Trading In 3-D

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Trading In 3-D

I would love to write about the SPX today, but it would basically be a repeat of yesterdayís post:  The market looks ugly, traders seem perfectly happy to sell premium into this sell off.  Just a little food for thought on the market though:  the last time we threatened to break 1275 was during the Japan meltdown, the VIX touched 30 then.  As we approach the same number, it appears that that the VIX may not break 20.  It might take 1250 to get to 20 and even that may not do the trick.  Now on to a philosophical subject:

I had a great option mentoring session with a trader who recently got portfolio margin.  Needless to say it was an enlightening session for the trader.  It wasnít because I showed him some crazy adjustment or because I taught him some ësecret.í  It was because I made him think like a professional trader instead of a retail trader.  Let me explain:

Most retail traders are taught to trade in the world of Reg-T.  In my opinion the regulations in this world are designed to ensure limitations on a trader, not to help the trader actually make money.  Reg-T is an environment where the cost of the trade and the profit potential really do not matter.  It is only important that the trader canít lose more than what is in the account.  In fact, some of the rules are so archaic they actually can charge more for a less risky trades vs. a more risky trade (charging for both sides of a broken wing butterfly vs. only one leg on a standard butterfly for instance). 

In order to navigate this type of environment traders actually have to learn to think like a retail trader.  This means what I call ëthinking linearly.í  Traders learn to put on, adjust, and manage trades using trades with in the month or from strike to strike.  This type of trader fixes a condor by rolling it out and increasing the size and uses terms like credit and debit spread (despite the fact there is no difference).  In this world there is a long for every short, calendar and long diagonals are the multi-month trades, and owning premium might be evilÖunless it is a speculative trade.

Once a trader gets portfolio margin many traders have problems learning to think outside of the Reg-T box.  Here is a quick example:

A trader with portfolio margin thinks that AAPL is going to move, but is unsure of direction, taught to trade Reg-T the trader only looks at the price of straddles.  Meanwhile, if the trader knew better, he or she would have noticed that AAPL July IV is trading 5% lower than August IV, a historically wide spread even if Aug is an earnings month.   If the trader had thought outside of his Reg-T box he might have bought the AAPL July ATM calls and sold the AAPL Aug ATM Calls, creating a short time spread (you would be shocked how few people look at these types of trades).



Taking things one step further, the trader could have bought and sold different strikes, based on buying high and low vols at different strikes.  The trader could sell different amounts and different strikes to make the trade either premium or delta neutral.   Sound a little complex?  If you are trading more than a few hundred thousand dollars you probably should be trading this way sometimes.

The problem is they arenít trained to use their margin effectively.  Margin trading is not linear or horizontal; itís what I would call ëthree dimensional tradingí.  Traders can buy front month options and sell back month options, on different strikes, in varying numbers.  It can help improve spec trading, and for those ëincome traderísí out there, if you do not know how to use your margin to adjust properly, you are missing a huge portion of the value of a PM account.  It will improve the way you manage risk.

In the end, learning to use margin to ones advantage is what will separate those that have a lot of money, that trade for fun and those that have a lot of money, that trade professionally.  If you are new to PM, or are not using your PM account the right way learn to think in 3-D, if you are a Reg-T trader, learning to think in 3-D can improve your Reg-T trading as well.  Knowing what the other guy knows is a huge advantage.


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