There’s a good discussion about trader capitalization needs over on Dr. Brett’s TraderFeed blog. (The discussion now spans these three posts: Capitalization and the Economics of Trading Success, The Capitalization of Traders: Why It Is Crucial to Success, and The Psychology of Leverage ) That topic is probably the one I get the most email about. It’s one of those classic questions that deserves an “it depends” answer. At the very least you need to know how much the person needs to live off of and their system’s expectancy. The type of trading and whether the trader holds positions overnight will probably also come into play.

As a general rule I used to tell people that they’d need an absolute minimum of $50,000 but $100,000 is probably more realistic. But years ago, after reading Dr. Brett’s thoughts on the matter (which he’s based on working with so many traders) I modified my response to add that “Dr. Brett recommends over $200K”. You’ll see comments by Michelle B (remember her?) on Dr. Brett’s posts. Her comments match my thoughts on the matter almost exactly for a very specific situation — a true daytrader, who doesn’t take overnight risk and is willing to max out on 4x leverage. (If you’re trading with a prop firm you may get 10x leverage, so the numbers could be adjusted accordingly.) If you’re holding overnight you just can’t be as aggressive with leverage and thus your capital requirements will need to increase.

Obviously people will have to analyze their own situations and come up with a number for themselves. Dr. Brett provided some links to some Monte Carlo simulation tools which are invaluable for doing that kind of analysis. As with so many things, one’s own mileage will vary. One’s risk of ruin should decrease with more capital and it will also be easier to make the amount of money necessary to make a living.

Above we see the five-day average volume (top chart) for the S&P 500 Index (SPY) and the five-day average trading range (bottom chart). One theme stressed on this blog is the importance of trading volume, largely because of its correlation with volatility.

As stocks have moved higher since the March lows, volume has steadily declined and so has the average high-low trading range. Stocks now provide almost 1/3 the expected range as earlier in the year.

This is why I find it crucial to adjust profit targets for volatility. (Note: SPY profit targets are posted every morning before the market open via Twitter; follow here or check the last five tweets on the blog page). Without such adjustment, we inevitably expect too much out of a trade when volatility comes out of the market, leaving us open to frequent and frustrating reversals.
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Excellent article from the Financial Times today reiterating a problem with open-ended exchange-traded funds like UNG (Natural Gas ETF) or USO (Crude Oil ETF), that trade futures contracts.

Traders are all atwitter about record volume in UNG recently.  But there’s probably an underlying reason, and it’s not necessarily that suddenly everyone’s getting in on the next bull market.

At issue currently is the rampant growth of the UNG, the natural gas positions of which have doubled since last month’s roll. This growth, by the way, is eerily similar to that experienced by the ETF’s sister fund, the USO, earlier this year.

In the UNG’s case, however, the growth has been so large that in order to avoid a regulatory clampdown on its futures positions the fund managers have been forced into the world of over-the-counter swaps. Accordingly, the fund’s swap positions are now 2.6 times larger than its future ones.

To give some perspective, if the fund was to put all that money into the futures market, Jakob calculates it would be equal to occupying 78 per cent of  open interest in the July Nymex contract. Meanwhile, the holding of large swap positions goes against the fund’s mandate as outlined in its prospectus.

They went on to show how rising positions in UNG is coinciding with increasing contango in the futures.

A similar thing happened with USO and Crude Oil.

Let me be perfectly frank…if you’re too lazy to read and understand what you’re trading, then you deserve to lose whatever money you “invest” in vehicles like these.

Source:
The Problem With Commodity ETFs
Financial Times, June 11, 2009

[Stocktwits will filter tweets based on your portfolio or on whose tweets you want to follow. It is a free useful service. - gyatz]

* The Wall St. Cheat Sheet site offers an interesting inside look at trader and entrepreneur Howard Lindzon. Howard is the guiding force behind Stock Twits, which brings together tweets from across the trading world.

* I often receive inquiries regarding simulation platforms for those getting their feet wet in the markets. Apex Futures in Chicago offers its platform in simulation mode, with a nice feature that treats fills for limit orders conservatively, rather than assuming that you’ll be filled as soon as the market touches your price. Craig Ross at Apex tells me that TraderFeed readers trading the S&P 500 e-mini market will be given a discounted, all-inclusive $4.25/rt price per contract that includes phone support; you may want to check them out.

* Henry Carstens offers a free e-book on Testing Trading Ideas, as well as numerous papers on trading topics. Great resource. I’ll be interviewing Henry for the blog shortly.

* Many thanks to Charles Kirk for including The Daily Trading Coach in this site’s listing of favorite investment books. Check out The Kirk Report’s regular linkfests; the selection of articles and posts provides an excellent overview of economic and market themes.

* NewsFlashr offers an excellent way to stay on top of recent postings for a number of market-related blogs; also check out Corey Rosenbloom’s Editor’s Picks each week.
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Natural gas has gotten cheap compared to oil. That happens for many reasons one of which is that they have slightly different markets. Oil is an international commodity, shipped all over the world, while natural gas is pulled out of the ground and fed into pipelines that go to manufacturing plants all over the midwest and homes in the northeast.

If you believed that natural gas will move back up compared to oil, you could buy UNG and short USO or buy UNG calls and USO puts. UNG is the natural gas ETF and USO is the oil ETF.

Here there are subtleties too. The oil complex ETFs actually hold futures contracts for the near month. That means that every month they have to roll those contracts forward to the next month. If the futures curve is flat, there is no expense or profit in the roll. If the futures curve is upward sloping (contango) the ETF has to pay up to roll forward and that can have a large impact on the return of the fund. Of course, if the curve is downward sloping (backwardation) the fund makes money on the roll.

The upshot of this is that you are not really buying spot oil or natural gas, rather have a position in the futures which the roll can affect significantly.

Another problem is that UNG has grown so large that it cannot hold enough futures for all the money that has come into the fund. It has entered into swaps contracts with counterparties to buy the gas. So now there is counterparty risk and it is unclear what effect the roll will have on its returns.

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The amazing thing is that the pool was $29 million so the banks were just betting their TARP money.

Next Amherst got the servicer, Aurora Loan Servicing, to issue clean up calls to buy in the loans. That way, Amherst will not have to pay off on the CDSs they sold, since all the loans paid off at par.

He knows his way around options and his blog has some interesting posts and discussions. Here he discusses diagonal backspreads as a way to profit from a market move. He wrote these at the end of March when the market was moving up. It is something to keep in mind if the market ever breaks out of its range and moves down (or up some more).

In Back Spreads Standard and Diagonal he talks about the risks of a credit spread. Say you sell XYZ June 90 and buy XYZ June 100 calls. If XYZ is trading at 92, you can do that for a credit. The risk is that XYZ finishes somewhere between 93, say, and 100 where the calls you sold are more expensive and the calls you bought, the 100s have no value.

In a backspread you sell 10 XYZ June 90s and buy 15 XYZ June 100s. Here you might be able to collect a small premium, which if XYZ goes the wrong way, down, would be your profit. If XYZ moves past 100 those five extra calls give you unlimited upside. Again, if XYZ finishes below 100 your long calls are worthless and your short calls could put you in the hole for $1,000 each.

In the next installment of our saga Back Spreads Standard and Diagonal II he takes as an example the Russell 2000, RUT, which was at 429 at the time. The diagonal constructed is sell 10 May 460 Calls @ 16.70 with a delta = – 363
and buy 16 June 500 Calls @ 11.70 with a delta – 369. So this is delta neutral initially.

This might help you to follow his discussion.

One way to look at this is as a calendar spread of -10 May 460 Calls/ +10 June 460 calls; and a backspread in June -10 June 460 calls / + 16 June 500 calls. We have just added and subtracted the 10 June 460 calls. The calendar spread does well if implied volatility increases and the June backspread does well if the stock rises rapidly to overcome the drag of time decay and decline of implied volatility which usually accompanies rising stock price.

You can triangulate the position the other way too. That is, it is equivalent to a May backspread -10 May 460 Calls / + 16 May 500 Calls and a calendar spread -16 May 500 Calls / +16 June 500 Calls. The backspread wants a move clear through 500 or not to reach 460 and the calendar spread wants an increase in implied volatility.

The last in the series Back Spreads Standard and Diagonal III shows the return graphs with the effect of changes in implied volatility. It doesn’t show the effect of time decay which would give a surface. Worth reading.

I am looking into this trade for QQQQ because the top ten stocks in the index make up almost 50% of the index. So you can capture most of the correlation with many fewer options. One of the killers of the trade is the transaction cost of buying so many equity options.

The way to do this is to buy the stock options in rough proportion to their weight in the index. So one would buy twice as many AAPL options as QCOM. Seven QCOM straddles for every five MSFT straddles. Then sell the dollar equivalent QQQQ straddles for the equity options bought.

I will test this out and let you know the results.

See the series of blog posts about these multiplier ETFs in the Daily Options Report. The posts there talk a lot about hedge funds getting a heads up that these ETFs have to rebalance because of the move in the index and trading ahead of the ETF.

Another way to play this is to trade the mean reversion the next day. That is, if the market moves “too far” because of hedge funds front running the ETFs and the ETFs magnifying the move in the direction of the trend by their rebalancing, then there should be a move back the next day.

Fading the SPY

If SPY is up over three quarters of one percent sell it market on close and then buy it back the next trading day at the open. If  SPY falls 0.75% from the previous day’s close,  buy it market on close.  Then sell it back at the open of the next trading day.  This is the cumulative return doing that since the Direxion ETFs were launched.

This is like the above, except we close our position at the close of the next trading day.  This has a higher return.  What is interesting here is that the return has such a strong oscillatory structure.  Why is that?

Fading SPY Close to Open

Here we are closing out our position at the open of the next trading day. We are looking at a longer time span, from 1st February 2008 to 18 May 2009.

Fading SPY 2/1/2008 to 10/31/2008

Here we see the results of fading SPY before the launch of the Direxion ETFs.

Implied Volatility

Earnings announcements are important events for a company’s stock.  In fact, if you believe the efficient markets hypothesis, stock prices shouldn’t move at all unless there is a new piece of information about future earnings of the company.  Yet, we see stock prices fluctuating all the time.

Because of the uncertainty surrounding the earnings to be announced, the implied volatility of the options increases throughout the week.  Last week, Google April options were trading at an implied volatility of 60%.   Later option swere trading at 40%.  This morning, the implied volatility of April 370 options was 85%.   This increase in implied volatility makes the options more expensive.

Fighting this increase in option price is the time decay to option expiration.  Each day the options lose value because the clock is ticking, this is measured by theta.    The theta for the at the money options is  approximately -$152.  Each day, the option loses $152 in value.  How much does the implied volatility have to rise to compensate for that?  The vega for the same option is 17.2.  That means that for every one percent increase  in implied volatility, the option will increase in value by $17.2.  So each day implied volatility of the options have to increase by 8.8% just to compensate for the time decay.

Past Earnings – Expiration Weeks

The last column shows the change in implied volatility from Monday to Thursday.  (I don’t have access to data for the October2008 series).  If the decline in value of the option due to time decay is 9% per day, does it make sense to buy a straddle and wait for the value to increase until earnings are announced?

Here is how a near the money straddle evolved over the same week as in the table above.

So the increase in volatility does not compensate for the time decay.

This raises further questions. Since most of the time decay takes place overnight, does it make sense to buy the straddles as a day trade?