Trading Hard and Hardly Working

Trading With Titans 2 — 8/8/24

As mentioned earlier this week, these posts are done in conjunction with Trading with Titans. You can sign up for the full newsletter here:

On: Trading with a Job, stop-losses, hedging, 0DTE

It’s safe to say that a lot of people daytrading are not doing it full time. While the green button always looks grassier, a lot of us do have obligations that take us away from the charts, and usually we can work around this, but something will inevitably come up. (An old internet joke: “I even googled what time do day traders eat.”)

Two stories of mine from college exemplify this perfectly. In the first week of class, I was asked by the professor what I was doing with my laptop open. I replied that I was taking notes on LaTeX, when, of course, I was watching my call options. At the end of the semester, when entering the final for that class, I had some equity options expiring two days out. I was extremely green on these F calls, and figured, what the hell? It’s two hours, I can take the exam and then check my position. After the test, I saw that the market had sent down 2% (this was back when VIX was rarely seen above 13), taking my options OTM, thereby making them worthless. It was then that I learned that all the volume on Fed days comes in after the call, and that the muted volatility prior is because literally nobody trades before their announcements. Nowadays, I don’t daytrade Fed days (and you’ll notice that it’s useful to turn off automated intraday signals manually for the same reason.)

But an obvious problem arises — 0DTE options, as I’ve mentioned in my other writings, are ludicrously efficient leverage vehicles to trade with. You get everything you want — delta sensitivity, rapid movement, no more premium paid than is absolutely necessary for that move you’re trying to capture — and absolutely none of the fat on top. Futures, while delta one, offer a similar value proposition to capture intraday moves. Especially if you’ve seen stagnant markets, there’s basically no other option to regularly make money intraday than to regularly use these products. There are obviously some tools that exist to insulate against my college final scenario — we’re all familiar with stop losses. But my own preference is to avoid using tight stops as much as possible (in fact, I won’t use them at all while actively at my desk.) Remember Caroline Ellison of FTX fame?

While she is rightly a subject of derision, I saw this clip make the rounds and, as an options trader, I think she’s right about not using stops. (Of course, she’s wrong about a myriad of other things, I don’t think she’s a good example of a profitable trader.) Her background as a market maker led her to the same realization that I had — every order you place in the book provides liquidity. Every order filled takes liquidity. Especially with options, if you are regularly crossing spreads, you will erode any edge you had and then some because of the nature and nonlinearity of the leverage. A limit order inherently implies that you are paying that liquidity premium to fill your order at your preferred price. Really think about what a midpoint fill is — if I place an order in the middle of the spread, and I get filled, there is liquidity beneath the screens. The question becomes, what’s that price worth?

Tight stops run into the natural problem that you kill a lot of trades that might have rebounded in your favor. Let’s pretend this distribution represents all potential trading outcomes for a given strategy:

Ideally, with a stop loss, we want the left side of the distribution of trading outcomes to be prevented, while preserving the winners. The tighter your stop and profit limit orders are, though, you end up cutting off trades that might not have hit the deeper part of the left-side of the distribution that compose, in part, winning trades on the right side, and skew your distribution negative. (That’s where the age-old adage of “let your winners run” comes from.)

Other than sensibly planning around the equivalent of a final exam, there are better ways to reduce risk rather than just setting hard limits of where things can and can’t go while you’re otherwise occupied. As we all know, if we had an idea of precisely when real flow that drives moves comes, we’d never lose on a trade. Continuing from the idea of a trailing stop, we can effectively reduce the leverage and delta risk through nonlinear, correlated, and offsetting exposure. The beautiful part of modern financial markets is that there’s a product for literally everything, as I remarked here:

It’s useful to look at financial markets similarly to Newton’s Third Law — for every move in a financial product, there is some partially equivalent product that will adapt to that movement. Earlier this week, we were talking about how NQ is made up of primarily the biggest tech stocks. Well, those stocks make up a lot of ES, and drive its movement concurrently! By pairing these products against one another delta-one, you can “de-lever” without reducing the efficiency of your original entry. (A general rule of thumb I follow is that things converge on selloffs.) We can go a bit deeper — as I alluded to in the tweet, an ETF option is essentially a basket option. And given that there’s currently over 3000 ETFs, I can guarantee that there is a stock basket out there which becomes effective to hedge with. You won’t get a ton of size off on an esoteric gamer-themed ETF, but my favorite hedge when I am long “stable” big tech stocks (AAPL, MSFT) is to buy puts on high-beta driven ETFs like ARKK (which historically are driven by TSLA). In effect, I’m cheaply purchasing “high beta” insurance if I do this right. And if you’re not trading in institutional sizes, you can also spread out your exposure farther out. As we all know, a put that’s a month out is not going to be as delta sensitive as a put that’s a day out. If you’re just stepping away from the desk for a few hours out of the blue, you’re really not going to pay anything more than entry/exit liquidity costs for a longer-dated put if the market stays stagnant. (Hence why I emphasize trying to find the good fill in a spread.)

Some of this is an extension of basic pairs trading, which is where I got the idea from. If “opposing” stocks (Pepsi and Coke is the classic example) have a push-pull effect derived from their movement, why wouldn’t stock baskets work the same way? A resource I love using to find “pairable” stocks is etfchannel.com, which allows you to search the composition of an ETF, or which ETFs hold a specific stock. For example, if I’m long MCD, I can drop the ticker in and find out that XLY, a $17 bb AUM ETF, holds 22% AMZN, 16% TSLA, and 5% MCD. If you can find an efficient fill, you’re getting a ludicrously efficient blended quasi-NQ option, aren’t you? It wouldn’t be that hard to do a bit of napkin math and figure out a way to use these puts, right? Food for thought, and more to come.