Manage Risk Like Kenny Rogers

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:

"You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run"

First rule of risk management: always heed the advice of the famous song The Gambler (1978) by Kenny Rogers! You may also refer to the made-for-TV movie of the same name released a few years after.

Your goal is to hold a hand that has probability in your favor and get rid of it when it doesn't. In the biz, we call this positive expectation.

You do not want to be forced out of a good hand due to poor money management. The size of the bets should be commensurate with probabilities (easier said than done!)

Every decision can't be a winner. You must act on incomplete information and manage the potential outcomes better than others. Sometimes that requires taking a loss, but living to play another hand. Remember, Trade Like a Jumping Cholla

Second rule of risk management: the rules must be simple...simple to remember, easy to compute, but as you'll learn, not necessarily easy to follow. The problem with complex, multi-factor risk management rules is that you'll convince yourself that the rule "doesn't really apply" in this situation.

Third rule of risk management: just follow the damn rule! Do not "recalibrate" on the fly. You need to create a large enough sample size with consistent management to even start analyzing if your rules suck. (oh, and the rules don't suck, you do!!)

You get paid to manage risk; too little and you get diddly, too much and it's just a matter of time before you blow up.

BANG for Your Buck:

Thanks to Friday's 1.75% rally, SPX only closed a touch lower on the week, and is still up 3.5% YTD. Friday was also option expiration (OPEX), and approximately 25% of all option bets expired!

Dealers are now primed to take a ton of risk from the market. And remember, we are dealing with degenerate gamblers here...no chance they are leaving the casino!! 

Have the server grab you another pack of smokes and a black russian, then get back to those tables!

Things to look for this week

• OPEX rebalancing

  • Dealers' need to "re-hedge to stay market neutral" i.e. gamma is now much less sensitive due to options expiration

  • This opens the door for higher volatility

  • As large bets are placed, the dealers will need to instantaneously hedge in order to stay market neutral. This impact can cause larger temporary (1m to 1hr) run-ups and pull-backs. 

  • Ex: a customer sells 50,000 SPX calls with a 0.20 delta.

    • At the moment of the trade, dealers are stuck with the equivalent of 50,000*0.20 = 10,000 SPX underlying exposure.

    • They don't want that.

    • To get rid of that, that can do a couple of things:

      • sell stocks (highfalutin tech stocks like MSFT & AAPL are a fan favorite since they make up a large % share of the SPX index)

      • sell 20,000 ES futures (E-mini S&P 500 futures are half the notional size of SPX...pu$$ies!) Picking the Correct Tool for the Job

      • take more option bets to offset the directional exposure

      • Figuring out how to hedge is basically the dealers' real job

• Open Interest

  • Dealers are long 4000 strike

    • If the market pops over 4000, expect volatility to decrease. Review on how dealers hedge long call open interest

  • Dealers are short 3900 strike

    • If the market breaks 3900, there is major risk to the downside because dealer hedging will go with the flow of the market. Ex: as the market sells off, dealers also need to sell to cover themselves from directional losses. We've haven't covered dealer put hedging yet, but trust me...this is why the market "has fat tails"

    • It's a good old fashioned dog pile!

• VIX < 20 & implied volatility via options is less than realized volatility via underlying movement...again

  • This has generally marked a short-term topping process, and the expectation of a move lower

  • Moves greater than BANG, in either direction, need a catalyst...especially with large 3900 and 4000 open interest

• Reports / News

  • Typical economic crap that's a day late and a dollar short (inflation numbers, jobless claims, consumer sentiment, etc.)

  • We are really just waiting for February 1st FOMC (federal open market committee)

    • This is where a bunch of bankers, lawyers, economists, etc. sit in a closed room, shoot the sh*t for a few hours, set the Fed Funds rate, then they have a press conference

  • Remember, we don't care about what these numbers say, rather how the market reacts to them.

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