Learning By Doing

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.

Quote of the day:

"Experience is the best teacher"

Did your parents give you a book on cycling mechanics to teach you how to ride? Sh*t no! And I highly doubt you even had a helmet on before they tossed you on the bike and pushed you down that hill!

And if you did get that book, you should be much smarter and not reading this newsletter!

You can't build intuition from a textbook. You gotta feel it. You gotta fall over, scrape your knees, go way too fast to gain balance, then sh*t your pants because you don't know how to stop.

Today, we'll go over a simple trade using 0DTE options and the reasoning behind it.

BANG for Your Buck:

2023 started off with a bang!

January S&P 500 index was up 6.17%. And the NASDAQ Composite ended the month +11%...its best January since 2001 (hmm, what happened in 2001?)

I'm no prognosticator, but I figured this is a good reminder that exuberance doesn't always have follow through. In 2001, the NASDAQ composite was coming off one of its worse years ever thanks to the dot-com bubble (sounds familiar) and yet still proceeded to suck even more @$$!

Just remember to trade what's in front of you and don't get caught up in predictions. Spend your time calibrating risk to reward.

Today is FOMC day (1p CT rate decision and 130p CT presser).

When the unknown becomes known, volatility should decrease. There is still a potential to "spook" the market, but the options market is discounting that possibility.

As of the close yesterday, Jan 31, the options market only expects ~54 handles of movement for the next 24hr period. Since the BANG is around 50, anticipated overnight action was muted.

End of the Week Events

• Feb 1 - FOMC rate decision and press conference

  • This could set the tone for the rest of the year.

  • The bond market is pricing in a recession that will officially hit the books in Q3 this year and commensurate rate cuts will follow.

  • JPow keeps saying rates will be "higher for longer", and "his main mission is to fix inflation while maintaining high employment."

  • 25bps increase is the assumption. Market could move on his speech with Q & A

• Feb 2 - Jobless Claims / Earnings (including AAPL which is ~7% of the SPX)

• Feb 3 - Non-farm Payrolls

Large Option Positioning

• 4100 strike creates large positive gamma for dealers and will act as resistance. A definitive pop and close above 4100 should lead to a volatility collapse.

• 3900 strike creates large negative gamma for dealers, which will exacerbate movement near there. In general, a break under 4000 gets the dealers to start hedging with the direction of the market and a pop in volatility.

ODTE Trade Example - Jan 31, 2023

Setup

Start of day thinking: answer the simple questions and make the simple predictions.

• BANG is 50

• The prior close was 4018

• If SPX goes one direction, it's either going up to 4068 or down to 3968 (Formula: 4018+/- 50)

• If the trend switches mid-day, look for exhaustion to fulfill the BANG. Ex: market goes up 20 handles, then trend flips, I should be looking for a 30 handle down move.

• Large option positions around 4065 as well

• It's the end of the month, and the market loves "window dressing" because this is how fund managers get paid.

• Psychological crap: SPX closed on Nov 30th @ 4080...so if the market closes there today, it will have literally recovered all of its Dec losses

In my head, all this adds up to we're going higher, and if we do, we're at least getting to 4065!

Looking for Entry

I saw the trend flip. Notice my super clever technique: red background turned into a green background!

Opened at 4018, trend flip ~4034.

I pussy-footed around a bit and watched the market trade up another 10 handles to ~4045.

So, 27 handles (4045-4018=27) have been eaten up. 23 more handles to run... I think, as long as the trend stays the same, she's taggin' ~4070.

Strike Selection

• The strike must be lower than my expected closing level i.e. it has to end up in-the-money.

• The less "time value" the better.

• With a $10,000 account, I only want to risk 3% per trade.

Hunting and pecking around the option chain, I see the 4060 Call.

• Based on my thesis, it can finish 10 handles in-the-money (4070 closing price - 4060 strike = 10)

• It's currently out-of-the-money, so I will get decent "convexity" i.e. it will gain value rapidly, if I'm right

• It costs $3.20, so a 1 lot is $320 max loss (right in line with my max risk per trade threshold).

Underlying is now around 4040. I buy the 4060 Call for $3.20 @ 10:16a CT.

Risk = cost of the option = $320

Reward = Anticipated Closing Price minus Strike x 100 = (4070 - 4060) x 100 = $1000

Management

At first, I think the trade sucks...nothing is really happening. But remember, I set my risk and have a good, anticipated reward.

By 2p, I finally get that push near 4055.

Here's the beauty of options: I decide to take all my risk off the table, but still give myself $500 of upside.

I sell a 4065 Call @ $3.40. Effectively, I was paid $20 to be long the 4060 / 4065 Call spread.

There is one hour left in the day. If the market goes back down, I just make $20, but if it closes higher than 4065, I make an additional 5 hondo!

End of Day Liquidation

Just after my de-risking, the market breaks and I pat myself on the back for such an astounding maneuver!

Then the market pops all the way up to 4076...f*ck ME!!! If i did nothing, my call would have made $1600-$320 = $1280.

Instead, I had ZERO risk on for the last hour of the day and still made an additional $500 for a grand total of $520. You don't go broke taking a profit!

And these are SPX options, so even though both options are in-the-money, I don't have to liquidate. They expire, and they send me the cash money!

As always, pursue the process NOT the profits! See you tomorrow!