A Fundamental Introduction to Japanese Candlestick Charting

TRADE LIKE THE FLOUNDER

Acronyms and Shorthand Cheat Sheet

• PnL – Profit and Loss (P. and L. → P n L) • IV – implied volatility • IRA – Individual Retirement Account • Vol – Volatility (typically, IMPLIED volatility) • DTE – Days to Expiration • Roll – move an option from one strike and/or expiration to a different strike and/or expiration • ATM/ITM/OTM/DITM – At the Money, In the Money, Out of the Money, DEEP in the Money • Legging – trading a piece of a spread by itself instead of the whole spread • Skew – the difference between supply/demand (or IV) at different strikes or expirations • Front month – the shorter-dated contract of a multiple-expiration spread • Back month – the longer-dated contract of a multiple-expiration spread • Opex – Option expiration © Copyright 2018 TheoTrade, LLC. All Rights Reserved 3

PART 1 – WHAT KIND OF TRADER AM I?

What do I prefer to trade?

Ask most people that question, they will tell you what PRODUCTS they like to trade (GOOG, AAPL, VIX, etc.) but before you settle on a product, learn WHAT you’re trading.

Things you can trade:

Direction (up or down) Volatility (IV vs. HV) Correlation/Relative Strength/Beta (Pairs Trading) Mispricing/Difference in pricing (Pure arbitrage) Order Flow (HFT) M&A/Special Situations (Merger Arb)

Volatility trading defined

Volatility trading involves making a bet that predicted volatility (the amount of movement the market thinks will occur) will differ from realized volatility (what actually happens post-prediction).

As efficient as the market is, it almost never gets it right, with exception to major, major products.

We can bet that the product will overshoot its implied volatility (long vol)

We can bet that the product will undershoot its implied volatility (short vol)

I’m almost always found on the short vol side of the spectrum. There is a risk premium associated with being short vol that can be harvested with proper risk management. © Copyright 2018 TheoTrade, LLC. All Rights Reserved 6

Volatility trading vehicles

For the most part, volatility trading is done with options, with the exception of trading the volatility futures product VX. Since options carry a prediction of future volatility and stock does not, we must use options to construct trades to express our volatility opinions. © Copyright 2018 TheoTrade, LLC. All Rights Reserved 7

What products do I trade?

I trade anything with “juicy” implied volatility. As a premium seller, I seek to capture the risk premium in every contract I sell. Let’s look at a few examples:

Product Price per Share Implied Volatility 20% OTM Premium @ ~60DTE

AAPL $170.41 24.97% $0.32

SRPT $127.87 74.74% $5.40

OLED $110.71 46.06% $1.37

NFLX $347.57 45.61% $5.35

NVDA $148.17 48.18% $2.64

TSLA $305.80 61.97% $7.60

Liquidity Concerns

I sell options naked with plans to expire them or close them for nickels or dimes. As such, I don’t care about liquidity. I’ll enter as the sole OI for a strike without concern. If I can get my target entry price/IV level, I’m happy knowing that in all likelihood, I’ll just hold the short position until it expires.

What Time Frames do I Trade?

I’m primarily a swing trader, taking short vol positions with a 2 week to 3 month maturity window. Anything shorter than 2 weeks becomes highly exposed to very small changes in the underlying (gamma effect) and anything more than a few months out becomes highly exposed to changes in supply and demand (vega effect).

What Structures Do I Trade?

The main structure for a volatility trader is either a straddle or strangle. Adding wings to a straddle creates a butterfly and adding wings to a strangle creates a condor.

Put more simply, vol trading is all about straddles/strangles (naked) or flies/condors (covered). As such, my primary trading structures are flies and condors. © Copyright 2018 TheoTrade, LLC. All Rights Reserved 11

What Do I Aim For?

With the larger account, I largely aim to hit base hits (singles, doubles, and the occasional triple) with a very high win rate. I don’t mind taking 5-10% over and over again with the very (very, very) occasional 50-100% loser on large size trades.

With a smaller account, I’ll be more aggressive looking for trades that pay 100% -200% (and have opportunity for better), and I don’t mind losing a larger percent of the trades.

There are a lot of ways to skin the cat, and allocation is just as important (if not more so) than strategy.

What Do I Aim For?

Portfolio Win Rate Ave Win Ave Loss Profitable?

1 30% $300 $100

2 55% $500 $500

3 90% $100 $500

4 15% $550 $2000

5 25% $400 $100

6 5% $1000 $50

7 99% $100 $5000

8 90% $500 $4500

9 85% $100 $100

10 65% $450 $300

What Do I Aim For?

Portfolio Win Rate Ave Win Ave Loss Profitable?

1 30% $300 $100 Yes

2 55% $500 $500 Yes

3 90% $100 $500 Yes

4 15% $550 $2000 No

5 25% $400 $100 Yes

6 5% $1000 $50 Yes

7 99% $100 $5000 Yes

8 90% $500 $4500 No

9 85% $100 $100 Yes

10 65% $450 $300 Yes

PART 2

Implied Volatility Ranges

For SPX trading, having “ranges” of volatility that trigger certain trading styles and choices can be helpful. Here’s the rough ranges that I use:

VIX<10: Hedge your tails off AGGRESSIVELY (carry lots and lots of long vomma/vanna in the way of far OTM puts – they are extremely cheap at the moment). General bullish bias

VIX 10-15: Hedge aggressively with long puts (they are still cheap), this is business as usual and where things have been living for a while. General bullish bias to keep up with market

VIX 15-20: Sell premium and build structures with a more neutral bias. Hedge with verticals or condors. Start hedging upside bounce risk with vol neutral structures

VIX 20-30: Sell premium more aggressively while hedging intermediate downside risk with condors/flies and verticals. General bearish bias

VIX 30-50: Back up the truck on premium selling. Hedge your risk with verticals and condors. Start selling off your vol hedges.

It’s all Greek!

Having a solid grasp of risk and profitability metrics is essential to understanding your risk and earnings profit. These are measured using the “greeks,” a tool for measuring PnL changes across a variety of scenarios.

There are “first order” greeks, as well as second and third order greeks.

- The first order greeks affect PnL directly. - The second order greeks affect the first order greeks, - The third order greeks affect the second order greeks. © Copyright 2018 TheoTrade, LLC. All Rights Reserved 17

Delta

Delta is a first-order Greek that tells us how much profit (or loss) to expect with a 1-point change in the underlying.

• Delta is the ANGLE of the T+0 line. If the angle is positive (left to right, low to high, bullish trend) then delta is positive. If the angle is negative (left to right, high to low, bearish trend) then delta is negative.

• 1 delta is equivalent to 1 share of stock

• Delta is the only Greek than can be hedged/adjusted by buying or selling the underlying

• Bullish delta is positive

Gamma

Gamma is a second-order directional Greek that tells us how our DELTA will change with a 1-point move in the underlying.

Gamma is the curvature of the T+0 line.

Positive gamma will improve your delta in either direction

Positive gamma makes your T+0 line “smile”

Negative gamma will make your delta position worse in either direction

Negative gamma will make your T+0 line “frown”

Theta

Theta is a first order Greek that measures PnL change over 1 day of time. Note that the decay rate is estimated and NOT GUARANTEED EVEN REMOTELY.

Theta is how much the time value portion (extrinsic) of an option SHOULD decay given one day of time passing.

Remember, intrinsic value doesn’t decay.

Charm

Charm is a second-order directional Greek that tells us how our DELTA will change with a 1-day increase in time.

Charm is completely useless for day traders

Charm is important for non-directional swing traders (What will my directional risk be tomorrow?)

Juice

Juice (dTheta dTime) is the second order Greek that measures the change in theta over 1 day in time.

Almost no one I’ve ever met uses Juice, but I find it to be a handy adjustment trigger tool (if theta starts shrinking, adjust!)

You could think of Juice as the acceleration or deceleration of theta.

Juice will be highest under a peak of an expiration structure near expiration, and ahead of a binary event in which the Theta is not “coming out.” © Copyright 2018 TheoTrade, LLC. All Rights Reserved 22

Vega

Vega is a first order Greek that measures exposure to option supply and demand, though no one ever describes it that way.

Long vega = long demand/short supply

Short vega = short demand/long supply

Vomma

Vomma is the second order Greek that measures changes to vega with an increase in IV (option demand)

In a crash, the more positive vomma you have, the more yachts you can buy

You can think of vomma as the acceleration (or deceleration) of your vega

Vanna

In addition to being America’s favorite assistant, Vanna is a second order Greek that measures changes to vega with directional movement.

Think of Vanna as the slope of the vega line over a directional range.

How to break some legs (or wings)

The mechanism for changing a butterfly to a broken-wing or unbalanced butterfly is something I use all the time. You’ll need to understand it for neutral trading.

You can either:

1) Sell additional credit spreads (unbalanced fly)

PART 3

Bearish Strategies

The MountainTop Strategy

- A layered broken-wing butterfly strategy that’s designed to capture profits on a pullback in the market, but that generally will make small profits during bullish trends

The StairCase Strategy

Neutral Strategies

The FruitFly Strategy

- A broken-wing butterfly + put credit spread strategy that’s designed to capture profits while the market it ranging. Will take pain on hard down moves, and generally will break even during hard up moves © Copyright 2018 TheoTrade, LLC. All Rights Reserved 29

Bullish Strategies

The SkyLine Strategy

- A broken-wing condor strategy that’s designed to capture small but consistent profits during bullish trends while remaining defensible to the downside

The Risk Reversal

PART 4

Bearish Strategies

Balanced Butterflies

Neutral Strategies

SPX Calendar Spreads

- A strategy used to exploit inflated IV and decay rates between expirations

Skew arbitrage

Bullish Strategies

Dividend Capture

- A covered call + put butterfly designed to capture a dividend with limited risk. Works best when market is bullish due to excessive downside risk