Stocks Are Stupid

Good morning fellows and fellowettes of Evil Speculator! While Mole is recovering from his cPanel eviction, I’m here to drop relevant knowledge for you to use and better your trading. This is my first post since returning from the greatest party and spiritual adventure in the galaxy, Burning Man 2019. It was my  third burn and my first with the pinnacle of red neck engineering, Burn Force 1. That’s me attempting to catch some sleep post dawn one morning.

I found Burn Force 1 in the Cocoa Beach, FL Craigslist section as a neglected 2001 Winnebago Journey diesel pusher. Complete with a leaky roof and plenty of water damage. Only this particular model had a Clark forklift disassembled and attached to the chassis of the RV on the back, repurposed into a platform lift. As a mechanical engineer myself, I was really impressed with how well executed it was and the 9 months it took to build it. Why would someone attach a forklift to the back of a RV?

So they could drive Burn Force 1 to the infield of NASCAR races and watch the race from the viewing platform, which holds 12 people and extends 4 feet over the roof.

At Burning Man, we repurposed the lift into the Burn Force 1 Space Program ™ for viewing sunrises and sunsets on the playa. Getting Burn Force 1 repaired from it’s years of neglect was tons of work in 2 weeks, but when fellow burners said watching the sun rise from the viewing platform was the highlight of their burn, it made it so worth it.

On to the main course for today..

Today I’m not going to geek out on standard deviations, Kalman filters or any other quant dorky stuff. Instead I’m going to go in the opposite direction and talk about something that I really think all traders need to really pay attention to: what instruments are you trading? Futures, stocks, crypto, currencies or options?

If you would’ve asked me that question 5 years ago, I would have said stocks. If you would have asked me a year ago, I would have said primarily stocks and maybe options. And on October 8th, 2019, I declare the answer is we all need to be trading options. Period.

So why the shift? The short answer is I’ve seen too much and I know too much. This year, the majority of my trading profits are coming from my options trades. I do some quant geekery to get in and out of my trades, but I’m placing them just like normal humans using manual order entry. Only as a professional, I’m 100% aware of the risk I take and have checks in place to make sure I’m not going to blow some shit up.

That’s all nice, but the real reason all of us should be trading options stems from a conversation Mole and I were having on Saturday. We were discussing some market conditions that are likely to be in place for the foreseeable future:

1. We are going to be living in a world of more whip saws intraday
2. Volatility is going to remain higher, i.e. the average VIX reading will be higher
3. #1 and #2 make trading more difficult

As an example, let’s look what happened yesterday into the close in IYR, I trade I was long in and got stopped out for a scratch:

The majority of the market did a U Turn Jones in the last 90 minutes of trading and headed south. Here you can see IYR goes crashing through VWAP when it had been flying high all day.

The important thing here is I got stopped out. With any trading instrument, stock, future, crypto, etc. unless you’re a theorist who doesn’t believe in stop loses (until that theory falls apart and you go broke), almost any sane trader is placing a stop order as soon as they enter a trade.

This is where the magic of options come in that I feel like most traders miss, including me for a long time. Let’s say we have a super simple trading strategy, we enter long with a stop at -1R and a target exit at 1.5R. Once our stop is hit, we’re out of the trade with -1R and onto the next one. Simple enough even the fine folks on the trading desk at Wu Tang Financial could comprehend.

However options change the game here. Let’s say you have a $100k account and 1R = $1000 which means for standard position sizing, I would need to buy 3444 shares of IYR or roughly $320,000 in order to make the trade. The first thing your probably noticing is that if your a retail trader, almost all of your trading power is now deployed in one trade with 4:1 leverage. Not ideal at all and this trade would suck on the retail front.

The IYR near expiration options are very liquid and the spreads are tight.

I could duplicate the same trade using options. Now I’m going to pay more in the spread, but I’ll more than make up for it because of the compression vs. expansion of the option as the price moves in my favor or against me. In options geekery this is delta and gamma. In English, if the price of IYR moves up by $1, my options might increase in value by $.70. And if the price moves against me by $1, my options might only decrease by $.55. This is a huge advantage if you wash, rinse repeat over many trades.

The second benefit, and the biggest in my opinion, is that if this trade is setup correctly, we are immune to whipsaws in the market. By setting this trade up correctly, the total cost of the options should be $1000. So if the trade goes to shit, I’m out $1000 worth of options. And if it goes in my favor, the $1000 worth of options I bought are not worth $2500 (1.5R). No stop loss needed, the position sizing when getting into the trade takes care of this. This of course takes some more work than a stock trade of finding the right delta/gamma combo or the trade, but it’s work that is well rewarded.

Circling back to whipsaws, if the stock whipsaws and the options collapse in value, I don’t close the trade out. I let it ride because my risk is already defined by the total amount I paid for the options, $1000. There is a high probability that I will close the trade out for less than a -1R loss and I’m still in the game after a whipsaw move. This is a huge advantage especially for new traders that will struggle to place stop losses. Or when the trade is moving against them, they start widening the stops with the “…but I just know I’m right!” mind fuckery broadcasting in their head. We’ve all been there.

If you want to test this out on a trading strategy, try removing the stop loss from your trading strategy and running a backtest. In many cases, you’ll find your expectancy won’t change much or might actually improve, but you’ll end up taking some massive -20R loses along the way, which is totally unacceptable for most traders, including me. However what you’ll probably notice that in many cases after a stop loss is hit, the stock/future/crypto does a U Turn Jones and ends up hitting your profit target.

That’s it for today. Like Wu Tang, get, grab, in, out. If you’re a stock trader, start looking at options in place of your stock trades and you’ll be well rewarded.