- The Jumping Cholla
- Posts
- Stop Losing Money When You're Correct
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!
Quote of the day:
"If you do the same thing over and over again, you'll get really good at it!"
I don't know about you, but becoming an expert at getting kicked in the nuts isn't that intriguing to me. Don't get me wrong, taking a tactical nut shot from time to time in order to protect your core assets is crucial...
But walking up to a ninja...spread eagle... seems a bit self-defeating.
Today let's focus on the "management burden" that comes with the massive benefits options provide.
BANG for Your Buck:
| 1/5/2023 SPX = 3852.98 | Handles of Movement | 1-Day Implied % Move |
|---|---|---|
| BANG (intraday) | 53 | 1.4% |
| BANG (weekly) | 118 | 3.1% |
In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...
Quick Review
Examples to satisfy the BANG:
The BANG tells you what the option bookmakers are pricing potential underlying movement.
Market opens at 3840, and chugs upward to 3893, which is 53 handles higher. Or market opens at 3840, goes to 3850, then down to 3807 (10 + 43 = 53 handles). Any variety of underlying movement scenarios can satisfy the option implied volatility required to justify current option prices.
As the BANG expands (expected volatility in the market), bookmakers are pricing in larger potential underlying movements. As BANG contracts, the expected range of possibilities contract as well. Not to say it’s perfect, because exogenous shocks are what cause the most pain and profit potential… but if you’re doing this every day, you will see the BANG get satisfied 68% of the time.
This is why we like to call it BANG for your buck. If you are long options and the market exceeds BANG, you got a good deal. Granted, to actually profit off this sweet, sweet deal you got, you have to manage your position in very specific ways.
Today's Learnding Moment
Options are the most effective and efficient way to express and opinion in the market.
When used properly, they can convey:
Direction as bullish/bearish/neutral
Trading range consolidation/expansion
Interest rate increases/decreases
Prediction over single/multiple timeframes
These puppies are amazing! By reading the Jumping Cholla daily, you will learn how and when to use options but more importantly, you will build an intuition for constructing a portfolio to achieve your desired "prognostication."
Great, options are cool, but what's the catch?
Look at the list above. Not only can an options position do any of those things, but also, they are ALWAYS doing some percentage of each one of those things!
The failure comes from not recognizing the parts of the trade you don't necessarily want, but regardless need to manage.
And if you try to remove all the management requirements from the onset of your trade, you're gunna be left with binary gambles such as The Long Butterfly Lotto Ticket.
For example, when you are long an option, you are also betting that:
Trading ranges will expand (long volatility)
Interest rates will remain the same or decrease over your holding period
Your prediction will happen within a specific timeframe (you lose a little bit of money every day you hold the position)
But you just bought that Call because it was cheap and believe the market is going up?!
Well, let's say you were spot on and the market goes up, and your call appreciates in value. If you do not decrease your volatility or time decay exposure, you can still lose money! (unless the market really takes off)
Even by being correct on your chosen primary exposure, mismanagement of ancillary exposures can (will) cause you to lose money!
Make Me a Better Trader
Let's implement a trading idea (or in high finance speak "trade thesis") and walk through some management.
Baseline: SPX is at 3850
Trade Thesis: The market will go up to 3950 sometime within a week. And it could get there sooner.
Implementation: Buy the 3900 call that expires in one week for $10. It is currently out of the money (OTM) aka it is worthless unless the market goes up.
You are paying $10 for the chance that your bet to win! It currently has no intrinsic value! It only has value because of the probability the market is assigning to it!
We are buying an OTM call because:
Low fixed cost (the maximum loss you are willing to take is known and will not change)
It aligns with your prediction i.e. it will increase in value if the market goes up to where we think it will go (if the market gets to 3950, it will be worth at least $50 ...5x payoff)
It can make us even more money! (technically unlimited upside)
"Super smart" finance bros like to describe these bets as asymmetric payoffs.
Time goes by and prices change:
Within 3 days, the market goes up to 3905...sweet!!!
The call is now valued at $25.
If you do nothing, and the market closes at 3905 in a few days, that call will only be worth $5...but wait, you paid $10...yep, you lose money!!
For you visual learners: Look at the gap between the yellow line to the red line; that is our cost of time decay.
So, we have to do something!
We need to offset time decay but not remove all the upside...I do think we will get to 3950!
Management Trade: Sell the 3950 Call for $5
If the market closes here (3905), at least I scratch the trade
Make $5 off the long 3900 C [3905 - 3900 = $5] + $5 collected by selling 3950C = $10
No harm, no foul and I got to play for free.
This is better by $5 than doing nothing!
If the market goes higher but stays under 3950, I make more money than I would have with my original trade by $5!
If the market goes higher than 3950, I'm limiting my profit to $45
My asymmetric payoff is still in place but now it's paying out 9x
$10 initial - $5 time decay offset = $5 cost to make a max of $45
45/5 = 9x
Now if I'm wrong and the market moves lower, I only lose $5 not $10.
In a nutshell, I limited my originally unlimited upside, decreased my cost basis, and increased my payoff ratio at my prediction level. Not a bad do!
In options, there are no right answers, just levels of being partially right and partially wrong. If you do not act as the probabilities change, you are not trading, you're gambling.