The journal focuses on options trading rather than equity trading. The focus is not arbitrary; it is the result of the structural differences between options and equities, and the ways the differences shape the methodology. This article explains the differences and the rationale for the focus.
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Leverage
Options are leveraged instruments. A single option contract gives the holder the right to buy or sell 100 shares of the underlying (for equity options) or the equivalent notional value of the index (for index options). The premium paid for the option is a fraction of the underlying's price, and the option's price movement is a multiple of the underlying's price movement.
The leverage is the source of the options market's return potential. A trader who is correct about the underlying's direction can make a multiple of the premium paid, and a trader who is correct about the underlying's volatility can make a multiple of the premium collected. The leverage is also the source of the options market's risk: a trader who is wrong about the underlying's direction can lose the entire premium, and a trader who is wrong about the underlying's volatility can lose a multiple of the premium collected.
The journal's view is that the leverage is a tool, not a strategy. The journal uses the leverage to size the position to a specific risk level, and the journal's sizing rule is the mechanism by which the leverage is controlled. The journal does not use the leverage to amplify the position's directional exposure; the journal uses the leverage to keep the position's risk at a level that the journal can absorb.
Time decay
Options have a time component. The option's price is a function of the underlying's price, the time to expiration, the implied volatility, and the interest rate. The time component is the source of the options market's time decay: the option's price decreases as the time to expiration decreases, all else being equal.
The time decay is a source of return for the options seller. A trader who sells an option collects the premium and benefits from the time decay as the option approaches expiration. The time decay is a source of cost for the options buyer: a trader who buys an option pays the premium and loses the time decay as the option approaches expiration.
The journal's view is that the time decay is the source of the playbook's edges. The journal's short-premium structures (credit spreads, iron condors, iron butterflies) exploit the time decay by selling options that are more expensive than the realized volatility justifies. The journal's expected value calculation is based on the time decay: the position's expected value is the time decay collected over the position's life, minus the realized volatility's cost.
Defined risk
Options have defined risk. The risk of an option position is bounded by the option's price (for long options) or by the option's max-loss (for spread structures). The defined risk is the source of the options market's risk management advantages: the trader knows the maximum loss at entry, and the trader's risk management is designed around the known max-loss.
The journal's view is that the defined risk is the foundation of the playbook's risk management. The journal's sizing rule is based on the structure's max-loss, and the journal's portfolio construction rules are based on the sum of the structures' max-losses. The defined risk is the reason the journal can size the position to a specific percentage of NLV and the reason the journal can limit the portfolio's total exposure.
The defined risk is also the reason the journal's edge sources are more stable than the equity market's edge sources. The equity market's edge sources are typically based on the equity's specific drivers (earnings, management, industry), and the edge sources can change quickly as the underlying's drivers change. The options market's edge sources are based on the options market's structural features (the volatility risk premium, the tax treatment, the European exercise), and the edge sources are more stable than the equity market's edge sources.
Position sizing
Options can be sized to a specific risk level. The trader chooses the number of contracts based on the structure's max-loss and the trader's risk tolerance, and the position's risk is the product of the position size and the structure's max-loss. The position sizing is the mechanism by which the trader controls the position's risk.
The journal's view is that the position sizing is the most important part of the risk management. The journal's rule is that no single position may risk more than 2% of NLV, and the position's size is calculated from the structure's max-loss and the 2% rule. The rule is mechanical, and the rule is applied to every position without exception.
The equity market's position sizing is less mechanical. The trader chooses the number of shares based on the equity's price and the trader's risk tolerance, and the position's risk is the product of the position size and the equity's price. The position's risk is not bounded by the structure; the position's risk is the equity's price, which can go to zero.
The journal's view is that the options market's mechanical position sizing is a structural advantage over the equity market. The mechanical position sizing is the reason the journal's portfolio can be sized to a specific percentage of NLV, and the reason the journal's drawdown limits can be applied to the portfolio.
The trade-off
The options market's structural features come with a trade-off. The defined risk is the source of the position's risk management advantages, but the defined risk is also the source of the position's limited return. The leverage is the source of the position's return potential, but the leverage is also the source of the position's risk. The time decay is the source of the playbook's edges, but the time decay is also the source of the cost of the long-premium positions.
The journal's view is that the trade-off is favorable for the journal's methodology. The journal's edges are derived from the structural features of the options market, and the structural features are persistent. The trade-off is also favorable for the journal's risk management: the mechanical position sizing is the foundation of the portfolio's drawdown limits, and the defined risk is the foundation of the position's risk management.
The trade-off is not favorable for every trader. A trader who is looking for uncapped upside (e.g., a long position in a high-growth equity) is better served by the equity market than the options market. The options market's defined risk is the source of the position's risk management advantages, but the defined risk is also the source of the position's limited return.
The journal's view
The journal's view is that the options market is the right market for the journal's methodology. The methodology is built around the structural features of the options market, and the structural features are expected to persist. The methodology's edges are derived from the structural features, and the edges are expected to produce a positive expected value over time.
The journal's view is also that the options market is the wrong market for traders who are looking for uncapped upside. The options market's defined risk is the foundation of the risk management, but the defined risk is also the source of the position's limited return. A trader who is looking for uncapped upside is better served by the equity market, and the journal's methodology is not designed for the equity market.
The journal's view is that the focus on options is the journal's way of exploiting the structural features of the market. The journal's methodology is built around the structural features, and the structural features are the source of the journal's edges. The journal's view is that the focus is the right choice for the journal's methodology, and the journal's methodology is the right choice for the focus.