To the right, you will find recent and most popular posts, as well as a search bar. Also, every post will be labeled with a category and tag(s) so you can easily find content that interests you. I invite you to comment below, and I will do my best to respond. My goal is to update this blog on a regular basis. If you subscribe to my mailing list you will get an email every time I post a new blog entry. New website content will also be posted on my Facebook, LinkedIn, and Twitter pages (links to these are at the bottom of the page). I am always open to suggestions for blog post ideas, so please send them my way.

Adam M. Singh
adam@voledgetrading.com
(480) 862-9330

The post Welcome to My Blog appeared first on Vol Edge Trading.

Market-makers hedge dynamically by trading the underlying stock/future in order to flatten their delta position. By using stock, or futures, they can hedge cleanly by isolating delta only. Additionally, market-makers have superior execution ability, as well as greater margin (pros call it “haircut”). That’s great for them, but where does that leave us, the market-taker? As position traders, we typically have an option position that we, hopefully, entered for edge.

So, we are faced with two questions,
• Should I hedge?
• If so, how do I hedge?

Before we answer those questions, let’s lay out some basic hedging facts,
• A hedge is designed to lose
• A hedge neutralizes the risk you DON’T want, while preserving the risks you DO want
• A hedge is meant to keep you in a position long enough for your edge to be realized
• A hedge should never turn into a directional trade
• Hedging after-the-fact is always done at edge-loss

Now that we know the rules, let’s answer the first question; should I hedge? This seemingly complex question is quite simple if you think about it intuitively. I like to look at it in terms of risk/reward. Hedging must improve the risk/reward ratio of a trade in order to be justified. How do we measure risk/reward? Solve for the trade’s max gain at peak, then add enough of a hedge to reduce these gains by 50%. If losses on the other side aren’t reduced by more than 50%, then don’t hedge. If it preserves the risk/reward ratio, but doesn’t improve it, then just reduce trade size (since you’re effectively doing the same thing). For example, a trade makes $1000 tomorrow. Add hedge, it now makes $500. What does it lose on the downside? It better be less than $500, or else the hedge isn’t effective. If it does improve the risk/reward, then add the appropriate amount to maximize the ratio.

So, say we’ve decided to hedge. What’s the best product to use? Here is my ranking for optimal products to hedge an option position,

1. Futures
2. Stock
3. ETF
4. Options

Keep in mind, we are talking about hedging delta or directional risk of the underlying. Futures are the ideal hedging tool for a few reasons. Futures are pure delta, they are liquid, and trade most of day/night. I typically use the E-mini S&P 500 (Es) futures contract as my primary hedge for a book of options positions, or for an option position in SPX. If you have a position in NDX, use Nq, and so on. Stock would be my next choice, or if you’re looking to hedge an equity option trade (buy/sell AAPL shares to hedge AAPL option trade). Alternatively, if you have an index option position, like SPX or NDX, you can use shares of the corresponding ETF (SPY or QQQ, in this case).

That’s all fine and good. But what if I don’t have the margin required to hedge with futures/stock? Then you can use options. These are my recommendations for options as hedges,
• Use in-the-money options (approximately 60-75 delta)
• Use single calls/puts, not spreads/combos
• Use the same expiration as the underlying trade
• Use a liquid contract (decent trade volume and tight bid-ask spread)

The key thing to keep in mind when hedging with options is that they will alter your trade’s other greeks aside from delta. So, try to stick with options that closely replicate a position in the underlying stock. And above all else, less is more in this case. Unless you like generating commissions for your broker, keep it simple. An option trade is complex enough on its own. A hedge is supposed to reduce stress, not add to it.

Adam M. Singh
adam@voledgetrading.com
(480) 862-9330

The post Losing on Purpose (Hedging) appeared first on Vol Edge Trading.

Book smarts, with regard to trading, invariably means math skills. Look at the interview questions for any decent prop firm and you will find a dizzying array of probability, mental math, and brainteasers. It’s daunting. I was always average at math. In school, I wish they told you how much money you could make from math, because I would have paid more attention. Being a math whiz doesn’t guarantee your success, but it makes it easier. But, for those of us never destined to be quants, there is hope. You don’t need to be able to derive Black-Scholes via Ito’s Lemma to make money trading options, but I do think you need some understanding of some key concepts. In my opinion, you should be familiar with statistical distributions, skewness and kurtosis, and probability theory. Professional bettors and traders are often one and the same, so their skillsets are analogous. Every prop firm interview will inevitably have a question on the expected value of a dice roll. And, I typically use sports handicapping, blackjack, or poker examples to illustrate concepts in options trading. This is because I think a solid understanding of odds vs probability is important for a trader.

Next, let’s look at street smarts, or what in the trading world we refer to as intuition. There is no book, class, or lecture that can teach you intuition; it’s all on-the-job training. A trader develops intuition looking at, and participating in, the markets every day. Training programs at market-making firms almost always involve mock-trading exercises, where you must make a market on an option while managing inventory and hedging risk. These games are all about price discovery. There really is no fair value, it’s what the market is willing to pay. I often have clients that struggle with this part of the trading process. They understand option theory, they know how to model risk, but they have no “gut feeling” on a given trade. The advice I give them is to go out into the market and start pricing trades and send them to me. It doesn’t matter if the trades they find are good or bad. The value of the exercise isn’t the outcome, it’s the process. “You know how to get to Carnegie Hall, right? Practice.”

Here is a common example I use in a mentoring session with a client; before we look at the option prices for a stock, I ask them to guess the value of the at-the-money straddle. They usually respond with hesitation until I press them to give me a number. I don’t care how accurate their guess is. It gives us a starting point, something that we can adjust down the road. It forces them to use knowledge and the limited information about the stock to make a snap decision. If you were to repeat this exercise each day, I bet you would get pretty close to the true value at the end of the week. So now, when you pull up the straddle, you have an expectation. When the market value deviates from it, whether it’s justified or not, you’ll be able to identify it immediately.

Lastly, I want to talk about discipline. There are many other skills a trader should have, but discipline is a skill a trader must have. The most successful traders I know have the discipline to stick to a routine (we’ll talk more about my morning routine in the next post). Most importantly, they stick to the plan. You must never deviate from your plan. A wrong plan is still better than no plan. When things are good and you are making money, sticking to the plan seems less important. But when you’re in a losing trade, you begin to panic. If you maintain discipline, and stick to the plan, you’ll never be in a situation where you don’t know what to do. If you need help with any, or all, of the skills I’ve mentioned here please feel free to contact me anytime.

Adam M. Singh
adam@voledgetrading.com
(480) 862-9330

The post What Skills do I Need? appeared first on Vol Edge Trading.