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Saturday, April 27, 2013

The Myth of stocks "Filling the Gap"

Tom Sosnoff of Tasty Trade is working hard at changing retail option trading, and exposing the myths of Wall Street.  He has set up an incredible research team to examine historical data and to mathematically do calculations on a whole number of things.  This data is collected on the Tasty Trade.com website as "Market Measures."  His latest (4/26/13) presentation "Mind the Gap"  involves the time honored belief system that when stocks gap up or down, they will retrace and fill said gap.   Goodness knows I've always believed that, and yes, I've even traded on that assumption.  Every chartist will teach you that.

They took a sample of 25 stocks from their own well used watchlist (liquid, tradable stocks) and looked for large moves that produced gaps during the last 3 years. They were only interested in price moves that were larger than 1 Standard Deviation expected move (either up or down) which produced gaps in the charts of these stocks.

There's a lot of ways to calculate one Standard Deviation (I've written extensively about it already) but for this study, they looked at the closest expiration option chain, and took the ATM Straddle price (on the day before the gap) times * 85% = estimate of 1 Standard Deviation.

On this sample of 25 stocks, they discovered a total of 36 gaps that met the criteria of a greater than 1 SD move. Then the job was to see if the stock filled the gap over the next 30 days, and then over a 60 day period. (30 and 60 were used as those are the TastyTrade typical timeframe for trading options.)

I find the results astonishing. While traders walk around thinking stocks ALWAYS fill the gap (and of course they can and do sometime over a period of many months or years) but for a 30 to 60 day time period, they only fill gaps approximately 15% of the time. If you think your chances of that gap filling is 50-50, think again! Here's a recap of the actual data figures for a one standard deviation gap:

Okay, you might say, but what if it gaps down MORE than one standard deviation. Maybe a larger gap means a more certain retracement!? Tom's researchers thought of that too, so they continued testing. So they looked at 1.5 standard deviation, and 2.0 standard deviation move.

Compare the number of times the gaps filled, when the gap was even larger and you can see that the gaps filled even LESS often.

The 2 Standard Deviation move (a HUGE gap) produced the following statistics for this study, even smaller probabilities:

Correction: Both of the last two slides have typos on them, should show 30 days and then 60 days. (not 30 days/30 days)

This study shows 2 things:

1. The chances of filling that gap, in even up to 60 days, is less than 1 in 5.

2. As the gap increases in size, the likeness of retracement decreases.

Obviously this study does not mean that gaps might not fill on a different set of stocks in a different set of numbers. Obviously gaps DO fill, and you can easily look at a chart to prove it. But what's the probability? So this is not a NEW belief system to replace the old one that gaps always fill. What it is is a caution for you to stop and consider the probabilities before mechanically trusting such belief systems in your trading.

Sosnoff doesn't believe in trading by technicals or fundamentals. He believes in a probability/volatility game and to learn more of his amazing studies, see the archives on Tasty Trade.com.


Monday, April 15, 2013

What makes Tasty Traders Different than Other Traders?

I often mention Tasty Trade to people who say they are traders, but their interest  in what I'm trying to say is as vague as if I was another cold caller on the phone offering a new investment scheme.

Tasty Trade is the antithesis of investment schemes.  I was thinking the other day that I need to organize (in my mind) just why I love this approach to trading so much, and need to define what are those differences from the rest of the options universe.. IT IS AN ENTIRELY NEW APPROACH if you are watching TV financial gurus, or subscribing to Option schools and mentors.  Obviously many other professional traders know and use these techniques, but they aren't sharing it with the retail public traders.  This is where TastyTrade excels.  They truly want to educate people, not grab their money.

WHY BELIEVE ME?  I know everyone is trying to tell you how to trade.

The answer is:  I'm not trying to sell you anything.  And I'm earning approximately 5% per month on my capital using this trading philosophy..  That should make you sit up and take notice.  I never did that trading with any other system.  In fact, all I did was lose money.

So here's my attempt at letting you know what they represent, and how they work:  (the real deal is easy to obtain by simply opening a ThinkOrSwim account through the TastyTrade website, for free, and see the fabulous archives of endless information therein).

  •   Nobody else can handle your money better than you can.  If you don't know how, learn. 
  •  The stock market goes up and down.  Nobody can predict which direction it is going, not with charts, not with fundamentals.  It's a 50-50 crap shoot unless you play probabilities.  The news doesn't matter, the talking heads don't matter, the experts don't know any more than you do about the market's future.  Only mathematical probabilities can give a trader an edge.  (There is a multi billion dollar industry out there trying to convince you that you NEED their services.  You don't.)
  • Mathematical probabilities are based on the strategy selected for the circumstances, and the NUMBER OF OCCURRENCES.   In other words, the number of trades you make increases your probabilities of success. (think flipping coins. Flip one coin for a 50-50 chance of success, but what about 10 coins?) There are books to be read on probabilities.  Read them!  So the Tasty Trade anthem is:  Trade small and trade often.  
  • If you keep the number of option contracts small, you can afford to lose 30% of the time as long as you win 70% of the time.  If you "go for the home run" (taking uncalculated risk) you are likely to lose everything you've gained previously.  It happens over and over and over again to new traders.  This bears repeating:  Trade SMALL and trade OFTEN.
  • The particulars of strategies are fascinating.  The more you risk, the better your probabilities of winning.  You have to be willing to take calculated risks which means that always playing it safe is going to give you very little in the way of success.  Naked options (done properly) have a better success rate than Iron Condors, as an example.  But Defined Risk spreads make total sense in some situations.  Tasty Trade has a staff of researchers who are testing the data, going back years in different market conditions, to ascertain which strategies have the highest probabilities of success and how they relate to Delta and number of occurrences. (it's all in the archives)
  • Sellers of options are infinitely more successful than buyers of options.  Be a Seller.
  • The philosophy is that everything returns to the mean, so Standard Deviations (one, two or three) have an active role in choosing your strike prices, and deciding your probabilities. Tasty Traders are mostly contrarians.
  • Volatility and very liquid underlyings are the name of the game.   Compare the volatility of a stock you're interested in  to that of  Netflix or Apple, and check out the daily volume.  Liquid stocks are fairly priced and are efficient.  Slow moving stocks are not.  (even when they have excellent fundamentals and a fantastic chart!)  Sell options into high volatility when premium is rich.  In low volatility markets (like we've had for so long this year)  you almost have to have directional assumptions (which are just that,--pure assumption) and do credit spreads that are directionally biased or  calendars and neutral strategies until  volatility picks up at earnings time.  (many say to do debit spreads in low vol but remember that debit spreads are a 50-50 proposition, whereas credit spreads are more forgiving and can still be directional.)
  • Manage your WINNERS, not your losers.  Trades should be managed at the time you put them on. Do not trade more than you are willing to lose.  If it goes against you, don't waste time managing it, either get out of the trade, let it go, or roll it.   In an iron condor, if one side goes against you, then roll the OTHER side closer to the money, to reduce or eradicate the loss of the losing side.  Take winners when they're winning (close the trade for profits) and don't be greedy holding every trade to expiration in the hope of making more.  (I personally have a $100 expectation;  if my trade reaches profits of $100 per contract, (no matter what the original premium) I close it and get out.  Take the money and run.  Each trader's expectation will be personal, but do have a figure in mind for your escape hatch.  It only takes some wild reverses in the market to convince you that $100 in hand is so much better than $100 loss overnight.
  • The whole concept of Portfolio management is part of this philosophy.  Basically, you manage the entire portfolio with Delta, and Beta weighted, (I use the SPY) to make underlyings correlate.  I am still wrapping my head around this, but I can see that keeping your eye on the overall portfolio makes very good sense, as the market swings direction.  Individual trades become less important, and become just cogs in the giant wheel of trading small and often.

Friday, April 5, 2013

Standard Deviations for Dummies (and me)


I always think I know things when I really just have a vague-ish idea of it.  Standard Deviation is one of those.  Yeah, yeah, I know that sounds stupid.  But think about it.  I'm not a mathematician, I'm not even a thoroughly seasoned option trader.  My education has major  holes in it, (no mathematical or statistical)  so I lean on the internet.  Do You?  It makes my  head hurt.


I read things on the internet, like:

In options trading, standard deviation refers to a range of possible stock prices.  It can be useful to an options trader who would like to estimate how likely it is that a stock price will rise above or fall below a specific price level..

Well, that's somebody's definition.  Does that mean that I  now "get" it?  I don't think so.


Or should we delve into  tech speak?

A standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. 

1.      A specific numerical value for the annual standard deviation can be calculated using the implied volatility of the options  using the formula: :underlying price X implied volatility

2.      This standard deviation can be adjusted for the specific time period under consideration by multiplying the value derived above by the square root of the number of days divided by the square root of 365

Question: Huh? Do I need to do this math in order to trade?   
Answer:  No.  But you do want to understand what it is you’re doing when you use the standard deviations and probabilities that others provide you, right?

Options Playbook has good  explanations of options, and this is how they show the danged formula:

And here’s a square root calculator for you, if you’re the kind of geek who wants to do this!
 Square Root Calculator


Well, thank heaven for Tasty Trade, because I FINALLY found some definitions that make sense to ME.


The volatility of an option is by definition equal to a 1 standard deviation expected move. So, if we sell a put: 1 standard deviation below the current stock price, it has a 84% probability of expiring out of the money.

Now isn't that more helpful???  THIS GIVES YOU A MECHANICAL MEANS OF DECIDING ON YOUR STRIKE PRICE/PROBABILITIES, given that you pick the right strategy...

and furthermore, check out these probabilities:

There are chart studies on Think or Swim (and other platforms) which actually draw standard deviation lines for you, so this math is done for you automatically.


Here's some more info I picked up and want to pass on for those of you who want a little more explanation.

Let’s consider the price of an underlying asset (be it a stock, index, future, whatever).  Let’s call that  price “the mean”.  Prices higher and lower than the mean might be considered “data values” or “data points.  The prices of any given underlying can be considered to be distributed on a classic bell shaped curve. 

Plus / minus one standard deviation from the mean will include 68% of the individual price points, two standard deviations will include 95%, and three standard deviations will include 99.7%

These derived values are immensely important for the options trader because they give definitive metrics against which the probability of a successful trade can be gauged. An essential point of understanding is that the derived standard deviation gives no information whatsoever on the direction of a potential move.  It merely determines the probability of the occurrence of a move of a specific magnitude.

(It is important to note that no trade can be established with 100% probability of success; even boundaries of profitability allowing for a three standard deviation move have a small but finite probability of moving outside the predicted range. A corollary of this observation is that the trader must NEVER “bet the farm” on any single trade regardless of the calculated probability of success. Black swans do exist and have a nasty habit of appearing at the most inopportune imes.)

The higher the volatility, the bigger the standard deviation.
The further the future date is, the bigger the standard deviation.
The larger the stock price, the bigger the standard deviation.

Usually you need a table of standard deviations (SD) to calculate exactly. However, option-traders use the following approximations:
• Plus or minus 1 SD of the mean includes 68.3% (approximately 2/3) of all possible results.
• Plus or minus 2 SD of the mean includes 95.4% (around 19/20) of all possible results.
• Plus or minus 3 SD of the mean includes 99.7% (roughly 369/370) of all possible results.

In other words, we can expect a result that ends further away from the mean in:
• 1 SD in 1 out of 3 occurrences
• 2 SD in 1 out of 20 occurrences
• 3 SD in 1 out of 370 occurrences 

Remember, that most charts allow you to put on Standard Deviations as an Indicator,  and Think or Swim give the Probability %'s right on the Option Chain, so there's no math needed once you truly
understand what you're looking for.

Tasty Trade has many "Market Measures" regarding Standard Deviation, plus many Iron Condor videos showing that 1 Standard Deviation (which is what Tom Sosnoff uses to trade) is not always the best choice, that 2 SD's have a higher success with Iron Condors.  But I'll do another blog post about that later.

From Tasty Trade: Liz & Jenny's video on STandard Deviation (a normal distribution curve)


A nice article about Tom Sosnoff:

Interview on Daily Finance