Friday, October 28, 2005

I think I got shaken out.

Yesterday as I was watching most my profits over the past month or so evaporate, I was saying to myself if only the market could come back I'll do the right thing and hedge like I should have a few days ago when I wrote my last post. This morning with the market up I felt that the fear I had experienced yesterday shows that I was too leveraged right now. I didn't want to end up being negative on the year because I got too bullish near the end (this happened last year). The market at this point wasn't up enough so that I could put on the hedges that would make me feel good about weathering a downside while still having plenty of opportunity to benefit from more upward movement, like I could have when I made my last post. So I decided to use the up day to do a little bit of liquidating. I think I liquidated too much, and now I feel worst then I did yesterday. Obviously if the bottom falls out of the market I'll be happy that I lightened up so heavily, but I really feel that my bearishness got out of hand this morning.

My take away is that when I'm up big I need to take some profits. When I wrote my last post, I could have hedged most of my spy inventory for almost a guaranteed profit and still be long wing gamma. I could have hedged all of my XLE for a guaranteed profit, by completing a bullish butterfly for a credit, and still had the opportunity to benefit for further major upside gains. I could have liquidated half of my SMH position and eliminated almost all of the risk going forward in SMH as well.

(NOTE: I'm only talking about my short-term options portfolio. My long term portfolio is untouched.)

Monday, October 24, 2005

Stocks flying along with my ego.

Today's trading was difficult even as my account soared into new all-time highs. My trading has been near flawless for several weeks. As my account rises each day, so does my ego. On days like this, I have to remind myself that I used to get excited when I made this much money in one day, and yet my fear of losing these profits is completely absent, while in the past I couldn't stop myself from locking in profits on days like this. I have to remind myself that most of the profits today are all paper and could evaporate on another day easily.

In an attempt to fight my ego back, I remind myself of the huge mistake I made last week when I did not hedge to Delta Neutral in ECA the day it was up almost 5 bucks on take-over rumors. The next morning I shorted shares against my calls, after it had given up half that gain even though the rumors were somewhat true. (Apparently they had been offered 65 a share earlier and turned it down.) My ego fights back though. I remember when I hedged my short calls way too soon a month back into the beginnning of the decline, and missed making twice as much money off of that short position as I did.

My Spy position and my XLE positions were up big today. I was 100% long in both. I unhedged all of my ECA on Thurseday near the close. I have scalped those calls enough so that the options are essentially free, but I could give up significant profits from a downward move in the stock or the implied volatility. ECA common was up a buck sixty or so today and yet my calls were only up 0.05. I haven't checked where IV was at prior to today. It looks pretty high today, so it must have declined off some pretty high levels for me to not have made money off such a strong move in the underlying today.

On balance I think my ego won the battle. I did lock in some of my profits in SPY by hedging 40% of my deltas. I didn't hedge any of my gains in the oil sector though. At least I didn't do any new buying today.

Thursday, October 13, 2005

Did I turn bullish?

With the close of trading today, I have to wonder if I turned from short-term bearish to bullish? I don't feel very confident in this market, but my trading says something else. I found myself buying stock and selling puts today.

I lightened up on my ECA stock short today, returning my position in ECA to delta-neutral. I think I have have scalped about $0.45ish off of the long ECA calls at this point (I would have to look through my statements to get the exact number). I wrote in my last post that I planned on covering all of my short stock after the profits from the short position were large enough to cover the entire price of the calls, leaving me with a free call option. At one point today I probably could have done this while hanging onto almost a buck in profits. I just couldn't bring myself to do this though. I still feel that ECA will go lower.

I also bought GG shares against some GG puts I purchased a couple days ago, to bring myself to delta-neutral in this position. This locks in about 70 cents in profit on those puts at this point. This puts me into the synthetic GG Jan 20 straddle at about $1.80 I think. This is almost half the current market price to buy the straddle.

My buying today was not limited to getting delta neutral in my straddles though. I have been closing out my inventory of SPY options over the past few days to lock in profits on the bearish side. My position in SPY as of today, now consists entirely of some Dec 113 short puts (which was originally part of a bull put debit spread). I also opened up a position in the SMH Nov 35/32.5 bull credit spread which is profitable by about 0.80 on the close. I am pleased with the execution of the SMH position. I believe I legged into this spread for what was the highest credit a retail trader could have obtained today for that spread.

My long term portfolio has given up almost all of the gains I had in this latest decline. Fortunately, gains from my shorter term trading during this decline have offset about half of that loss. So far this leaves me still nicely positive for the year. I do really regret being to quick to hedge my short SPY calls early in the decline. They could have offset all of the losses and then some...

With my new bullish positions in SMH and SPY I am now more exposed to downward market movement than I have been so far during this decline. I definately need and am betting for a turn-around soon, so regardless of how I "feel" about the market, I must be a strong bull.

Thursday, October 06, 2005

Trade Dissection: ECA Synthetic Straddle

One of the advantages of options trading is that as a trade progresses, one type of risk can be traded for another. Buying stock is kind of a crapshoot. You make a guess and you hope you're correct. Once your in the position there isn't much you can do to change your odds, aside from closing part or all of the position out. For example if you buy stock for 50 bucks and it goes up a dollar, without using options the only way to close the position out is to sell some of the stock. If you sell all of your stock though, you can't profit from further movement. Alternatively, you could sell half your shares instead. This gives you the opportunity to profit from further upward movement, but substantial capital is still at risk. There is no good way to fine-tune these adjustments with just the underlying issue. Since options have a non-linear profit graph, they provide the power to fine-tune the nature and type of risk that the trader is exposed to.

Here's an example of what I mean by trading one type of risk for another. Yesterday in about the last hour trading, I was looking at Encana (Symbol:ECA). ECA had allready fallen over 3 bucks that day. This was on top oflarge losses the day before as well. Cramer had written an article on basically stating that he though companies with natural gas exposure like ECA would have good earnings and their stocks would go up on those earnings. (I don't think he was saying to buy at that instant though.) The entire energy sector was imploding, and ECA was down almost 10 % in 2 days. This was not the time to play countertrend. I was not interested in entering any bullish positions in ECA at that point in time but I was interesting in positioning myself for the earnings report.

Going long or short is kind of a crapshoot. In a volatile time like this, I would prefer to get into a position where I can benefit from large volatility whether or not the stock goes up or down. I didn't know where ECA would be in a month, but I was reasonably confident that in a month, it would make a big move away from the current price it was trading at, which was 54ish. The easiest way to construct a position that can benefit from a big move when you don't really know which way the move will be is to buy a straddle. The problem is, I was not the only one who thought ECA could make a big move. Everone thinks this, and the price of the at the money (ATM) November straddle reflected this. It would cost well over 7 bucks per straddle. This means ECA would have to move over 7 bucks for me to merely break even. The stock had almost moved that much in 2 days allready, so it might not have been that bad of a bet to make. (I will explain later why I wanted November instead of October.)

I wanted to get into the straddle at a better price though. My plan was to leg into a synthetic straddle. To build a synthetic straddle, one buys/shorts stock and also buys 2 puts/calls for every share of stock bought/shorted. In order to get a better price than 7 bucks or so for the straddle, my plan was to leg into the straddle.

This is what I mean by "legging into a trade". A straddle is a combination between a bullish and bearish position (like most option strategies). In my case the bearish position would be shorting a share of stock, and the bullish position would be buying 2 calls for each share of stock shorted. One can reduce the price of the over all straddle by entering the bullish position at a lower price than when you enter the bearish position. The idea is to speculate on the short-term movement of the stock in an outright directional trade. By speculating correctly, the profits can be used to reduce the cost of the eventual neutral position.

Why did I choose to use the synthetic straddle(short stock + 2 calls) instead of the regular straddle (put + call)? I had recently read this article on the Daily Options Report Blog about shorting stock and buying calls on a ratio. He says he gets better executions this way, so I just wanted to give it a try.

Yesterday, the entire energy sector was selling off in a panic. ECA had dropped quite a bit. I didn't think that ECA (or the energy sector in general) was done selling off, so even though I felt like I was late to the party I decided to sell ECA stock short in the last hour of trading. I waited for ECA to uptick about 10 cents and then put in my short order. I was executed, and the stock dropped another 40 cents or so from my execution by the end of the day, so the trade was off to a good start.

Selling the stock short was the first leg of my straddle. I was taking on a lot of upside directional risk for hopefully a short period of time. Hopefully by being early enough into the sell-off, the upside risk would be small, but there was no real way to know at that time if I was early enough into the sell-off (a sell-off that had been going on for 2 days). It turns out that this time, shorting the stock worked. This mornign when I woke up, ECA was down over 3 bucks on the day.

Now I had 3.74 profit on my ECA short. The November 50 calls were selling for 3.70 bid and 3.80 offered, so my profits from the ECA short were just about enough to pay for about half of the spread, since I need to buy 2 calls for every share shorted. Afterwards I glanced at the puts and they were 3.30 bidand 3.50 offered, so I definately was getting a better execution buying the calls then I would have obtained buying the call and the put. I saved myself 10 cents extra by not having to pay that 20 cent spread in the put. (The spread in ECA shares themselves the day before would have been like a penny or 2.) By legging into the trade, and using the synthetic straddle instead of the regular straddle, I purchased the straddle for 3.86 when the market offer price was 7.30. This puts me into the straddle for about half of what the risk would otherwise now be at that point, but I had to take all of that upward directional risk to get to this point.

Making 3.74 over night was just about ideal. This turned out better than I had hoped. At that point I could have just covered my short and taken the 3.74 profit and I would have been quite happy to do so. I wanted to do better than the 3.74 though, and that is why I changed the position into the straddle. The profit gave me the opportunity to stay in the game, but change my odds going forward by building a better trade than what I started out with.

This is how the trade looks now. At the moment I am completely delta hedged. That means that I have no risk of losing money do to changes in the stock price. In the near term I have locked in most of that 3.74 profit from the short sale by turning the position delta-neutral. This is what I meant earlier by trading one risk for another. I have traded my delta risk for theta risk and vega risk. Since I am negative theta and long gamma, this means that I will lose money slowly every day. I need the stock to move enough to overcome this time-decay. Assuming, I hold the position until expiration I need the stock tomove at least 3.74 between now and then to overcome my theta and any potential vega losses. If I had not legged into the trade I would need a movement of 7.30 instead.

Vega risk is my exposure to changes in the implied volatility. Volatility in ECA is high and my straddle will be worth less money if implied volatility lowers. With earnings aproaching, I doubt that there will be much IV loss any time soon. I also make money if IV goes up, but most likely the bulk of any gains will come from actual stock market movement. If there is an IV increase between now and when I sell the calls this most likely be small bonus. It is unlikely that IV will increase enough in these calls to create profits significant compared to those that could be obtained from actual stock movement.

Here is my plan going forward. If the profits from the short stock part of the straddle exceed the cost of the calls in a short period of time, I will probably look to cover the short stock. If that happens, going forward the trade would be completely risk free, as I would be sitting on a free call option. The plan at that point would then be to hold the call into ECA's earnings which are on Oct 26th I think.

This is why I chose to buy the Nov. Call, instead of the Oct. call. I wanted the ability to hold through earnings. The Oct. call expires 5 days prior to earnings. However, I won't necessarily hold through earnings. I just wanted the option to do so if I need to. If there has been a lot of apreciation in the stock prior to the earnings, and if I have a profit I will consider closing the position out just before earnings. After the earnings come out there is danger of a volatility implosion (remember my Vega risk) since uncertainty will be removed from the market.

With a little luck in my timing, I might capture downside profits as the energy sector continues to sell off, and then make money on the way up if ECA recovers into earnings.

Wednesday, October 05, 2005

Hasty Decisions

I slept in today, and I think this negatively affected my trading today. I rarely make a point of waking up in time for the market open. Over the years I've generally found that when I trade in the morning I usually trade poorly. My solution to this has been to wait until the afternoon before placing trades. Generally, I've prefered to make my trades in the last 5 minutes of trading.

Recently though, I've been legging into a lot of trades, and have modified this plan. I've still been entering new trades in the afternoon, but when there are adjustments to an existing trade that I want to make, I've been making a point to wake up in time for the market opening. The morning is usually the most volatile time of the day, and this can provide good opportunities to get the prices I need to finish an option spread at the price I want. This has been working well for me lately. I still have a specific routine though. I wake up and then turn on CNBC so that I can see where the market is while my computer boots up. Then I load up Trader Workstation, take a glance at my positions, and then I read, Niederhoffer's site, and the options report before I make any trades. This gives me the opportunity to see what is going on in the market before I make trades.

This morning I made a point to not wake up for the open. I thought that the market would probably open near it's high for the day, and continue in it's downtrend as the day progressed, so I would allow myself to sleep in and miss the temptation to adjust my bearish positions at bad prices in case the market gapped up.

The S&P and the OIH were both down a little bit when I woke up this morning.
My plan for OIH was this. OIH was well below the bearish wing of the former iron condor, I mentioned yesterday. Yesterday I had closed the short portion of the bull wing of the iron condor. This left me with long gamma to the downside. I was hoping to close out the rest of the IC with the OIH at around 115. If I didn't get that price, my plan was to wait for a few days, and then just close the position out at whatever price at that point. Right about the moment that Trader Workstation booted up the oil inventory numbers were released and the OIH immediately reversed and turned positive. I panicked and closed out all of my OIH options. This cost me 30 cents or so of profit. Almost the second I was out of all of my OIH options the OIH reversed again and plunged almost a buck as traders finished reading the report and concluded that the report was bearishinstead of bullish (do to low gasoline demand I believe). Lesson learned: "Don't trade immediately when news gets released!!". I should allready know this lesson... I could have easily gotten another buck per spread if I had been more patient, which would have put me right at my profit target.

At about the same time as the OIH fiasco SPY also ticked up slightly. I immediately finished the 117/120/123 SPY butterfly by buying the OCT 117 calls on the offer. This puts me into that flys for a little over a $1 credit. The thing is, I had decided last night to let my shorts run, and not try to complete the butterfly, since the current profit from the SHORTS was allready better than half the maximum profit from the butterfly. But I made a hasty decision. At the very least it would have made more sense to just close half my naked 120 calls at a great profit, and leave the rest to run as bear spreads, with no or almost no risk. This probably would have been the optimal decision at that point with regards to risk/reward. As I stand now, I've locked in a little less than half of my current short profits, with an opportunity to keep the rest of them, and potentially make another 33% or so, if the market doesn't move too much between now and expiration (not a likely prospect).

Basically what happened today was I woke up late at the exact same time that news was breaking which moved the market, so I skipped my usual routine that gives me perspective. This lead to emotional trading. Waking up earlier would have given me more time to prepare and be calm. Waking up later would have helped a lot too, as I would not have been trading into the morning volatility. Maybe I should make a point of sleeping in until lunch time in New York anytime I can't wake up before the market opening? If I am going to trade during the volatile morning, I need time before the market opens to be ready for it.

Tuesday, October 04, 2005


Wow! What a move!. With the market so strong early in the day, I was pleasantly surprised to see that I was moving into new all-time highs for my portfolio. These gains came despite a large short position in the October 120 SPY calls, that I built up into last week's strength. Early in the day I benefitted because tech was much stronger than the market as a whole. My long-term portfolio is overweight in tech, and has slightly positive gamma. Even though I was taking losses in my large (large for me) SPY short, the gains in QCOM, QQQQ, LU, more than made up for the losses in SPY which surprised me. Oil moved down quite a bit today too. The OIH was down around 2 to 3 bucks early in the day. This was also probably helping to hold the SPY back, since the oil sector has become a larger portion of the S&P over the past year or so. The oil pull-bakc further mitigated my losses in the SPY short since this was taking OIH closer to the center of my 130/125/115/110 iron condors.

But if I thought things were going great when the market was going up, the portfolio really started to rocket when the market began to tank and my short SPY position started to kick in. I like to think I learned a lesson last week. I had the oportunity to hedge some of my upside risk in the SPY today and I took it, unlike last week where I had opportunities to reduce risk and I didn't. (In fact last week, I doubled up instead.) I turned my short SPY OCT 120 call position into the 120/123 call 2:1 backspread by buying some OCT 123 SPY calls in the last hour of trading. Now I am in that backspread at a pretty good price. More importantly my total position in SPY (I have other SPY option positions besides this backspread.) is now long gamma in both directions. I am still leaning strongly to the short side though.

At the end of the day, OIH really started to tank. It was down like over 4 bucks, and was now past the midpoint of my 130/125/115/110 iron condors. I legged into this IC position during the hurricanes for a debit of around $0.67 (including commissions), and was quite pleased with how I legged into it. It had a maximum profit potential of $4-something and a 10 point range over which the maximum profit could be made. Today the position was profitable for like 2.87. When OIH really tanked at the end of the day, I bought back the 115 put (for a profit). I may have panicked a little bit...I now have a bearish position in the OIH. Hopefully I can do as well of a job legging out of the position as I did legging into it, and maybe increase my profit...but I fear that after a move like today it will come-back some, and I may give back more profits. I just couldn't bring myself to close out the whole thing for only $2.87 today.

I think my fear with the OIH was this: I'm not sure if I believe the widely heald view that last week's broad market strength was purely end-of-quarter window dressing. However, I do believe that the strength in OIH last week was window-dressing, and I was very concerned about losing my profits to more downside movement in the OIH.

I need to be especially careful now though. The times when my portfolio is at highs are always very dangerous for me. The temptation to over-trade is great. Making money is intoxifying. It can make you feel like a genious who will never make a bad trade again.

Monday, October 03, 2005

The Hindenburg Omen

I noticed there is a bit of chatter on the web about something called the "Hindenburg Omen". The Hindenburg Omen is a technical indicator that supposedly predicts crashes. Or more specifically, when the Hindenburg Omen is triggered, supposedly there is a high probability of a market crash in the next 30 days. This website explains how to compute the Hindenburg Omen, but it doesn't give any specific information for us to know what the past performance of this indicator has been. Specifically I wanted to know how many times this has happened in the past, and what was the average return of the S&P 30 days later. I Googled "Hindenburg Omen" and found lots of sites talking about this omen. Most seem to agree this is a "very bad sign", but amazingly almost none of the people who've discussed this indicator seem to have bothered to check if it has actually been a bad sign in the past. I would backtest it myself but I don't have the necessary data (or time). I was just about to give up, when I found this site which has a backtest of the "Hindenburg Omen" back to 1965.

The backtest has 35 instances of the Hindenburg Omen. The average return is -0.7%, so that may indeed indicate a negative tendacy after a Hindenburg Omen has been triggered. The Omen has indeed been triggered before several major market downturns, but it has also preceeded several major upturns as well. The author of the website seems to be saying that although the Hindenburg Omen doesn't necessarily portend a market crash, it might be predictive of volatility since the standard deviation is 8.5%:

...thought it would be instructive to include the standard deviations of returns, which are large. What does that tell us? It shows that while there may not be a distinct bias to S&P performance after these signals, the market does tend to move well in one direction or the other.

I pulled his numbers for the 30 day return after a Hindenburg Omen into Excel and I took the absolute value of the returns. The average 30 day move after a Hindenburg Omen has been 13%. This suggests that maybe it might be a good idea to buy some out of the money calls and puts when the Omen is triggered.

Here's the thing though. I kind of suspect there may be a little bit of curve-fitting happening here. Here's what I think may happen. Naturally the time periods prior to a crashes get heavily scrutinized by technicians after the fact. Just by shear coincidence there are bound to be some set of indicators that taken match up in some way across many of the pre-crash time periods scrutinized ( This is curve fitting). Since the Hindenburg Omen was most likely created after the fact to explain crashes that had allready happened, the sample space is biased because the time period being analyzed includes all of those crashes that we were looking at in the first place. Or more simply, the Hindenburg Omen probably has preceded volatility because the person who "discovered" the omen was looking at volatile times when he made the "discovery".

The most recent Hindenburg Omen was triggered 2 days a couple of weeks ago on September 20th and then the next day on the 21st. October options expire 30 days later on October 21. SPY options 6% out of the money are selling for around 10 to 15 cents. I think the Hindenburg Omen is probably bullshit, but I might just buy a few of the 116/127 combination just for th hell of it anyways.