Systematic Options Trading - Minimizing Risk Exposure & Optimizing Edge · David Sun
markets speculation and risk this is the chat with Traders podcast we're on episode 248 and I'm Ian host of Chat With Traders and we're going to mix things up just a little bit today where Tessa will be interviewing Our Guest David Sun David's background is in electrical engineering but he got turned on to options trading over the years and appeared on the tasty trade show as a rising star guest with a talent for options trading he then went on to start his first hedge fund in 2018 and then added a second one in 2021. in this interview Tessa discusses an overview of David's systematic options trading it has to do with a multi-layer approach using stop losses which is not common in options trading and even advised against and how David takes advantage of high implied volatility not in the way most option Traders would think and his take on managing the win size to loss size ratio this episode assumes that you do have some basic level of options trading knowledge so options Traders I think you're in for a treat and May Come Away with some actionable ideas by the way David will make an appearance inside the chat with Traders Community where I will dive deeper with David into the mechanics of his strategy please join us in this live online discussion on December 7th go to community on the chat with Trader's website to join we hope to see you there we would now like to introduce you to Our Guest David Sun hi David welcome to chat with Traders hey Tessa thanks for having me on yes it's very good to have you on um we have a lot to cover and why don't we just dive into it now but before we get into the the nuts and bolts of things I usually like to hear a little bit more about the human side of Traders so if you don't mind can you just share it with us a little bit about yourself your background yeah no no problem so my backgrounds actually uh in electrical engineering so that's my education and so I don't have a formal Finance background um I got into options when I was actually doing my masters and it was a buddy at grad school that got me a new options at the time I I randomly just wanted to get in the market because I think it was like the 2008 2009 time so obviously the the markets and the stock market in general was kind of on people's minds whether or not they were you know into trading um and at the time I had no knowledge you know I was just randomly watching CNBC and like following Jim Cramer and just picking stocks and so my my buddy got me into options interestingly enough actually from the point of view of selling options because I know people get into it tend to get into as buyers of options and almost like speculating directionally so I was actually selling puts very early on For Better or For Worse and again not knowing really anything and just kind of blindly selling puts um I wasn't even rolling I was just like picking based on how much premium I wanted thinking like hey um uh if I collect this amount premium then I can make this percent and I think occasionally uh if it did get challenged I would like he was like hey you can rule for a credit so it was very unsophisticated and uh the bad thing is it worked for a couple of years so you know made a decent amount but then at some point the market turned and I gave a bunch of it back um so I got a little disillusioned and uh I kind of stopped doing it for a bit but I had a friend who was also trying to get into the market or just doing research on stuff because he knew I was in options so he introduced me to tastytrade and this was in 2017. so that was I guess the beginning of like kind of the the reinvigoration of of my interest in options um because if people follow taster trade at all they know that it's kind of retail oriented there's a lot of content um a lot of stuff to learn you can just host drinking all up and that in terms of the learning curve was kind of what accelerated things for me um so I started kind of getting a little better and I got confident enough you know this was like a year and a half in that I I was doing well and something gave me the idea that hey it'll be cool if I could scale up what I'm doing and I was like well if I could do this for others and just kind of keep trading but I can make money doing it you know I basically started a hedge fund in late 2018 um did that you know that was going well I started a second hedge fund in 2021 and so you know it's been four years and so I've been kind of just continually pushing my own knowledge and developing strategies and you know that was kind of just a trajectory yeah so that was like a uh from beginning to end probably like a 10-year Journey 10 plus years at this point and that's that's kind of the very high level quick quick fly through so from electrical engineer to options Trader now hedge fund manager yes I wanted to back up just a little bit before options trading did you just trade stocks at all or you just went straight into options so I picked stocks for like a couple months because as I mentioned that was around the time I was in grad school and I was telling my friend about it and he got me into options so I basically dropped stocks pretty quickly I mean it was still uh involved in the sense that I sold puts on what I would have bought stocks on and again very unsophisticated it was literally like see what Jim Cramer mentioned or pick five random socks or it was like apple and Visa or like uh you know just just and then just selling a put and then doing that so yeah I wasn't trading stocks from early on it was basically just selling options for after like two or three months of you know quote-unquote trying to learn the market because that was kind of like uh what people usually start out with when they when they first trade options right on the sell side they usually sell puts that's kind of a popular thing to do is that true once you get past the buying kind of cause to speculate on the upside or buying puts selling puts and especially cash the card puts one of the kind of the intro strategies is like the wheel which is basically selling cash secured puts which is selling a put on a stock where you have enough funds to take assignment and buy 100 shares of that stock if you know if if it's put to you or gets to signed and then turning around and you know selling covered calls against the shares so I think that's kind of the introductory or like the first quote-unquote first strategy is that you know new Option Traders will learn right yeah so I I'd like to ask some questions about your hedge fund the reason is because we've had great episodes so far that mentioned the use of options to trade or use them as part of a hedging of a portfolio or options seems to be uh widely used in hedge funds but I don't know if we've taken time to pick one or two strategies and really break it down far enough at the level where even though these can be Advanced and in complex strategies in in some of these hedge funds um I think us reach retail Traders can still get some ideas to possibly really you know play with and experiment with more to be able to implement into our own strategies so I'd love to get into a bit a little bit about that and why start a hedge fund are you a Founder owner or you just manage hedge fund um both actually so a hedge fund is essentially just like a a broader investment vehicle so there's a number of parties that pull their capital and it's set up kind of like a limited partnership so all the people investors who are just providing Capital not their limited partners and I am a general partner which essentially trades the account it's all commingled funds just kind of like an administrator that does the books and allocates the profits uh proportionally to each partner so basically everybody gets the same return regardless of how much they've invested and so this kind of structure is a way to manage a large pool of capital without having to trade multiple accounts so some people might be familiar with something called smas or separately managed accounts where you're kind of giving somebody a manager access third-party access to your personal account so they trade in your account and they have something where they do a strategy and you know the trades get kind of pushed to all of the different accounts at the appropriate size but you know each if Master still kind of keeps control of the funds and they can see what's going on whereas a hedge fund it's called mingled and that makes it easier that's my preference because you can think of as trading one large account as opposing multiple small ones and for Capital efficiency and margining it just kind of works more easily but to answer your question yes I started found it if you will and also manage kind of too too small I mean don't get me wrong I'm not Ray dalio I'm not managing hundreds of billions of dollars there's a relatively very small and the grand scheme of things but it's kind of a similar setup yeah I I asked because it takes a certain mindset to be able to go from Trader just a regular Trader and then now to open up a hedge fund it tells me that you have an entrepreneurial you know side of you it's it's hard it's hard to be able to do that right to manage the business and also the money would you be willing to um describe some of your main bread and butter hedge fund strategy that you're using uh the kind of uh regulation that we operate under is we can't do public marketing so to speak and we can't raise capital in public and talk specifically about performance and stuff but I do share overarching philosophies and general strategies maybe not exactly the way they're set up right in the fund but like I said you even went through my own podcast which I think you've heard a couple episodes of like I share kind of different facets and and the approaches and ideas behind them and so I'll give kind of an overarching philosophy behind the two funds and like what the approach is and so one of them is using options as a tool to combine with traditional Buy and Hold so you know people talk about long-term passive investing if you're buying a whole spy right the S P 500 ETF you're gonna get the market returns and it's passive and you'll get you know nine to ten percent return a year or whatever it is which is great um but once you do that right it's a passive approach and you're pretty much subject to the whims of the market and you take what the market gives but with options and the way because they're Capital efficient and the way they're margin you can essentially run an option strategy on top of a a passive Buy and Hold portfolio and it's basically an overlay so if you think about it if you were to run option strategy and even Target some very small return one two three percent whatever it is and you can consistently do that and that's basically stacked on top of your Buy and Hold You know whatever your core it doesn't even have to be s p just whatever you want to typically do as a you know uh stock investor you're basically just adding that return on top right so basically you get to kind of enhance the return if you will so that's the approach of one it's like you have some core portfolio and you can consider that like a personal benchmarking view or something that you'd have regardless and if you can just add a little bit on top you're essentially kind of enhancing the yield um and so options is that the tool to basically overlay a strategy um and then the other fund is kind of more of a pure option strategy we don't have any underlying no equities or stocks and it's kind of a rather than a benchmark approach it's considered an absolute return right we're just trying to generate some Target um or some level of return regardless of what the overall Market or any other benchmarks are doing and it is using pure option strategies so okay so these are the two what you the two those are the uh approaches I haven't gotten to the strategy specific ship which we can dive into one of them but that's kind of I wanted to give a high level of kind of the approach and what you can do in kind of my vision for how you know because different funds have you know different mandates or different strategies or different philosophies or kind of what they're trying to do and that's kind of the two approaches that that we happen to have yeah I'd love to dive into um each of those two approaches that would be great and would love to know too because we just had a recent episode on episode 242 uh where we had Chris Studio on as a guest and he described you know some of the approach in in his hedge fund strategy to using options more like I think like an insurance right um you know with the long Vol trade and also mentioned the other side of it having absolute an absolute return strategy like the one that you just mentioned I would love to also understand what the main differences are in what you're doing yeah so it's kind of interesting and this is a good example of what I meant about kind of different mandates so Chris's fund is meant to be a tail hedge protection for no an institution or somebody that has some other portfolio that they want to protect right and so they would allocate some Capital to Chris's fund as kind of the insurance policy and in his fund uh he broke it down to where they have one part that is the hedging you know or buy and put options on S P or whatever else that's meant to be the protection but he used the example when you pay for insurance there's always a cost right and there's the bleed so if you want large protection you're going to pay a large cost and if you pay a large cost in you know this event or whatever you're protecting is never manifest then you basically have no benefit it's just money down the drain right so to offset that bleed to the extent possible there they run some other option strategies on the side that's kind of the absolute return strategy and they're using that to quote unquote Finance the cost of hedging and so what happens is in his kind of product you don't really expect a return so to speak because the under normal circumstances the options you know the income from the absolute return strategy it's just going to go offset the bleed from the Hedge so the you know you're not going to get like a profit from allocating with him on enormous circumstance but the reason you do so is because if you can that if you can get that quote unquote free hedge then when the event does happen you know his fund is designed to have a large payout you know a few hundred percent so you get that large return on investment um and so the Mandate and kind of the risk profile of it if you think of his fun as just a product right because you know what are ETFs and mutual funds they're fun they're just products so hedge funds are just you know private funds but that's kind of his approach whereas um the second fund I mentioned for us is whereas we just have because we do short-term trading we're not we're not trying to have some kind of large convex or tail hedge profile we're just trying to generate you know uh some return that's irrespective you know uncorrelated to the overall market so that's kind of one way to kind of compare and contrast or just think of funds as different products right uh but we're just not ones you can go out and buy on you know on the exchange right it's not something like ticker symbol we can trade interesting okay so let's um yeah I would love to learn more about this um second hedge fund first because since you just mentioned it can we break that down a little bit more yeah so the approach that we take and just to be clear that both the first and second fund use the same types of strategies as the return or the options portion the only difference in why the return profile still difference because the first one uses you know index funds for example as a base and options are kind of a small piece to sort of enhance that whereas if you separate those drop the index funds and just focus on options and size that up you get a certain return on that and so one thing I kind of want to point out is that again options are just tools right you can size them up or down and use them in different ways in conjunction with other you know pieces of your portfolio to design an overall profile um so if that makes sense like you know again what what Chris is doing with our second one our first one it's it's our options but how you use it and when you use it that's what makes a difference but let's talk about kind of our approach on options because when we saw options um and I know your audience uh probably is mostly familiar with stock trading so they may not have intimate knowledge of like Greeks and stuff so we'll try to keep it very basic well we'll mention that you know Greeks are something you have to be aware of but you don't have to kind of dive into how they're calculating everything but when you sell a put for example depending on where you choose the track price and there's a Delta involved with every option and Delta very simply is just a measure of how much an option price will move for every uh dollar move of the actual underlying but when you look at options and look at option chain the Delta can be kind of a a proxy of the probability of profit or the probability that that option will expire in the money at expiration and so if you have some probability of success and the thing is a lot of new traders who get into option selling they always want to focus on high win rate or high pop you know probably a profit and so they'll sell these far out of the money options that presumably will have a 80 win rate or 90 win rate but the issue with this kind of approach is because options are non-linear what happens is you have a high win rate of winning some small defined amount but when they move against you they can move against you very heavily so you could have like a five x multiple loss or 10x multiple loss and so it doesn't matter if you have a high win rate if when you lose you lose big right you basically give it all back so what I set out to do was using different mechanics I wanted to fix that when to loss ratio so I used kind of a simple example if I sold an option and I clicked it we'll just use round numbers a hundred dollars that's your maximum potential profit right you can't make any more than a hundred dollars but you can lose a lot more and two simple mechanics I'll do one no we will close the option at a certain profit right because we don't there's risk involved with holding them all the way to expiration so let's say I want to capture sixty percent of the profit and so this is a little thing where when people are selling options they have to learn to kind of turn things around I've sold something and I've collected this credit of hundred dollars to kind of enter the position so if I if that option decays and the Press goes down and I buy it back or buy to close for 40 right so I collected 60 and I paid 40. my net profit is 60 right which is 60 of my original Max profit of 100. does that make sense yes okay now that's taking a profit on a winner so on the
other side we've mentioned that options can move largely against you so I don't want to risk a 5x loss or 10x loss so let's say I want to cap my loss at 200 percent right so if I'm maximum profit is a hundred dollars because that's what I collected and I'm not willing to lose net more than two hundred dollars what I'll do is I will stop out or buy back the option if it goes to a price of 300. so if we step back if I sold it for a hundred but I paid 300 to close out and get out of the trade I've netted a loss of 200 or 2x does that make sense okay so this creates a very simple win-loss ratio right if I win you know sixty percent on a winner and I lose 200 on a loser it's like a roughly a risk three to make one right so you've just defined your max loss yes in practice and and people talk about like what if there's a big gap or what if you can't get out at that price those are all real considerations but just from a theoretical standpoint you're right I have basically defined my win loss ratio win size to loss size ratio risk to return so to speak and so in my podcast um I talk about this concept called expectancy hacking and the idea is when you talk about expectancy which is kind of how much you expect to profit on average for every trade right once you factor in all the winners and losers and I mentioned people always focus on a win rate but they don't focus on the Lost size so if I have now fixed the win loss ratio through my mechanics the only thing that remains to determine my expectancy is the win rate right expectancy is kind of a function of those three things the win rate the win size and the loss size now even if I have fixed the win loss ratio I don't know the future like I can't know exactly how much my roommate's going to be but I will I know that if the win rate is high enough right and expectancy you can kind of multiply it out like your One Rate times how much you win and then minus the loss rate times how much you lose you'll get some average expectancy per trade and so the win rate's High Enough the expectancy will be positive and then if it's too low it'll be negative right period That's it's either above or below kind of that so-called break-even win rate and so the only last piece is you kind of have to find a strategy you can do back testing or you can just kind of play around with different uh mostly through back testing at least you get some context obviously you have to live trade to see if things play out but if I have a you know with my strategy well one of them that we do and getting back to the Delta if we sell a put option you know at you know 15 Delta or whatever it is we found that the probability profit of such a strategy using you know the proper take and the stop loss you know it's somewhere in the neighborhood of you know 87 88 and long story short that basically is high enough to kind of generate a consistent positive expectancy you have to let it play out over kind of a number of trades right any one trade could still win or lose but the idea is to look at the long-term Trend right so after all the trades right and you kind of fix this win to loss ratio at the end of the day you look at how much you've kind of netted in terms of profit so let's say every trade I sell I clicked 100 and if the expectancy at the end of the day after everything's done including all the losses is I'm averaging about let's call it 25 25 for every 100 I sell so that's what I call kind of the premium capture rate because what when all said and done I've netted or captured 25 of all the premium I've sold right and I shortened that to PCR for premium capture rate and it's for me kind of a measure it's like okay I'm basically trying to net 25 cents on a dollar if you want to kind of bring that down to a smaller um easier to easier number to to talk about so that concept of the expectancy hacking in the premium capture rate using those very simple mechanics of shaping your win loss profile and letting the win rate play out over long term in a very kind of systematic probabilistic way that's kind of the approach um how do you prepare for like big spreads and slippage and things like that in your premium capture rate how do you take that into consideration right so firstly I've only been applying this to the most lucrative instruments which is spy or SPX it can be done with yes options you know many s p Futures options or if for smaller accounts it can also work on mes which is the the micro options the Futures options so that's the first thing on a very liquid instrument the spread will be tighter right if we try this approach on some really low volume or you know Meme stock probably not going to work the same so that's for one and the other thing is to focus on longer dated options I know recently what kind of like the the the meme stock and the retail and the Robin Hood no Mania you know there's people trading very short data like weekly options and you see all these videos on YouTube about like weekly paychecks and write seven DT options the the shorter data the option the certain um parameters or Greeks about the way they move and reacting to in reaction to how the market moves that will basically cause the spreads to be wider right that's kind of what you're mentioning so I generally apply these strategies to like 90 days or further right 90 DTE so that's kind of one other way and those two will mostly keep you kind of more protected in terms of having very liquid options that you're Trading but at the end of the day you're right there are times when you have to cross the spread right if volatility gets really high or even if there's a gap right again I mentioned the caveat is that you have to kind of hope that you can control that loss amount and sometimes let's say you close you know the end of the day and that the option is sitting at close to your stop loss or 180 or whatever and the next day the market gaps down right likely by the time the Market opens the prices already passed your stop now you should still get out but in this case like yes you're going to take a stop that's higher than you anticipated but from what I've found with enough occurrences and long term even with those instances where you have to cross the spread or bad slippage you just bake that into your expectancy Max right so let's say what that kind of perfect three to one ratio some win rate X win rate is going to give you y expectancy but you'll find through testing when and live Trading with the slippage your loss is a little bit higher than x right which just means your expectancy is a little less than y and you just basically break that in right so I sometimes get pushback about this approach of it can't work because you'll never get out the slippage and this and that um but my response is just well just Embrace those things right if we know they happen figure out a way to mitigate or work around them and just incorporate them into your models and that that's kind of my Approach on it to minimize that the spread and slippage possibilities from from the very start you don't really get into individual stocks basically right that's correct for this approach I don't I'm focusing okay it's mainly focused on right now as the SMB index because that is in fact right the most liquid um yeah okay but if you do I mean if someone wants to not do that and and go into like individual stocks for example I I actually like to pick individual stocks but that are super liquid as well probably not as liquid as SPX but but then if you also do that and also diversify have not just one underlying stock but several maybe like say five to ten with that make it less risky as well um so that can help in the sense that if the individual you know tickers you're trading aren't completely correlated right you're going to get some diversification of just the what the Market's doing but in that case you may not because I actually they do just use stop orders and you may not want to do that with individual symbols or you may want to kind of manage them uh and the thing is if you trade longer data options they do move slower so you will have time you know presumably to actually look at what's going on in your portfolio I'm like okay this position is approaching or it's at the level of lost that I want to take right so you can manually either do an adjustment or stop out or whatever it is you may not want to leave it to just a hard stop order because if those trigger right and I don't know if you've used those before but you are at the subject you know to the whims of the liquidity right and there's any market makers or counterparties that are willing to fill you at a reasonable price so yeah I uh I think for me I'm comfortable using kind of just typical stop orders and I've and this is one of those things that like people always kind of are skeptical about but you know I've done it and on this particular instrument in this particular situation but if that's not something you're comfortable with then yeah the the approach you can still apply but you may want to kind of take a little bit more of a Hands-On approach and exit yourself and work the order as opposed to relying on like a hard stop or just a mechanical order yeah that's that that's something that I think maybe most beginner options Traders weren't taught to you know apply uh actual hard stop losses versus adjusting your positions or rolling out early or closing out before expiration or just leaving it until expiration so what are the risks of using um stop losses even on liquid like index the SPX for example what are the risks of using that so in terms of the actual implementation I I think the main risk that people think of is again those weird times when the bid ass spread is really wide and you take a huge fill that's way above what you want to get out at right so that's kind of like the the really practical consideration so we talked about how to manage those but I think the other more conceptual risk in this mindset of not using stops it kind of boils down to your approach and the type of strategy you use and what I what I mean is you know you talk about picking individual symbols right and having positions and adjusting as opposed to stopping out I kind of can the way I view it is uh kind of uh opportunistic trading versus systematic trading right opportunistic meaning you know maybe you have a way to look for positions where you think you have an edge maybe you you know look at charts and if you think there's someone on bottom you know you sell a put which is you know a bullish thesis or vice versa everything just kind of kind of is hitting a resistance and you sell a call right which is kind of a bearish thesis or you might scan for tickers that have high volatility right because you think there's more premium and there's some Edge there but you're essentially kind of hunting for these different opportunities and once you get into them you want to you don't want to lose or you don't want to take a loss so when things don't go your way you can adjust you can roll and you're almost kind of managing these on like an individual level but what I wanted to get you to think about is so my Approach is more systematic right I'm actually for example selling a put option you know 90 DTE 15 Delta every single day regardless of what the Market's doing now if I were to say you know hit a stop one day and on that because the Market's going down and then because I'm going to enter a new trade anyways that trade the new trade is probably going to be at a different strike further out of the money right because I always entering at the same Delta right and so I've closed one trade that I'm losing and I've entered another one at a different position maybe a different time what does that sound like does that not sound like a role you know because it sounds like a role right a role is closing one position opening another right right but so the way I kind of uh reconcile the two is you can talk about stops right and use that you know it's almost like this word that shall not be spoken right or what if I completely change it around I'm not going to use the word I'm gonna say I enter multiple positions and diversify across time and I'm constantly adjusting the Delta and exposure of my book when the market moves too much and I'm showing a profit I want to lock in some profits and take risk off the table and kind of lighten the position size that I have locking gains and when the market moves against me and I'm getting you know my deltas and my my risk is getting too high I want to manage my exposure by closing some positions you know opening new ones that have a slightly less Delta right so I've said all this but I'm talking about it in the context of managing risk and managing exposure but but guess what that is exactly what I do with my profit taking and stop losses right and so this mindset shift of I'm using what is called a stop but it's just a tool to adjust exposure right and I want to kind of challenge you on one more thing like let's say you have a habit of you know entering at a certain DTE and maybe regardless of what it's doing you want to exit or roll at a certain like let's say tasty trade talks about entering at 45 days DTE and then exiting one of the options at 21 GTE because they want to avoid kind of that late cycle risk and call it gamma risk or let's say you enter at a certain Delta let's say 10 Delta right and you have a habit of rolling out to uh let's say the option moves against you the Delta goes up to 20 and you want to roll it back to 10 right that's a stop right a stop is just there's something that's triggering you to make an adjustment and so this thought of and I think what people kind of push back against is necessarily is exiting a position and then being done right so if you enter a trade and you stop out and you don't do anything out they just take the loss and move on right I guess people feel like for one you don't want like to lose and for two you if you think there's still some opportunity left like you kind of want to stay in that position you want to still be engaged with that ticker but you want to change the exposure right to manage risk but really that you've stopped out right but you just re-engage in a different position and so because my system for this particular strategy is just entering constantly but using profit takes and stop losses to adjust the position that's really just a continuous process of adjusting right so that that's kind of like the message I've been kind of trying to spread is it's like I use the word stop but like I could I could literally just explain what I do without using the word stop once but it could be the same thing and I almost feel like sometimes yeah that would be taken better right so that kind of mindset shift and that's like what I wanted to challenge people to think about differently I also see your uh the difference too is when you implement stop losses it's it's more systematic it takes the emotion does that too of course sure whereas rolling you're you're still stuck in it should I roll it now or leave it in there there's a lot of discretionary decisions you have to make and when you roll things out that's true I mean it's funny you say discretionary but I would I don't want to make assumptions but I would hope that for one there should be kind of some absolute loss limit where if it's too much you just gotta move on right because you've got to protect your Capital but on the other hand if you roll yes you want to stay in a Trader and want to stay engaged with that position but you probably should also have the same whatever thesis you had to begin with that thesis should still be intact right so if you just don't believe that position is going to have the edge or it's gonna do play out the way you think it is you shouldn't rule right you should just get out so I I want to say that even when you roll and there's some discretion it's almost like rather than having one rule or two rules that I use you have like ten you have like a a set of rules and you're still trying to stay within the confines it's not completely without a plan you know um that that's how I see it anyways yeah that just emphasizes the importance of having your trading plan in place right um do you adjust your strategy for periods of very high or low implied volatility how does implied volatility what is it the role that it plays in in your strategy so with the idea with expectancy hacking which we talked about the math behind that there's one other element and this kind of bakes in the implied volatility that you're asking about if I were to sell a 15 Delta option at 90dte the amount of Premium that takes in that's going to change what the level of implied volatility right but if I do for example a fix one contract every day that basically means every trade is going to collect a slightly different amount of Premium based on what implied volatility is doing now if I still apply the same 60 profit take 200 stop loss those amounts relative to each trade will stay fixed as a percentage right 60 and 200. but because the premium is different in absolute terms the dollar amount will be different so for example on a trade that I collected two thousand dollars on sixty percent you know is going to be twelve hundred dollars right and if I only collect a thousand dollars then sixty percent and six hundred dollars so this could introduce what's called sequence risk which is just path dependency if through pure bad luck I only won the small trades and I got stopped out at the big ones that's basically going to skew the probabilities right because you're essentially not sizing consistently right because I because of the way my strategy is set up the amount of Premium you collect for me is a proxy for the amount of risk right because everything is tied to that percentage relative to the credit so the adjustment I make is I tailor the size of the trade to always Target so my phrase is called credit targeting I'm targeting the same amount of Premium per entry so what can happen essentially on high IV I will scale down the size of it because you're collecting more premium per contract so I don't need a Salesman contracts and vice versa when volatility is lower I'll go up in contract a bit to collect because each contract collects less premium so by targeting a fixed level premium this essentially minimizes that sequence risk because every single trade is sized consistently but again consistently in terms of credit not necessarily in terms of contract size I think that's kind of a a mechanic that I haven't seen people talk about and that that's something that is actually key to um my type of systematic approach uh David what what exactly do you mean when you say sequence risk sequence okay so if I were let's just say there is I make four traits and trade one I collect 100 Trade two I click 200 trade three I clicked 100 and Trade four I clicked 200 right so small big small big if I happen to lose all the small ones right the 100 ones and sorry um lose the big ones the 200 trades and I win the small ones you're not gonna get the same expectancy as if let's say somebody else did the same strategy but like their their sequence of Trades was different they're offset right and their winners and losers will reverse right they won the big ones and they lost the small ones even if each in this case even if we trade the same approach because one person won the big ones whereas I won the small ones our p l is going to be different so the expectancy is dependent on the sequence of events or the sequence of Trades that's sequence risk but by leveling the amount of premium for every trade I'm basically trying to eliminate that sequence Risk by making each trade sized consistently yeah uh okay equalizing it you don't want to be uh I guess if you want to just call it bad luck you don't want to be subject to bad luck that's I guess the the Layman I see yeah so you mentioned that you have you take a top-down approach um can you describe what that is exactly in I think it's related to what you just mentioned about yeah if we put all this together and so let's just say high level like I've tested this one strategy and I think the long-term expectancy or PCR premium capture rate so let's just call it 25 for kind of a use Simple numbers so if I had a if I wanted to make 10 so if they had a hundred thousand dollars and I'm trying to make 10 10 is 10 000 and that's the Prof the piano I want to make in a given year so if I'm expecting to long-term net 25 of all the premium myself I take my 10 000 p l Target and basically divided by 0.25 so you get 40 000 which means if I sell forty thousand a premium in a given year then if I net 25 of that right that's my 10 000 Target and so basically I have to sell forty thousand dollars a premium and now if I'm trading every day there's 252 trades you know I take the 40 000 and I divided by 252. and that gives you the daily so-called credit Target and essentially the
plan is if you sell that amount of Premium every day and let the strategy play out right at the end of the year you would have sold 40 000 in premium and if at the end of the year you've captured 25 you would have captured the you know ten thousand dollars and so you can kind of set a high level return Target and use that to back into the size of each individual trade and again size in this case is determined by the amount of Premium not necessarily the contract size so does this only work on can this work this top-down approach can it work on choosing individual stocks there's two ways you can look at it if your approach is kind of systematic to a degree that it can be back tested and there's actually quite a few off-the-shelf Services people can use to to back test different strategies and you think there's some kind of consistency there in terms of the uh the capture rate then yes you can kind of use that to size um the trades but if you take what's you call kind of a systematic sorry more of a discretionary approach than you might need some history of uh live trades right and then log them and sort of see hey you know you know I use a certain amount of capital per trade and I usually um able to you know make X dollars and for every dollar risk and once you have some kind of expectation it's all about expectations right and again it's not a prediction right even with a system like mine where the the PCR I think it's 25 that's going to vary year to year right long term and maybe 25 maybe right but one year it could be 40. one year could be lower one year could be zero like this year is probably gonna be zero for for the one I'm running which is fine because again the market went down like 25 as of you know the Friday right um but it's more about if you've traded enough to kind of have some expectation of what you get out of you know the capital that you that you put at risk then you can use it as a guideline for kind of sizing up and down um I think that would be how I would approach it to kind of use the same same philosophy I guess going back a little bit to the the volatility you mentioned something I thought was very interesting in another podcast you were on that you use high volatility not to make more but to make the same with less risk I don't know if you can uh expand on that a little bit give a little context to that because I really thought that's interesting so that was basically baked into what I mentioned about the fact that because I'm credit targeting and you're gonna cut more premium when IV is high I naturally size down when volatility is high which also kind of answers your question or from earlier about do I do anything different from a strategic standpoint there is no change to the mechanic but because of the nature of options pricing it naturally scales up and down in such a way that during High volatility so if I'm targeting some X return which means my credit Target is you know some number then what's super high IV I can collect the same amount of Premium as my target using less contracts smaller size and actual you know notional or contract size terms and kind of that's what I mean I don't have this approach because some you know when people first get into options selling sometimes they're taught that like high volatility is opportunity right you you stay small when Ivy's low and then you throw a bunch of buying power when IVs have like that's when you make the most money that's not untrue necessarily but when IV is high it's high for a reason right it's probably just some event the Market's coming volatile so you still have to be very cognizant of risk and manage the trades right if you want to kind of load up so to speak on high IV and that's just that's just one approach but in my case I just basically kind of take the opposite where like I'm actually scaling down not because I'm like trying to be more conservative but just because my mechanics dictate that since I'm trying to Target the same level premium I just don't need to use as much leverage or capital or um contract size when the IV is high that's all when the vix is high or when the when there's a lot of option premium wouldn't we want to take advantage of those times so in a manner of speaking yes um but I kind of alluded to the fact that when vix is high it's when the it's high for a reason right and it's because the market believes that there's going to be a lot of volatility and the underlying or the S P or whatever is going to move a lot and when it moves a lot right you can be at risk especially if you're selling options and so the supposed Edge is that because volatility is you know they call it mean reverting right when it's when there's a lot of fear in the market right usually high levels of fear are not sustainable and so volatility levels will come down and so there's a supposed Edge is when you sell High volatility you know there's an The Edge comes in because it's not sustainable volatility should have actually come down when volatility comes down the prices of options comes down which means remember when you sell hot you're selling high buying low that that's a kind of the backwards thinking that people who first get into options don't have to get around because we normally think of yeah Buy Low cell habits and sell High Buy Low um so yes they're supposedly presumably There's an opportunity that presents itself when volatility is high but you just have to caveat what that doesn't mean number when you don't go all out and just blow all your buying power and so everything right and on the other hand you still have to have a plan right even if there is some more Edge when volatility is high you always have to have a plan and you have to to be able to know how much risk you're actually taking and be able to manage it accordingly your strategy is very data driven right do you do a lot of back testing that's right we do and um and as I mentioned there's a lot of uh um I don't know if you heard of optional Mega and there's like e Delta Pro and those are those have different tickers you can test there's uh optional Mega even has like five minute data which you don't really need that for longer data strategy but I know there's a lot of people who like like to test um like intraday strategies but these kind of software available now for retail like you can do a lot of different enumerations and they're fast right so you're not waiting ages to do a back test and so this kind of like uh automated back test lends itself very well to testing systematic strategies right you can throw out a bunch of enumerations and different things and and just really like kind of focus on on you know different different patterns and stuff yeah so I now want to kind of get into um from your perspective some of the misconceptions about options trading this is for the benefit of especially for those um who are currently trading stocks and are interested in in trading options or have started you know learning about options trading but maybe stuck on moving forward and what's your take on kind of addressing some of this misconception first about is it riskier and is it hard to learn and then where do you start yeah I think uh one of the misconceptions is that option trading has to be super leveraged and I think that comes from more of the fact that if you have access to the leverage because the options themselves are by definition leveraged instruments and the way the the margin is used for example if I wanted to buy a thousand dollars worth of stock right you have to put out a thousand dollars of capital right to buy those shares but if I wanted to have an instrument or an option that can give you the same exposure as that thousand dollars of stock your broker may only require you to put up one-fifth or even one-tenth of that as margin and you're not even outlaying any cash right it's just like the margin account will be deducted and you'll see the buying power go down and so first of all if people don't understand that they're leveraged then they can unknowingly leverage a lot higher than they've realized right so in this case if the option is a ten to one leverage instrument and I use 50 of my Capital thinking oh I'm using half my Capital well you're actually levered you know five times more than you think right because it's like um sorry if it's ten to one margin then you're leveraged like 500 right you're using 50 Capital but your notional exposure is like 500 so I think it's more about a not misunderstanding of how the option works in terms of what the broker requires of the capital you put up and so you can use them super leveraged but you don't have to right and another misconception is like uh for so people like I guess in again like the 2020 2021 like the Robin Hood and the meme stuff phenomena and YOLO call buying where you're only using options to get super crazy gains right 500 thousand percent and yes options are non-linear meaning you can spend a little bit of cash and buy these out of the money option that have a low probability of success but when they have to hit huge but that's not the only way in fact that's like we don't use options that way options are literally you know tools and I think that's one of the reasons like people can get lost is because first of all even the same symbol right there's options at different expirations different maturities there's different strikes and so the way to behave and then there's Greeks which you know describe how option price moves in relationship to the direction of the underlying with relation to the level of implied volatility with and with respect to you know time right um and so um again for us I think it's just the understanding that you can use options to express different hypothesis that you have on what the market will do which direction to go when it's going to happen and I think that's that that's kind of the beauty of it but also the complexity like there's just a lot you can do and I think really you have to kind of figure out like what your goal is and you can craft the strategy um and then lastly it's like options are like for degenerates for gambling like obviously you can again like you can buy these lotto tickets but like really I think they can and they don't have to be seen as a super exotic thing and they can really be used in conjunction with kind of more modest and Conservative Strategies and just kind of more as an enhancement or a way to express different opinions right and you know a lot of the the strategies we talked about and not just here but in general people talk more about on the South Side you know selling options versus buying options I feel like there's not enough talk about you know when to buy a long put or something simple like that as a starting point when to buy a long put or buy a long call what do you think about that as kind of starting out like just to learn the basics if you know coming from maybe like a stock trading background like you know when there's trading stocks you're generally kind of trading directionally right and the direction you pick may be based on some technical analysis fundamental analysis whatever it is that gives you a thesis now if you have a direction that you want to bet on right options are a tool to again give you Leverage in a way that's capital efficient and limits your loss right if I pay you know 50 bucks on this out of the money call option on this stock that's the extent of what I can lose right but there's that possibility to make a big gain and so that's kind of the appeal so if you have an assumption right you can buy puts and calls as a way to express that directional opinion now on kind of the more sophisticated side you know people might look at um kind of historical levels of volatility uh versus kind of what's going on in the market and if they have an opinion that like right now volatility is very high or the implied levels of volatility right it's like the option pricing but they don't believe the the Market's gonna actually be that volatile right so they believe the implied volatility is higher than what's going to be realized what's that's going to happen What I'm trying to get is they believe the options are so called expensive right this is kind of when you want to sell them and on a vice versa if for some reason they think there's going to be some kind of vendors coming volatility but the market is kind of the implied level is very low and kind of believe that it's under pricing the risk that's out there and they believe it's cheap relative to what's going to happen right this is when you kind of go around and buy options so it's the same idea of trying to buy low sell high but that's in relationship to what your analysis tells you about the level of volatility is like when you think options are price cheap you can buy them right and vice versa um so that's just another another angle yeah so far the strategy that you described with expectancy hacking with adjusting your win size loss size risk reward ratio that's that's a form of risk management yes and it sounds like you have a very good tight risk management in place you know some people they it's drilled into them too is you know you have to you've got to have risk management you know you got to have that layer in there and that's Jordan my ingrained in me too to have risk management but at some point though you can have so much risk management that you can almost have no Edge and what comes first what's more important risk management and then Edge or Edge and then risk management or both if you want to trade and sell options firstly you have a fundamental belief that there is some Edge in the mispricing or general overstatement of options right because if you believe that even the Market's efficient it's hard to well you can't perfectly price the future right the unknown which is why there's that supposed overstatement of volatility overpricing of options and all the mechanics are right because even if we blew that edge is there you can't just sell options willy-nilly because occasionally the risk is greater than the market thinks right and you blow up right and that's why you have risk risk management and mechanics but something to consider is that regardless of the how much Edge there is and this is something that's true for all trading and this is just general kind of bankroll management you you know that concept that people talk about of like if you lose one percent then you only have to make about a percent to catch up right if you lose about 10 you've got to make like 12 or something to catch up and the extreme examples if you lose 50 50 you have to make 100 to get back to zero right you've probably heard that there's like these charts and stuff and and that's the idea of the volatility tax and it just means when you talk about compounding your account right it's asymmetric right it's it's almost faster a compound downward than it is to compound upwards so my point is regardless of how much Edge you think you have or there is in a strategy if it's not size right that nature of the kind of the asymmetric compounding will basically destroy whatever Edge there is because you won't if we're too volatile you'll just kind of end up going nowhere if if any one trade or any one you know loss kind of wipes out a huge amount of the bankroll so like the bankroll management that in and of itself needs to be almost considered as a mechanic right and that's why um Focus so much on the credit targeting and using that as a proxy of risk right because I for me I'm like if I collect this much credit because I've told myself I'm going to get out at this level one way I look at is I look at all of my positions that I have open on the books and if I have X amount of credit of for open positions I'll know that if they all get stopped out right at the level that I intend right that's the caveat then my realized losses you know twice that for example and so I have kind of a a general idea of like my entire book size if that's lost what that represents as a percentage of
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