The Option Pit Method

Why investors need

to take the Option
Pit Gold Course

Option Pit

Why take the Gold Course?

Learn to trade and invest in any
market
Understand how options work first to
diagnose market conditions
Practice Conditional Trading
Learn how to find edge in the market
Employ the concepts of Trade
Structure, Risk Management and
Efficient Use of Capital

First a story on Risk

Management
Risk Management is about what you
dont know
The entire financial crisis was a risk no
one thought of, but there was an
earlier one: LTCM
What killed them? Short option
positions and trying to pick up nickels
that cost 100s of millions of dollars to
billions of dollars

What Brought Them Down?

Risk Arb in the Ciena/Tellabs take
over
CIEN collapsed as LTCM lost 100s of
millions chasing a $1 arb
which was essentially selling an ATM put
at the top
Lesson- deploying huge capital for small
returns

What Brought Them Down?

Carry trade in two different securities
causing long/short misallocation
3nd World Debt/US Treasuries on the
Russian default
We saw this is the Spring of 2013/Winter of
2014 when the Fed eased
Lesson not enough liquidity to support the
position and too much leverage

What Brought Them Down?

Selling Premium in the SPX at 13 IV
tens of millions of dollars- Yes selling
near position limit at a 13 VIX.
Data set only went back to the early
90s
Lesson- Selling too much Vega 7 points
below the VIX mean

LTCM Implosion Is Instructive.

Remember according to LTCM, the
risks they were taking were next to
impossible to lose money on
REALLY?
If they could have held on,
LTCM would have eventually made
money
The key is risk management!

Vanilla Risk Brought Down

LTCM
Risk Management is for what you dont
know
Retail traders experience Mini-LTCM all of the
time
You cant win the war if you lose too many
battles
Death by 1,000,000 Paper Cuts

Use the Greeks

Delta, Gamma, Theta, Vega

Profit and Loss targets to help manage risk

Learn how to trade and invest in any market

How do you do that? You need to

find where there is some edge in
the market.
But first-

Traders need to learn to diagnose

market conditions so they can find
where the edge is.

Learn how to trade and invest in

any market
Simply put why are things trading
the way they are? Investors need to
understand how to price options first.

Option Pit calls this conditional

trading

Use this with the 3 pillars of option

trading trade structure, risk management and
efficient use of capital.

What is Conditional Trading

A concept of creating options
positions best suited to perform in
the current and future market
conditions.

What is Conditional Trading

To succeed traders need to

know and use to a high degree

The Option Pricing Model

A working knowledge of how
volatility affects market prices
The Greeks- essentially knowing how
a position structure will perform
before during and after the trade.

What is Conditional Trading

Selecting positions in terms of
Greeks and Risk Management
techniques
as in instead of I like a stock the trader
sees the Greeks associated with the
underlying at current pricing levels will
help generate edge in a trade.
It is fine to own a stock but what is the
plan for it?

What is Conditional Trading

Finally- Creating a balanced book of
option trades so if disaster falls from
the sky you as an investor can
respond when conditions are multiple
times better to trade.
The key is to add trades which you feel
have edge in them.

You dont need GIANT ideas just

ones large enough for the size you
trade.

What is edge
Finding a disconnect between option pricing
and expected movement in the underlying
security. The popular term is Volatility Risk
Premium.
We call it the juice.

The reason is that stock and options, while

connected to a common underlying, can
take very different paths depending on
liquidity flows.
The edge is being able to identify a cheap option
relative to an expensive option.

What is edge
Some paper wants to hedge, some speculate and
conditional trades operate somewhere in the middle
when trading becomes interesting.

What is edge
The reason why lots of big money
does not trade this way is because of
liquidity. There is good size liquidity
here for a large retail trader but not
enough for a $1 billion dollar fund.
HFT will correct markets but only to a risk
level

Traders can add trades with edge

when opportunities appear.

Simple Greeks
Delta is the option exposure to the
underlying
-Velocity of the position
Gamma tells how much the delta will
move with a change in underlying
price
Acceleration of the position so gamma
gets larger as the underlying moves to
the strike

Simple Greeks
Vega is the options sensitivity to a
change in volatility
Theta is the options sensitivity to
the number of days to expiration we
call this time decay

Option Pit Extra Risk

Use Option Pit extra risk measures
Units- Options with small Greeks that
are hard to define
Net Contracts- the number of all
synthetic calls and puts in the
position netted out to a call or put
count
Remember, stock is a long call and
short put!

Units
Options that have little or no value
Unpredictable Greeks

If you are a student of mine and hold

a position like this, I will fly to where
you live and bop you on the head!

Net Contracts
It is okay to be Net Short for the right
price, and in the right position, BUT
be VERY CAREFUL!
Be tight with targets, and close
quickly
NEVER BE NET SHORT CHEAP
CONTRACTS

From our Jan 17th 2014 blog

Result?

Summary
Understand how option model works first
Learn to find edge in the market place
by studying volatility
Understand how the Greeks work to
construct and manage positions
Use Position Structure, Risk Management
and Efficient use of Capital to build a
book of option trades that will withstand
withering market conditions.

Summary
Risk Management is for what you
dont know
Dont run out of margin!
Use the Greeks
Adjust short Gamma with 1/3 1/3 1/3
rule
DO NOT ROLE OUT
Live to fight another day

Special Offer
Sign up for our Gold Course by
Friday, May 16th and save $150.00
Use Code OP57

joann@optionpit.com
1(888) Trade-01

Thank You for Attending!

For questions, contact:

joann@optionpit.com
1(888) Trade-01

Delta Trading
Delta risk- keep a reasonable stop routine
on the deltas
Dont turn a winner into a loser (if you can
help it)
Keep a running stop on the winners so
you let winners run longer than the losers
Time to expiration- the longer the term,
the less sensitive the options are
Match the time to the duration of the hold

Short Gamma and Short Vega

Overall there is a give and take
between Gamma and Vega
Gamma means more closer to expiration
Vega means more farther from
expiration

Separate trades into short gamma

and long gamma

What Is a Short Gamma

Trade?
The bad: The Delta of the position
moves in the opposite direction of the
underlying
The good: Positive time decay- the
position makes money for standing
still
Iron Condors, Butterflies, Calendars,
Short Put Spreads and Call Spreads
(credit spreads)

Short Gamma Trading

-100 gamma at $10 means every .10 tick up
the position picks up -10 deltas
A $1 move up and the position is short -100
deltas
-100 gamma at $10 means every .10 tick down
the position picks up 10 deltas
A $1 move down and the position is long 100
deltas

The problem with short gamma is that the

position is growing in the opposite direction
of the underlying.

Managing Short Gamma

Net Contracts KEEP THEM FLAT (OP
rule)
Units for protection- Have a few
downside puts around for Vega when
the VIX is cheap
Adjusting by the 1/3 1/3 1/3- this is
crucial to keeping the losers to a
manageable size
NEVER ADD TO MARGIN OF A TRADE

Why Adjusting?
Keep the Delta generated by the short
Gamma manageable
Do not roll down to ride this generates
potential huge loses
The point is not to trade Delta! But to
generate Theta with an IV decrease
If you roll the Delta, now the
position has a different intent from
the initial trade plan!

1/3, 1/3, 1/3 Rule

Establish the initial credit (absolute max
loss) you expect to take in for a reasonable
scenario
For most short Gamma trades look to collect
about the credit (max loss) you start with
Where the Vega risk is bigger than the Gamma risk

For shorter Gamma trades think more like

10-20% of the credit as target
Where the Gamma risk is bigger than the Vega
risk

1/3, 1/3, 1/3 Rule

We will manage the trade as follows (for
short Gamma trading)
Down 1/3 of max loss cut delta in
Down 2/3 of max loss cut delta in
Down 3/3, get out

Never hit absolute max loss: the total

credit
Absolute max loss is a level that you never
allow your position to reach within 1 standard
deviation of the current underlying price

IWM Iron Condor WalkThrough

We will look at a few adjustments on

tradeMONSTER