In - Amazon S3 › lttfp › Big+Banks+Strategy.pdf · Big Banks and Institutions 2016 Learn To...

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Big Banks and Institutions 2016 Learn To Trade for Profit.

In this report, I am going to share with you a very simple strategy.

This strategy is based on methods used every day by big banks, wirehouses, and market makers to generate consistent profits. I’m also going to show you the 5 reasons most option traders lose money and how you can avoid them.

Finally, I will give specific examples demonstrating how to deploy this strategy properly and identify the best times to use it.

But before we dive into the details of this trading method, we must answer a very important question – one that few traders ever consider.

If you ask the 90% of option traders who lose money to give a reason for their lack of success (assuming they admit to it), you’re likely to hear things like poor chart reading, wrong stop placement, early profit taking, or the all‐too‐common “psychology” excuse.

Educators love the psychology cop out.

It’s a catch all that can be used to justify just about any failure.

This needs to be nipped in the bud immediately. If a strategy works… it works. A trader’s emotional tendencies have little, if anything, to do with his profitability.

No. The question we must ask – the most overlooked and under researched of all is…

If you want another great options guide then I recommend downloading Bill Poulos' "Simple Options Trading For Beginners" guide:

Tap here to download this FREE options eBook now

http://clickmetertracking.com/5aa5


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Are options fairly priced?

Although great attention is given to delta, theta decay and order flow, few traders pause to consider whether the price of each contract is justified. In other words, does the risk justify the potential reward?

If so, most traders should break even over time.

Every trade has a buyer and a seller. Someone wins, someone loses.

The law of large numbers predicates that the group should break even over a long period and a bell curve should form.

But 90% lose money. Why?

The answer ‐ inflated implied volatility.

Implied volatility is artificially skewed by market makers on a regular basis, especially on out‐of‐ the‐money options.

This higher IV generates higher option prices, requiring traders pay more than they should for the potential gain.

You see, stock options are priced according to the Black‐Scholes model.

If you’re not a mathematician, don’t worry. There is no need to solve the equation.

The important thing to note is the variables that go into it.

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In the key above, only one variable is manually set by market makers – volatility.

Rate of change, commodity price, time and the risk free rate are all known inputs.

Why is this important?

Let’s examine the effect of changes to this manual implied volatility input.

The following Black‐Scholes models represent a hypothetical option contract:

$100 stock (current price)

$110 call option

3 months to expiration

I have circled the resulting option price of each in red.

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As you can see, the effect of changes to volatility is enormous. Option prices can increase as much as 1,200% because of changes to this single input.

Implied Volatility Option Price

10% $0.07

20% $1.04

30% $2.63

40% $4.45

80% $12.29

100% $16.27

Being of such obvious importance and influence on price, the obvious next question is –

How is implied volatility determined?

Theoretically, it is set by a mathematical formula that estimates the potential magnitude of future price movement of the stock.

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In reality, implied volatility of options is determined by the market maker's assessment of public expectations.

This is important.

Because market makers have an obligation to maintain liquidity in the market.

This means selling when everyone is buying and buying when everyone is selling (often referred to as a “one‐sided market”),

When forced to sell, these market makers want to get as much money as possible for the options they are selling.

So they use the only tool at their disposal... IMPLIED VOLATILITY.

By increasing their “assessment” of implied volatility, option prices increase. This allows them to sell from higher prices and reap larger profits.

When forced to BUY options, they do the opposite. Decreasing IV brings down the option values, allowing them to buy at lower prices and reduce their risk again.

Option traders often wonder who is buying the options when everyone is selling and who is selling the options when everyone is buying.

In these one‐sided markets, option traders are actually dealing directly with market makers instead of another option trader.

This is why implied volatility tends to rise in a bear market and drop in a bull market.

In a bear market, traders usually rush into put options all at once.

In a bull market, the buying of call options tends to be more spread out and less "hurried".

Is it making sense?

Everyone buying = Increased IV

Market makers receive more $ for selling

Traders over pay for options

Everyone selling = Decreased IV

Market makers spend less when buying

Traders receive less premium than they should

This is why most option traders lose money.

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In theory, option traders should break even ‐ half make money, half lose money (excluding commissions). It’s the law of large numbers.

In reality, over 90% lose money. And this is primarily due to market maker manipulation of implied volatility.

So, how do you become part of the profitable 10%?

Easy... trade like a market maker.

When implied volatility is high because everyone is buying – sell options. Use the implied volatility manipulation to your advantage.

Capture premium, book some profits, and give up the pipe dream of your $100 option turning into $1,000.

Get on the same side as the market maker.

As I referenced in the beginning of this report, there are 5 reasons most option BUYERS lose money:

1. Option purchases are “limited risk” speculation… but the limit is 100%2. Options lose time value from the moment you purchase them3. Commissions on option transactions are high4. Options are short‐term, and they expire5. Option prices are not formally related to the price of the underlying stock

But we can turn those five disadvantages into profits. Here’s how.

1. Option purchases are “limited risk” speculation… but the limit is 100%

Buying any option risks losing all invested capital

Selling an option (specifically puts) creates immediate income and potential for a lowcost basis to buy a stock

An Apple (AAPL) option may go to zero, but I highly doubt the stock will

SOLUTION: Sell options, don’t buy them

2. Options lose time value from the moment you purchase them

This is known as a “depreciating asset”

Just like your car, it will be worth less every day that you own it (all else being equal)

By selling options, this works to your advantage

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Time value decay creates profits for the seller

SOLUTION: Sell options, don’t buy them

3. Commissions on options transactions are high

Stock trades are generally $5‐$10 flat

Option commissions are usually $7‐$10 PLUS an additional per contract fee

Brokers love to promote complex option strategies

The more legs, the more contracts. And the more contracts, the greater the commission

SOLUTION: Keep it simple. Sell single options. Avoid spreads, butterflies, condors andthe like.

4. Options are short‐term and they expire

Picking stocks that will go higher is easy

Picking WHEN they will go up is nearly impossible

Option trading is the only arena where you can be right and still lose money

Selling options removes the element of timing

You collect premium whether it happens next week or next year

SOLUTION: Sell options, especially short‐term

5. Option prices are not formally related to the price of the underlying stock

Implied volatility is manipulated by market makers

Buying when IV is high then selling after it comes down can result in a loss even thoughyou were correct in forecasting the price of the stock

High IV creates opportunities to “sell insurance” and collect large premiums foreveryone’s fear

SOLUTION: Sell options when IV is high. If you still want to buy options, do it when IV islow.

Are you beginning to see why most people lose money trading options?

And how the option market is manipulated and stacked against the retail trader?

Do you see how taking the side of the house will help you actually MAKE money in options?

Now let’s talk about how to be in the profitable 10% of option traders – those “in the know” who trade on the side of market makers and Wall Street institutions.

The idea is simple – use market maker behavior to your advantage and force the market to pay you to do business.

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In the last article, I shared the house analogy.

You find your dream house listed for $500k. You offer the owner $400k.

He does not accept your offer now, but pays you $10k to leave it on the table for 3 months.

And after 3 months, 1 of 2 things happen: 1. You buy the house for $400k AND keep the $10k2. He does not sell you the house BUT you still keep the $10k

In either case, you come out a winner.

This is strategy we will deploy in the option market – forcing others to pay us for making low ball offers for stocks we wish to own.

And in the rare case that we ARE forced to buy stocks (albeit at much lower prices), we can flip the equation over and force the market to again pay us – this time for offering our stocks at prices ABOVE the current bid.

So why is this possible?

Believe it or not, most people don’t know much about stocks.

And this lack of knowledge makes them scared. They want to limit their risk and feel safe with an emergency exit.

These people will pay us to be their safety net.

Let’s look at an example.

In late July 2016, Tesla (TSLA) stock was trading at $222. After a volatile first half of the year, the stock was finally beginning to stabilize.

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Option trading volume was still high, however, and market makers had the implied volatility set at an astounding 64.61% for the Aug5 contract.

At‐the‐money put options were selling for $11 per share. So anyone wishing to protect their investment would have to spend 5% of the stock price – just for 12 days of protection!

It’s absurd.

Option sellers, however, had a great opportunity. As long as Tesla remained at its current price or higher at the end of 12 days, these sellers would capture a 5% return on their investment in less than 2 weeks.

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If you want to get technical, it would actually be a 10% return since most brokers require only 50% of the underlying stock value to sell the puts naked.

100 shares of TSLA: $22,200

50% margin requirement: $11,100

Option premium received: $1,100

Gain on successful trade: 10% in 12 days

Now I know what you’re thinking. “Yeah…but what if the stock falls below $222?”

Let’s explore that.

Let’s assume the stock falls 7% over the next 12 days leading up to the option’s expiration date.

First of all, this is a pretty big move. It is unlikely, but we will use it for this example.

A 7% decline in Tesla stock would put shares at $206. And since this is below the 222.5 put we sold, we would be forced to buy the stock.

Our new cost basis would be $211.50 ($222.50 purchase price minus $11 option premium). Although the stock has fallen a full 7% in value, we are only down 2.6% because of the money we received for selling the put option.

At this point, we can simply reverse our strategy – selling a call option in order to get paid for selling the shares. We will again be selling an out‐of‐the money option, thus demanding a price higher than it trades today.

We own the stock for $211.50. It now trades for $206.

Looking out another 2‐3 weeks, we can sell the $210 call option for $8.00 per share. This immediately puts another $800 into our account and lowers our cost basis again to $203.50 ($222.50 ‐ $11 put option ‐ $8 call option).

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If Tesla stock climbs above $210 over the next few weeks, the shares will automatically be sold from our account at the $210 price. And since we own the stock for just $203.50, this represents a gain of 3.2% ‐ nothing to write home about, but not bad for a one‐month trade.

If, on the other hand, Tesla remains below $210 when our option expires, we can simply repeat the process – selling another near‐term call option above the current price and further lowering our cost basis.

The process is simple. You don’t need to use five‐legged option strategies or analyze complex concepts like theta decay to make money in options. In fact, doing so will more than likely hurt your performance.

You do, however, have to look at options differently. You must use them as they were intended and let go of the lottery ticket mentality.

Sellers are able to make consistent profits. Buyers almost always lose over the long‐term.

This strategy is not without risk, however.

It is far safer than most approaches and even carries less risk than simply buying stock outright – but it is not foolproof.

If a stock falls dramatically, losses can still be had.

For that reason, I recommend only selling puts against stocks you are ready and willing to own.

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When Enron was on the verge of bankruptcy, options on this stock carried enormous premiums. Volatility was well in excess of 150%. Option sellers saw opportunities to make 40% returns in less than a month!

But no amount of option premium could save them when the stock to zero.

Blackberry offered a similar situation in 2008. Premiums were high, but the stock fell almost 95% before finally stabilizing in 2012.

Sales were falling, profits evaporating, and the iPhone was taking control of the smartphone market. This was not a stock you wanted to own, and therefore was not a reasonable choice for the put selling strategy.

I prefer selling puts against large cap, blue chip stocks. Although the premiums will be less than with riskier alternatives, the profits are far more consistent.

Plus, I’m happy to have shares of a stock like Procter & Gamble (PG) put to me.

It pays a 3% dividend that has grown every year for more than a decade. The stock is a staple in almost every American mutual fund. And it has grown for more than 25 years.

Selling puts against PG does not scare me.

Selling them against a solar energy start‐up with an unproven business model and no profits? Yeah…that scares me.

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If you insist on selling naked puts against riskier equities, do so in smaller amounts. My personal allocation per trade is as follows:

Large Cap Blue Chips (Home Depot, Wal‐Mart, Berkshire Hathaway)

Up to 10% per trade

2nd Tier Stocks (First Solar, Netflix, 3D Systems)

Up to 5% per trade

Speculative Trades (turnarounds, small caps, new IPO’s)

Up to 3% per trade; 10% of portfolio or less

When using this strategy against “boring” blue chips, it helps to do so after volatility‐spiking events. As we covered in the Black‐Scholes demonstration earlier, times of higher than normal volatility will increase option prices and allow traders to reap greater gains.

“Higher than normal” is a vague description – I get that. But the precise implied volatility of each stock will vary according to its price history.

You’ll want to look at all the months in an option chain in order to determine if the current IV is above average. For a stock like Wal‐Mart, 30% is very high. For Netflix, it’s an average number.

But as a general rule of thumb, anything above 40% is considered high.

When seeking out high volatility, there are three key times that are ideal for this strategy.

1. Missed Earnings – For Wall Street, earnings season is the equivalent of the Super Bowl. Hugebest are placed on whether companies will beat or miss estimates made by market analysts.

Many investors are even foolish enough to take part in this lose/lose game – buying options to gamble on these forecasts.

Instead, earnings announcements can be used as an opportunity to sell puts against great stocks at temporarily depressed prices.

Wall Street is famous for overreacting. A company that was expected to earn $2.50 per share for the quarter earns only $2.40 instead. Within seconds, the stock falls more than $10.00 per share.

This is an overreaction. A mere 10 cent miss causes traders to dump shares and sink the price by 1,000 times the miss.

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Take Microsoft (MSFT) for example. On July 18, 2013 the company was scheduled to report earnings. Wall Street was predicting 74 cents per share. Instead, Microsoft reported profits of just 52 cents, missing forecasts by less than a quarter a share.

Not that big of a deal, right?

Wall Street thought otherwise. Shares of Microsoft fell from $35.44 to $31.02 in a single trading day. This 12% drop in price was more than twenty times the amount of the short term miss.

Most people panicked. Many who held the stock sold it and few were looking to buy after such a decline.

But savvy investors saw this as an opportunity. The stable tech giant was now trading for less than 13 times annual earnings – more than a fair price for a quality blue chip stock.

What happened next? Shares surged for the next five months, dipping below the $31.02 low only once before climbing more than 25% in under four months.

Microsoft (MSFT), June 2013 – Dec 2013

2. Temporary Bad Press – Another opportune time for put selling is after any temporary badnews for the company. This can come in a number of forms including:

A lawsuit filed against the company. You would be astonished at how many lawsuits arefiled against public companies every day. Unless there are sustained allegations ofsevere wrongdoing by the company – ignore it.

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A failed product line. Most companies launch dozens if not hundreds of products in theirlifetime. Some of them are going to fizzle. But if you are looking at a strong companywith a long history of profitable operations, this setback is likely temporary and presentsa valuable opportunity to sell puts when shares are at a discount.

The unexpected retirement of a senior executive. Executives step down all the time. Butwhen they do so without warning, Wall Street panics. Again, stable businesses are notdependent on any one man or woman. Odds are that the enterprise will continue tothrive long into the future.

Analyst downgrade. Analysts are a dime a dozen. Many do a mediocre job at best whenit comes to predicting the future of a given stock. Yet most investors look to them forguidance and hang on their every upgrade and downgrade as if it were derived from acrystal ball. Unless the company is in real trouble, i.e. posting large losses orexperiencing dwindling sales, pay no attention to the predictions of Wall Street.

A product recall. In March of 2011, Toyota (TM) announced the recall of about 680,000vehicles in the United States. Investors panicked and shares fell 35% over the next ninemonths. While this was indeed a setback for the company, its effect on the lifetimevalue of the company was minimal. Shares gained as much as 123% over the followingtwo years.

The important thing here is to make sure the bad press is temporary. If the company is allegedly cooking the books or guilty of significant fraud – stay away.

If their product or service is no longer relevant (think Blackberry) – avoid it.

But short‐term negative factors will cause Wall Street to drastically overreact and often create valuable opportunities for seasoned investors.

3. Out of Favor Stocks/Sectors ‐ For a variety of reasons, many stocks and sectors go throughcycles of popularity on Wall Street.

Take solar energy as an example. Once thought to be the answer to the world’s energy crisis, traders couldn’t find a price too high for solar stocks in 2007. First Solar, the US leader in this sector, soared from $25 to $317 in just six months – a gain of over 1,000 percent!

Solar was hot and Wall Street brokers were buying up every share they could get their hands on.

But this popularity soon vanished, and the solar energy sector fell 95.8% over the next five years.

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What about these stocks changed? Nothing. In fact, First Solar (FSLR) actually doubled its profits the following year. But the stock still lost more than two‐thirds its value over the same ten months.

First Solar (FSLR), Nov 2007 – Jan 2014

The bears of the solar industry finally put away their claws in November 2012 as shares of most solar firms reached severely discounted prices.

Contrarians that saw this for the opportunity it was invested heavily and watched solar stocks climb an average of 232% over the following twelve months.

The story of solar is not a black swan, however.

There was the tech boom of the late nineties, the financial stock collapse of ’08 and ’09, the healthcare surge, the 3D printing bubble and the wild swings of the alternative energy sector.

The trick is not to guess what the next hot sector will be, but to wait for an area of the market to be so unloved and out of favor that stocks offer tremendous value to new investors. And should your chosen stocks manage to outperform their dire forecasts, the upside can be huge.

Not only will Wall Street be forced to recalibrate based on better than expected earnings, but the renewed hope for the company will propel shares even further as demand for the stock increases.

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Most people will continue to under perform the market. They are wired to buy when stocks are trending higher and sell when they are falling. This is what makes the stock market fundamentally different than any area of our everyday lives.

When buying a house, is a lowered asking price good news or bad news for you?

What about at the mall. Do you avoid anything on sale and only buy merchandise at full price?

Maybe you’re in the market for a new car. If the dealership is offering a 20% discount on your dream sedan do you wait for the price to go back up before buying?

The answer to all of the above is a resounding no. Yet this is how people buy stocks.

When great companies are offered to them “on sale”, they avoid them like the plague. Yet when stocks are being sold at above average prices they can’t buy fast enough.

By flipping this equation… and thinking differently than the average Wall Street sheep, investors can experience huge success.

The combination of an unorthodox option strategy with a contrarian stock‐picking mindset is one of the safest ways I’m aware of to build real wealth and outperform most who attempt to play the markets.

If you want another great options guide then I recommend downloading Bill Poulos' "Simple Options Trading For Beginners" guide.

Tap here to download this FREE options eBook now



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