variables. Test results are shown starting in table 7, page 96.

This doctoral dissertation was completed by Vincent Campasano entitled “Essays on the Term Structure of Volatility and Options Returns (2018)”. Doctoral Dissertations, 1220, University of Massachusetts, Amherst, Scholarworks@UMass Amherst.

https://scholarworks.umass.edu/cgi/viewcontent.cgi?article=2280&context=dissertations_2

This entire paper is worth reading for anyone serious about option trading. From backtesting methodology to listed source material, this paper would be part of a good foundation for profitable options trading.

 

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Attached below is my Account Performance Report for August. Instead of trading my system on Weds and Thurs last week and making better than 1% each day, I managed to find a couple of losing trades that cost me about .5% each day. The losing trades were not the big issue. Not taking my signals and the missed opportunities was the real drag. In response, I have simplified my system, will use less complex strategies, and will use better defined entry and stop rules.

 

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Was caught net long ES delta when PMI report hit. I had a partially hedged risk reversal that I exited, but kept my hedge consisting of 4 short MES contracts. As ES rallied, I unloaded 1 MES at a time until flat. My decision to trade MES this way ended up costing me about $250 more than closing all immediately. Later, 1 shorted YM and covered for a $235 profit. After the ES rallied again, I decided to buy a couple ES diagonal spreads to satisfy my bearish outlook for this week and to take advantage of term structure inversion between Sept 6th and Sept 9th expirations as well as significant put skew. This trade has a static probability of profit of a little over 50% and a best case reward to risk of 4:1. This position has positive theta and even a little positive gamma.

Before the PMI came out, I noted YM was substantially underperforming ES or NQ. This should have told me something. I imagine it is not hard to model the PMI or even or to do one’s own survey and I wondered if several hedge funds, etc., were doing this and positioning themselves accordingly. After the news hits, positions can be covered into heavy volume. I will review Friday’s and Monday’s ES price action for “Sticky bids” and YM price action for “Sticky offers”. However, I would think currencies, bonds, and gold would have been stronger if my theory was correct. Maybe only one hedge fund, if any, was involved and they did a pair trade with major volume by selling YM and buying ES, thus causing the price divergence between these two instruments.

I am reviewing my hedging strategy on ES risk reversals. It seems more effective for me to sit through non major losses because theta decay will eliminate most of them by the end of the week. In order to maintain defined risk and maximize ROC, I will buy a 2 SD put for downside protection. This is very expensive insurance from a IV standpoint and reduces my theta significantly, but the ease of position management, risk reduction, and higher ROC is worth it. As a bonus, if the market were to ever seriously unravel, I would not have to worry about IB increasing margin requirements 4x or whatever, on any ES hedges. As it was today, the Bid / Offer on my risk reversal did not update for a while before widening from .50 to 2.00, which was a few minutes after the initial PMI selloff.

 

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Account value down about .4% on ES rally versus my diagonal put spread. A profitable MES scalp and a open profit in a CAD backspread in calls were not enough to offset the decline on the diagonal. I will likely try to salvage what I can tomorrow from this trade. The equities markets have been zigging and I have been zagging lately.

I took a bullish line on the Canadian dollar today because of a broad based rally in other currencies, strong crude, and a nice bounce in copper, finally. US equities were up about 1% and bonds were only down a little. GEU2019 was actually up. The Trump administration wants a weak dollar, several recent US economic reports have been other than impressive, and the Fed generally seems to be in an accommodative mood. The breakeven points at expiration on my CAD backspread are .7505 and .7649. The October 4th options show a 1 standard deviation move to the upside to be about .7700 from here. The weekly chart shows a couple of touches at .7685 in the last 6 months. This area is my profit objective. My plan is to hold this trade either until my profit objective is reached or two weeks, as theta decay between my breakeven points will start to hurt on this trade strategy. If the Fed takes a “Nobody is going to be more accommodative than us” stance or China and the US reach a trade agreement, CAD could easily sail through the .7700 level. However, a trade agreement or market perception of a super accommodative Fed are not likely to happen within my trade timeframe. Continued favorable crude oil price action should help my position. In addition, spot freight for US trucking has improved lately, giving me some additional confidence. Assuming today’s action in correlated assets does not appear to be an isolated event, I will look to enter additional bullish positions on CAD if we correct to the .7530 to .7540 area. I’m not looking to do large trade size because I am not yet convinced we are out of the economic woods yet.

 

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No new positions in the last two days except for a small GC calendar spread in puts.

I have an open loss on a ES diagonal spread that is almost two times my single trade loss allowance. Most of the loss in this now almost worthless position was balanced by profitable intraday trades. Normally I would have exited this trade at a loss of 50% of my debit, but allowed myself to be caught off guard by the market rally. Further, not only did I violate a money management rule, but I was on the wrong side of a significant move. I never even saw evidence of consolidation that was right in front of my eyes. Why was that? Bias. Part of my pre-trading routine will be to intellectually take the other side of my trading thesis. Although I have plenty of metrics that help me avoid staying in a trade too long or being on the wrong side of the market, better appreciation of the weaknesses in my thesis should help me when market action invalidates my idea. Always having a specific hard stop price will eliminate my money management issues. I can still have a soft stop area that is more conservative as long as my hard stop will keep me from losing more than my risk allowance. My soft stop can allow me to ride out certain quick adverse price spikes while potentially either exiting the position at a more favorable price or even keep the position if the price recovers by a defined amount within a tightly defined time frame.

I will post in depth analysis of my longer term trading ideas in future posts that will include market structure changes and possible reasons for those changes. It is not unusual for there to be structural changes in the underlying and or its options before a trend change. I will consider various trading conditions, trading triggers, the size of the expected move, and trade structure optimization given my expectations and the confidence of my analysis. I will also attempt to vigorously refute my own thesis to try keep myself centered and unbiased as possible.

 

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One of the challenges I have been working on is safely increasing the utilization of my account buying power. I can look for low correlated instruments and strategies, but correlations change frequently. Hedging can help, but some high alpha single names seem to have different betas according to market conditions. For example, on a broad market down trend day, a high alpha single name may have a beta of 3. On a narrow range consolidation down day, its average beta may be 0. On a up day, its beta may be 2. It is important for me to be reasonably accurate in modeling this as I’m hoping to avoid large adverse daily PnL swings.

I have been the exploring the following diversification and hedging ideas. A tentative list:

1. Company specific scheduled events - Earnings, new issues, convertible securities, warrants, and trade shows. This is mainly for higher priced single names that have good option volume.

2. High alpha single names that have a reasonable business model. It is a major challenge for me to feel comfortable entering these “Over priced” high flyers. But oh, the performance and the price action of these “In play” stocks is alluring. The key here seems to be starting with a very small initial position and either averaging down to a certain extent while still having a money management plan with wider price tolerances or to use a Martingale system where a initial trade is made and normal money management is used. If a loss results, I can enter on the next buy signal with larger size. A Martingale system will not give a unsound trading system a positive expectation and will contribute to lower utilization of buying power. However, the psychological benefits for me to diversify into this category makes this system worth considering as a start.

3. Structural market or policy changes - Legislative decisions, regulatory changes, exchange rules, and monetary policy changes. This category will be the basis of longer term trades. Careers have been made by positioning early in a major long term move.

4. Strategy diversification such as butterflies, iron condors, calendar spreads, etc. that consider skew, term structure, volatility levels, and expected move size.

5. Broad asset class diversification - Credit markets, currencies, equity Indexes, industrial commodities, precious metals, and agricultural commodities.

6. Pairs trading based on fundamental differences in prospects. This can be sector to sector, industry to industry, or even two individual stocks within a particular industry.

7. Geographical diversification.

8. Partial hedging on convexity trades to improve reward to risk. For example, if a 1% adverse move in the underlying causes a $250 loss and a 1% favorable move causes a $350 profit, the reward to risk is 1.4:1. If I hedge $200 of risk, 1% adverse move is now $50 and a favorable move is net $150, for a reward to risk ratio of 3:1. Increasing the size of this partially hedged position will help increase my buying power utilization while maintaining acceptable per trade money management levels and favorable reward to risk ratios.

The above is a lot to keep track of, but it may be possible by maximizing the efficiency of my workflow. Besides, above average returns with low drawdowns are not just going to fall into my lap.

 

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Will be looking to greatly increase my intraday scalping after applying a much shorter time frame to one of my systems. Target daily probability of profit is 95%, target average per trade RR is 1.5:1, and target daily ROI is 1.5%. If I realize these lofty, but not baseless goals, it will be quite the change in status quo. Whatever my ultimate results, I will breakout my scalping performance from my swing option trades and post results here on a weekly basis. I believe the key for me to reach stated metrics is to consistently follow my trading system. Basically I am looking for areas where I may be able to front run larger institutional orders on equities. Stop loss areas are short term S/R areas. Exit areas will include S/R, wide range bars, and changes in short term S/R levels. Entries are determined by S/R and positions are weighted according to my intraday outlook. After a few consecutive profitable days, I will substantially increase my buying power utilization while maintaining a low cost downside hedge as appropriate to my directional and account exposure.

 

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Had a positive day with my new scalping strategy. Although I expect to average about 20 trades per day, I only completed 3, mainly because of numerous kinks and allowed distractions. My list of trades, errors, and proposed refinements below:

Long AAPL, + 6 ticks (+ 6 cents). Paid 12 ticks more than intended on entry because order price reverted to current price instead of my limit price. My limit price would have been filled. Missed out on an additional 9 ticks of profit because I did not have resting order near resistance. AAPL’s price action and market context demanded I have a resting order. I must always double verify the order price is what I intend just before I send it on this recurring issue. I will discuss exit strategy refinements later.

Short MNQ, + 9 ticks. Same entry issue as above, costing me 3 ticks and shorting at the low of the move at that point. Was very close to being stopped out, but trade soon went in my favor. Feeling confident about the trade, I took a moment to pet someone’s exotic parrot. I missed a higher low exit point and easily missed out on 20 ticks. Idiot. I’m not talking about the parrot or the parrot’s owner. Someday, when I take trading seriously, I will not allow myself to be distracted. Beautiful parrot, though. Idiot.

Long FB, +29 ticks. At least I finally opened a new position without issues. However, I still did not have a limit order near resistance and missed out on 15 ticks easily.

Depending on market conditions and my broader outlook for the day, I will adjust the proportion of my various exit points according to the following table:

1. Trend day - S/R, 30%; wide range bar, 30%; adverse S/R level changes, 40%.
2. Range day - S/R, 40%; wide range bar, 30%; adverse S/R level changes, 30%.
3. Polarized day - S/R, 50%; wide range bar, 30%; adverse S/R level changes, 20%.

This table is likely to be modified over time. I will also at least partially close positions near previous day’s high or low and at the 1 standard deviation level.

Now for some “Napkin” calculations of my scalping profit potential while considering buying power and the effect on daily returns of a losing streak. This will help me with determining capital allocation with my scalping and options trading strategies. Also, I wish to avoid excessive daily drawdowns when the inevitable losing streaks happen.

My initial win rate estimate is 50%. Estimated overall profit to loss ratio is 1.5:1. My current maximum buying power is roughly $135,000 on this account, less overnight option position margin requirements. The stocks I trade are in the $80 to $360 area, with a average daily range over $2.00. I expect to average 20 trades per day. Most of my scalping will be stocks for their typically better signal to noise ratio versus futures and better trading idea isolation. My daily scalping profit target is 1.5%, or $500.00, rounded up. This comes out to an overall net of $25.00 per trade, with average profit of $75.00 on a winning and a average loss of $50 on a losing trade. Utilizing about $60,000 in buying power and a typical price of $200 on trading stocks, implies my typical share size will be 300. Therefore, allowing a transaction cost of $.02 per share the average per share profit would need to be at least $.27 with per share losses not exceeding $.18. $.27 is less than 14% of the average daily range of my stocks selected for my scalping strategy. If I hit these numbers, I will exceed my daily % goals.

Over the course of a 1000 trades and considering my metrics above, it is reasonable to expect a losing streak of 10 trades in a row to occur every 2 1/2 months. Long story short and assuming I can keep my emotions in check, my projected net result would be a $405 loss that day, or 1.2% of account value. I am willing to tolerate a 3% maximum daily drawdown. These calculations leave me with several things to consider: Obtaining additional capital through a prop firm and or eliminate my swing options strategy in order to maximize my allowable daily drawdown and thus daily profits. My plan at this point will be to try to trade well for the rest of this year. If my trading results warrant seeking additional capital, I will do so. I wish to continue to develop my options trading skills and will continue to trade options at the potential cost of overall account returns. Besides, if I hit my lofty account performance goals, I’ll be doing ok, maybe well enough to buy my own parrot! Idiot.

 

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Account value up a modest amount on intraday scalping.

Only completed two trades today, but had plenty of other profitable opportunities, including lunch hour.

Long CAT returned 31 ticks, averaged. My first exit was resistance plus a few cents. My second and last exit was a second break below a potentially lower high, but there was no lower low forthcoming. Had I applied my longer holding strategy on the balance of my position, I would have gained an additional 17 ticks, averaged.

Long V returned 29 ticks. Although I fought the underlying down trend here and jumped the gun early with my expectations V would rally late in the day, there did seem to be active support for V when I entered my position. I closed the entire position in a single trade because I had second thoughts after other related stocks were not seeing much investor interest.

I attempted to go long NVDA, but was not able to send my order. I had changed some things on my platform the previous night, including my order entry window. causing a still unknown issue. When I used the old order entry window, I could send orders again. The missed trade was easily worth 100 ticks. Lesson here is to test drive all aspects of one’s platform before a new trading day starts after making changes.

I am learning some nuances based on time of day and type of stock I am trading. For example, on CAT, the likelihood of a out sized wide range bar is less than say a tech company. Therefore, I should reduce the proportion shares dedicated to that exit type. A breach of a high or low price will tend to have less follow through.

As the trading day progresses from the early morning and there has been meaningful price changes, it seems best to dedicate a larger proportion of shares of my exit strategy at S/R levels because of the tendency of reduced price extensions through S/R.

During NY lunchtime, CAT actually did have a wide range bar (By CAT standards), approaching its open of the day. What a perfect place to catch a falling knife. The broad market was maintaining its gains and CAT’s opening price would have likely found heavy support. CAT never reached it’s open. In the alternative, I could have bought bar break to the upside as minor “confirmation” of my idea.

TSLA rallied strongly to a new daily high during lunch, setting up a tempting shorting opportunity, especially since I consider the macro environment for TSLA to be mixed, at best. Had I took the trade, i would have taken about 30 ticks out of it. TSLA did make a new daily high later on before finally seeing healthy profit taking later in the day.

BA has been particularly strong the last couple of days, yet I have no trades to show for this. As BA is on my watchlist, I need to do an investigation to see if there was some information premarket that might have given me an indication of a large potential price move. BA gave at least 4 pain free signals that preceded very large moves today.

There were several more signals in NVDA as well as other stocks that overall, would have been profitable for me to take. There would have been several losses, but the gains would have more than compensated. ROKU had several fast and large intraday moves. Because ROKU moves so fast, I will watch it a few more days before trading it with normal size.

I have not looked at new option strategies in the last few days, but really want to come up with a strategy to address potential long term change in global investment activity. It struck me as odd Destriero taking a public and confident position in CAD. I looked at CAD futures term structure and saw some months inverted. This is in contrast to the other major currency futures versus the US dollar. I take this as a bullish indicator for CAD. Further, in the back of my mind for the last few months, I’ve been thinking about investment dollars flowing from developed countries to developing countries as the global economy improves. A China and US trade deal will probably significantly accelerate foreign investment into countries as represented by ETFs EEM and VNM. If China, the US, and North Korea makes the right moves, there may be an exceptional new investment opportunity that presents itself, especially for early investors. A major key for developing countries to attract substantial foreign investment is having a strong court system that helps fairly enforce laws that protect outside investor interests.

 

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Account value increased by a modest amount on intraday single name scalps and a EUR calendar spread.

Because of volatility term structure inversion of Sept 13 / Sept 18, I bought a couple of put calendar spreads with a strike of 1.1050 at an average price of .00055. Although it took several hours before my orders were filled, at the time I entered the trade, IB’s platform showed a probability of profit near 60% and RR better than 3:1. Too bad I took a moderate directional assumption on this trade and EUR moving, at least initially, contrary to my directional assumption. Who would have thought the market might have anticipated ECB’s moves today? Too bad I didn’t. This position is still open and IB shows a slight unrealized profit on it.

Long AXP returned an average of 10 ticks. The card payment network industry opened strong. Anticipating a test of an earlier high and seeing firming of the bids, I decided to get long in this early session trade by using an aggressive marketable limit order. As it turned out, I probably could have saved 3 cents by being less aggressive. I then entered a additional buy order a little below the inside market, but soon cancelled after a selloff in ES, fearing a price move under AXP’s open would result in downside acceleration. AXP declined only .15 before trading in a narrow range for a few minutes. I decided to close half my position at a loss of .11 as a time stop. Oops. I also put a order to sell the balance of my position a little above the high of the day. Oops. This level was soon reached. AXP then had a minor correction before moving up by a significant amount. I would have been able to realize 50 ticks on any remaining portion of my initial trade. If I had any.

Long VLO returned an average of 23 ticks. Although I entered this position 10 ticks late, it was heat free and I exited at a perceived resistance area. The key word here is perceived. VLO ran 110 ticks, including a wide range bar where I would have exited any remaining shares if I had any. VLO still continued to run before finally correcting. Clearly I have no sense of how large potential price moves might be, even though I have very well defined exit strategies for multiple scenarios. The key is for me to consistently utilize all of my exit strategies by allocating a portion of each position to them. My over emphasis on loss avoidance is a false economy where I am losing the opportunity to make dollars while risking pennies.

Although still early in the US trading day, I decided to take a nap because my long nights this week had caught up with me. Returning after lunchtime, I decided to focus on watching how various industries performed by their relative strength to the ebb and flow of the market. The strongest performing industry on my watchlist maintained firm bids and narrow ranges during minor futures selloffs. After futures rallied, prices of the higher relative strength stocks popped up like a spring. I considered taking a reversion to mean trade on HD because of a wide range bar to a new high of the day. I was too slow and missed a 20 tick profit. As it turned out, this was HD’s high of the day. HD later gave, by intraday standards, a longer term sell signal.

Later, I noted DIS came under significant and sustained selling pressure. Because of context, the way I saw it at least, I took this as a sign the broader market might soon experience a correction. After a little while, additional large cap stocks started to weaken. Futures stayed within their range, however. The card payment network stocks continued to outperform by at least maintaining their price levels. Finally futures started to sell off. The card payment network stocks initially held firm before finally participating in earnest with the selloff. During index futures rallies, these stocks had robust bounces, giving favorable prices for selling in anticipation of future selloffs. The alternative of selling weaker performers would have worked fine as well.

I am excited with the trading concepts I have been coming up with. I am beginning to model structural inefficiency in the market and assigning a value to each category of market participant. I am also considering the effect of dominant trading styles and assets under management. It is critical to define the source of one’s edge and anticipate changes that could affect that edge. AI is exponentially increasing it’s influence on our lives and is becoming a greater threat on the status quo. I can currently visualize 4 levels of trading knowledge. Most market transactions are at level 0 or 1, in my opinion. Personally, I just need to implement what I know at level 0 and 1 to make good money while making minor adjustments along the way. AI will marginalize the value of people in a lot of ways and will greatly affect employment opportunities, including trading. There is still time... for me to keep my mouth shut! Included below is a video of a AI speaker with a favorable view of our future:

I hope the speaker is not a robot talking his book!

The right investments and moves in an AI world will offer unprecedented opportunities to completely change one’s situation in life and thus worth devoting considerable thought and research into the many repercussions of AI. Especially the effect of AI on systems already known to be inefficient.