Directional Options Trading Made Easy Part I Market

Directional Options Trading Made Easy Part I: Market Forces, Statistical Distributions, and Break Outs/Break Downs Keith Harwood For Educational and Information Purposes Only

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Keith Harwood, MBA • >10 years trading options – Equities/ETFs, Fixed Income, and Commodities – Former Floor Trader and Market Maker – Former CTA Manager/Derivatives Strategist – Currently Prop Trader and Options Educator at Trade Academy For Educational and Information Purposes Only

The BIG Agenda § Market Forces § Statistical Distributions § Blue Sky Break Outs and Break Downs § Short-Squeezes and Long Liquidations § Technical Setups that Pair with Verticals and/or Butterflies § Technical Setups that Pair with Calendars and/or Diagonals § Hedging For Educational and Information Purposes Only

Today’s Agenda § Market Forces § Statistical Distributions § Low IV, Blue Sky Break Outs and Break Downs § Fair IV, Blue Sky Break Outs and Break Downs § High IV, Blue Sky Break Outs and Break Downs § Trade Examples For Educational and Information Purposes Only

Market Forces • There are Naturally sellers of calls and buyers of puts due to hedging activity • Options are insurance contracts – the retail market is naturally long and looks to hedge • Risk OFF scenarios tend to be more violent than risk ON (but not always) For Educational and Information Purposes Only

Statistical Distributions • Risk Calculations on Positions are Based Upon Volatility – Lower Volatility Larger Positions – Higher Volatility Smaller Positions – Can you see the driver of Fat Tail Risk? • Normal Distribution or Negatively Skewed Return Profile? From Managedfuturesinvesting. com For Educational and Information Purposes Only

Statistical Distributions (continued) For Educational and Information Purposes Only

The Technical Setup - Rectangles • I need a horizontal line to signify the break out/break down if I’m going to trade to a new high on the break out (or new low on the break down). From Chartpatterns. com

Statistical Distributions (continued) For Educational and Information Purposes Only

NOT The Technical Setup – Flags and Pennants • This is not the play for today – I’ll come back to this. Remember the benefit of the Pennant, though – tightening ranges leads often leads to frustrated long Gamma holders. This can help depress Implied Volatility just before the move. From Chartpatterns. com

The Technical Setup That’s Even Better • It has all the benefits of a pennant (low HV driving low IV), and all the benefits of a rectangle (no resistance). From Chartpatterns. com

Statistical Distributions (continued) For Educational and Information Purposes Only

Low IV, Blue Sky Break Outs and Break Downs § If Implied Volatility is historically low, I am getting very cheap leverage. I avoid reducing my leverage, and simply buy an outright long option so as to not cap my upside. § As a reminder, I DON’T CARE about low Historical Volatility here. § Since I target a move of 1 standard deviation to the upside (for my time period), I tend to buy outright 30 -Delta options as a balance of leverage and probability. § I target 3 weeks to expiration since this helps keep me long Gamma but without needing the move to confirm immediately – if I catch a trend instead of an explosion, I still win! For Educational and Information Purposes Only

Low IV, Blue Sky Break Outs and Break Downs § I look at an exit once the stock hits an individual day 2 standard deviation move. § I roll out and up if the stock is grinding higher and IV remains low. § If the IV regime changes (ie, IV goes up) but I still want to be in the trade, then I look at different structures and hedges – why not take some profits on my long Vega if IV increases? For Educational and Information Purposes Only

Fair IV, Blue Sky Break Outs and Break Downs § I really like to keep my upside un-constrained. So rather than adding a short strike, I tighten my strike to be closer to at-themoney and/or shorten the time to expiration. § If I shorten the time to expiration, I am betting this thing is explosive NOW, so I need higher conviction on the technical setup (which is naturally necessary if I have no edge on volatility). § Into a rally, I would expect IV to drop, so I want to add Delta risk on a per option basis – I will end up with fewer long options that have more Delta, so that my Vega risk is lower. § There also ways to hedge my Vega by adding a retracement hedge. This will be discussed later. For Educational and Information Purposes Only

High IV, Blue Sky Break Outs and Break Downs § I hate this scenario. I absolutely hate it. The market is aware that the break out is going to happen and is on to the same thing that I am. § I have no edge with options, and the market is telling me that they see the same thing, so I have no real edge on technicals relative to the rest of the market. I am best off doing nothing. My technical edge is only a little bit good, my potential for an explosive move is there, and yet, I cannot get leverage easily. § Instead, I look for this as an entry on a failed break out or break down, and I will talk about this later, as well. For Educational and Information Purposes Only

Trade Examples • • • ADSK ADM AFL CMI PF For Educational and Information Purposes Only