This is from Vitaliy Katsenelson at Minyanville.  Psychotherapy for Traders in a Bull Market

Lately I’ve been getting this powerful feeling that everything I touch turns to gold. Every time I buy a stock, it goes up. Did I finally figure out the stock market game? Did I find a secret way to follow Will Rogers’ advice: Buy stocks that go up, and if they don’t go up, don’t buy them.

No, I didn’t get much smarter — and my stock-picking skills haven’t improved that much over the past year. I was simply a willing participant in the latest (cyclical) bull market. A bull market makes you feel smarter than you are in the same way a bear market makes you feel dumber than you are.

Feeling smart makes you do the opposite of what you should be doing. The euphoria of the golden touch is a dangerous thing, because it can make us careless. We forget about risk (since we haven’t seen it in a while) and focus only on rewards. You have to actively make yourself aware of the 4-letter word: R-I-S-K!

How do you do that? My favorite way is to remind myself how dumb I am. I pull out an annual return report of a company on which I lost a boatload of money and masochistically try to read it from cover to cover, reliving my errors.

Or you can join Losers Anonymous and every time you sit down at the computer to look at the market say: “Hi, my name is Gil, and I am a loser. I have it in me to do serious financial damage to my account.” (This is from Alexander Elder’s book Trading for a Living: Psychology, Trading Tactics, Money Management (Amazon link)). The first time I read this, it really offended me. But the more I think about it, the more realistic it seems. He argues that just as an alcoholic has to acknowledge that they are powerless over alcohol, traders have to acknowledge that they are powerless over the market. We can only limit our losses, not eliminate them.

If you let the market tell you what to do, you have no process.

We all have stocks in which we lost a lot of money because we were overconfident. We tend to forget about them during a bull market. But I suggest you remember them now, so you’ll have fewer of those names to remember in the future. Risk is still there; it’s just hiding under the joyful sentiment of the bull market.

Believe me, it will show its ugly face. It’s just a matter of time.

Discipline Counts
In a bull market, it is easy to forget about selling discipline and then turn into a “buy-and-forget-to-sell” investor. Every time you sell a stock, you look dumb because it usually goes up afterward.

I recently sold several stocks. Shamelessly, paying absolutely no attention to the fact that I sold them, they went higher. I don’t feel smart about that decision. However, when I bought those stocks, I set valuation targets. When they approached the targets, I quickly reviewed their fundamentals. They hadn’t changed much. The decision was obvious: Sell.

Cyclical bull markets teach us not to sell, while cyclical bear markets teach us not to buy. If you let the market tell you what to do, you have no process.

But the bell doesn’t ring when bull or bear markets are over.

You can’t worry about marking the top in every sell. My objective isn’t to buy at the “bottom” and sell at the “top.” My objective is to buy a great company when it’s cheap and to sell it when it’s fairly valued. I suggest you do the same.

Not to pick nits, but you can also put in trailing stops so that the market tells you when to sell. No need to trust your own valuation model.

Click here for “7 Secrets to Make $1,000 Per Week Trading Options”

I don’t know.

I like to think as far forward as options expiration, next one is 20th June.   What is my best guess of what might happen until then and how can I make a few profitable trades.

I deeply respect people who can buy GE now and wait patiently for the economy to improve and GE to clean up its balance sheet and grow all its businesses.  I can’t do it.

My last boss at Millennium used to talk to floor brokers all the time and ask them, Why is the market up?  Why is it down?  The stories they told him satisfied him.  “Soros has split a large order among five brokers and it is getting executed …”  Something like that.

Trading shows how well aligned I am with reality.  I like models and finding and testing a trading strategy.  But all trading strategies bother me.  What is left out?  What are the hidden factors that are really driving the profit in the strategy?

In an up or sideways  market, you can do really well selling puts.   It is simple, and with a little technical analysis and no news to move the stock, like earnings, you can get some comfort that the put will expire worthless.  Also, you can use an options calculator to calculate the probability of success  based on the historical volatility.   That is comforting too.

In a down market selling puts will kill you.  So you have to know the difference short term, until the next expiration.

Edge has many fascinating essays written by giants in their field, well worth browsing.

Nassim Taleb wrote Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and The Black Swan: The Impact of the Highly Improbable.  These first two I have read and found very interesting.  The Edge essay excerpted here  summarizes some points from The Black Swan . Dynamic Hedging: Managing Vanilla and Exotic Options (Wiley Finance) was his first book on managing an options book.

1) Avoid Optimization, Learn to Love Redundancy. Psychologists tell us that getting rich does not bring happiness—if you spend it. But if you hide it under the mattress, you are less vulnerable to a black swan. Only fools (such as Banks) optimize, not realizing that a simple model error can blow through their capital (as it just did). In one day in August 2007, Goldman Sachs experienced 24 x the average daily transaction volume—would 29 times have blown up the system? The only weak point I know of financial markets is their ability to drive people & companies to “efficiency” (to please a stock analyst’s earnings target) against risks of extreme events.

Indeed some systems tend to optimize—therefore become more fragile. Electricity grids for example optimize to the point of not coping with unexpected surges—Albert-Lazlo Barabasi warned us of the possibility of a NYC blackout like the one we had in August 2003. Quite prophetic, the fellow. Yet energy supply kept getting more and more efficient since. Commodity prices can double on a short burst in demand (oil, copper, wheat) —we no longer have any slack. Almost everyone who talks about “flat earth” does not realize that it is overoptimized to the point of maximal vulnerability.

Biological systems—those that survived millions of years—include huge redundancies. Just consider why we like sexual encounters (so redundant to do it so often!). Historically populations tended to produced around 4-12 children to get to the historical average of ~2 survivors to adulthood.

Option-theoretic analysis: redundancy is like long an option. You certainly pay for it, but it may be necessary for survival.

By “optimize” I think Taleb means trying to squeeze all the return out a trade by using maximum leverage – a dangerous practice.

2) Avoid prediction of remote payoffs—though not necessarily ordinary ones. Payoffs from remote parts of the distribution are more difficult to predict than closer parts.

A general principle is that, while in the first three quadrants you can use the best model you can find, this is dangerous in the fourth quadrant: no model should be better than just any model.

How do you know if you are in the fourth quadrant? That is where you are subject to the appearance of Black Swans, rare events that can wipe you out. Since such an event may happen only once every ten years, you don’t know when it can strike. So Taleb never sells naked options. He is always a buyer or spreader.

3) Beware the “atypicality” of remote events. There is a sucker’s method called “scenario analysis” and “stress testing”—usually based on the past (or some “make sense” theory). Yet I show in the appendix how past shortfalls that do not predict subsequent shortfalls. Likewise, “prediction markets” are for fools. They might work for a binary election, but not in the Fourth Quadrant. Recall the very definition of events is complicated: success might mean one million in the bank …or five billions!

The real problem with the analysis of Long Term Capital Management was that they did not look far enough into history. Taleb argues that it doesn’t matter how far back you look, it will not tell you the limits of possible events in the future.

4) Time. It takes much, much longer for a times series in the Fourth Quadrant to reveal its property. At the worst, we don’t know how long. Yet compensation for bank executives is done on a short term window, causing a mismatch between observation window and necessary window. They get rich in spite of negative returns. But we can have a pretty clear idea if the “Black Swan” can hit on the left (losses) or on the right (profits).

The point can be used in climatic analysis. Things that have worked for a long time are preferable—they are more likely to have reached their ergodic states.

5) Beware Moral Hazard. Is optimal to make series of bonuses betting on hidden risks in the Fourth Quadrant, then blow up and write a thank you letter. Fannie Mae and Freddie Mac’s Chairmen will in all likelihood keep their previous bonuses (as in all previous cases) and even get close to 15 million of severance pay each.

This is a typical problem of misalignment of interests. Traders at hedge funds or prop desks have an incentive to take large risks since if they win, they get paid big; if they lose, they have to find another job, but the payoff is very asymmetric.

6) Metrics. Conventional metrics based on type 1 randomness don’t work. Words like “standard deviation” are not stable and does not measure anything in the Fourth Quadrant. So does “linear regression” (the errors are in the fourth quadrant), “Sharpe ratio”, Markowitz optimal portfolio, ANOVA shmnamova, Least square, etc. Literally anything mechanistically pulled out of a statistical textbook.

My problem is that people can both accept the role of rare events, agree with me, and still use these metrics, which is leading me to test if this is a psychological disorder.

The technical appendix shows why these metrics fail: they are based on “variance”/”standard deviation” and terms invented years ago when we had no computers. One way I can prove that anything linked to standard deviation is a facade of knowledge: There is a measure called Kurtosis that indicates departure from “Normality”. It is very, very unstable and marred with huge sampling error: 70-90% of the Kurtosis in Oil, SP500, Silver, UK interest rates, Nikkei, US deposit rates, sugar, and the dollar/yet currency rate come from 1 day in the past 40 years, reminiscent of figure 3. This means that no sample will ever deliver the true variance. It also tells us anyone using “variance” or “standard deviation” (or worse making models that make us take decisions based on it) in the fourth quadrant is incompetent.

Kurtosis measure how fat the tails of a probability distribution are. That is, how many large moves does oil or US dollar or a stock make. That 70 – 90% of the kurtosis comes from one day in the past forty years is fascinating. Does it mean that it can be ignored? That the normal distribution is actually better than we thought? Taleb would scream: NO!

7) Where is the skewness? Clearly the Fourth Quadrant can present left or right skewness. If we suspect right-skewness, the true mean is more likely to be underestimated by measurement of past realizations, and the total potential is likewise poorly gauged. A biotech company (usually) faces positive uncertainty, a bank faces almost exclusively negative shocks. I call that in my new project “concave” or “convex” to model error.

Do not confuse absence of volatility with absence of risks. Recall how conventional metrics of using volatility as an indicator of stability has fooled Bernanke—as well as the banking system.

9) Beware presentations of risk numbers. Not only we have mathematical problems, but risk perception is subjected to framing issues that are acute in the Fourth Quadrant. Dan Goldstein and I are running a program of experiments in the psychology of uncertainty and finding that the perception of rare events is subjected to severe framing distortions: people are aggressive with risks that hit them “once every thirty years” but not if they are told that the risk happens with a “3% a year” occurrence. Furthermore it appears that risk representations are not neutral: they cause risk taking even when they are known to be unreliable.

It does sound more frequent to say “3% per year” rather than “once very thirty years”. I had to do the calculation to see that it was the same. P = 3% / year = .03 / 252 = 3 / 25,200 = 3 times in 10 years.

Boy, was that a mistake!

GMCR went from 53 at the close yesterday to 73 now (2 PM). So my short straddles are deep underwater.

The writer of the Daily Option Report traded FSLR with an iron butterfly and limited his loss.

Stocks often go nowhere for a while, then change their state and trade at a whole new level.  The reason commodoties seem so much more volatile is because of the leverage.

Today I lost money.

The pain of it is that I was pretty sure that the trade was good.

Here is what happened. I bought the 7.50 April straddle for Alcoa Aluminum yesterday and I sold the July 7.50 straddle. The idea was as explained in earnings trades, that the drop in implied volatility would make the trade profitable today.

What happened was that the April volatility dropped alright but the July options volatility held up. Look at the table below:

What I didn’t tell you is that I put on the same trade with MOS and FDO. So I really got hammered. What this tells me is that the front month volatility collapses but not the far month. Look at MOS, Mosaic Corp a chemical company that also announced earnings last night.

So what we really want to do is sell the near month and buy the far month to take advantage of the volatility collapse. What about a large movement in the stock? How do we protect against that?

To be continued….

Since the market was between two strikes, I put on a spread ratio trade. I bought the 79 strike call and sold three times as many 80 strike calls, for a small credit. If the market stays between 787 and 803 I will have a profit. If it wanders out of that range, I will take the trade off. The best possible outcome is if the market closes at 800. Then the 79 calls that I am long, have their maximum value and the 80 calls that I am short are worthless.

1:45 PM the S&P has moved up to 803 which is touching my breakeven point. If it gets to 805 I will sell out the position to avoid large losses.

2:45 PM The S&P has moved to 810. I have bought back the short calls and left the long calls on.

3:45 PM Now the market has turned over so that I have losses from the short calls and the long calls are losing value. It is the worst possible scenario, but I was trying to recoup my losses on the short calls by keeping the long calls on. That was a big mistake. If I kept the trade on to closing, it would have made money according to plan, but the move to 810 was too large to keep the trade on safely

So my idea in the last week of February was to sell the puts and perhaps have NLY put to me in time to get this quarter’s interest payment. This is only a good idea if the stock does not fall too far. There is no point getting 1.3% interest if the stock falls 10%. That is a bad trade.

Sure enough, on 6th March, NLY was trading around $12.50. Not wanting to lose any more on the trade, I saw the delta on the puts was -.8 and I sold about half that in stock. That is, for the 10 puts the equivalent stock was 800 shares so I sold 500 short. Not quite matching the delta, but stopping the bleeding.

Today, the market was up over 6% and NLY was up 7% to 13.90 near the 14 strike. I wasn’t thinking about my position going from net long 300 equivalent shares (delta of the 10 puts .8 => .8 * 10 * 100 = 800 – 500 shares that I am short) to net flat. Since the puts have a delta now of near -.5 that is equivalent to 500 shares and I am short 500 shares.

That is OK. Tomorrow, if the market continues to rise, and it closed on its high of 719.60, I will become net short if NLY continues to rise also and its delta continues to drop. Then I will have to adjust my position.

I did the same thing with Hatteras Financial, another mortgage REIT. They trade the shorter term mortgages which matches their funding more closely. So HTS trades less wildly than NLY.

There is nothing wrong with condors and limiting loss is the most important thing that you can do in trading.  But the fact is, there is no trade that is without risk that can earn more than the risk free rate.  The risk free rate now is one half of one percent at the short end of the yield curve.

If there was a trade that earned more than the risk free rate, arbitrageurs would borrow at the risk free rate and put on the trade locking in a profit.  Then the trade would go away since they would do the trade in size.

Delta neutral trades are a favorite with the mathematicians.  That is, trades where you either buy a put and a call at the stock price or near it or sell the same.  The problem is that delta neutral trades do not stay neutral.  The stock underlying it moves and the trade is out of whack.  No longer neutral.

What to do?

Recognize that you will have to fix the trade.  With that in mind,  start the trade small.  If you were going to sell 30 puts and 30 calls, first sell 10 of each.  Then when the trade goes bad, close it out and redo it larger to make up for the loss on the first smaller trade.

This brings us to position size.  No trade should be more than one to two percent of you r account.  That way, you do not damage your account with a small loss.  This is a whole treatise in itself.

Lottery Tickets

There are ways to buy lottery tickets that increase your chances of winning. For example, many people bet their birthdays or their kid’s birthdays. So if you bet the numbers greater than 31 you have increased your odds of winning. There are also syndicates that wait for the lottery pay off pot to be large enough and then they will buy tickets with every combination to ensure that they win.

Good Reasons to Buy Out of the Money Options

Most books talk about the probability to profit at option expiration. But that isn’t the whole story. If the stock or future underlying the option is very volatile, or there is an event that leads to high volatility, an out of the money option can make you money before expiration. Then, an out of the money option might be the best bet.

Delta

Delta is the change in the option value for a one dollar change in the price of the underlying. For the mathematicians, it is dV/dS. It is not just a mathematical relationship, it has some very important properties. For one, it is the probability that the option is in the money at expiration.

An at the money option has a delta of one half, so that tells us that there is a 50% probability that it expires in the money. Out of the money options have lower probabilities to end up at a profit.

Here is a quick and dirty way to calculate delta with the information that you can find at your broker’s website.

Volatility

The volatility is the standard deviation of the price changes for one year. That means, that a $100 stock today with a volatility of 30% has a 68% chance to be between $70 and $130 one year from now. The 68% is because the price has that chance to be within one standard deviation for a normal distribution.

What is the daily volatility? There are 252 trading days in a year. As the stock price wanders in its random walk, the price can get farther and farther away from where it is now. In our example the daily volatility is 1.89% = 30% / square root(252) So, there is a 68% chance for the stock to end the day between 98.11 and 101.89. If we are looking at an option that has 20 trading days until expiration, the volatility is 1.89% * squareroot(20) = 8.45% Our $100 stock has a 68% chance to end up between $91.55 and $108.45.

What About that $110 Call?

Say you are thinking of buying a $110 call with 20 trading days until expiration. Is this a good bet? It depends. If there is an upcoming earnings announcement and there is a lot of uncertainty about earnings, it might be a good trade because the volatility will increase and make the call more valuable.

If there is no upcoming event to increase volatility, is this a good probability trade?

Let’s look at the probability to be in the money at expiration. $10 above the current price is 1.18 standard deviations away. 86.5% of the price curve is below $110 so that leaves you 13.5% probability for the price to be above $110 at expiration.

(How did we get the 86.5%? $100 is at the center of the price distribution, so half or 50% is below $100. $10845 is one standard deviation above the center, so 84% is below that. There is 34% above the center and 34% below the center. I estimated that 0.18 above that has 2.5% of the distribution in it.)

Long odds.

There are five pieces of information that fix the price of an option. Four of them are open for anyone to see. They are the price of the underlying stock or commodity, the strike price of the option, the time to expiration of the option, and the interest rate. The last hidden variable is the most important – the implied volatility.

Volatility is how much the price moves around. If the price were fixed, the volatility would be zero. If the price bounced wildly the volatility could be 100%. With the large drop in the stock market last fall, all volatilities have increased. The market as a whole has a volatility, measured by the VIX , of 40%. This measures the expectations of traders for the fluctuations of the market.

Last fall, the VIX hit 100%

The highest reading ever.

To have the best chance for a trade to pay off, you have to see where you are in the volatility cycle. Is the volatility relatively low for Apple? Maybe that means it is a good time to buy options. Is the volatility relatively high for Apple? Then you want to sell options.