On the Battlefield

There are various weapons used on the battlefield.  Same applies for the markets.  There are times where leverage is useful, and times when its too risky.  You can divide it into 3 main types:  cash instruments (stocks, bonds), futures, and options.  There is a time and place for each type.  In general, the higher the conviction on future price movements, the more leverage one should utilize.  Leverage is a double edge sword.  It amplifies volatility, which is a negative more often than a positive.  Excess volatilty without a big edge is a long term drag on returns.  

Let’s get down to the main reason why people use leverage.  Its to get rich quick.  On Reddit, you usually see traders post their P&L after big wins.  Sometimes after small wins.  But rarely after losses, big or small.  So what people see on social media is a distorted view of trading.  You see traders post a lot of big wins, some small wins, and very few losses.   Big wins are glorified.  Losses are not mentioned and ignored.   Other traders see this, get FOMO, try to replicate those big wins by betting bigger through leverage.  The most popular form these days is to be long shorter dated options that have low premiums but lots of gamma.  Of course, there is a steep price for that gamma.  Its in extremely fast theta burn, or time decay.  Dramatically lowering the odds of winning.

Its hard enough to pick the right direction.  With options, you add another layer of difficulty by trying to predict when that move happens.  The shorter the expiration, the smaller the time window you have for that move to happen.  If the moves doesn’t happen before expiry, your option ends up worthless.  A 100% loss on investment.  If you go all in on options, you only need to be wrong once to be wiped out.  Even if you don’t go all in, just going in more than 20% with each option trade will eventually whittle down your account to dust.  

It seems obvious, but avoiding big losses is the number one priority as a speculator.  Everything else is a distant second.  You cannot treat all losses the same.  But a lot of traders do.  Traders hate losses.  That’s just evolutionary conditioning.  A small loss of 2% that happens ten times in a row will be way more tilting and annoying than one 30% loss, but you have to take those small losses even if they make you feel bad.  You don’t necessarily take small losses because you are wrong.  You take small losses to prevent them from becoming big losses.  

The best way to give your trades room to work (wider stops) and still have small losses is to trade small.  But most people who are attracted to trading are not interested in grinding it out by playing small ball.  And I don’t mean small ball in the form of daytrading for small wins to try to make money every day.  I mean trading longer time frames with smaller size to keep losses small, to reduce the volatility of your account balance.  That is what’s necessary for long term winning.  Not slinging huge size for quick, big scores.  

Let’s compare trading to war.  As there are various weapons of war, there are various ways to express a trade.  

Here is a list from least leverage to most leverage:  

Cash instruments (stocks, bonds, commodities)

Futures

Options (Shorter expiration = more leverage)

Here is a list from least risky to most risky: 

Cash

Treasuries (longer maturity = more risky)

Corporate Bonds

Stocks and Commodities

Cash = ammo, unloaded guns, unloaded missile systems

Bonds = defensive instruments: anti missile system, mines

Stocks = machine guns, grenades, bazookas

Futures = artillery, drones, glide bombs

Options = bunker buster bombs, tactical nukes

I see too many traders trade options like its a machine gun rather than the big bombs/tactical nukes that they are.  Options markets have the widest bid ask spread and most slippage of the major trading instruments.  They are costly to trade.  They are more appropriate for high probability special situations and intermediate term trades that last from 1-4 weeks.  They are not appropriate for day trades or even swing trades.  But I see way more traders use options for quick trades than longer term moves.

Futures and stocks are more similar except for the leverage available.  Futures give you more firepower if you want to use it.  Futures are the most liquid and flexible trading products out there.  Futures have much less slippage and lower trading costs than options.  So those wanting to day trade or play for short term moves are better off trading futures than options.  In most cases, futures are the best way to express a trading view.  

Within the options space, there are various strategies that range from low risk to super high risk.  Contrary to what they say, shorting options is not riskier than being long options.  Given the much higher margin requirements for shorting options, you just won’t be able to put on nearly the same size as you can being long options.  That’s why most retail traders trade options from the long side, because of the much higher leverage and size they can put on.  Its the lotto mentality.  You can only make as much as the premium you  sell when you short options.  But being long options, you pay the premium to have much greater potential upside.  Like a lotto ticket.  But just like lotto tickets, the odds are almost always against you.  

Not all options trading is negative EV, but the most popular ways of trading options are negative EV.  Most retail options speculators are not putting on spread positions.  They are putting on naked long options positions playing for a quick up or down move.

There are options spreads which mitigate some of the negative EV of just being long options, like put or call spreads, calendar spreads, etc.  In most cases, its better to be long put spreads than long puts.  The same cannot be said for call spreads because OTM calls are usually underpriced, while OTM puts are usually overpriced.  The reason is that investors like to sell covered calls (selling OTM calls against underlying position) and buy puts (hedge against market downside), regardless of price.  

Bottom line, in most cases, buying options is like being the player at the casino.   Selling options is like being the dealer at the casino.  But there are special cases and exceptions where options are too cheap, but its usually not short dated options, but longer dated options that are underestimating long term volatility.  

Back to the current markets.  Last week was uneventful, with sideways chop.  The big event was NVDA, and it ended up being a bit of a dud, not what bulls were looking for, as most of the weekly calls evaporated into nothing.  And it wasn't much of a winner for bears, as the stock only went down a few percent, less than the implied vol of the ATM puts.  So most of the put buyers also lost money trying to play for downside on NVDA earnings.  The only real winners in the options trades last week were the market makers who made out like bandits, with NVDA calls and puts both losing a lot of their value post earnings.  

The COT report released on Friday showed a continuation of the trend of asset managers adding to net longs.  This time, small speculators added a lot to their already sizeable net long positions, bring them back up to near their highest levels of the year.  

The systematic traders also were likely adding long exposure as the vol control funds will have slowly been adding to stocks as volatility dies down, and the 30 day look back period replaces volatile late July moves with much less volatile late August moves.  The CTA fund that I track has also added a bit to their S&P 500 longs last week.  

In the options market, I continue to see more complacency with low put/call ratios and less put hedging.  The options players are not leaning as bullish as they did in early/mid July, but still quite bullish overall.  

Got short bonds on Friday for a short term trade.  With SPX back near all time highs and recent economic reports coming in better than expectations, there is a window for weakness for the bond market.  The price action also looks heavy considering the weakness after a very dovish Powell at Jackson Hole, and a run of the mill GDP report last Thursday.  Also, leveraged funds massively covered shorts from August 20 to 27, which should alleviate a lot of potential buying pressure from fast money players. Not looking for anything big, just a pullback after an extended up move over the past 4 months. 

For the stock indices, it takes time for the trauma from a sharp down move and big VIX spike to fade away.  As August 5 goes further into the rearview without any big moves, investors feel more emboldened and confident in the continuation of the bull market.  That sets up an opportunity heading into a seasonally weak time period of the year, mid September to mid October.  

Just from looking at the price action last week, while the market was basically flat from the start to close of the week, you had quite a bit of intraday volatility.  This tells me that there is not a huge underlying bid to this market, as the first sign of a lack of a steady bid is higher intraday vol.  HFTs are very adept at sensing big buyers and big sellers laying in the weeds.  If they sense that there are no big buyers, they will not provide much liquidity, and you will see quick dumps of 20-30 SPX points on little volume.  That happened quite a few times last week despite SPX going nowhere.  A sign of weakness underneath the surface. 

There seems to just be one more hurdle left for the bulls to clear before they regain full confidence in this unstoppable bull market.  That is the nonfarm payrolls report on Friday, September 6.  I expect latecomer bulls to buy after the report, good or bad, as there is still some lingering fear about economic weakness.  Once that uncertainty clears, and if we are at all time highs, that could be the time to put on shorts.  Need to see how this week plays out and how the market trades going into and out of that report.  The more intraday volatility, the better the signal will be to fade a rally.