- Trade Execution
Planning needs to be done in sports, in construction, and in trading. In sports or construction, once the game has begun those plans can go out the window. Conditions on the field can change or real estate conditions can affect the development of a skyscraper. The same can hold true in implementing a TOMIC trading plan. However, unlike with sports and construction projects, the TOMIC trader has a much greater ability to control outcomes. The key, as it is in many businesses, is executing a plan in a way that is disciplined but adaptive, a form of having guidelines and an approach without having “trading rules.” Just as in a James Dean movie, rules are made to be broken, so traders need to be flexible. In this section you will walk through the process of implementing a TOMIC plan from start to finish. To do so, you will follow a checklist that demands a thought process, guiding you in your trading decisions. Then you will walk through getting an order filled effectively.
Conditions of the Market
The first step is to evaluate the market. At any given time the market can be either volatile or calm. It can have inflated or undervalued implied volatility. Different contract months can be underpriced or overpriced. Within a contract month different strikes can be overpriced or underpriced. With all of these moving parts going back and forth at any given time, the market is going to be more or less favorable to specific trades. Many books and courses teach trading based on entering the same trade every month regardless of conditions; this is an extremely flawed approach. Instead, take the same approach an insurance company would take: See what condition the market is in, and sell an insurance policy that is least likely to be exercised by the buyer. To do so, you need to first understand how to evaluate the situations.
Evaluate Potential Realized Volatility
When Mark was a trader on the floor, one of the things he quickly realized was that he did not need to have an opinion on a company’s earnings or an FDA decision, but he did need to know that the event was coming up. TOMIC traders need to have the same approach, especially for nondirectional policy selling. Does the company have earnings, is the federal government releasing important data this week, is the federal reserve having a policy meeting, or is there potential trouble in a far-off place that could potentially affect financial markets? These are all questions you need to be able to answer before moving on. It is somewhat difficult to evaluate the premium in a particular insurance policy without knowing what factors could cause that policy to be enacted.
All the research in the world will not predict earthquakes, terrorist bombings, and other catastrophic events. Reason number one is that looking at HV (historical volatility) can equate to “pissing in the wind.” This is why you need to evaluate and have your worst-case scenario in the back of your head at any given time. Looking into the past gives you insight into how the market might react.
If you assume volatility is mean reverting (an assumption the entire option universe relies on), a stock or index moving at an extremely high rate of speed is likely to slow down. A stock moving much more slowly than normal is likely to increase in velocity. Taking this into consideration helps you evaluate how expensive or cheap an insurance policy might be.
Evaluate Implied Volatility
The price of an insurance policy is constantly in flux. At any given time the insurance policy might be expensive or inexpensive. If you assume that HV is mean reverting and this is the basis of IV (implied volatility), you can almost be certain that implied volatility mean will revert as well. This is an important assumption for any trader selling insurance. But is there a way to prove that IV reverts? Rather than run a bunch of numbers, a more interesting way to see proof of expectation of implied volatility mean reversion can be accomplished by looking at VIX options.
The VIX options are cash settled and European-style. Because there is no risk of early assignment, if IV gets too low or too high, the VIX options should not price to the cash market, but toward some expectation of the VIX reverting to its mean. Thus, on an IV spike, in-the-money calls should appear underpriced, and when the VIX is oversold, calls should appear overpriced.
During the flash crash, at 3:30 EST there was still a lot of confusion. The VIX was trading at just under 40%. Take a look at the price differential between the VIX 30 calls and the VIX 47.5 calls, as shown in Figure 4.1.
Figure 4.1. Notice the relative price of the 47.5 calls to the 30 calls. (Source: OptionVue6)
Despite one being in-the-money and one out-of-the-money, the two were not that far apart in price. This is because the VIX future was actually trading 29.20, so both were technically out-of-the-money if you look at the futures (although you would consider the 30s the ATM option). Even with the market exploding, the expectations of calming down stopped VIX futures (and thus VIX options) from hitting the 40% that the VIX cash was trading at the time. One interesting thing to note is that the 30s were out-of-the-money in relation to the futures. The relative value of this future compared to the 47.5 calls was quite clear. One of the worst trades in the world is to buy VIX OTM calls in the middle of a crash. The mean reversion of VIX will kill most of these trades.
You will find market expectations of mean reversion, and you can see how to use this assumption in selling insurance. In general, when implied volatility is trading at a premium to its mean, it is likely to be a better sell than a buy. The trader is selling a policy that historically is overpriced. However, this equation is not that simple. There can be good reasons that IV is elevated. This is why you need to walk through step one before evaluating implied volatility. If there is a good reason for IV to be higher, the sale may not be nearly as good as it appears. For a policy to be sold, you need to have a clear picture of the risks of the policy when trading. Only then can you decide that a policy is overpriced.
Evaluate the Months
Once you have an overview of volatility, it is time to get your hands dirty and dig into the nitty-gritty. Evaluating overall volatility is not enough. For an effective TOMIC, you need to evaluate the overall surface, starting with term structure. This is how the different months within a product are priced against one another. Contract months are tightly correlated to each other; however, that does not mean they are tied at the hip. At any given time, paper flow, the direction and size of customers buying or selling options, can cause one month to be more or less expensive than another. By evaluating how the different contract months are priced, you can spot the best month to buy or sell at any given time. It can also present different chances to spread one month against another.
Remember, your goal is to sell the most expensive policy relative to the risk. Finding the most expensive contract month greatly improves collected premiums. There can be different drivers in different months. If you are selling a specific month, or spreading one month against another, doing a little bit of digging to see why the months are priced might reveal a trade that is not nearly as good as it first appears. However, sometimes a large trader with an ax to grind (a major position to put on or take off) can pull the contract months out of whack. When this happens, you should use this information to your advantage.
Evaluate the Skew
One of the most underused and commonly mispriced parts of options is the skew curve. Skew is a term for how cheap or expensive calls and puts are relative to ATM options in reaction to hedging activities. For instance, in equities, IRAs, 401(k)’s, and pension funds, everyone wants to protect against the underlying falling. To do this, most funds employing options collar their positions. This means they buy puts with strikes below current market price and sell calls with strikes above, to help finance the put. This creates puts that are more expensive than ATM options and calls that are less expensive than ATM options. This is not always the case, but if you take a look at the structure of SPX, you can see how hedging activities affect the volatility surface.
Hedging activities are not constant, and at any given time calls and puts can become overpriced or underpriced. The curve moves up or down constantly. Depending on the steepness of the curve, different trades can become more or less favorable as you buy and sell relatively cheap or relatively expensive options. Knowing how expensive the curve is can be a powerful weapon in your arsenal. It helps you determine what trade to enter and where to execute.
Evaluate Other Products
Most SPX trading firms also trade OEX, RUT, NDX, ES, and many individual option names because of the correlation between all the indexes. Traders must be certain not to “fall in love with” one product. For example, the OEX has a beta relative to the SPX of about .98 historically. Yet because of liquidity there are times when they may be significantly overpriced or underpriced relative to the SPX. If you trade one product, you may be missing out on significantly better opportunities in another closely related one. Before entering any trade, figure out whether that is the absolute best trade available at that time. If you like a particular product, you may take the time to explore highly correlated products and walk through the process we just walked through in evaluating those products. Remember, an insurance company does not care who it insures, only that it is selling statistically the best product at the highest price, with the most return.
Trade
Now that you have narrowed your decision to a specific product, it is time to design the trade, then get it executed. To get the best trade, you need to pick strikes, and get the trade filled, as inexpensively as possible.
Picking Strikes
As a large customer buys or sells different strikes up and down the skew curve, specific strikes can become overpriced or underpriced relative to each other. Consistently buying the relatively cheap strike against selling a relatively expensive strike can produce a higher relative credit on credit spreads. Although it might seem small at first, even squeezing out a few pennies per trade can make a big difference in a portfolio. A fully funded TOMIC can trade as many as 15 to 30 trades in and out with more than 1,000 contracts per trade in a given month. That amounts to between 10,000 and 100,000 contracts per month. Improving the average fill price by as little as one cent per contract can add up to big dollars pretty quickly.
The key is to not be married to delta or percentage out-of-the-money. If you want to sell a 10 delta put or call, but the 11 or 9 delta option is the best sale, you are better off selling that option. If you like to sell spreads 5 points wide, but in relative terms the best credit is available by selling 10 or 15 points wide, you should do so. Evaluate the surface when setting up a trade and sell the most expensive option around the strike you studied.
Price
One thing new traders tend to forget is that volatility equates to price. With every cent you give to the market makers, you are selling a slightly lower IV. If you know the IV you are trying to sell, you need to know the equivalent price. Then attempt to execute at that given price. If you cannot get the trade done at your price, you are better off not selling than conceding too much on the trade. Remember, there is an advantage only if you receive the right price.
You might not be able to get a fill at the midprice, but you might not have to. If you know the lowest implied volatility level you are willing to sell down to, you can easily calculate your minimum sale price. To determine how much you are willing to concede, use IV and vega.
For example, suppose the sell side of an option spread has an IV of 21%. This produces a price of $2.00; you are willing to sell the spread down to an IV of 20%. The net vega of the spread is .05. Multiplying .05 × 1% (× 100) produces .05 of flexibility in the spread price. Thus, you are willing to sell the spread down to $1.95, but not any lower.
Order Entry
When Mark was a trader on the floor, he used instant messaging to talk to brokers all the time. Some of the largest institutions in the world would show him some of their “flow,” and sometimes he would trade it. That was his job, to make markets and take the other sides of trades. However, there were times when he became the broker. It was then that he had to choose a broker to represent my order. At first he tested every type of broker: floor execution broker, upstairs broker—heck, he even tried representing himself in a crowd or two to get an order filled. Over time he began to learn which brokers could get the best fills for different stocks and ETFs. The number of brokers quickly fell off to very few and eventually he used only three. Why? Because, as with traders, the cream of the brokers rises to the top. He found the best brokers for the specific things he was trying to accomplish and used no one else. They rewarded his loyalty and consistent flow with better fills and lower rates. He never used only one. It was important to him to have the flexibility to send an order to the broker he thought was most likely to give me the best fill.
You might not talk to brokers every day, but you will use a broker every day if you are executing a TOMIC. Selection of the best broker matters for several reasons:
• One broker is going to be better at trading different types of products. If you add futures options to TOMIC, it may become necessary to add a second broker. Most brokers offer everything, but that doesn’t make them good at everything. Once your TOMIC is big enough to have money to trade in futures, it should be allocated to the best futures broker. Have money to trade options allocated with the options broker. • If you are interested in learning or trading a product and the broker doesn’t carry the product, consider opening a small account with another firm to learn the product. • One broker might have better analytics, while lacking great execution. It might become necessary to leave a few dollars with one broker or another just to get real-time data and great analytics.
When selecting an options broker at TOMIC, you should keep a few things in mind.
• Low commissions: When first learning, a low or nonexistent ticket charge is very helpful. However, a ticket charge with lower per-contract commissions typically ends up being a better deal over time. • The ability to read spread books: One of the things many traders do not realize is how valuable order information can be. When looking through a spread book you can find valuable information such as better offers than the order you are trying to fill, and counter offers to your orders. • The ability to route orders to an exchange: You need to know that “smart routers” are in fact smart, just not in the way they are presented to the general public. Orders are routed via an algorithm that calculates where the broker will make the most money from the order, not based on where the order is mostly likely to receive the best fill. With the ability to route to specific exchanges, you take away the ability of the algorithm to stop from getting a great fill. Although it may sound trivial, routing to a specific exchange can get trades filled at better prices relative to the price of the underlying. In other words, when buying a call, you will be able to get filled with the stock price slightly higher. It only takes seeing your price trade once on an away exchange while your order doesn’t fill to learn this lesson.
Once you have picked the best broker for the product you want to trade, you should pick the best exchange. First route the trade to the exchange with the best bid or offer. The exchange that has the best market will generally provide the best fill, unless the best offer is one of the so-called “maker taker model” exchanges. Interestingly, those exchanges with the best offer will have little effect on your ability to get the order filled.
If the counter bids or offers are all the same, the biggest bids or offers will probably improve things. This belief is unfounded; however, if there is one exchange in particular that trades much larger sizes relative to other exchanges, it may be beneficial to route to that exchange.
The key is to route to exchanges providing the best fills. The best fills occur at two exchanges, the CBOE and the ISE. Next on the list are the PHLX, NYSE-ARCA, and AMEX. These exchanges may be the best to route to if they are particularly dominant in a product. Never route a “maker taker exchange” unless you are hitting a bid or lifting an offer. Market makers almost unilaterally hate paying to fill orders they are hitting, affecting the fill price significantly.
Now that you know what to trade, the next step is how to send in the order. Here are a few ways to get your orders filled.
The first thing you need to know is how small orders are filled. Back in the days before computers, if a complex order came into the crowd, the market makers would price each leg individually, add and subtract the buys and sells, and come up with a market. In that environment, where the market maker could look at the order before it was traded, market makers were willing to improve the price on individual spreads. Spreads offered more security because it was buying one option and selling another, meaning part of the position was already hedged and the trader likely had to sell less underlying to hedge the position entered. Even then if an order got too complex, market makers never liked trades with multiple strikes, different months, weird spreads between strikes, or anything else that was unusual.
Nowadays, things are very different. Complex orders are mostly executed by an algorithm instead of being quoted by the individual trader. Because of this, market makers have to be especially careful of how much edge they are willing to give on any type of order. Firms like Timber Hill and Citadel, much like computer hackers, are constantly testing the exchanges to find weaknesses in the system. If they can pick off a quoting algorithm they will do it quickly, efficiently, and in as much size as they possibly can.
Because of this, the simpler the trade, the more easily you are likely to get it filled. Individual option orders will fill at, relative to the underlying price, better prices than spreads almost all the time. The problem is that this brings the concept of directional risk into the equation for the TOMIC trader, something you are constantly trying to avoid. So buying or selling individual options to set up a spread is not advisable unless you are planning to trade the underlying back and forth as you fill the spread.
In fact, even though the order is going to be tougher to execute, newer traders should almost exclusively put the delta-neutral trade in at once. As you become more experienced at order execution, you should begin to break orders apart. In fact, as a retail trader you will find that you have at one time or another mispriced and could have gotten better fill than breaking the trade up. Remember, individual option quotes are the most efficiently priced; thus, you are less likely to get messed over by market makers, but you may also be less likely to get a great price from the marketplace.
As you become more experienced, first try to fill the whole order. If this cannot be done at an efficient price, break up the trade. This may be your best choice. Call and put spreads are much easier to fill than iron condors or butterflies. In order of difficulty to fill, you can see the best order for breaking apart your trade:
Nontraditional spreads Iron condors Double diagonals Straddles Strangles Butterflies Vertical spreads Calendar spreads Single option trades
One caveat: There are times when a small trade with unusual strikes may fall into a spot in which an algorithm wants to execute the trade. So nontraditional spreads may fill at prices that surprise you.
Size of Order
Trades under ten contracts will have an easier time filling than trades larger than ten. Most algorithms are designed to let the market maker know that there is an order to trade and not set to trade a massive spread, unless it has a ton of edge, or the firm runs an airtight quoting system. Starting small with a spread of fewer than ten contracts helps you get a better fill.
Working an Order
Just because the quote gives a “midprice” does not mean the quote is the midprice. “Book orders” can throw off the bid-ask spread. Book orders can also throw off volatility calculations because they can artificially lower or increase the IV of the calculated midprice. What you are using as a calculation when trading volatility affects this. Once you have established the midpoint, it never hurts to try to do better than that price.
Just because it is a computer quoting the price doesn’t mean that it can’t screw up. If you have dumped in the wrong IV, the computer might fill the order. Also, a trader or trading group might trade in a manner that causes the trading group to fill the order even if it is above the quoted midprice. Chalk this one up to the “it never hurts to try” category.
Most market makers train for at least a year before “getting on a badge.” As a TOMIC trader, you are self-backed, trading your own money. Be as rigid as possible with how you trade and become skilled in getting the absolutely best possible price you can. Remember, saving .05 on a ten-contract trade every day equates to $12,500 a year.
So, to make things easy, here is the thought process I go through and encourage all traders to go through when they enter the market. By following this checklist, traders can develop an approach that will hopefully hone them in on a trade with edge.
Trade Execution Checklist
Before the trade:
• What market are you going to trade? • What is the direction of the market? • Did you check the volatility conditions of the market? What is the historical volatility of the market? What is the implied volatility? Did you check the skew? • What is the strategy you will be using? • If this is a complex spread, how will it be executed? Is it worth executing at the individual component level? Will you be legging into the spread? Will it be sent as a complex order? • What is the maximum allowed loss? • Is the expected return within the underwriting parameters? • What is the target profit for this trade? • What is the size for this trade? • Does it conform to the position sizing parameters? • At what point would the trade require adjustment (if any)? • Do you know the possible adjustments to make to the trade (if needed)?
During the trade:
• Has the trade hit an adjustment point? • Has the trade hit the profit/loss target?
After the trade:
• Did you log the trade in the trading diary? • Did you follow the trading plan? • If you did not follow the trading plan, why not?