DECEMBER 2010 | Vol. 1 No. 10

M O N T H LYT H E O P T I O N T R A D E R S J O U R N A L

An IntervIew wIthGary KatzBuilding a Swan Catcher: Part I

the Future oFOptiOns EXCHAnGEs

EXCHANGES

CHANGESIN

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M O N T H LYT H E O P T I O N T R A D E R S J O U R N A L

Ta b l e o f C o n T e n T s

4 editor’s notes Bill Luby

5 ask the Xperts The Expiring Monthly Editors

7 building a swan Catcher: Part IBill Luby

9 the new option trader: some strategies to ConsiderMark D Wolfinger

11 a Decision Tree for Delta HedgingJared Woodard

13 eXPIrIng MonTHly feaTure The future of options exchangesMark Sebastian

19 wolf against the world: Payment for order flow Is a bad IdeaMark D Wolfinger

21 follow that trade: VIX MinotaurBill Luby

24 gap QuotientSteve Lentz, Guest Editor

27 an Interview with Ise Ceo gary KatzMark Longo, Guest Contributor

32 How Market Makers Drive the Quotes you TradeMark Sebastian

34 book review: options Theory and TradingMark D Wolfinger

36 back page: I’d rather be right Than be luckyJared Woodard

e D I To r I a l

Adam WarnerBill LubyJared WoodardMark SebastianMark Wolfinger

D e s I g n / l ayo u T

Lauren Woodrow

C o n TaC T I n f o r M aT I o n

Editorial Comments: editor@expiringmonthly.comAdvertising and SalesExpiring Monthly PresidentMark Sebastian: marks@expiringmonthly.comPhone (773) 661 6620

The information presented in this publication does not consider your personal investment objectives or financial situation; therefore, this publication does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation to buy any security. The investment strategies or the securities may not be suitable for you. We believe the information provided is reliable; however, Expiring Monthly and its affiliated personnel do not guarantee its accuracy, timeliness, or completeness. Any and all opinions expressed in this publication are subject to change without notice. In respect to the companies or securities covered in these materials, the respective person, analyst, or writer certifies to Expiring Monthly that the views expressed accurately reflect his or her own personal views about the subject securities and issuing entities and that no part of the person’s compensation was, is, or will be related to the specific recommendations (if made) or views contained in this publication. Expiring Monthly and its affiliates, their employees, directors, consultants, and/or their respective family members may directly or indirectly hold positions in the securities referenced in these materials.

Options transactions involve complex tax considerations that should be carefully reviewed prior to entering into any transaction. The risk of loss in trading securities, options, futures, and forex can be substantial. Customers must consider all relevant risk factors, including their own personal financial situation, before trading. Options involve risk and are not suitable for all investors. See the options disclosure document Characteristics and Risks of Standardized Options. A copy can be downloaded at http://www.optionsclearing.com/about/publications/character-risks.jsp.

Expiring Monthly does not assume any liability for any action taken based on information or advertisements presented in this publication. No part of this material is to be reproduced or distributed to others by any means without prior written permission of Expiring Monthly or its affiliates. Photocopying, including transmission by facsimile or email scan, is prohibited and subject to liability. Copyright © 2010, Expiring Monthly.

www.expiringmonthly.com DECEMBER 2010 3

About the

Expiring Monthly teamAdam Warner

Adam is the author of Options Volatility Trading: Strategies for Profiting from Market Swings released in October 2009 from McGraw-Hill. He co-wrote the options column on

Street Insight from spring 2003 to spring 2005, and is currently Options Editor at Minyanville.com.

When not writing, Adam is a proprietary option trader with Addormar Co, Inc. He traded as a member of the American Stock Exchange from 1988 –2001, and in several off-floor locations since then.

Adam Warner graduated from Johns Hopkins University with a degree in Economics.

Bill LubyBill is a private investor whose research and trading interests focus on volatility, market sentiment, technical analysis, and ETFs. His work has been has been

quoted in the Wall Street Journal, Financial Times, Barron’s and other publications. A contributor to Barron’s and Minyanville, Bill also authors the VIX and More blog and an investment newsletter from just north of San Francisco. He has been trading options since 1998.

His first book, Trading with the VIX, is scheduled to be published by John Wiley & Sons in 2011.

Prior to becoming a full-time investor, Bill was a business strategy consultant for two

decades and advised clients across a broad range of industries on issues such as strategy formulation, strategy implementation, and metrics. When not trading or blogging, he can often be found running, hiking, and kayaking in Northern California.

Bill has a BA from Stanford University and an MBA from Carnegie-Mellon University.

Jared WoodardJared is the principal of Condor Options. With over a decade of experience trading options, equities, and futures, he publishes the Condor Options newsletter

(iron condors) and associated blog.

Jared has been quoted in various media outlets including The Wall Street Journal, Bloomberg, Financial Times Alphaville, and The Chicago Sun-Times.

In 2008, he was profiled as a top options mentor in Stocks, Futures, and Options Magazine. He is also an associate member of the National Futures Association and registered principal of Clinamen Financial Group LLC, a commodity trading advisor.

Jared has master’s degrees from Fordham University and the University of Edinburgh.

Mark sebastianMark is a professional option trader and option mentor. He graduated from Villanova University in 2001 with a degree in finance. He was hired into

an option trader training program by Group 1 Trading. He spent two years in New York trading options on the American Stock Exchange before moving back to Chicago to trade SPX and DJX options For the next five years, he traded a variety of option products successfully, both on and off the CBOE floor.

In December 2008 he started working as a mentor at Sheridan Option Mentoring. Currently, Mark writes a daily blog on all things option trading at Option911.com and works part time as risk manager for a hedge fund. In March 2010 he became Director of Education for a new education firm OptionPit.com.

Mark WolfingerMark grew up in Brooklyn and holds a BS degree from Brooklyn College and a PhD (chemistry) from Northwestern University. After working as a

research chemist for Monsanto Company, in December 1976 he packed his belongings, left a career as a research chemist behind, and headed to Chicago to become a market maker on the trading floor of the Chicago Board Options Exchange (CBOE).

Over the next 23 years, he worked primarily as a market maker, and also held a variety of positions in the industry.

After leaving the CBOE (2000), he became an options educator and stresses conservative methods, as detailed in his newest book, The Rookie’s Guide to Options.

He currently resides in Evanston IL with his life-partner, Penny.

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Editor’s

notesBill Luby

The December edition of Expiring Monthly touches on several important themes, including the options exchanges; payment for order flow; directional vs. non-directional trades; and the strategy development process.

Mark Sebastian authors this month’s feature article, The Future of Options Exchanges, which looks at the evolution of the options exchanges over the course of the last decade. Mark shines some light on the progression from payment for order flow to penny pricing and the maker-taker model. I expect many readers will find this subject to be a revelation.

In our feature interview, Mark Longo talks with Gary Katz, President and Chief Executive Officer of the International Securities Exchange, which has been a disruptive innovator in the options exchange space. Elsewhere, Mark Wolfinger squares off with Gary Katz on the practice of payment for order flow in Wolf Against the World.

In his recurring column for new options traders, Mark Wolfinger divides the world into directional and non-directional trades and offers his thoughts on each hemisphere. For more advanced traders, guest author Steve Lentz drills down on opening gap behavior and details one approach to quantifying opening gap tenden-cies in the context of non-directional trading strategies.

Elsewhere, Jared Woodard walks the reader through how to think about and execute a delta hedging strategy in A Decision Tree for Delta Hedging, while Mark Sebastian talks about the role volatility plays in how market makers adjust their quotes for changing market conditions.

My two efforts for this month are quite different, but have a related thread. In Building a Swan Catcher – Part One and a Follow That Trade piece which utilizes a VIX-VXX pairs trade, I explore two different ways in which to take a trading strategy idea and begin to develop and refine that idea.

For those considering some holiday reading fodder, Mark Wolfinger reviews Ron Ianieri’s Options Theory and Trading: A Step-by-Step Guide to Control Risk and Generate Profits. Mark is not an easy grader, but Ianieri is clearly up to the task with this effort.

True to form, the EM team is back again to answer reader questions in Ask the Xperts.

Finally, on the back page Jared ponders the concepts of luck, time and expectancy over the course of a trading lifetime.

As always, readers are encouraged to send questions and comments to editor@expiringmonthly.com.

Have a good expiration cycle and a happy holiday season,

Bill Luby Contributing Editor

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Ask the

pertsThe Expiring Monthly Editors

Q: I anticipate a drop of $2 in a $45 stock — within the next 2 to 25 days. Do I go for ATM, ITM, or OTM puts? Which expiration month? Or should I be basing decisions on an analysis of the Greeks? So many questions! What factors would you use to guide such a choice?

— DS

A: My reply is based on how you intend to profit.

Is the plan to sell your options for a quick profit? If yes, then you want something that will benefit from both the price change and a pop in IV. Time decay is not an issue. I suggest owning an ATM, or very slightly OTM, put. If the move does not happen quickly, you will pay a lot of time premium. Make this choice only if you truly expect a very quick move.

If you plan to make your money based on the decline, then you want to be essentially short stock. Choose a high delta put. You must choose between

not paying too much time premium and not spending too many dollars — just in case the stock surprises by shooting much higher. Probably the front or 2nd month put with a $50 strike. Because time premium is small, you are still okay if the drop takes awhile to occur. This is the better play. You have no chance to gain on an IV rise, but are still in good shape when the move occurs at the end of your estimated time period.

Alternative: Buy a put spread or sell a call spread. Here, the quick move will be far less beneficial than if the move occurs in three weeks. Don’t choose the spread if 2-days is your true expectation.

Greeks are not the answer for this play. Decide how many dollars you want to invest.

— Mark W.

Q: What is the advantage of a condor over a short strangle, or of a vertical spread over just selling the

desired option? The strangle will always have a bigger credit. Admittedly, you need to define a stop, but this doesn’t seem to change the conclusion.

— Vic R.

A: The fact that the strangle offers a larger up-front credit in dollar terms is meaningless unless defined in relation to the risk in the position. Absent a quantified risk level, any comparison between a risk-defined spread (like a vertical spread or a condor) and an unlimited-risk trade (a short strangle or naked short option) is misleading. To achieve a genuine comparison, you would want to define a stop loss point for the strangle so that a closing trade at your stop level would incur a loss equal to the maximum possible loss on a similar condor. Once those risk parameters are set, you should find that the return profile over time of the short strangle doesn’t look much different (in

fact, the short strangle should look a bit worse due to higher path dependency).

Part of the added risk in a naked option or a short strangle is the fact that large jumps occur overnight or even during market hours (cf. May 6, 2010). I’m not a fan of hard stop orders resting on exchanges, and even a pre-set stop order sitting at the exchange may fail you in the event of an overnight or sudden intraday gap where prices move beyond your stop. Risk-defined option spreads don’t face this problem, and that gives them a relative advantage.

Another advantage of risk-defined spreads is that they allow you to “lock in” certain levels of implied volatility (IV). If the underlying declines to your predetermined stop loss point, the price of the put side of a short strangle may be higher in IV terms than the IV of the options purchased when constructing a

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condor, making the strangle exit consistently more expensive on a relative basis.

Finally, a risk-defined option spread like a condor or vertical spread will have more favorable margin requirements than a short strangle or naked option position. Therefore, even if you structured a strangle with stop points such that it was synthetically equiva-lent to a condor in profit/loss terms, and you knew the future such that there would be no adverse

jump risk, the risk-defined spread would still be the obvious choice from the standpoint of capital efficiency.

One exception to some of the points above would be in the case of a trade with a very short holding period, e.g. a straddle or strangle sold after a short-term pop in implied volatility that was intended to be held only for a few days.

— Jared

Q: In an environment where VIX is low (I am concerned about condors) and there is contango (concerned about initiating calendars), is there any suggestion on how to structure income trades?

— Gary

A: That is the million dollar question. Believe it or not, when the VIX is low, that is when income trading can be at its best. If the market isn’t doing much then selling premium is not a hard job. One thing also to

remember: when there is high contango that means that there may be more value in selling back month options that are ‘rela-tively’ overpriced. It is the ‘breakouts’ that can be a real problem for traders. I would generally suggest in an environment of low volatility that traders hedge an income position by either using insurance puts (units), using options on the VIX or some other volatility product, or going out and trading the VIX futures.

— Mark S.

Ask the Xperts (continued)

Specializing in Trade Structure, Risk Management and Capital Efficiency

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For Information Call (888) TRADE-01

Visit Our Website

www.expiringmonthly.com DECEMBER 2010 7

Building a

swan Catcher: part iBill Luby

With a wide range of threats to the global economy from Spain to the Korean peninsula to California to the local unemployment office, investors can certainly be forgiven for demanding portfolio insurance that will provide a buffer from another geopolitical or macroeconomic seismic event.

Not everyone is looking for ways to mitigate disaster. Some traders, for instance, are more intent on finding ways to profit from it. With that idea in mind, this article explores one way to think about and construct options positions so that the specu-lative trader can profit from a large downturn in stocks. The goal is not that different from the trapper who sets a trap in the woods, departs and hopes to passively snare his quarry. Here I also hope to be able to fund that trap with the proceeds from some additional options sales. Whether the quarry turns out to be a black, gray, white or plaid swan is a secondary consideration, but in order to capture the essence of this strategy, I call it the swan catcher.

BackgroundI start with a hypothesis that when all is said and done, it would be nice to have a funding strategy which allows me to be able to own, essen-tially for free, puts on the S&P 500

index that are 10% out of the money. There is nothing magic about 10% except that it is a round number and seems like a good place to start. To further simplify matters, let’s assume that these 10% OTM puts are purchased with one month until expiration and are rolled at the close on the last trading day for these options. Again, this may not be the optimal approach, but we need to have a baseline before we can start to look for a preferred or even optimal strategy.

The question now becomes one of what type of income strategy would it take to be able to finance the purchase of one 10% OTM put each month.

Condors and butterflies are both excellent income strategy approaches, but I am setting them aside for now on the assumption (which I can always revisit later) that the cost of buying the wings in order to limit risk makes these funding approaches less effective than other more aggressive funding strate-gies. Initially, I intend to evaluate

selling calls and selling straddles as two potential funding approaches, because I anticipate these funding approaches are likely to yield a bigger bang for the buck. For the sake of simplicity, I elect to focus my initial analysis on selling puts and calls that are 3% out of the money.

Research and AnalysisIn terms of selecting appropriate data in which to back test the swan catcher strategy, I am wary of using any of the extreme volatility from September 2008 through the early portion of 2009, as well as the strong rally from March 2009 through the end of that year. In an effort to focus on what I generally consider to be more normal vola-tility and trend data, I am limiting my first pass to just 2010 data.

Figure one below shows the 2010 data for the Thursday close just prior to expiration for SPX options. Included are the data for the +3% OTM call and the -3% OTM put, as well as the data for the -10% OTM put. The first group of data includes options prices and position values

what type of income strategy would it take to be able to finance the purchase of one 10% otM put each month?

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for a position consisting of a short 3% straddle and a long -10% put. The second group of data updates the prices and position values at the end of last trading day of the expira-tion cycle, one month later. Finally, a third group of data calculates the profit and loss for the 3%/10% short straddle, long put strategy for each cycle and also provides a cumulative profit and loss calculation for each subsequent month. Finally, the last column captures the change in the SPX for each month. (Note that the cycle data are not included for the November cycle as this cycle had not been completed as the time of this writing.)

initial Conclusions and Areas for Further AnalysisThe graphic shows what would happen if a 1:1:1 ratio were main-tained, meaning that one contract of each of the +3% calls and -3% puts were sold in conjunction with the purchase of one contract of the -10% put. Using these ratios, when the short straddle was relatively inex-pensive — during February, March

and April — the swan catcher lost money. After volatility spiked in May, the price of the straddle was sufficiently elevated that the short straddles were able to return a profit even after the proceeds were used to purchase the OTM put.

One could easily strip out the -3% put sales and consider a strategy which would sell the +3% calls in order to purchase the -10% puts. The graphic shows that in using such a strategy, the +3% calls would be able to finance approximately two calls for every put sold.

In examining the data, it is important to keep in mind that the spike in volatility that carried the VIX to 48.20 is the highest the VIX has been outside of the September 2008–March 2009 financial crisis in 21 years of VIX historical data. In other words, if the swan catcher is not capitalizing on the May spike in volatility and the 11+% drop in the S&P 500 index during this period, then it is not functioning as a swan catcher strategy, but as a different

strategic approach. The 1:1:1 ratio approach outlined in Figure 1 is one such strategy that does not capitalize on sharp downturns in stocks and increases in volatility, even though it makes money during the test period. A 1:0:1 ratio, which eliminates the short -3% put is better suited to catching swans (gaining 25.13 points in the April to May expiration cycle), but struggles over the course of the balance of the year. Keeping all other factors constant and experimenting with different ratios is the first step in enhancing the swan catcher strategy.

For these reasons, in Part Two of this exercise next month I will examine quite a few different ratios using the 3% and 10% increments, and also experiment with two other important variables: the moneyness of the options; and the time until expiration. I will also discuss substi-tuting different indices, sectors and geographies for the SPX in order to arrive at a better swan catcher strategy that uses a different under-lying. eM

Building a swan Catcher: part i (continued)

Figure 1 Swan Catcher Raw Stats — Initial Cut

VIX

and

Mor

e

www.expiringmonthly.com DECEMBER 2010 9

some strategies

to ConsiderMark D Wolfinger

Through this column, I’ve offered some general advice for option rookies. Today, let’s try to get more specific on trading options. Your ultimate goal may be to become the guy in the picture above, but please recognize that he did not achieve his status overnight.

I know that it’s important to gather a basic education before beginning to trade, and I hope you recognize how true that is. But at some point, you have done your reading, proven to yourself that you understand how options work, and are ready to paper trade to gain some real expe-rience, or have passed the practice stage and are looking to get started. But what should you do next?

It’s not wise to grab onto a strategy and just hope that it works for you. Even more difficult is finding some strategies from which to choose. This month, let’s consider some viable trading alternatives for rookie traders.

There are two groups of trades. The first is to bet that the market, or an individual stock or index, is going to make a bullish or bearish move. When correct, you earn a profit for being so smart and take a loss when you were not so clairvoyant. We refer to this as trading with a directional bias.

The alternative is to trade without a directional bias and use market-neutral strategies. Again, there are two choices: The first is the trade that earns a good profit when a large move occurs (and it doesn’t matter in which direction). These are trades with positive gamma. The second is to trade with negative gamma and collect profits when times passes and the option prices erode because the stock is moving nowhere.

i. Directional BiasI believe this is the most difficult way to earn money as an option trader, and hope to get you to think carefully before attempting to make your money by adopting this approach.

buy calls or puts. This is a straightforward approach. When bullish, buy calls, when bearish buy puts. Choose an option that not only fits in with your directional prediction, but also with the timing. Choose an option that does not

expire before your expected move occurs. Also avoid buying low delta, far out of the money options.

There is much to discuss about which options to choose and how to determine whether the price you pay is reasonable. However, this intro-ductory article cannot go there.

buy spreads. You can build bullish and bearish spreads with either calls or puts. These have the advantage of reducing investment costs, but in return, profits are limited.

ii. non-Directional BiasPositive gamma spreads. The typical spread is buying a straddle or strangle. This means buying both calls and puts, hoping that one of those will undergo a large increase in value. That large increase is needed because the other option is going to lose all value — and your option must increase by enough to overcome that loss.

This is a high risk play because the chances of success are small. Yet, it has its followers because the potential payoff is big.

Other positive gamma spreads include backspreads in which you trade all calls or all puts. The strategy is to buy more options than you sell, and to sell the option with a higher delta. This is a

T H e n e w o P T I o n T r a D e r

It’s not wise to grab onto a strategy and just hope that it works for you.

www.expiringmonthly.com DECEMBER 2010 10

sophisticated strategy and I strongly suggest that you avoid it for now (or even forever).

negative gamma spreads. These are generally referred to as income-generating trades because the objective is to score a series of steady profits by ‘selling premium.’ The most risky route, and one that is NOT recommended, is to sell calls and/or puts. The much better, much less risky play is to sell call spreads and/or put spreads.

The objective is to sell spreads that are out of the money and that you hope will remain out of the money until you buy them back at a profit, or they expire worthless. There are more details to understand, but these trades win a large percentage of the time. That is what makes them

so attractive. However, because of the nature of the strategy, when losses occur, they tend to be much larger than any individual gain. The possibility of losing a year’s worth of profits in a single trade is enough to scare some traders away from this strategy.

To succeed as a trader of negative gamma spreads, one must be skilled as a risk manager. That’s one reason why paper-trading is excellent

practice. It gives you opportunities to manage risk and gain real experi-ence — without the chance to lose any cash. Good risk management is the key to success, no matter which strategy you adopt.

Covered call writing is another negative gamma spread to consider. This is a very popular strategy used by millions of investors and traders. It’s a bullish strategy and should be included under the category of trading with a directional bias. However, most traders don’t see it that way and consider it as a way to generate income. It’s an easy strategy to learn, and thus has a lot going for it. However, this is a killer of a strategy when markets tumble. So be careful not to devote too much of your portfolio to this (or any) single strategy. eM

the new Option trader (continued)

Good risk management is the key to success, no matter which strategy you adopt.

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A Decision tree for

Delta HedgingJared Woodard

Unless you trade exclusively price-directional positions, there will be times when it is necessary to hedge the delta exposure in a trade so that other risk factors can be isolated and exploited. After the decision to hedge price-directional exposure has been made, there are still some questions to be answered about the type and specific structure of the hedge position. To clarify the process of delta hedging a position, we will review this series of decisions individually. Figure 1 is a flowchart representing the steps to be discussed.

The first step in any process of delta hedging is to define the option position to be hedged. The position or portfolio to be hedged could be as simple as a single option contract or as complex as a portfolio comprised of several butterfly, vertical, and time spreads. Once the position to be hedged has been defined, a precise delta target should be determined, i.e. the number of deltas to be bought or sold to achieve the desired risk profile. This is not a trivial decision, and will obviously depend on the specifics of the core position and of the investor’s market forecast. For our purposes, assume that the delta target has already been set.

The next step is a choice between one of two types of hedging trades: delta one hedges or hedges with optionality. “Delta one” vehicles are any assets that have only price exposure (no optionality) and have a delta of one or close to one, meaning that a 1% change in the underlying will be mirrored by a 1% change in the delta one product. Examples include futures and ETFs. Because they have no other greek exposure, they can be used to augment the delta bias of a position without having any effect on the other risk exposures.

The second type is any hedge that includes non-delta greek exposures, like bought or sold puts and calls or other familiar spread types. The most important consideration when selecting a hedge with optionality is whether the hedge is compatible with the core position. By “compat-ible,” I mean that the hedge does not unduly alter the risk exposure the investor wishes to retain. For example, if I have sold an out-of-the-money (OTM) put spread and wish to keep the short gamma /

3. Which hedge is the most efficient

use of capital?

2. Which type of hedge is

desireable?

1. What is the position/portfolio

to be hedged?

Time spread, set of butterflies, condors, etc.

Delta one

Futures / ETFs / Underlying

Synthetic long/short

Hedge with optionality

Compatible option spread

Compatible option spread

Compatible option spread

Figure 1

www.expiringmonthly.com DECEMBER 2010 12

long theta exposure of that trade, but also want to reduce my delta exposure, some options-based positions will be excluded. Buying an at-the-money (ATM) put option will offset some of my delta exposure, but the long gamma / short theta profile of that put option is contrary to the core position exposure I want to retain. A compatible alternative trade would be to sell an ATM call or call vertical spread to reduce my price-directional exposure without canceling out the desired risk in the original position.

Note that the short call vertical actually adds to the desired short gamma / long theta exposure of my total portfolio. If risk-enhancing options-based hedges are possible,

why would anyone choose a delta one product? The reason is that a trader might be satisfied with existing exposure levels and unin-terested in increasing them, in case her basic forecast or thesis is incorrect. Another consideration is that options-based hedges (excluding synthetic long and

short positions, which we’ll address momentarily) are necessarily tied to particular strike prices; using them increases the overall “strike depen-dence” of the portfolio, meaning that further hedges or adjustments may be required because of how the underlying moves in relation to the strike price(s) of the hedge. By contrast, a delta one hedge will have a fixed level of exposure no matter what changes in price or volatility occur. Simplicity is usually a virtue.

The last step in the process is to determine which specific spread or product provides the best risk reduction for the least amount of capital/margin used. In the case of delta one products, for an equity or ETF position it may be advantageous

from a margin perspective to take a synthetic long or short position instead of buying/selling shares of the ETF or underlying outright. A synthetic long position is constructed by buying a call and selling a put with the same strike price in the same expiration cycle; synthetic short positions are constructed by selling calls and buying puts in the same way. Futures traders will observe that margin requirements often make the underlying futures contract more attractive than an equivalent synthetic trade. For other options-based hedges, the optimal trade may involve a trade-off between margin efficiency and likely future adjust-ment. Using the previous example, selling very far OTM call vertical spreads to reduce positive deltas has the advantage of being unlikely to need further adjustment — the calls should simply expire worthless — at the cost of being very inefficient from a margin standpoint. On the other hand, an at- or near-the-money spread will require less margin but will also need more attentive management. eM

A Decision tree for Delta Hedging (continued)

the most important consideration when selecting a hedge with optionality is whether the hedge is consistent with the core position.

13

M O N T H LY F E AT U R E

Mark Sebastian

IN THE LAST 10 YEARS, THE NUMBER OF STOCK

EXCHANGES HAS GROWN FROM FOUR TO NINE,

WITH SEVERAL MORE ON THE WAY. WE EXAMINE THE

CAUSE OF THIS EXPLOSION AND WHAT EFFECT THE

NEWER EXCHANGES ARE HAVING ON THE MARKETS.

EXCHANGESOPTIONS

THE FUTURE OF

www.expiringmonthly.com DECEMBER 2010 14

the Future of Options Exchanges (continued)

In 1999, there were four options exchanges: The Pacific Coast Stock Exchange, the American Stock Exchange, the Philadelphia Stock Exchange, and the Chicago Board Options Exchange. This was a good time to be a market maker. The spreads were usually at least ¼ of a point between the bid and the ask, the markets were still all open outcry — making the ‘pick-off trade’ much more difficult — and volume was surging. Then, in 2000, the International Securities Exchange launched. The exchange brought many positive things to the option markets. In every product the ISE entered, spreads tightened and liquidity increased. The ISE forced the other exchanges to enter the world of electronic trading or go bust. Some exchanges excelled, like the CBOE and the PHLX. Others disappeared or were forced to sell themselves, like the AMEX (although the exchange has made a bit of a comeback).

While the ISE was certainly a game-changer, it was more of a symptom than a cause of what has happened to the option markets since 2000. To call the battle for order flow (sometimes called “paper”) fierce would be an under-statement. If the ISE hadn’t forced the exchanges to go electronic, the massive increase in volume and the multiple listing of equity options across all of the exchanges would eventually have brought some other player into the market. From 2000–2007, the competition for orders caused spreads to tighten and tighten.

This competition also brought about a new practice: payment for order flow (PFOF). Started by the individual firms and eventually adopted by the exchanges themselves, payment for order flow has been the root cause of many of the changes the exchanges

have seen over the last three years. Payment for order flow is also the cause of the creation of many of the new exchanges that have emerged over the last three years. If not for payment for order flow, it is likely that C2, the BATS exchange, and the NASDAQ options market would not exist. Had this practice not become dominant, it also would have likely impeded the increases in the market share the NYSE Euronext and the PHLX carved out of the once mighty American Stock Exchange. Whether you approve of the practice or not, payment for order flow has had and will continue to have a massive impact on the trading world.

History of payment for Order FlowWhile many are aware of Bernie Madoff only because of the multi-billion dollar Ponzi scheme that will force him to die in jail, his most significant achievement will have been begin-ning the practice of payment for order flow. In the early 1990’s, the NYSE was the dominant force in stock trading. Even in the most active stocks, New York Stock Exchange specialists regularly set bid-ask spreads .25 wide or greater. By paying firms for stock order flow, Madoff’s firm essen-tially created a third market, managing to siphon off up to 10% of the NYSE’s market share. With the wide spread Madoff’s traders were receiving, the small payment the firm paid to brokerage houses for the orders paled in compar-ison to the amount of money the firm made. When the

spreads began to tighten, the ability of the firm to continue to make money was extremely hindered. This is what led to the massive Ponzi scheme[i].

The option markets began the practice in a similar fashion.

At the time, exchanges were just starting the practice of multi-listing options and option markets were still quite

Payment for order flow has had and will continue to have a massive impact on the trading world.

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the Future of Options Exchanges (continued)

wide. In October of 1999, in order to gain order flow in the new options markets, Susquehanna Investment Group began making agreements with brokerage firms. It was soon followed by Spear Leads and Kellogg. By the middle of 2000, there were at least 11 other specialist firms paying for order flow[ii]. Like Madoff, these Designated Primary Market-Makers (DPMs) and Specialists were willing to pay a small price for order flow, because the bid-ask spread made the price worth it. As spreads tightened, and exchange competition heated up, the exchanges themselves soon took over managing the practice of payment for order flow. The exchange would collect “marketing fees” and distribute them to the indi-vidual specialists and DPMs. The main system the exchanges instituted to “pay for order flow” was what I will call, for lack of a better term, traditional payment for order flow.

traditional payment for Order FlowThe traditional system was a great system when option spreads were wide. This system involved paying order flow providers (brokers) for hitting bids or lifting offers. Thus if a market on IBM 145 calls was 1.10–1.25, an order coming from a broker to buy the calls for 1.25 or sell the calls at 1.10 would receive a payment from the exchange. Non-marketable orders, orders that were not hitting a bid or lifting an offer would generally not receive payment. As spreads tightened, payment was often expanded to include any order that hit the National Best Bid and Offer (NBBO). During the process, the practice of what the exchanges now call “best execution” was instituted, aimed at insuring that orders would receive the best price in the NBBO either at the CBOE or via exchange linkage (a system that allows orders to move from one exchange to the next)[iii]. The exchange itself does not make money from collecting payment; instead, it makes money by charging fees for each trade, and the combination of fees and PFOF made being a market maker or DPM a

very expensive practice on these exchanges. However, the volume and spreads were perceived by the liquidity providing firms as worthwhile.

Before the practice became widespread, the SEC had ample opportunity to rule on it. However, the govern-ment agency chose and has continued to choose not to rule that the practice is illegal. The commission has instead stated that it does not prefer the practice and has insti-tuted rules and regulations that try and force the practice out without necessarily calling the practice itself illegal. One of these practices was the penny pilot program.

In late 2007, the SEC essentially forced the exchanges to make option markets in top products price in pennies. A market in MSFT that had been .25–.30 was soon .27–.28. Even in more expensive options, spreads shrunk from at least a dime to a nickel or less. While this process was certainly good for the general public, it made quoting much more difficult for individual market makers. Tighter spreads require better modeling, better computers and more bandwidth, all of which cost a lot of money. Added technology costs and the losses from tighter spreads themselves combined to damage significantly the value of being a market maker or DPM on a traditional exchange. If the exchanges had retained the status quo, it is possible that the SEC might have achieved its goal of killing payment for order flow. However, the exchanges got creative.

the Maker-taker ExchangeThe exchanges stayed in heated competition for the next several years. It was not until the NYSE bought the Pacific Coast Stock Exchange, at the time a dying option market, that the practice of payment truly morphed. At the time the PSE was facing shrinking volume and even less liquidity to provide the volume it did have. In order to draw liquidity to the marketplace, the exchange began

www.expiringmonthly.com DECEMBER 2010 16

the Future of Options Exchanges (continued)

the practice of what is popularly called the ‘maker-taker’ model on many large equity and ETF products. Started on the BOX exchange (a small exchange that never seemed to gain any legs in the market) it was the NYSE — an exchange that still controlled some order flow — switching to the practice that made the model work. In this practice, the exchange does not pay the order flow provider every time an order hits a bid or lifts an offer. Instead, the exchange pays the market maker a fee every time his or her bid is hit or offer is lifted. The customer pays a fee every time every time he or she removes liquidity. Rather than charge transaction fees to both parties, the exchange (more or less) scalps the spread between what they pay the market maker and what they charge the customer[iv].

Soon after the NYSE began the “maker-taker” model, the NASDAQ (owner of the PHLX) launched a similar exchange. In 2010, we have seen the CBOE launch C2 and the BATS exchange launch. There are at least two other exchanges rumored to be entering the market. These exchanges provide a framework and scalp payments between maker makers and market takers.

The model seems relatively easy to execute and needs little market share to begin turning a profit. The volume on these exchanges has been light, to say the least. In November 2010, volume in the NASDAQ[v], Bats, C2[vi], and BOX accounted for less than 10% of the total option volume in the United States[vii]. In many less liquid penny pilot products, indi-vidual strikes are often quoted with markets 1.00 wide or more, only tightening when there is a working order in that particular strike.

Unintended ConsequencesHowever, the maker-taker model has produced a few prob-lems. With the introduction of a maker-taker model, it has become possible for an order flow provider to collect payment whether it is taking a market or sending a non-marketable order. While data is scarce, the scenario for a real problem exists. There is a major hole in the best execution rule. It makes no reference to the actual width of a market an order is sent to, or to the size of the bid or offer. Imagine a trader wants to buy calls in IBM. If the trader wants to hit a bid or lift an offer, the order will likely be routed by his or her options broker to a traditional exchange. The firm is getting

Figure 1

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the Future of Options Exchanges (continued)

the best execution (good for the customer) and getting paid payment for order flow (good for the broker).

What about non-marketable orders, though? Non-marketable orders do not get payment for order flow on the traditional exchanges, the exchanges that generally have the tightest markets and the most liquidity. Instead, it is entirely possible that a broker could route this non-marketable order to one of the maker-taker exchanges. This would allow the broker to receive payment for “making a market.” The problem is that most traders do not want to pay order flow fees to trade a borderline option order, especially liquidity providers. Since these

liquidity providers on maker-taker exchanges have to pay for hitting the bid or lifting the offer, this eats into the ‘edge’ (the price of the option rela-tive to it theoretical value) of the trade. With spreads as tight as they are almost all traders account for transaction costs in calculated edge when trading, Thus, maker-taker exchanges will have less edge than a traditional exchange. This will invariably cause the stock price to be lower for call buys (put sales) and higher for call sales (put buys). There is also the issue that there are few players in these markets. Fewer eyes typically entail worse execution. Thus, these non-marketable orders, while still receiving best execution by the rules, are in many ways likely not receiving the best execution possible.

ELX ProvidEs ALtErnAtivE AccEss to intErEst rAtE FuturEs

http://www.elxfutures.com/

www.expiringmonthly.com DECEMBER 2010 18

the Future of Options Exchanges (continued)

Payment for order has few winners and many losers. While it certainly has forced many changes in the option trading world — some of them great — there are many reasons the SEC views this practice as generally a bad thing. For those that are interested in learning more on the effect of payment for order flow, we would encourage you to ask your broker. Some do accept payment, and others do not. For those that have brokers that do accept payment, they will argue that it lowers commission costs for the retail customer — which is likely true. But at what cost?

Here is an interesting experiment: Find a penny pilot stock that has markets that are wider than three or four cents, enter a non-marketable order, and see what exchange that order ends up on. If it ends up on one of the ‘maker-taker’ exchanges, how good is the opposite market and what is

the size? Ask if that order would have been filled or would likely receive better fills if it had ended up on a traditional exchange. eM

[i] Farrell, Greg, “SEC inaction that helped fuel scheme,” Financial Times (December 23, 2008).

[ii] Securities and Exchange Commission, “Special Study: Payment for Order Flow,” (December 19, 2000).

[iii] Cf. http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p003889.pdf

[iv] Mehta, Nina, “Options Maker-Taker Markets Gain Steam,” Traders Magazine (October 2007).

[v] http://www.nasdaqtrader.com

[vi] http://www.c2exchange.com/publish/C2FeeSchedule/C2FeeSchedule.pdf

[vii] Optionsclearing.com

Fearful investors: keeping option premiums artificially high since 1987.

historical volatility

implied volatility

Condor Options Advisory Newsletter (iron condors)

Calendar Options Advisory Newsletter (time spreads)

Backtesting & Research Mentoring & Consultingadmin@condoroptions.comwww.condoroptions.com(212) 203-0693

www.expiringmonthly.com DECEMBER 2010 19

payment for Order Flow is a

Bad ideaMark D Wolfinger

P r oBy Mark D Wolfinger

Exchanges profit from order flow because every trade executed on an exchange results in revenue for that exchange. That’s their business — acting as a location for transactions, and the more such transactions, the better.

Traders who make markets at those exchanges benefit by getting to fill orders from retail customers.

Those who solicit the order flow gain. Is that a bad thing? After all, they are paying brokers to send orders their way. Aren’t they entitled to earn money any (legal) way they can? It’s the American way. Just look at our banking system as a reasonable example of how private enterprise works. The bank’s customers sign agreements. Those agreements are written such that the average customer has no chance to understand what is being agreed to. But it’s within the law, and so the customer runs up a bunch of fees with no idea of how to avoid them.

Bottom line: If the retail trader is likely to lose money on his/her trades, why not pay for the right to take the other side of those trades? The question is, does this practice

harm the broker’s customers? If the customer gets a fair deal, is there any reason for this to be a problem?

If the practice does harm customers, then it presents an ethical challenge for the brokers. They are expected to exercise a fiduciary responsibility and route orders to the exchange at which the customer can get the best possible price for his/her order. Any broker that deliberately fails to do just that is potentially harming its customers. Can you imagine any business hurting its customers just to increase its own bottom line?

So we ask: does payment for order flow hurt the customer? Is that customer getting bad fills? Yes, he or she is. Direct proof is difficult to come by, but there are some situa-tions that are obviously problematic:

• When the order goes to some exchange other than the exchange with the highest trading volume, then there is a reasonable chance that the customer is missing out on the best price. If there is a constant stream of customer limit orders at one exchange, there would be a much higher probability that any customer’s order would trade with another customer — at a price that is better than that offered by the market maker. Just

w o l f a g a I n s T T H e w o r l D

Background: In financial markets payment for order flow refers to the payment that a third party sends to a broker. In return for the payment, the payer gets to tell the broker where to route client orders. Generally, market makers and securities exchanges are willing to pay for the right to trade with any broker’s clients because they believe those clients (retail customers) are likely to be on the wrong side of the trade.

When market makers can buy at the bid and sell at the offer, and trade with a retail customer, the market maker has an excellent chance to profit from the trade. That makes paying for order flow an inexpensive cost of doing business.

www.expiringmonthly.com DECEMBER 2010 20

Wolf Against the World (continued)

the possibility that the customer misses that opportunity is harmful.

• I’ve seen locked markets where the bid and ask were the same price. But the bidder was unable to take the offer on another exchange because the broker refused to send the order to that other exchange. Similarly, the seller was unable to hit the bid because the broker would not move the order. Where’s the harm? Doesn’t the option eventually trade, despite the locked market? Sure, it does, but one of those customers may never get a fill, when both were entitled. (With today’s electronic markets, this example can no longer occur, but it used to.)

I look at this as a pretty simple situation: orders should be routed to the exchange that gives the client the best chance to get the best price. Period. Under normal circumstances, that’s the exchange showing the best bid or offer. When the client enters a limit order that is not immediately executable (it neither pays the offer nor sells at the bid), it’s probably best to send the order to the exchange that regularly trades the most volume in that class of options.

The client cannot benefit, and can be harmed, when the broker sends orders to an exchange where the

traders are willing to pay to get those orders. Just the possibility of losing the chance to get a better trade execution is harm enough.

One argument that favors payment for order flow is that brokers and exchanges that receive the payments may use some of the cash to better educate customers. That’s the right thing to do. However, providing better fills is their ethical responsibility.

The options industry has always had a difficult time with its public image. Paying for order flow can do nothing but further hurt that image. But, in 21st century America, the bottom line is the bottom line, and brokers look out for themselves.

This practice should not be allowed. I consider it to be bribery. In general, bribery is considered to be a criminal offense and the people involved face jail time. Right now there are two notable exceptions: bribery is legal if you pay for order flow or lobby Congress.

C o nGary Katz, CEO and President of ISE (International Securities Exchange) was interviewed for Forbes.com in Jan 2010.(Note: I did not try to reach Mr. Katz for an interview)

Katz feels that payment for order flow helps customers by lowering commissions because firms that collect such funds use them to provide better technology, better Web sites and infrastructure that support the customers.

I am not privy to how firms use their cash, but it would be surprising to hear that they do anything other than keep the money as additional profit. However, there is no denying that firms are making a much better effort to educate their customers, and it is possible that money from order flow payment is used to help customers learn more about options trading. eM

www.expiringmonthly.com DECEMBER 2010 21

ViX

MinotaurBill Luby

RationaleIn Greek mythology a Minotaur was a hybrid creature with the body of a man and the head of a bull. Such a creature provided the inspiration for a pairs trade involving short VXX at-the-money calls and long VIX at-the-money calls.

The holiday season has a shortage of trading days and a history of a bullish bias. As a result, December VIX futures have a tendency to remain relatively muted when compared to January VIX futures. Assuming I am able to establish this position for a net credit, a seasonal play on vola-tility involving short VXX calls paired with long VIX calls has an oppor-tunity to profit if any one of three critical factors dominates:

1. volatility declines and both options expire worthless

2. the VIX futures remain in contango

3. volatility spikes and the VIX is more sensitive to the spike than VXX

It is possible to backtest this strategy, but sometimes I like to put the trade on, see how it develops and get a sense of some of the potential hurdles. I fully understand that the results will not be statistically significant and making any inferences about a strategy from one trade is dangerous, but I do find some value in what I call these “proof-of-concept” trades with real money.

With most trades, achieving maximum profitability at minimum risk is the only goal. With a proof-of-concept trade, profits are important, but so is information. For this reason, I have a tendency to leave proof-of-concept trades on longer than I would when trading with an established strategy.

In terms of ratios, my intent is to keep this simple. The VIX is trading at just under 49% of the VXX at the moment and my research indicates that VXX generally moves about 48% as much as the VIX on a daily basis, so with the VIX at about 22 and VXX at about 45, I elect to do this pairs trade on a 1:1 ratio basis, using 10 contracts of each to keep the math simple.

setup and EntryIn a world of maximum profitability, I would probably wait for some sort of relatively high VIX level before

entering this trade, but because I am also focusing on the informational value of the trade, I choose to open the position early in the trading day on November 22nd, with the VIX at about the middle of its 10-day range.

With the VIX at 22.03 and VXX at 44.98, there is a strong temptation to stay strictly at the money and short the VXX December 45 calls while going long the VIX December 22 calls. For ten contracts, the potential profit should both options expire worthless is less than $1000. Given my expectations for seasonally low volatility and also given the high level of contango in the VIX futures, I elect to shave the odds a little and short the slightly in-the-money VXX December 44 calls and go long the VIX December 22 calls. This raises the potential profit if both options expire worthless by another $200. After trying to work the order a little, I relent and take what the market gives me, recording slippage of $175 on the VIX side of the trade and $100 on the VXX side of the trade. I still manage to pocket $800 on the trade, which leaves me long VIX December 22 calls for 2.30 and short VIX December 44 calls for 3.10.

f o l l o w T H a T T r a D e

Contango an upward term structure curve in a futures product (e.g., VIX futures) in which front month futures are priced lower than back month futures

www.expiringmonthly.com DECEMBER 2010 22

position ManagementThe first important point to keep in mind while managing these two positions is that they run on different expiration cycles. The VIX options expire on December 17th and the VXX options expire five days later on December 22nd. For that reason, I anticipate that I will exit the position no later than December 16th, which is the last day the VXX options are traded.

Monday, November 22 – As luck would have it, the VIX fell 8.3% between the time the trade was executed and the end of the day, pushing both calls out of the money and securing a $500 profit for the position.

Tuesday, November 23 – The VIX reversed to the upside today and is now 0.60 higher than when the VIX calls were purchased. VXX lagged during today’s spike and is 0.06 below where it was when the VXX calls were sold. The relative weakness in the VXX sounds positive for my position, but VXX calls jumped 64% today while the VIX calls rose only 39%. The prof-itability of trade has turned from +$500 to -$175 in 24 hours.

Monday, November 29 – After some seesaw action immediately before

and after Thanksgiving, the weekend saw the Irish bailout formalized and tensions heating up on the Korean Peninsula. Both the VIX and the VIX December (front month) futures closed near the 21.50 level, while VXX spiked up to 46.10. The VIX calls and VXX calls are both in the money and my position is now down $475 in one week. I am now the beneficiary of $36 of theta each day, but I am disappointed that the VIX spike has had more of an impact on the VXX calls than the VIX calls.

Tuesday, November 30 – The VIX closed at 23.54, its highest closing level since September, as concerns lingered about the future of the euro zone and the Koreas. My VIX long calls are now 15% in the money and my VXX short calls are 10.7% in the money, yet the VXX calls continue to be more sensitive to increases in volatility. Today the VXX calls jumped 62% while the VIX calls rose 54%. The position lost $975 today and is now down $1450 in aggregate. If this were not a proof-of-concept trade I would either be exiting the trade or making adjustments to limit risk at this stage. As it is, I will let the trade ride, as my preferred indicators suggest the VIX is ‘over-bought’ and is ripe for some mean reversion. My $36 of theta is just a drop in the bucket now.

Wednesday, December 1 – Today was a huge turnaround. The VIX fell 10.2% and VXX declined only 5%, yet the VXX calls lost 50% of their value while the VIX calls dropped only 27%. The result saw the position swing $2000 to a gain of $550.

Friday, December 3 – After falling more than 10% on both Wednesday and Thursday, the VIX fell another 7.7% today, as geopolitical and macroeconomic concerns faded and were replaced by a rising sense of optimism. Over the course of three days, the VIX has fallen 23.5% from 23.54 to 18.0 while VXX has fallen 16.2% from 49.29 to 41.30. With both calls well out of the money and the aggregate gain in the position up to $825 (above the $800 profit target), here is where I would exit the position and lock in profits, but this is a proof-of-concept trade, so I will let it ride . . .

Friday, December 10 – Figure 1 below details the full life cycle of this trade, which is coming to an end today. Of notable interest, during the last week the VIX was relatively steadfast, while VXX lost signifi-cant value due to negative roll yield and a general drop across the VIX futures term structure. The result is that VXX, which was 2.1% in the

Follow that trade (continued)

www.expiringmonthly.com DECEMBER 2010 23

money when the calls were shorted is now 15.4% out of the money, with the calls fetching only 0.15. The VIX has fared much better, starting out 0.1% in the money and now 13.6% in the money. Due to the greater volatility of VIX options and also the extra five days in the VIX expira-tion cycles, the calls still hold a value of 0.55. For the last three days, the position has been registering a profit in the $1150–$1200 range. As this is almost certainly going to be whittled back to $800 in the 1 ½ weeks until expiration, I am electing to pull the plug on this trade.

Epilogue and takeawaysThe first key takeaway is that with a little patience, a VIX minotaur trade with a net short VXX position can indeed be profitable. On the flip side, this trade can be highly volatile

and requires that significant attention be given to risk management. In anything other than a proof-of-concept environment, I would have exited the this trade for a loss long before it had a chance to work its way back to profitability.

I was a little disappointed that the VIX spike did not provide the same lift to VIX options that it did to VXX options. This was due to the fact that VXX options turned out to be much more sensitive to changes in the underlying than VIX options, which is a key lesson. Future trades should attempt to establish whether this is a persistent theme.

Another important consideration is the timing of the two expiration cycles. In this instance the position benefited from the fact that VIX

options expiration was after VXX options expiration. In August and September, VIX options expired before VXX options, so I would have expected a more challenging envi-ronment for this trade during those two expiration cycles.

Future efforts may wish to tweak the degree to which both the VIX and VXX options are out of the money and also adjust the units in the ratio to give a higher weighting to VIX options.

Finally, score one point for the proof-of-concept trade. When real money is on the line, perceptions are more acute, emotional responses and their interaction with the trade are more realistic and ultimately any lessons learned are more deeply etched in the trading psyche. eM

Follow that trade (continued)

Figure 1 Summary Profit and Loss Chart

VIX

and

Mor

e

www.expiringmonthly.com DECEMBER 2010 24

Gap

QuotientSteve Lentz, Guest Editor

Gaps are the enemy. Yes, that’s right. Some traders have real enemies in life and, for some, gaps can rank right up at the top.

At DiscoverOptions, we teach non-directional short option premium strategies used successfully by both our mentors and money manager students. One fly in the ointment for these approaches is price gaps in the underlying asset from the closing price to the next day’s open price. When gaps occur, a position trader has no time to make adjustments to help hedge risk. Large gaps can occur quite often with individual stocks due to company announcements and unexpected events. That’s why we

prefer applying these strategies with index options so that company risk is greatly mitigated.

But regardless of what underlying assets you trade, you should be aware how gaps affect that market relative to other assets. To illustrate, Figure 1 shows the gap behavior of the SPY during the crash of 2008.

Before September 2008, SPY opening gaps were well under 1%. But then, on 9/19 and 10/13 of that fall, the SPY had gaps of 5.5% and 6.0%, respectively. Until this time, these were rivaled only by the post-9/11 gap on 9/17/01 of 8.2%.

More important, though, is the overall character of an asset’s gap behavior. We calculate this through the use of average gap levels. Although daily gaps are charted in Figure 1, we can take an average of the most recent 20 trading days’ gaps and display it with the gap levels.

In Figure 2, the gap levels were multiplied by 100 for decimalization and scaling purposes. The solid black line is the Gap Quotient (GQ), which is a 20-day simple moving average of the opening gaps. Notice how the GQ before September was well under 1% and then rose to over 2% by the end of September 2008.

Figure 1 Daily Gap Levels Figure 2 Gap Quotient — A 20-Day SMA of Daily Gaps

Met

aSto

ck

www.expiringmonthly.com DECEMBER 2010 25

It’s now time to rank several assets by their Gap Quotients. My program of choice for this is a program called MetaStock, available from Equis International. Figure 3 displays the formula for the Gap Quotient within the MetaStock Explorer feature. Digitally, it reads as follows:

Mov((Abs(OPEN-(Ref(C,-1)))/Ref(C,-1)),20,S)*100

We now run Explorer on a group of pre-selected candidates, and we like to use a list of underlying assets with very tight spreads between the option bid and option asked prices.

Figure 4 displays Gap Quotient Rankings from a list of 21 stocks and ETFs that have very tight option bid/ask spreads. These came from a scan I did within OptionVue’s OpScan service that can query option bid and asked prices. See the Side Bar for more information.

With a GQ of 0.4417%, GLD clearly has more stable opening gap behavior than FXI with a GQ of over twice as much at 1.1499%. This is valuable information if you are an option premium seller and wish to avoid the early morning excitement that opening gaps can bring.

But what is a typical opening gap? Is GLD’s level relatively good or bad?

Gap Quotient (continued)

Figure 3 Gap Quotient Formula

Figure 4 Gap Quotient Rankings of Tight Markets List

www.expiringmonthly.com DECEMBER 2010 26

When running a Gap Quotient ranking on the entire S&P 500 list of stocks, the median gap as of this date is 0.643%. This means that GLD’s GQ is 30% lower than that of the S&P 500 median level. Not bad.

Of course, some trading approaches might actually favor opening gaps. In that case, a trader could invert the approach and rank assets with the highest Gap Quotients at the top. In this case, I suppose we could amend the opening declaration to say, “Gaps are my best friend.” eM

Gap Quotient (continued)

TIGHTEST MARKETS

Steve Lentz is the Director of Education and Research at DiscoverOptions, the educational arm of OptionVue Systems, Inc. He can be reached via email at Steve@DiscoverOptions.com or via phone at 847-816-6610.

www.expiringmonthly.com DECEMBER 2010 27

An interview with isE CEO

Gary Katzby Mark Longo, Guest Contributor

Recently, Mark Longo of The Options Insider sat down with Gary Katz, CEO of the ISE Option Exchange. It was such a fascinating interview that we decided to post a few highlights for our readers. You can listen to the full Options Insider interview, which originally aired on November 18th by clicking here. The interview is heavy on exchange politics, but then again, so is the way your order gets filled. Enjoy.

Mark Longo: The primary reason we brought you on is your recent comment letter to the SEC that asked the commission to examine certain anti-competitive and discrimina-tory fee practices at three options exchanges, namely the CBOE, BOX, and PHLX. Your comment letter was an addendum to some earlier comments you had made regarding the SEC’s proposed changes to rule 610 of Reg NMS. The changes they have been proposed would essentially prevent an exchange from blocking or otherwise limiting access to its quotes by certain market participants. You claim that certain fees at BOX, CBOE, and PHLX are being used in exactly that way as an anti-competi-tive barrier.

You wrote, “We have identified three instances where other options

exchanges are using their fee schedules to stack the deck in favor of firms that seek to trade against their retail customer order flow and deny these investors the full benefits of market competition for their orders. As part of their ongoing review of market structure issues, we urge the SEC to examine these practices and take the necessary actions to prevent discriminatory fees that harm retail options investors.”

I know the exchanges do compete very aggressively and one is usually not hesitant to call out another one when they see the other doing something they don’t like, but it’s another step to send a public comment letter to the SEC which, in effect, accuses other exchanges of what amounts to illegal activity. It’s also a little out of character for your exchange. The ISE has always been an example of how, if you “build a better mousetrap” and compete effectively, it can lead to success. Your exchange has never been one in the past to wield the regulatory cudgel against your competitors. Why did you feel it was necessary to change course now and take this rather extraordinary and public step?

gary Katz: Let’s look back a few months, prior to the BOX’s rule filing that prompted our comment letter. It was in regard

Gary Katz is President and Chief Executive Officer of the International Securities Exchange (ISE) and is a co-founder of

the Exchange. Prior to assuming his current position, Mr. Katz served as Chief

Operating Officer of ISE.

Mr. Katz is one of the principal devel-opers of ISE’s unique options market

structure — an auction market on an elec-tronic platform. He is named as inventor

or co-inventor on six patents that ISE has received or applied for relating to its

proprietary trading system and technology.

Mr. Katz is a Director of ISE and serves on the Executive Board of Eurex. He is also

on the Board of Directors of The Options Clearing Corporation and Direct Edge

Holdings, LLC.

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An interview with isE CEO Gary Katz (continued)

to a fee practice at Philadelphia that the SEC had abrogated. At the time, Philadelphia had a fee structure in place that had a differential between different participants of a nickel. If someone wanted to interact with their own flow that they had brought to the exchange, they were able to do so for a fee that was five cents cheaper than another entity that would have wanted to interact with that flow. At that time, without any comment letters whatsoever, the SEC pushed back on that rule filing and said that a two cent differential was an acceptable level of discrimi-nation. The term that they used was to recognize not something illegal, but to recognize that the firm worked hard to bring that flow to the exchange and could benefit for that by having a difference in price by up to two cents. This, in essence, set the standard for the industry. We felt that those were the rules the SEC was asking all exchanges to play by. Since that time there were a number of exchanges, the ISE included, that put in rules that incorporated this two cent differential because that was the standard that the SEC had set. In the BOX filing that created a larger differential between a firm that has customer flow that brings it to the exchange and those that compete to give that flow price improvement, we found a much

larger difference, as high as a 40 to 50 cent difference from the firm that brought the order to the exchange. We thought it was important that we highlight that this was exactly opposed to where the SEC had been leading the industry up until just a few months before that. We were not saying that anyone was doing anything illegal by pointing out that this was a practice that existed at the CBOE and PHLX. We were showing how this type of discriminatory fee practice can exist at different exchanges. By its own definition and because it’s a rule approved by the SEC at those exchanges, it’s not illegal, and certainly the ISE was not saying or even implying that there was something illegal the exchanges were doing. We were pointing out to the SEC through a proper process that there was a situation that looked very similar to what they were trying to change in the past, and the public comment mechanism is the appropriate manner for highlighting that to the SEC. That’s exactly the path we took.

Mark: As expected from you, that is a very measured and rational response. Of course the other responses that were received to your comment letter were a little more heated. The CBOE is a good example. They had a very strong response to your charges, of

which I will read a portion here. They wrote, “Competition between the various options markets is at an all time high. However, recklessly hurling unfounded regulatory accusations against competitors is slanderous. We can only surmise that ISE is attempting to improve its competitive footing by submitting and publicizing unfounded regulatory complaints. Regardless of the motive, we look to the commission to carefully assess not only the substance of ISE’s complaints, but also to assess the appropriateness of the very serious and damaging public accusations.” The responses of some other exchanges were similar. They all essentially claimed or dismissed your charges as an attempt by your exchange to use regula-tors to improve its market share. They also question the means by which you made the charges, essentially stating it is somewhat inappropriate for an exchange to use such a public forum to level such serious accusations. I believe the CBOE went so far as to say that you have set a dangerous precedent. How do you respond to these rather heated responses to your claims?

gary: We stand by the mechanism that we used. The comment process is something that the SEC asks of not just exchanges, but of partici-pants in the industry to comment about the filings and policies the SEC is considering. As you know, for

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An interview with isE CEO Gary Katz (continued)

example, when the SEC goes out and asks the public for their comments on short sale restrictions, or flash proposals they might be considering, they ask the marketplace to respond through the comment letter process. The SEC publishes the comment letters from everybody on their website and makes them available for all to see. It is very important for that dialogue to take place in a trans-parent environment. We didn’t do anything differently than we normally do. We chose to highlight an issue that we would like the SEC to clarify. This is a perfect example of it. The other exchanges can get upset if they would like to. It’s not something that I feel is helping the situation. What we are asking the SEC to do is to be very clear as to what the rules of the marketplace should be and to make those rules consistent across all exchanges and across all functionality of the exchanges. Pricing is one aspect that should be consistent across all markets. There should not be discrimination in any market. We were asking the SEC to clarify their position to abrogate the rule filing that BOX put in and for them to look at the practices that were beginning to develop across the industry. ISE has always taken the leadership in these positions and we are going to continue to do so. I’m not shy when I think that

there is something wrong. I’m not shy when it comes to pointing out that a customer that is using the product, whether it is at the ISE or at any other exchange, is being hurt by a practice that exists on another market. This is a good example where customers who normally would hope to get price improve-ment through an auction will have a much lower probability of getting that price improvement because for another entity to enter into that auction and to actively compete for that customer’s order, they have to pay a higher fee to do so. As you can imagine, if I asked you to compete in an auction and you knew that the individual or the firm that you were competing against had a much lower fee of entry, you would turn to me and say, “Something is not right. The deck is stacked.”

Mark: I want to get into all of that in a couple seconds, but I do want to address the other claims that the exchanges made: that it’s no secret that the market share numbers have trended lower at the ISE. We’ll get into the details of that but I just wanted to quickly get your comments. The other exchanges view you taking this action because of the dwindling share numbers at the ISE. They claim that you can’t compete your way out of the hole so you’re, instead, using the regulators to

leverage yourself out of it. How do you respond to those charges as well?

gary: They’re completely indepen-dent. I spend every hour of every day trying to figure out how we can improve the quality of markets at the ISE and the amount of business that we do. How do we continue to innovate and provide greater customer service for the partici-pants that use our exchange? At the same time, I have a responsibility to ensure that customers that use this product are protected by the rules — whether they’re on the ISE or in any other market and, as I said before, will not shy away from highlighting when another exchange is abusing a process that I believe hurts the customer. Ultimately, that will hurt the growth of this industry. It won’t just hurt the ISE. It will hurt all the exchanges that are involved. I have no issue with pointing that out. I’d also like to add that, for example, Citadel commented on the same BOX rule filing, highlighting the same issues that we raised. They didn’t highlight the issue with the CBOE or the PHLX and that’s their right to choose what they will comment on, but if an exchange says that there is no issue and no discrimina-tion involved, and a leading exchange like ISE sees a problem, and the largest market-maker in the options

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An interview with isE CEO Gary Katz (continued)

industry highlights a problem, publicly, then I think that where there’s smoke, there’s fire.

Mark: The CBOE was also quick to point out that they believe, according to your own statement, that the ISE has committed some of the same infrac-tions that you leverage against the other exchanges. I assume they’re referring to the two cent pricing increments that we discussed earlier. How do you respond to those claims as well?

gary: As I pointed out, there are rules that are being placed at all of the exchanges, including ISE, that have similar attributes. Our calling out to the SEC is not “look at them and not us.” It’s to look at what is best for the industry as a whole. Set rules in place that are consistent to all markets. ISE has some thematic element. It is similar in nature whether it is discrimination with regard to pricing. Let’s level that playing field across all exchanges. I think that is very important for the healthy growth of this industry.

Mark: One of the reasons we wanted to have you on, not just because of the salacious nature of the debate involved with the fee structure, but also it raises a very interesting issue — and one that we have always been keen on discussing — is the growing propensity for institutional firms to disenfranchise

retail order flow. It’s growing quite a bit and it’s definitely a disturbing trend that we’re seeing more and more in the options space. Your average retail customer expects a fair and open marketplace for the execution of his order. He doesn’t want his order held up or leaned against or in any other way disadvantaged, but that is increasingly becoming the case. There used to be a lot of safeguards in place to protect the customer against this type of activity, things like public customer priority or the inability for firms to cross orders on the bid-ask spread. As the market has evolved and adapted over the past 10 years, those protections have fallen away. Some proponents say the current market is better than ever for retail customers because executions are very fast and markets are very tight. That is all true, but it’s also important to keep in mind how an order is executed, not just how fast an order is executed. In the current environment we have a legion of backroom deals between order flow providers and liquidity providers, as well as order routers that preference one exchange or one firm over another as well as a fee structure that, at best, can be described as Byzantine. With so many conflicting issues, relationships, and fees in place, it’s a wonder that an order can be executed at all. Some may take exceptions to your comments and the method you chose to make them, but I wonder if it isn’t a good thing

at the end of the day that you would shed some light on the issue of fees in the options market right now. It is something that is extremely confusing and potentially very dangerous to retail and a growing number of institutional customers as well.

gary: I could not agree more with everything that you just said. Considering that this is a public forum, I’m sure that you just said the same thing we did publicly. I don’t think you did anything wrong or said anyone is doing anything illegal, just as we were not. You’re pointing out the facts as they exist today and that’s why we must look to the SEC as the rule-making authority to create a level playing field. For years, their focus has been on that retail customer and protecting the retail customer. The attributes that you describe, the tight and deep markets and low cost of trading, didn’t happen by accident. They happened through a well-crafted and thought out set of rules all designed to force an auction for that retail customer’s flows so that they were getting the best price possible. It didn’t happen overnight. It took time. What we’re raising our hand and saying is, “Do not take that for granted.” It’s very important that we not allow an exchange or firm to take advantage of the process and allow things to

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change that ultimately don’t benefit the customer. That’s the reason we’ve been so vocal about this. That’s the reason we will continue to be public about it and to use the mechanisms and systems that are in place that allow us to make these issues public so that the debate can take place. If ISE did not raise this in its public comment letter and did not raise this in its announcement, then we wouldn’t be talking about it on this interview and we wouldn’t be in different conferences where the exchange leaders get together and debate these issues. It would just go on in the background and ultimately, over time, the experience that the customer has would deteriorate. We’re seeing that to some degree already where the quality of the auctions in some of these market-places has deteriorated. Ultimately, as I said before, that is a negative for this industry. We have had double digit growth rates for years as a result of the improving quality of the market structure. Now is not the time for us to lose sight that the retail customer has been and will continue to be the driver of growth.

Mark: We receive a lot of email and questions about the proprietary products that you guys run at the ISE, particularly the FX options and the index options. What is happening

with the FX options portal? Have you made any updates there? Also, the ISE is known for picking some interesting underlyings to base indices around. What is the volume like these days with the proprietary indices and do you have any interesting new ones on the horizon for our readers and listeners?

gary: The new product in FX options is actually not a product, but a time. That is the opening of trading at 7:30 a.m. and having a 2-hour window where you can trade FX before the regular market opens. This is, of course, aligned to the marketplace in Europe that is already up and running at that time when the U.S. customers are coming into their offices. It’s an opportunity to begin trading a couple of hours early and we’ve seen interest in that timeframe. This aligns with our plan to create a link between ISE and Eurex. We call that our “International Link” that will allow order flow to come into the U.S. from outside. We believe that having earlier hours for FX options will align with the customer’s interest because that’s in the middle to end of their trading day. That’s something that we’re very inter-ested in watching and seeing how that grows. We continue to maintain our FX portal, as you mentioned. It’s a great website. There’s a lot of material on FX options. There are

webinars being held that you can download as an mp3. You can watch videos of our educators that help you understand how to use this product. It’s very interesting and I encourage everyone to look at that. From the index side, we’ve actually seen a lot of interest in our indexes being used as the basis for ETF products. As those ETF products grow and there is a larger amount of money and assets under management, ISE continues to benefit from the growth of those products. While the index options have not been as successful, the indexes themselves have been the basis from strong ETFs which then can have options trading on them and can trade as securities on the listed exchanges in the U.S. market. eM

Mark S. Longo is the founder of The Options Insider.com,

the premier destination for options information. An options trader and former member of the Chicago Board Options Exchange, he is also the co-founder of The Options Alliance, a consortium of options publishers, brokers, exchanges and vendors.

An interview with isE CEO Gary Katz (continued)

www.expiringmonthly.com DECEMBER 2010 32

How Market Makers Drive

the Quotes You tradeMark Sebastian

When I was on the floor, I was always fascinated by how interested the general public was at what I used to do, namely making markets. I suppose it makes sense that tour groups would find it interesting. Groups visit the NYSE all the time and those guys are only quoting one price per product (stock). As a market maker, I would be making markets in calls and puts on at least five or six months, on at least three strikes (but usually more than six) per month. That adds up to about 60 to 100 prices to quote at any given moment . . . and that is just one product. I can remember at one point in time quoting as many as 80 stocks at one time, although I usually stuck between 30 and 50 products at a time. Think about that: there were points in time where I had to manage 6,000 quotes at once . . . certainly not an easy task. This is the process in which market makers manage the quotes of a given stock.

First let’s take a look at a six-month stock chart of IBM (Figure 1).

Notice how, while IBM has had a general up trend, there are within the trend constant fluctuations in the stock price. This is caused by imbalances of buyers and sellers. In order to manage this flow, and keep markets orderly, the stock markets have market makers and specialists that quote the market. With IBM trading at 144.80, a NYSE specialist or market maker might make a market that is 144.78 bid for 5,000 and 5,000 at 144.82 (on the floor you buy for and sell at). In other words, the specialist will buy 5,000 shares of IBM for 144.78 and sell 5,000 at 144.82.

Suppose the specialist gets hit on his or her bid, thus buying 5,000 shares of IBM for 144.78. The Specialist would then lower his or her bid AND offer. The quote might now

be 144.75 at 144.80. The specialist is hoping a trader comes in and buys the stock back from him or her for 144.80. The specialist would end up with .02 in his or her pocket and have no position on. If a trader comes in to sell the stock, at least the specialist is buying the next lot for .03 cheaper.

Option traders would love to have trading that easy. However, since options are derivatives, it would be impossible to manage 6,000 quotes by actually moving the price every time one of the five main factors in an options price changes. Going back to our IBM example, imagine a market maker trying to update 100+ quotes every time IBM’s price moved two cents. To make matters worse, if the implied volatility changes, a few hours pass, or there is a change in cost of carry, the trader would also have to update the actual prices.

Figure 1

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Thankfully, the price for an option quote is actually an output, not an input. It is the five factors of the model that are actually inputs. Making things easier, price, time to expiration, strike price and cost of carry can be automated. We know what these inputs are. It is the vola-tility that traders use to actually drive quotes that hit the market place. To see how, look at Figure 2.

This is a graph of the volatility curve for IBM. This curve is what market makers are constantly toying with, updating and managing in order to drive quotes. For example, the IBM 145 strike has an implied volatility of about 18%, see Figure 3:

Figure 3

This is what the market maker is using to drive his or her quotes. The market maker would set an implied volatility width for IBM around that 18%. Thus, the market maker is thinking, “I am 17.5% implied volatility bid for 50 and I would sell 50 at 18.5%,” instead of actually being locked into a given price. If the trader gets hit on his or her 17.5% bid for 50 the trader would then go in and adjust the implied volatility on that strike down to 17%. Now the trader would be 17% implied volatility bid for 75 and have 50 at 18.25%. This change in volatility will actually make the market maker a less aggressive buyer and a more aggres-sive seller on the 145 strike (just like an NYSE specialist).

The adjustment process is not over, though; as we know, options for a given product are all interrelated, so

the trader would have to look at the shape of the new curve. Now that the trader has lowered the implied volatility of one of the strikes, he must adjust the curve accordingly to the current conditions. I can tell you that there is nothing worse than buying a 50 lot on one’s bid and then being lit up on the strikes around it by the same customer, by a broker dealer, or by other market makers.

Market making is certainly not as simple as stock trading, but with proper understanding and manage-ment of volatility the markets seem to work. As a market taker, under-standing how the market maker is thinking and trading can help traders become better at executing orders. Trading stocks is not easy, trading options . . . well, that should seem pretty simple now, too. eM

How Market Makers Drive the Quotes You trade (continued)

Figure 2

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Book

ReviewMark D Wolfinger

Right off the bat, I like the book’s subtitle: A Step-by-Step Guide to Control Risk and Generate Profits. That’s what trading is all about. Those who underestimate the importance of controlling risk have little chance to find success as a trader.

This book is targeted to beginners, and Ianieri’s stated goal is to help investors learn to manage an investment portfolio. That includes learning to use options to improve the bottom line of their financial investments, with less risk. Does he meet those objectives? Read on.

Instead of concentrating only on making money, he correctly wants readers to know that options are designed to protect investments as well as offering opportunities for financial gain. He believes in theory first, strategies next.

This book surprisingly (to this reviewer) is filled with details. If that sounds like it’s more than you want to know, then being a successful option trader is probably not in your future. For the student who wants to under-stand what he/she is doing — in addition to making money — this book provides a solid background.

pricing ModelsThe author spends more time on option pricing models than most other books. That’s a decent approach because it not only rein-forces the idea that these models are not guaranteed to predict option price changes to the penny, but that each model type has its own weakness. Ianieri again takes the extra step of explaining kurtosis (takes into account the fact that the tails of the bell curve are more common than theory dictates) and skewness (takes into account the probability that one of the tails has a higher probability of occurring than the other).

These are excellent concepts for the beginning options student to learn. The math may be complex, but just being aware that most option pricing models ignore kurtosis and skewness is enough to keep many traders out of trouble (by not selling those cheap options). Skewness and kurtosis can be measured, and when using appropriate option pricing models, those numbers can be included when calculating theo-retical option values. I wish I had had access to this information early in my career.

Options Theory and Trading: A Step-by-Step Guide to Control Risk

and Generate Profits, Ron Ianieri (Wiley Trading: 2009)

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the GreeksThere is no lack of detail here. A thorough discussion of the major greeks is followed by a good explana-tion of ‘second-tier greeks.’ Ianieri uses that term to represent how one greek affects another, such as how a change in volatility affects delta. He is a solid teacher who wants his readers to learn how to use options effectively.

One of my favorite topics for rookies is the concept of equivalent positions. Although this topic is neglected by many in the arena of options education for rookies, Mr. Ianieri does justice to this topic. He devotes a lengthy chapter to a detailed look at how stock is the synthetic equivalent of owning one call and being short the corresponding (same strike, expira-tion date) put. Other basic synthetic positions, such as the synthetic call and put, are included in the discus-sion. If a reader wants to understand the concept of why some positions are equivalent to others, this book offers an excellent opportunity to do just that.

trading strategiesTrue to his word, after option theory, the author turns his attention to trading strategies. The remainder (2/3) of the book is divided into three sections: basic

strategies, advanced strategies and combination strategies. He provides numerous examples of each strategy (and there are enough of them), and then offers real world examples of each strategy in use.

There may be some repetition, but the concepts are well covered, and if the reader is a beginner, with no knowledge of these strategies, he/she should find more than enough meat in the discussion to satisfy the need to know. I’d suggest that a more in-depth understanding of each strategy (and especially how to manage the position) is necessary before beginning to trade, but you will find enough information to decide which one (or few) specific strategies appeal to you as a trader.

He patiently explains how to take “delta leans” (i.e., trade from the long or short side) when a trader has a market bias. More importantly, he describes the appropriate time to use each of the strategies.

We never know what lies ahead, but readers of Options Theory and Trading will get their option trading career off to a solid start. There’s plenty to recommend in this book, and I heartily do.

The topics are well covered and there is enough detail for any reader. I’d suggest learning more about any single strategy before putting it to use, but that’s what paper trading and other educational materials were designed to offer.

The book meets the author’s stated goals. It should help any options novice gain a good understanding of how to use options. With the infor-mation in this book as background, the reader is well-placed to continue to learn more about options and should be able to increase that bottom line by using options to manage investment risk and earn money. eM

Book Review: Options theory and trading (continued)

Ianieri again takes the extra step of explaining kurtosis (tails of the bell curve are more common than theory dictates) and skewness (probability that one tail has a higher probability than the other).

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i’d Rather Be Right

than Be LuckyJared Woodard

The oft-repeated slogan, “I’d rather be lucky than right,” is either trivially true or is pragmatically disastrous.

I think it’s fair to interpret “right” as referring to having correctly identi-fied the relevant factors that would motivate a trade. In other words, being “right” means having a good understanding of whatever data is relevant and of what the prob-ability distribution of outcomes looks like. Conventionally, we might call this “having an edge.” Counterposed to this, the repeater of this slogan evinces a preference for being “lucky.” In context, being lucky seems to entail making a profit on a particular trade in spite of odds suggesting that a loss was more likely — after all, we don’t call someone lucky who predicts an outcome that was nearly certain to happen anyway. In sum, being lucky instead of right means realizing some profitable, low-probability outcome and not knowing why (or knowing why, and willfully ignoring over-whelming evidence pointing to the opposite conclusion).

Maybe this interpretation is unchari-table. Maybe “I’d rather be lucky than right” is not an either/or disjunction — maybe being lucky doesn’t exclude having evidence-based, justified beliefs about the

likely outcome of a trade. In that case, the slogan can be rephrased as “I’d rather be lucky and have justified beliefs than be unlucky and have justified beliefs.” But that’s trivially true — banal, in fact. All else being equal, of course we’d all rather book winning trades than losing ones. So if the slogan doesn’t force a choice between being profitable for no reason or being unprofitable for good reasons, then it’s no more informative than simply saying, “I prefer winning!” On this interpreta-tion, anyone who utters the slogan is likely to tell you next that they prefer joy to sadness, or that it is better to be healthy than to be ill.

There is another interpretation of the slogan that makes it non-trivial, albeit pragmatically disastrous. Under this non-trivial interpretation, the speaker would rather have an incorrect forecast, poor reasoning, bad evidence, etc., and yet make

a profit than he would have good evidence, sound reasoning etc. and yet incur a loss. Now, I take it that the slogan is a report of a continuing preference, rather than just a momentary indiscretion. So let’s assume that the speaker is going to be a market participant for twenty years, and that during that time he’ll follow a strategy that trades once a week, for a total career comprised of 1,040 trades. Instead of doing research or basing his trades on any particular market thesis, our speaker will flip a coin to determine long/short positioning and then hope for the best (note that we’re already imposing some very helpful apostasy on our speaker; a truly orthodox proponent of the slogan shouldn’t be constrained by a coin toss when there are astrological signs and homeopathic inklings to draw upon). So the strategy “Lucky” has a 50% win rate with equally sized profits and losses per trade. Figure 1 shows a Monte Carlo simulation for this strategy over the sloganeerist’s career. In Figure 2, we assume that a trader opting instead to be ‘Right’ is able, through hard work and careful analysis, to boost his win rate up to 55%, still with equally sized profits and losses on each trade. The differ-ence is obviously dramatic: Lucky has no positive expectancy over time, while Right has positive expectancy

b a C K P a g e

Knowledge can improve your edge in the future; luck may or may not be gone tomorrow.

www.expiringmonthly.com DECEMBER 2010 37

and a minimum return (in this simula-tion) that is still positive. In practice, the Lucky trader is indifferent to any results, while the Right trader uses new information to raise or lower his credence in particular beliefs.

Maybe taking slogans like this seriously is a big waste of time. But in chat rooms and on Twitter, I hear this slogan offered at least every week or two. Clearly, its proponents regard it as valuable advice, and I think I under-stand why: the intended spirit of the thing is that someone who believes some proposition p shouldn’t become more invested in the truth of p than they are in the practical outcome p was supposed to achieve.

That’s reasonable, as far as it goes. But if you come to believe a proposi-tion that turns out to be false, the answer can’t be to give up on analysis altogether in favor of luck! The answer is more, and better, analysis. So the reason I’d rather be right than be lucky is that knowing why a trade did or did not work is more valuable than the profits available in that one instance. Knowledge can improve my edge on the next 1,039 trades; luck may or may not be gone tomorrow. eM

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