How do we choose which underlying to trade?

[Music] ready Linda fire up please really good job here come by our guys this morning on a research team putting together some I hate I don't tell anything we do basic but it's very important to hammer home especially because there's so many new listeners to hammer home a lot of the stuff that we talk about all the time and to make it very real I sprinkle the infield with some review yes one of the things we're focusing on now Tony is we are focusing on adding a little bit more a few more stories into the mix of just information so so they're not rants or whatever else they're just stories analysis analogies just just lots of different kind of complimentary amounts of information as much as we can pile on to support just everything we talked about strategically we're often asked what criteria we use 400 Lang selection while while it is more of an art than a science there are a few common themes to be aware of as we develop or as you develop your own selection strategy one of the things that we had to do as a individual retail investor was start to develop Tony we had to come up with a whole new universe of trading after we left being a member of an exchange as an exchange remember what most people don't realize is even though you're an exchange member you don't really it's almost like being a reporter you're not a reporter for Major League Baseball if you're a baseball Porter you're rarely a reporter for Major League Baseball you're really a reporter for your team correct you know most people are beat reporters or they are locked down with one team so they get to know all the ins and outs because that's what's valuable traders the same thing you're not a traitor traitor if you get hired by a firm to be a traitor they don't say hey you know what here's a couple of million dollars why don't you just use your brain and come up with some ideas and put the money to work that's so crazy okay that would be insane usually what they say is hey here's a stock and you know what you better become damn good at this stock and or here's a few stock and learn everything there is to know about the way these stocks trade about the liquidity about the open interest about the volatility about pricing about all the theoretical 's and all the greeks and everything you have to know about this and this is what you're gonna trade and you're like okay that's cool when I first got out of college there wasn't a lot of derivatives trading so a lot of my friends got jobs as as not really specialists but as market makers as over-the-counter market makers and specialists for different firms on Wall Street because a lot of us and finance majors and Wall Street at the time was hiring and and so they became market makers and over-the-counter stocks and you don't get like a hundred stocks you get like I don't know three four right that's it okay let's go next slide maintain a list of thirty to fifty liquid products we're just getting back to the basics and then we'll get a little more intense in a few minutes maintain a list of thirty to fifty liquid stocks build your sense of market awareness by monitoring these products from your list from this list a large majority of our trades and assumptions are made here's the craziest thing outside of earning place 98% of our trades come from our watch list correct you come in here and you call in and you talk about a stock that we've never heard about before and there's a one in a hundred or two and a hundred chance that we're gonna do something with it and occasionally I will I even talk about the show we do it sometimes right then when we're talking to people but for the most part you talk about something we got I don't really trade that stock I've never heard of that stock if it's on our quote our liquid list futures and/or option stocks whatever it is outside of earnings plays we're all over it that's it we stick to the things we know the best we feel the most comfortable adding to those positions let's go next slide when considering an underlying to trade we look at a few key statistics we look at implied volatility we look at implied volatility range we look at liquidity we look at binary events we look at price strength or I'm sorry we look at price weakness or strength but we also must consider our existing portfolio as well as overall market conditions now I got to the retail business in 1999-2000 when we built thinkorswim and for the first time I was introduced to people looking at a stock without looking at the market I got very confused TP and I used to sit down and go how can you look at this stock without knowing what the markets doing it's worse how can you the stock without knowing what the futures are doing and then even worse where's my portfolio how can I look at this stock look at my positions and try to determine what to do without knowing what's in my portfolio and what the markets doing this is not a one-off business nobody makes money being one-off now this will explain why and I'm gonna save this piece for tomorrow but we're gonna do an a a really fun study on hey you know what everybody comes on and says if you're just buy and hold if you just believe in this this is your return it doesn't work that way right I'm gonna show it to you tomorrow right now you have to consider your existing portfolio because what if you're short ten different things you don't need to be right you don't need another one or you've got a positive and something else you gotta keep that one on it kind of offsets the whole portfolio of course listen I hate some of these stocks I despise Yahoo here mm-hmm all right all I want to do is sell that stuff but you know what I don't all right I'm already too short everywhere else correct to sell Yahoo it's not my it's not it's not worth it for me I answer people that way when they send me email sometimes I'll say hey look at this stock ABC you know it's got a high volatility looks at the higher end the range I think it's a great candidate for doing a vertical spreads you know what it does but I'm already short the market that's right that's right I'm full this is my beautiful what do you like cannolis this is a beautiful cannoli though Via del C del V Adele this is a beautiful sphere del thank you okay but I just had two desserts and then you're like okay did stop you yesterday you still eating my birthday cake yesterday it's pretty good I know let's go next sequels as a winner it was really good implied volatility implied volatilities very important statistic in our underlying selection as well implied volatility tells us the expected move and it's a key factor in the pricing of options in our selection process we look to compare and applied volatility to the overall market and to correlated products listen I don't care if you ever if you know what implied volatility is if you don't I mean obviously the more you know the better off you are but it is very valuable to be able to put context around your decision if you're about to buy IBM here at 200 where's IBM right now IBM is trading for 199 85 so if you are about to go out and buy IBM at $200 it did trade as high as almost 201 294 if you're about to buy the stock at $200 it would be really nice to know before you tell your friend I might be I'm at 200 cuz I think it's going to 220 it'd be really nice or I'm going on by IBM at 200 because I read this goldman report said it's going to 230 it'd be very nice to know hey you know what I'm buying IBM at 200 because the statistical chance of it trading at 205 is 48 percent or 98 percent actually it's probably about 35 percent chance to trades at 205 I'm just guessing and that means there's a 70% chance to touch this right okay and that's just taking some just ballpark numbers that's a cool thing it's really nice to sit down at a blackjack table and have and I talk about this all the time when I'm doing seminars it's really cool to have random strangers tell you what the exact odds are of winning the hand in blackjack random drunk strangers who you don't know who have an IQ of less than 90 okay and they're telling you what the statistical chances of an of you winning this hand based on your card and yet nobody in the world can tell you what IBM is going from 200 to 205 realistically probability of a touch in the next whatever 35 days right okay 100 days whatever it is come on let's get our act together next slide the IV range is a look at the current IV implied volatility relative to its high and low over a period of time what's a reasonable period of time we say probably I don't know a year right and we look at the underlines that are trading high in their IV range to possibly play for an IV mean reversion again this is a discussion today on selecting underlyings so the reason we look at the IB range is we're always thinking mean reversion you're gonna hear mean reversion a lot more you're gonna hear mean reversion when it comes to I heard the term mean reversion yesterday or the day before when somebody was talking about athletes who are playing for their contracts in a contract year so this year for example Chicago Jay Cutler who's the quarterback of the Bears is in a contract year and the discussion was is Jake hunt is Jay Cutler going to have a great year so he gets a new contract and then next year revert to the meat and I loved that because that's what we do how can they have that conversation on sports write it we can't have that conversation with implied volatility that's the future man let's go next slide we look to liquid products as these will offer us the most efficiently priced options and again this is a hard thing for a lot of people to recognize our listeners are really smart about this if something has a one penny wide market it has to be better for you long run if you can find something doing there than something that has a wider market listen we've shown you on the market measures past market measures how much that affects your return at the end of at the end of one year it's just common sense I bought a couple years ago I bought a clean tens of thousands of dollars a couple years ago I bought a car for my son it was a it was a Jeep Liberty Liberty and what I didn't know at the time was the market on the Jeep Liberty was down to like $50 wide in other words he looked at he looks like three or four Jeep liberties and every car was within $50 to 100 hours of each other fishing market yeah it was I mean he used Jeep Liberty it's like whatever was twelve thousand dollars let's just say and the the market at one place was like eleven nine and these are these are individual owners two to twelve to so there was a there was a $300 wide market on four or five different jeep liberties that's an incredible the efficient market so at the time just pick whichever one you want does make a difference to me right okay cuz whatever they're all the same of one half dozen another when you bought your Lambo right this is what happens when you make a point scalp in two minutes on some Tesla calls this is gonna be I'll be when you bought your scooter another scooter okay when you pony from Mexico get that for me okay there is we don't have what good you buy a more expensive car mm-hmm then obviously the markets much wider so you buy like a $70,000 car $60,000 car of course you go to resell it all of a sudden one person is offering a 30 grand for these was the Marta's 5 grand warhead so so like I was trying to you know at the time teach my son a lesson this is this is an efficient market he goes I don't care about the efficient market I want the red one okay I'm like dude you gotta figure this stuff out and he's like I don't care about the efficient market stop talking about the efficient market I want this one because it has blah blah blah and then he turned to his girlfriend said it's right I do want the red one right family you're gonna have it's not good she's gonna cut you anyway that's the beautiful thing about liquidity Jeff our interns just I am mean said I'm up money and Walter from being down a couple hundred bucks now he's up a couple hundred bucks Wow look at that kid yeah he is getting it totally it's so funny because I go you know perform - that's awesome I got you know I've already talked about this I go I've completely ruined business school for him I know it's so funny though he sold the naked put in Walter and he has a very you know a smaller-sized account really tasty tasty bite-sized account the two million right yeah yeah this is the kid from goes under anthems I said listen do yourself a favor I said buy that put and you're reducing you know the put below and you're reducing the amount of capital using by about 4045 percent then take that capital that you just saved and apply it someplace else you'll be able to hold that position a lot longer and he's saying that that was really one of the key so it's awesome good for them proud of them what do you want to metal no just for listening in and using as my sometimes you have to do things because of the the account you have whether it be a naked option cuz you have a large size account or using a spread you just have to do different things Linda we're gonna try to get him down we'll start the paperwork please just doesn't watch the show cuz thank Neil your nose every we're just going to start the paperwork for sainthood okay that's all um anyway I will not win let me think I just went through this yes the following chart shows a variety of underlyings two of which do not trade due to lack of liquidity the key elements to look for our volume and open interest on the illiquid products let's go to the next slide please and what you can see here is and we tried to adil the color so you can pop up our Tesla GDX CLF and Cisco and which you can look it's the open interest on the at the money call and Tesla 3000 gtx 6000 CLF 13,000 and cisco 49,000 now take it down just to the bottom and there's two stocks fossil and RL and fossil has an open interest of 535 and RL has a open interest of 130 and the reason we're showing you this is because um we just want to put into perspective some of the things that we're talking about look at how wide the markets are 20 cents wide and fossil they're there 30 cents wide in Ralph Lauren the islands are penny wide markets you get a lot more open interest when you look at the relationship between implied volatility IV percentile and all again all this is all this is archived but the relationship between implied volatility implied volatility percentile open interest and the bid mask and you start to recognize here exactly what we're talking about gtx 126 127 CLF 101 104 cisco 71 73 and when you look at the IV percentile there the IV percentile is actually higher the IVs are higher and yet at the same time the pricing is much tighter correct and that makes for a more efficient trader now you look at Tesla it's $120 stock and has a 25 cent wide market with the open interest being a little over 3,000 in those calls you put a trade in or a bidder and offer a standing offer or even a vertical spread at the mid price the stock moves four five six eight cents one way or the other and you get filled were you do it in fossil or Ralph Lauren you're not gonna be able to get physicals just not enough liquidity let's go the next slide earnings binary events we use earning announcements and binary events for trading potential these events have significant impact and implied volatility and theta decay being aware of these events Kenneth can and their effect on option pricing is critical to our selection process because as you see with Tony and I we are very careful to exclude to only certain certain events in other words if stocks if too many of our stocks have earnings we don't play as many earning stocks if too many our stocks are involved in some kind of quote an event situation we try to migrate off of that something else yesterday we traded GLD because we didn't want to deal with anymore earning stocks that have upcoming earnings this week for next week yep and in the afternoon we're very careful to make sure that we're down to maybe one or two earnings plays and that's it yep let next slide please as concerns we buy into weakness that we sell into strength we look for the price action of the underlying to assist us in our selection process and it's not just price strength and price weakness it's also volatility strength and volatility weakness if we are buying stuff in one of the reasons we like or premium sellers we like to buy into strength because volatility contracts into strength we like to sell into weakness because volatility expands into weakness it's not just about price it's also about volatility contraction and expansion and then finally last slide in our underlying selection process we look for highly liquid familiar stocks we turn to absolute IV and IV percentile for potential trades covered by high pop probability profit and plausible ROC or ROC return on capital ultimately trades are triggered by our assumptions be they directional IV or otherwise which means we are not non directional it's a big key takeaway from this we are very opinionated we are very directional and and again so we're not suggesting that the world lives in this non directional delta-neutral it's all it's all governed by neutrality that's not it correct we're engaged we have opinions you saw that in IBM you saw that in - we don't we don't mess with that stuff we we just assume over time everything plays out very good sir good stuff we take a short break we've got Jake up in the house we're going to do the skinny an options math coming up next [Music]

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Id: dHUej1FPbQ0

Length: 18min 9sec (1089 seconds)

Published: Thu Jul 18 2013