Geometric Option Gains Follow-up By Ken Hodor 12/17/11

Preface

Trading Rules Jesse Livermore Buy rising stocks and sell falling stocks. Do not trade every day of every year. Trade only when the market is clearly bullish or bearish. Trade in the direction of the general market. If it's rising you should be long, if it's falling you should be short. Co-ordinate your trading activity with pivot points. Enter trades after market action confirms your opinion and then enter promptly. Continue with trades that show you a profit, end trades that show a loss. End trades when it is clear that the trend you are profiting from is over. In any sector, trade the leading stock - the one showing the strongest trend. Never average losses by, for example, buying more of a stock that has fallen. Never meet a margin call - get out of the trade. Go long when stocks reach a new high. Sell short when they reach a new low.

Useful Trading Guidance Jesse Livermore Don't become an involuntary investor by holding onto stocks whose price has fallen. A stock is never too high to buy and never too low to short. The highest profits are made in trades that show a profit right from the start. No trading rules profit 100 percent of the time. Markets are never wrong - opinions often are.

Main body of presentation The Meat of the presentation… or if Vegan The Beans of presentation Main body of presentation

The Expectancy Formula W P E = - L R Where E = Expectancy W = Winning Percentage L = Losing Percentage P = Average Profit (Win) R = Average Risk (Loss) If E > 0 you make money If E < 0 you lose money

Biased Coin Toss Negative Expectancy If Heads If Tails Win $1 per $1 bet Expectancy < 0 Would you play such a game? Lose $2 per $1 bet

Biased Coin Toss Positive Expectancy If Heads If Tails Win $2 per each $1 bet Expectancy > 0 Would you play such a game? For advanced money mangers What is the optimal percent of portfolio to bet? Optimal f = 25% Lose $1 for each $1 bet

Which way will market go? We don’t know Sell options With 50/50 price movement up/down--bias is against you Expectancy < 0 You have to predict direction to put probabilities in your favor Expectancy > 0 Buy options Biased in your favor using exit if touched 50/50 price movement—up or down Expectancy > 0 by design DO NOT wait for expiration—where Expectancy < 0

Exploit Non-linear Curve A 3% move in my favor >100% gain—doubles! Call move is up Put move is down A 3% move against position ~40% loss Call with underlying moving down Put with underlying moving up

AAPL 50/50 odds +- $10 Init Price New Price Init Option Price New Opt Price %Gain/loss $390 $400 2.9 6.7 131% $380 1.8 (38%)

Expectancy AAPL 50/50 odds +- $10 Init Price New Option Price Opt Price %Gain/loss Expectancy $390 $400 2.9 6.7 131% 1.9 $380 1.8 (38%) -0.55 1.35 Wow !

Bias Likelihood 50% chance of a win SPY Init Price New Price Init Option price New Option Price Gain or loss Expectancy 125 128 0.74 1.87 153% 0.565 122 0.35 -53% -0.195   0.37 GLD 170 174 1.35 2.35 74% 0.5 166 0.77 -43% -0.29 0.21 CSCO 18.6 19.6 0.25 0.8 220% 0.275 17.7 0.04 -84% -0.105 0.17 SLV 31.85 32.85 0.36 1.02 183% 0.33 30.85 0.11 -69% -0.125 0.205 AAPL 390 400 2.9 6.7 131% 1.9 380 1.8 -38% -0.55

WOW! Bias Likelihood 80% chance of a win SPY Init Price New Price Init Option price New Option Price Gain or loss Expectancy 125 128 0.74 1.87 153% 0.904 122 0.35 -53% 20% -0.078   0.826 GLD 170 174 1.35 2.35 74% 0.8 166 0.77 -43% -0.116 0.684 CSCO 18.6 19.6 0.25 220% 0.44 17.7 0.04 -84% -0.042 0.398 SLV 31.85 32.85 0.36 1.02 183% 0.528 30.85 0.11 -69% -0.05 0.478 AAPL 390 400 2.9 6.7 131% 3.04 380 1.8 -38% -0.22 2.82

What type of a Trader are you? “Seat of the pants”—no plan Conservative Take money and run Play with house’s money only--ASAP Between Conservative and Aggressive Aggressive Gambler Optimal f trader

Aggressive

Conservative Play with House’s money ASAP

Conservative Take money off table

Which Month to buy? Front month always provides best ROC Projected price indicates exit before expiration Last week of expiration Start migrating positions to next cycle

Which Strike to Buy 30 delta gives biggest bang for buck Good market size Many Investools’ traders are trained sellers of options 

Possible Exit Rules Pick one and stick with it Exit if lower low Exit if breaks trendline—Gann, lows, support Exit by indicator—stochastic, AMA, RSI, CCI… Exit at end of Jenkins’ cycle Exit if breaks support Exit if hits stoploss Exit if you made enough $ and don’t need any more One is not necessarily better than another

Buy or Sell Options? Long buying strategies return in excess of 100% per month ROC (Return On Capital) No upside restrictions Bias is with buyer As long as get profit and exit P&L Curve is concave up—like a smiley face Selling options Lucky to make 50% ROC Returns are capped Bias is against seller P&L Curve is concave down—like a sad face

What type of a Trader are you? Money Management Get back all $ and play only house’s $ ASAP Use stop losses along the way Trade till all $ back then no stops Exit on pull backs–lower low on underlying Set a exit target—2X, 4X, 8X, 16X… Gambler—let it all ride…exit…what exit?

Conclusion Start with small initial position Add onto position only if profitable Exit based on your trading style

References http://www.jesse-livermore.com/trading-rules.html Portfolio Management Formulas—by Ralph Vince Utilize long option probabilities and non-linearities—Ch. 4