248: David Sun - Systematic Options Trading - Minimize Risk, Optimize Edge

Chat with Traders is brought to you by Trade the Pool. Did you know that every decade the market reinvents itself? Online brokers opened the doors, mobile apps made trading seamless, and commission free trading erased barriers. Now a new era has begun. Meet, trade the pool, limited risk trading. And now you also have unlimited time to reach the profit target. From now on, your trading risk is capped, and your trading opportunities are limitless.

Trade the pool funds home-based stock traders with up to$200,000 in buying power. That means you can trade larger positions and scale your strategies without risking your own savings. It's time to trade with more capital, making it truly worth your time and effort. Ready to trade the pool? Click the link in the description and join the stock trading revolution today.

Trading in the financial markets involves a risk of loss. Podcast episodes and other content produced by Chatwith Traders are for informational or educational purposes only and do not constitute trading or investment recommendations or advice.

We're on episode 248, and I'm Ian, host of Chat with Traders, and we're going to mix things up just a little bit today. where Tessa will be interviewing our guest, David Sun. David's background is in electrical engineering, but he got turned on to options trading over the years and appeared on the Tasty Trade Show as a rising star guest. With a talent for options trading. He then went on to start his first hedge fund in 2018 and then added a second one in 2021.

In this interview, Tessa discusses an overview of David's systematic options trading. It has to do with a multi-layer approach using stop losses. Which is not common in options trading and even advised against. And how David takes advantage of high implied volatility, not in the way most option traders would think, and his take on managing the win size to loss size ratio. This episode assumes that you do have some basic level of options trading knowledge.

So options traders, I think you're in for a treat and may come away with some actionable ideas. By the way, David will make an appearance inside the Chat with Traders community where I will dive deeper with David into the mechanics of his strategy. Please join us in this live online discussion on December seventh. Go to community on the Chat with Traders website to join. We hope to see you there. We would now like to introduce you to our guest, David Sun. Hi David, welcome to Chat with Traders.

Hey Tessa. Thanks for having me on.

Yes, it's very good to have you on. Um, we have a lot to cover and why don't we just dive into it now? But before we get into the the nuts and bolts of things, I usually like to hear a little bit more about the human side of traders. So if you don't mind, can you just share with us a little bit about yourself, your background? Yeah, no no problem. So my background's actually uh in electrical engineering. So that's my

education. And uh so I don't have a formal finance background. Um I got into options when I was actually doing my master's. And it was a buddy at grad school that got me into options. At the time I I randomly just wanted to get into the market because I think it was like the two thousand eight, two thousand nine time. So obviously the the markets and stock market in general was kind of on people's minds whether or not they were, you know, into trading.

Um, and at the time I had no knowledge, you know, I was just randomly watching CNBC and like following Jim Kramer and just just picking stocks. And so my my buddy got me into options. Interestingly enough, actually from the point of view of selling options, because I know people who get into it tend to get into it as buyers of options and almost like speculating directionally. So I was actually selling puts very early on.

For for better or for worse. And again, not knowing really anything and just kinda blindly selling puts. Um, I wasn't even rolling, I was just like picking based on how much premium I wanted, thinking like, hey, um uh if I collect this amount premium, then I can make this percent. And I I think occasionally, uh, if it did get challenged, I would like he was like, hey, you can rule for a credit. So it was very

unsophisticated. And uh the bad thing is it worked for a couple of years. So, you know, mate made a decent amount, but then at some point the market turned and I gave a bunch of it back. Um, so I got a little disillusioned and uh I kind of stopped doing it for a bit, but I had a friend who was also trying to get into the market or just doing research on stuff because he knew I was in options. So he introduced me to Tasty Trade. And this was in 2017. So that was, I guess, the

beginning of like kind of the the the reinvigoration of of my interest in options. Um, because if people follow Taste Trade at all, they know that it's kind of retail oriented. There's a lot of content. um a lot of stuff to learn. You kinda just I was drinking it all up. And that in terms of the learning curve was kind of what accelerated things for me.

Um, so I started kind of getting a little better and I got confident enough, you know, this was like a year and a half in that I was doing well and Something gave me the idea that hey, it'll be cool if I could scale up what I'm doing. And I was like, well, if I could do this for others and just kinda keep trading, but I can make money doing it. You know, I basically started a hedge fund in late twenty eighteen. Um, did that, you know, that was going well. I started a second hedge fund and

2021. And so you know it's been four years. And so I've been kind of just continually pushing my own knowledge and developing strategies. And you know, that was kind of the just the trajectory. Yeah. So that was like a uh from beginning to end, probably like a 10 year journey, 10 plus years at this point. And that's that's kind of the the very high level, quick, quick fly through.

Mm-hmm. So from electrical engineer to options trader, now hedge fund manager. I wanted to back up just a little bit. Before options trading, did you just trade stocks at all? Or you just went straight into options? So I picked stocks for like a couple of months because as I mentioned, that was around the time I was in grad school and I was telling my friend about it and he got me into options. So I basically dropped stocks.

pretty quickly. I mean, it was still uh involved in a sense that I sold puts on what I would have bought stocks on. And again, very unsophisticated. It was literally like

see what Jim Kramer mentioned or pick five random stocks or it was like Apple and Visa or like uh you know just just and then just selling a put and then doing that. So yeah I wasn't trading stocks from early on. It was basically just selling options for after like two or three months of you know quote unquote trying to learn the market.

Mm-hmm. Cause that was kind of like uh what people usually start out with when they when they first trade options, right? On the sell side, they usually sell puts. That's kind of a popular thing to do. Is that true? Once you get past the buying kind of cause to speculate on the upside or buying puts, Selling puts and especially cash secured puts, one of the kind of the intro strategies is like the wheel, which is basically selling cash secured puts, which is selling a put on

an a stock where you have enough funds to take assignment and buy a hundred shares of that stock if you know if if it's put to you or gets assigned and then turning around and and you know selling covered calls against the shares. So uh I I think that's kind of the introductory or like the first quote unquote safer strategies that you know new option traders will learn.

Right. Yeah. So I'd I'd like to ask some questions about your hedge fund. The reason is because we've had great episodes so far that mention the use of options to trade or or use them as part of a hedging. of a portfolio or options seems to be uh widely used in in hedge funds, but I don't know if we've taken time to pick one or two strategies.

and really break it down far enough at the level where even though these can be advanced and in complex strategies in in some of these hedge funds, um, I think us re retail traders can still get some ideas to possibly, you know, play with and experiment with more to be able to implement into our own strategies. So I'd love to get into a bit a little bit about that and why start a hedge fund? Are you a founder owner or you just manage hedge fund?

Um, both. Actually, so i a a hedge fund is essentially just like a a pooled investment vehicle. So there's a number of parties that pool their capital. And it set up kind of like a limited partnership. So all the people, investors who are just providing capital, no, they're limited partners. And I am a general partner, which essentially trades the count. It's all commingled funds.

um just kind of like an administrator that does the books and allocates the profits uh proportionally to each partner. So basically everybody gets the same return. regardless of how much they've invested. And so this kind of structure is a way to manage a large pool of capital without having to trade Multiple accounts. So some people might be familiar with something called SMAs or separately managed accounts, where you're kind of giving somebody a manager access.

third party access to your personal account. So they trade in your account and they have something where they they do a strategy and you know the trades get kind of pushed to all of the different accounts at the appropriate size. But you know, each investor still kind of keeps control of the funds and they can see what's going on, whereas a hedge fund, it's commingled.

And that makes it easier. Uh that's my preference because you can think of as trading one large account as opposed to multiple small ones. And for capital efficiency and margining, it just kind of works more easily. But to answer your question, yes, I. Started

found it, if you will, and also manage kind of too too small. I mean, don't get me wrong, I'm not Ray Dalio, right? I'm not managing hundreds of billions of dollars. These are relatively very small in the grand scheme of things, but it's kind of a similar setup. Yeah, I I asked because it takes a certain mindset to be able to go from trader, just a regular trader, and then now to uh open up a hedge fund. It tells me that you have an entrepreneurial, you know, side of you.

It's it's hard. It's hard to be able to do that, right? To manage the business and also the money. Would you be willing to um describe some of your main bread and butter hedge fund strategy that you're using? uh the kind of uh regulation that we operate under is we can't do public marketing so to speak and we can't raise capital and public and talk specifically about performance and stuff, but I do share overarching philosophies and

general strategies, maybe not exactly the way they're set up, like in the fund. But like I said, even with through my own podcast, which I think you've heard a couple episodes of, like I share kind of different facets and and the approaches and ideas behind them. And so I'll give kind of an overarching philosophy behind the two funds and like what the approach is. And so one of them is using options as a tool to combine with traditional buy and hold. So you know people talk about

long-term passive investing, if you buy and hold SPY, right? The SP 500 ETF, you're going to get the market returns and it's passive and you'll get, you know, 9% to 10% return a year or whatever it is, which is great.

Um, but once you do that, right, it's a passive approach and you're pretty much subject to the whims of the market and you take what the market gives. But with options and the way because they're capital efficient and the way they're margined, you can essentially run an option strategy. on top of a a a passive

buy and hold portfolio. And it's it's basically an overlay. So if you think about it, if if you were to run option strategy and and even target some very small return, one, two, three percent, whatever it is. And if you can consistently do that, and that's basically stacked on top of your buy and hold, you know, whatever your core, it doesn't even have to be SP, just whatever you want to.

typically do as a you know uh e uh stock investor, you you're basically just adding that return on top, right? So basically you get to kind of enhance the return, if you will. So that's the approach of one it's like You have some core portfolio and you can consider that like a personal benchmark and view something that you'd have regardless. And if you can just add a little bit on top, you're essentially kind of enhancing the yield. Um and so options is that the tool to

basically overlay a strategy. Um and then the other fund is kind of more of a pure option strategy. We don't have any underlying, no, equities or stocks and it and then it's kind of a rather than a benchmark approach, it it's considered absolute return, right? We're just trying to generate some target um or some level of return regardless of what the overall market or any other benchmarks are doing and is using pure option strategies. So okay, so these are the two the what you the two

Those are the uh approaches. I haven't gotten to the strategy specifics yet, which we can dive into one of them. But that's kind of I wanted to give a high level of kind of the approach and what you can do and kind of my vision for how, you know, because different funds have, you know, different mandates or uh different strategies or different philosophies of kind of what they're trying to do. And that's kind of the two approaches that that we happen to have.

Yeah, I'd love to dive into each of those two approaches. Uh, that'd be great. And Would love to know too, because we just had a recent episode on episode two forty two uh where we had Chris Cityal on as a guest and he described, you know, uh some of the approach in in his hedge fund strategy to using options more like I think like an insurance, you know, with the long vault trade.

And also mention the other side of it having absolute, an absolute return strategy like the one that you just mentioned. Would love to also understand what the main differences are in what you're doing.

Yeah, so it's it's kind of an interesting, and this is a good example of what I meant about kind of different mandates. So Chris's fund is meant to be a tail hedge protection for uh no an institution or somebody that has some other portfolio that they want to protect, right? And so they would allocate some capital to Chris's fund as kind of the insurance policy. And in his fund,

uh he broke it down to where they have one part that is the hedging, you know, or buy and put options at SP or whatever else that's meant to be the protection. But he used the example of when you pay for insurance. there's always a cost, right? And there's a bleed. So if you want large protection

you're gonna pay a large cost. And if you pay a large cost and you know this event or whatever you're protecting against them or manifest, then you basically have no benefit. It's just uh money down the drain. Right. So to offset that bleed to the extent possible, there They run some other option strategies on the side. That's kind of the absolute return strategy. And they're using that to quote unquote finance the cost of hedging. And so what happens is.

In his kind of product, you don't really expect a return, so to speak, because the under normal circumstances, the options, you know, the income from the absolute return strategy is just going to go offset the bleed from the head. So the m you know, you're not gonna get like a profit from allocating with him on a normal circumstance, but the reason you do so is because if you can that if you can get that quote unquote free hedge.

then when the event does happen, you know, his fund is designed to have a large payout, you know, a few hundred percent. So you get that large return on investment. Um

the mandate and kind of the risk profile of it if if you think of his fund as just a product, right? Because you know, what are ETFs and mutual funds? They're they're funds, they're just products. So hedge funds are just, you know, private funds. But that's kind of his approach. Whereas Um, the second fundamental for us is whereas we just have because we do short-term trading, we're not we're not trying to

have some kind of large convex or tail hedge profile. We're just trying to generate, you know, uh some return that's irrespective, you know, uncorrelated to the overall market. So that's kind of one way to kind of compare and contrast. Or just think of funds as different products, right? Uh but we're just not ones you can go out and buy on you know on on on the exchange, right? Uh it's not some like ticker symbol we can trade.

Interesting. Okay. So let's um yeah, I would love to learn more about this um second hedge fund first. Cause since you just mentioned it, can we break that down a little bit more? Yeah. So the approach that we take, and and just to be clear, the both the first and second fund use the same types of strategies as the return or the options portion. The only difference in why

the return profile is so different is because the first fund uses, you know, index funds, for example, as a base. And options are kind of a small piece to sort of enhance that. Whereas if you separate those, drop the index funds, and just focus on the options and size that up.

you get a certain return on that. And so one thing I kind of want to point out is that again, options are just tools, right? You can size them up or down and use them in different ways in conjunction with other, you know, pieces of your portfolio. to design an overall profile.

Um, so if if that makes sense. Like, you know, again with what what Chris is doing with our second fund, our first fund, it's it's there are options, but how you use it and when you use it, that's what makes a difference. But let's talk about kind of our approach on options. Because

When we sell options, um, and I know your audience uh probably is mostly familiar with stock trading, so uh they might not have intimate knowledge of like Greeks and stuff. So we'll we'll try to keep it very basic. We'll we'll mention that you know Greeks. are something you have to be aware of, but you don't have to kind of dive into how they're calculating everything. But when you sell a put, for example,

Depending on where you choose the track price, and there's a delta involved with every option. And delta very simply is just a measure of how much an option price will move for every uh dollar move of the actual underlying. When you look at options and look at the option chain, the delta can be kind of a proxy of the probability of profit or the probability that that option will expire in the money at expiration.

And so if you have some probability of success. And the thing is, a lot of new traders who get into option selling, they always want to focus on the high win rate or high pop, you know, probability of profit. And so they'll sell these. far out of the money options that presumably will have a eighty percent win rate or ninety percent win rate. But the issue with this kind of approach is because options are nonlinear.

What happens is you have a high win rate of winning some small defined amount. But when they move against you, they can move against you very heavily. So you could have like a five. X multiple loss or 10x multiple loss. And so it doesn't matter if you have a high win rate. If when you lose, you lose big, right? You basically give it all back. So what I set out to do was using different mechanics.

I wanted to fix that win to loss ratio. So I used kind of a simple example. If I sold an option and I collected, we'll just use round numbers,$100. That's your maximum potential profit, right? You can't make any more than$100, but you can lose a lot more. And two simple mechanics I'll do. One, no, we will close the option at a certain profit, right? Because we don't, there's risk involved with holding them all the way to expiration. So let's say I want to.

capture 60% of the profit. And so this is a little thing where when people are selling options, they have to learn to kind of turn things around. I've sold something and I've collected this credit of$100 to kind of enter the position. So if I if that option decays and the price goes down and I buy back or buy to close for 40, right? So I collected 60 and I paid 40. My net profit is$60, right? Which is 60% of my original max profit of 100. Does that make sense? Yeah.

Yes. Okay. Now that's taking a profit on a winner. So on the other side, we've mentioned that options can move largely against you. So I don't want to brisk. a 5x loss or 10x loss. So let's say I'm gonna count my loss. uh at 200%, right? So if my maximum profit is$100, because that's what I collected, and I'm not willing to lose net more than$200. What I'll do is I will stop out or buy back the option if it goes to a price of 300. So if we step back, if I sold it for a hundred.

But I paid$300 to close out and get out of the trade. I've letted a loss of two hundred or two X. Does that make sense? Mm-hmm. Okay. So this

creates a very simple win-loss ratio, right? If I win, you know, 60%. On a winner and I lose 200% on a loser, it's like a roughly a risk three to make one. Yes. Have you ever watched a stock explode and thought, if only I had the capital, or sat on the sidelines because your account balance felt too small to matter? Good news.

With Trade the Pool's limited risk platform, you don't need millions or even thousands to start trading the US stock market. Bypass the PDT and tap into over twelve thousand US licit equities. From penny stocks to big caps, ETFs, even the newest IPOs, and short anything you like, with zero locate or hard to borrow fees.

Start your evaluation. Get funded with up to$200,000 in buying power so you can go big without risking your own savings. And now you can also have unlimited time to reach the profit target. It's a game changer. Not ready to trade yet? Trade the Pool offers a free demo and educational resources. Practice on live data, master the platform, and build confidence risk-free before you even pay a cent. Click the link in the show notes to start trading with Trade the Pool's capital.

In practice. And and people talk about like, what if there's a big gap or what if you can't get out at that price? Those are all. real considerations, but just from a theoretical standpoint, you're right. I I have basically defined my win loss ratio, win size to loss size ratio, risk to return, so to speak.

And so in my podcast, um, I talk about this concept called expectancy hacking. And the idea is when you talk about expectancy, which is kind of how much you expect to profit on average for every trade, right? Once you factor in all the winners and losers. And I mentioned people always focus on a win rate. But they don't focus on the lost size. If I have now fixed the win-loss ratio through my mechanics,

The only thing that remains to determine my expectancy is the win rate, right? Expectancy is kind of a function of those three things: the win rate, the win size, and the loss size. Now, even if I have fixed the win-loss ratio. I don't know the future. Like, I can't know exactly how much my room we're gonna be, but I will I know.

That if the win rate is high enough, right, and expectancy, you can kind of multiply it out like your win rate times how much you win, and then minus the loss rate times how much you lose, you'll get some average expectancy per trade. And so the win rate's high enough. The expectancy will be positive. And then if it's too low, it'll be negative. Right. Period. That's it. It's either above or below kind of that so-called breakeven win rate.

And so the only last piece is you kind of have to find a strategy. You either do back testing or you can just kind of play around with different um mostly through back testing, at least to get some context. Obviously you have to live trade to see if things play out. But If I have a, you know, with my strategy, well, one of them that we do, and getting back to the Delta, if we sell a put option, you know, at you know, 15 Delta or whatever it is.

We found that the probability of profit of such a strategy using, you know, the profit take and the stop loss, you know, it's somewhere in the neighborhood of, you know, 87, 88%. And long story short, That basically is high enough to kind of generate a consistent positive expectancy. It you have to let it play out over kind of a number of trades, right? Any one trade could still win or lose, but the idea is to

Look at the long term trend. Right. So after all the trades, right, and you kind of fix this win to loss ratio. At the end of the day, you look at how much you've kind of netted in terms of profit. So let's say every trade I sell, I collect$100.

And if the expectancy at the end of the day after everything's done, including all the losses, is I'm averaging about, let's call it 25 cent, uh$25 for every$100 that sell. So That's what I call kind of the premium capture rate because what when all said and done, I've netted or captured.

25% of all the premium I've sold. Right. And I can I shorten that to PCR for premium capture rate. And it's for me kind of a measure. It's like, okay, I'm basically trying to net 25 cents on a dollar if you want to kind of. bring that down to a like a a smaller, um, easier to easier number to to talk about. So that concept of the expectancy hacking and the premium capture rate.

using those very simple mechanics of shaping your wind loss profile and letting the win rate play out over long term in a very kind of systematic probabilistic way. That's kind of the approach. Um How do you prepare for like big spreads and slippage and things like that in your premium capture rate? How do you take that into consideration? Right. So firstly, I've only been applying this to the most liquid of instruments, which is SPY or SPX. Um it can be done with

ES options, you know, E-Mini um SP futures options, or if for smaller accounts, it can also work on MES, which is the micro um options, uh the futures options. So That's the first thing. On a very liquid instrument, the spread will be tighter, right? If we try this approach on some really low volume or you know meme stock, probably not gonna work the same. So that's for one. And the other thing is to focus on longer dated options. I know recently with kind of like the

uh the the meme stock and the retail in the Robinhood, you know, mania, you know, there's people trading very short data, like weekly options. And you see all these videos on YouTube about like weekly paychecks and write 7 DT options. Yeah, the the shorter data the option, the Certain um parameters or Greeks about the way they move and reacting to in reaction to how the market moves, that will basically cause the spreads to be wider, right? That's kind of what you're mentioning. So

I generally apply these strategies to like 90 days or further, right? 90 DTE. So that's kind of one other way. And those two will mostly keep you kind of more protected in terms of having very liquid options that you're trading. But At the end of the day, you're right. There are times when you have to cross the spread, right? If if volatility gets really high, or even if there's a gap, right? Again, I mentioned the caveat is that.

You have to kind of hope that you can control that loss amount. And sometimes Let's say you close, you know, the end of the day and the the option is sitting at close to your stop loss, right? 180% or whatever. And the next day the market gaps down, right? Likely by the time the market opens, the price is already past your stop.

Now you should still get out, but in this case, like yes, you're gonna take a stop that's higher than you anticipated, but From what I've found with enough occurrences and long term, even with those instances where you have to cross the spread or bad slippage. You just bake that into your expectancy math, right? So let's say with that kind of perfect three to one ratio. Some win rate, X win rate is going to give you Y expectancy. But you'll find through testing and and live trading.

With the slippage, your loss is a little bit higher than X, right? Which just means your expectancy is a little less than Y. And you just basically bake that in, right? So I sometimes get pushback about this approach of It can't work because you'll never get out, the slippage and this and that. Um, but my response is just, well, just embrace those things, right? If you know they happen, figure out a way to mitigate or work around them and just incorporate them into your model.

And that that's kind of my approach on it.

Mm-hmm. To minimize that, the spread and slippage possibilities from from the very start, you don't really get into individual stocks, basically, right? That's correct. For this approach I don't. I I I'm focusing i it it's mainly focused on right now as the S and P index because that is in fact right the most liquid um

Yeah, okay. But if you do, I mean, if someone wants to not do that and and go into like individual stocks. For example, I I actually like to pick individual stocks, but That are super liquid as well, probably not as liquid as SPX, but but then if you also do that and also diversify have not just one underlying stock, but several, maybe like say five to ten, would that make it less risky as well?

Um so that can help in the sense that if the individual, you know, tickers you're trading aren't completely correlated, right, you're gonna get some diversification of just the what the market's doing. But In that case, you may not because I actually do just use stop orders and you may not want to do that with individual symbols or you may want to kind of manage them. Uh and the thing is if you trade longer data options, they do move slower. So you will have time, you know, presumably to

Actually, look at what's going on in your portfolio. I'm like, okay, this position is approaching or it's at the level of loss that. I wanna take, right? So you can manually either do an adjustment or stop out or whatever it is, um, you may not want to leave it to just a hard stop order because if those trigger, right? And I don't know if you've used those before, but you are at the subject

you know, to the whims of the liquidity, right? And there's any market makers or counterparties that are willing to fill you at a reasonable price. So yeah, I uh I think for me, I'm comfortable using kind of just typical stop orders and I've And this is one of those things that like people always kind of are skeptical about, but you know, I've done it and

on this particular instrument in this particular situation. But if that's not something you're comfortable with, then yeah, the the the approach you can still apply, but you may want to kind of take a little bit more of a hands-on approach and Exit yourself and work the order as opposed to relying on like a hard stop or just a mechanical order.

Yeah, that's that that's something that I think maybe most beginner options traders weren't taught to, you know, apply uh actual hard stop losses versus um adjusting your positions or rolling out early or closing out before expiration or just leaving it until expiration. So what are the risks of using um stop losses, even on liquid like index, the SPX, for example? What are the risks of using that?

So in terms of the actual implementation, I I think the main risk. that people think of is again those weird times when the bidass spread is really wide. And you take a huge fill that's way above what you want to get out at, right? So that's kind of like the the really practical consideration. So we talked about how to manage those, but I think the other more conceptual risk.

in this mindset of not using stops, it kind of boils down to your approach and the type of strategy you use. And what I what I mean is, you know, you talk about Picking individual symbols, right? And having positions and adjusting as opposed to stopping out.

I kind of can the way I view it is uh kind of uh opportunistic trading versus systematic trading, right? Opportunistic meaning you know, maybe you have a way to look for positions where you think you have an edge. Maybe you you know look at charts and if you think there's some kind of bottom, you know, you sell a put which is, you know, a a bullish thesis or vice versa. If you think there's kinda kinda

it's hitting a resistance and you sell a call, right? Which is kind of a bearish thesis. Or you might scan for tickers that have high volatility, right? Because you think there's more premium and there's some edge there. But you're essentially kind of hunting for these different opportunities. And once you get into them, you want to

You you don't want to lose or you don't want to take a loss. So when things don't go your way, you can adjust, you can roll, and you're almost kind of managing these on like an individual level. But what I wanted to get you to think about is So my approach is more systematic, right? I'm I'm actually, for example, selling a put option, you know, 90 DTE, 15 Delta every single day, regardless of what the market's doing. Now, if I were to say You know, hit a stop one day.

And on that uh because the markets went down. And then because I'm gonna enter a new trade anyways. That trade, the new trade, is probably going to be at a different strike further out of the money, right? Because I always entering at the same delta. Right. And so I've closed one trade that I'm losing and I've entered another one at a different position, maybe a different time. What does that sound like? Does that not sound like a roll? You know, because It sounds like a wall.

Right. A role is closing one position, opening another. Right. Right. But so the way I kind of Uh reconcile the two is You can talk about stops, right? And use that, you know, it's almost like this word that shall not be spoken, right? Or what if I completely change it around? I'm not going to use the word. I'm going to say. I enter multiple positions and diversify across time and I'm constantly adjusting the delta and exposure of my book.

When the market moves too much and I'm showing a profit, I want to lock in some profits and take risk off the table and kind of lighten the position size that I have, lock in gains. And when the market moves against me and I'm getting, you know, my deltas and my my risk is getting too high.

I want to manage my exposure by closing some positions and opening new ones that have a slightly less delta, right? So I've said all this, but I'm talking about it in the context of managing risk and managing exposure. But guess what? That is exactly what I do with my profit taking and stop losses. Right. And so this mindset shift of I'm using what is called a stop.

But it's just a tool to adjust exposure. Right. And I want to kind of challenge you on one more thing. Like, Let's say you have a habit of entering at a certain DTE and maybe regardless of what it's doing, you want to exit or roll at a certain, like let's say Tasty Trade talks about entering at 45 days.

DTE and then exiting one of the options at 21 DTE because they want to avoid kind of that late cycle risk and call it gamma risk. Or let's say you enter at a certain delta, let's say 10 delta, right? And you have a habit of Rolling out to uh let's say the option moves against you, the delta goes up to 20, and you want to roll it back to 10, right?

It's a stop, right? A stop is just this there's something that's triggering you to make an adjustment. And so this thought of, and I think what people kind of push back against is necessarily is. Exiting a position and then being done. Right. So if you're in a trade and you stop out and you don't do anything else, you just take the loss and move on, right?

I guess people feel like for one, you don't want like to lose. And for two, you if you think there's still some opportunity left, like you kind of want to Stay in that position, you want to still be engaged with that ticker, but you want to change the exposure, right? To manage risk. But really.

that you you've stopped out, right? But you just re-engage in a different position. And so because my system for this particular strategy is just entering constantly, but using profit takes and stop losses to adjust the position. That's really just a continuous process of adjusting. Right. So that that's kind of like the message I've been kind of trying to spread is it's like I I use the word stop, but like I could rule I could literally just explain what I do without using the word stop once.

But it could be the same thing. And I almost feel like sometimes that would be taken better. Right. So that that kind of mindset shift. And that's like what I wanted to challenge people to think about differently. I also see your Uh the difference too is when you implement stop losses, it's it's more systematic. It takes the emotion. There's that too, of course. Sure.

Whereas rolling, you're you're still stuck in it. Should I roll it now or leave it in there? There's a lot of discretionary decisions you have to make on when you roll things out. That's true. I mean, it it's funny you say discretionary, but I would I don't want to make assumptions, but I would hope that for one, there should be kind of some absolute loss limit where if it's too much, you just gotta move on, right? Because you gotta protect your capital. But on the other hand,

If you roll, yes, you want to stay in a trade or want to stay engaged with that position, but you probably should also have the same whatever thesis you had to begin with, that thesis should still be intact, right? So If you just don't believe that position's gonna have the edge or it's gonna do play out the way you think it is. You you shouldn't roll, right? You should just get out. So I I want to say that even when you roll and it there there's some discretion, it's almost like

Rather than having one rule or two rules that I use, you have like ten. You have like a a set of rules and you're still trying to stay within the confines. It's not completely without a plan, you know? Um that that's how I see it anyways. Yeah, that just emphasizes the importance of of having your trading plan in place. Right.

Um, do you adjust your strategy for periods of very high or low implied volatility? How does implied volatility, what is it the the role that it plays in in your strategy? So with the idea with expectancy hacking, which we talked about, the math behind that.

There's one other element and this kind of bakes in the implied volatility that you're asking about. If I were to sell a 15 delta option at 90 DTE, The amount of premium that takes in, that's going to change with the level of implied volatility. But if I do, for example, a fixed one contract. That basically means every trade is going to collect a slightly different amount of premium based on what implied volatility is doing. Now, if I still apply the same 60% profit take, 200% stop loss,

Those amounts relative to each trade will stay fixed as a percentage, right? 60 and 200. But because the premium is different in absolute terms, the dollar amount. will be different. So for example, On a trade that I collected$2,000 on, 60%, you know, is going to be$1,200, right? And if I only collected$1,000, then$60% is$600.

So this could introduce what's called sequence risk, which is just path dependency. If through pure bad luck, I only won the small trades and I got stopped out at the big one. That's basically gonna skew the probabilities, right? Because you're essentially not sizing consistently, right? Because I, because of the way my strategy is set up, the amount of premium you collect for me is a proxy for the amount of risk, right? Because everything is tied to that percentage relative to the credit.

So the adjustment I make is I tailor the size of the trade. To always target so my phrase is called credit targeting. I'm targeting the same amount of premium per entry. So what can happen essentially on high IV. I will scale down the size a bit. Because you're collecting more premium per contract. So I don't need to sell as many contracts. And vice versa, when volatility is lower, I'll go up in contract a bit.

To collect because each contract collects less premium. So by targeting a fixed level premium. Essentially minimizes that sequence risk because every single trade is sized consistently, but again, consistently in terms of credit, not necessarily in terms of contract size. I think that's kind of a uh a mechanic that I haven't seen people talk about and that that's something that is actually key to um l my type of systematic approach.

Uh David, what what exactly do you mean when you say sequence risk? Sequence? Okay, so if I were let's just say there is I make four trades and trade one. I collect a hundred. Trade two, I click 200, trade three, I collect a hundred, and trade four, I click 200. Right? So small big, small, big. I happen to lose all the small ones, right? The$100 ones and sorry, um, lose the big ones, the$200 trades, and I win the small ones.

You're not going to get the same expectancy as if, let's say, somebody else did the same strategy, but like their sequence of trades was different. They're offset, right? their winners and losers were reverse, right? They won the big ones and they lost the small ones. Even if we tr in this case, even if we trade the same approach. Because one person won the big ones, whereas I won the small ones, our PL is going to be different.

The expectancy is dependent on the sequence of events or the sequence of trades. That's sequence risk. Excuse the last interruption here. This is Tessa. We hope you're enjoying this episode so far. If you love the podcast, Please give Chatwith Traders the best review you can on whatever platform you're listening from. This will help us to keep the episodes coming. Also, if you haven't subscribed to our email list, please hop on to chatwithraders.com and click on subscribe.

so we can keep you posted of information that may be of importance. Thank you. Now back to the chat with our guests. But by leveling the amount of premium for every trade, I'm basically trying to eliminate that sequence risk by making each trade sized consistently. Yeah. Uh okay. You don't want to be s uh I guess if we want to just call it bad luck. You don't want to be subject to bad luck. That's I guess the the the layman's

I see. Yeah. So you you mentioned that you have you take a top-down approach. Um can you describe what that is exactly in I think it's related to what you just mentioned Yeah. So if if we put all this together and so let's just say high level, like I've tested this one strategy, and I think the long-term expectancy or PCR premium capture rates of let's just call it 25% for kind of a uh use simple numbers. So if I had a

If I wanted to make 10%. So if let's had$100,000 and I'm trying to make 10%, 10% is 10,000, and that's the profit the PL I want to make in a given year. So if I'm Expecting to long-term net 25% of all the premium I sell, I take my 10,000 PL target and basically divide it by. 0.25. So you get 40,000, which means if I sell 40,000 of premium in a given year, then if I net 25% of that, right, that's my ten thousand dollar target.

And so basically I have to sell forty thousand dollars a premium. And now if I'm trading every day, there's two hundred and fifty-two trades. You know, I take the 40,000 and I divide it by 252, and that gives you the daily. so called credit target. And Essentially the plan is if you sell that amount of premium every day.

and let the strategy play out, right? At the end of the year, you would have sold 40,000 in premium. And if at the end of the year you've captured 25%, you would have captured the you know$10,000. And so you can kind of set a high level return target. And use that to back into the size of each individual trade. And again, size in this case is determined by the amount of premium, not necessarily the contract size.

So does this only work on can this work this top-down approach can it work on choosing individual stocks? Uh there's two ways you can look at it. If your approach is kind of systematic to a degree that it can be backtested, and there's actually quite a few off-the-shelf services people can use to backtest different strategies. And you think there's some kind of consistency there.

in terms of the uh the capture rate, then yes, you can kind of use that to size um the traits. But it if you take what's you call kind of a systematic uh sorry, uh more of a discretionary approach. then you might need some history of uh live trades, right? And then log them and sort of see, hey, you know, I you know, I use a certain amount of capital per trade and I usually um able to, you know, make X dollars and for every dollar risk.

And once you have some kind of expectation, it's it's all by expectations, right? And again, it's not a prediction, right? E even with a system like mine where the the PCR, I think is 25%.

That's gonna vary year to year, right? Long term it may be 25%, maybe, right? But one year could be forty, one year could be lower, one year could be zero. Like this year is probably gonna be zero for for the the one I'm running, which which is fine because again, the market went down like twenty-five percent as as of you know, the Friday, right? Um, but it's more about if you've traded enough to kinda have some expectation of

what you get out of, you know, the capital that you that you put at risk, then you can use it as a guideline for kind of sizing up and down. Um I think that would be how I would approach that to kind of use the same, same philosophy, I guess.

Going back a little bit to the the volatility, you mentioned something I thought was very interesting in another podcast you were on, that you used high volatility not to make it more, but to make the same with less risk. I don't know if you can uh expand on that a little bit, give a little context to that, because I really thought that was interesting. So that was basically baked into what I mentioned about the fact that because I'm credit targeting.

And you're gonna cut more premium when Ivy is high. I naturally size down when volatility is high, which also kind of answers your question or from earlier about do I do anything different from a Strategic standpoint, there is no change to the mechanic, but because of the nature of options pricing. It naturally scales up and down in such a way that during high volatility, so if I'm targeting some X return, which means my credit target is, you know, some number, then with super high IV.

I can collect the same amount of premium as my target using less contracts, smaller size and actual, you know, notional or contract size terms. And kind of that's what I mean. I don't have this approach because some No, when when people first get into option selling, sometimes they're taught that like high volatility is opportunity, right? You you stay small when Ivy is low and then you throw a bunch of buying power when Ivy is high. Like that's when you make the most money.

That's not untrue necessarily, but When IV is high, it's high for a reason, right? It's probably there's some event, the market's gonna be volatile. So you still have to be very cognizant of risk and manage the trades, right? If you want to kind of load up, so to speak, on high IV. And that's just that's just one approach.

But in my case, I just basically kind of take the opposite where like I'm actually scaling down, not because I'm like trying to be more conservative, but just because my mechanics dictate that since I'm trying to target the same level of premium. I just don't need to use as much leverage or capital or um contract size when IV is high. That's all. When the VIX is high or when the you know when there's a lot of option premium, wouldn't we wanna take advantage of those times?

So in a manner of speaking, yes. Um, but I kind of alluded to the fact that when VIX is high, it's when the it's high for a reason, right? And it's because the market believes that There's going to be a lot of volatility and the underlying or the SP or whatever is going to move a lot. And when it moves a lot, right, you can be at risk, especially if you're selling options. And so it the

supposed edge is that because volatility is you know they call it mean reverting, right? When it's when there's a lot of fear in the market, right, usually high levels of fear are not sustainable. And so volatility levels will come down. And so there's a supposed edge is when you sell high volatility, you know, there's an the edge comes in because it's not sustainable, volatility should eventually come down. When volatility comes down, the prices of options comes down.

Which means remember when you sell high, it it you're selling high, buying low. That that's the kind of the backwards thinking that people who first get into option selling have to get around because we normally think of buy low, sell high, but this is sell high, buy low. Um so yes, th there's supposedly presumably there's an opportunity that presents itself when volatility is high, but you just have to caveat what that doesn't mean number one.

go all out and just blow all your buying power and sell everything. Right. And on the other hand, you you still have to have a plan, right? Even if there is some more edge when volatility is high. You always have to have a plan and you have to be able to know how much risk you're actually taking and be able to manage it accordingly. Your strategy is very data driven, right? Do you do a lot of backtesting? That's right. We do.

And um and as I mentioned, there's a lot of Uh Um I don't know if you heard of Option Omega um and there's like e Delta Pro and those are It does have different tickers you can test. There's uh option mega even has like five minute data, which you don't really need that for longer data strategy, but I know there's a lot of people who like like to test um like intraday strategies. But

These kind of software available now for retail, like you can do a lot of different enumerations and they're fast, right? So you're not waiting ages to do a back test. And so this kind of mach uh automated backtest lends itself very well to testing systematic strategies, right? You can throw out a bunch of enumerations and different things and and and just really like kind of focus on on, you know, different different patterns and stuff. Mm-hmm.

Yeah. So I now want to kind of get into um from your perspective some of the misconceptions about options trading. This is for the benefit of especially for those um who are currently trading stocks and are interested in in trading options or have started you know learning about options trading but maybe stuck on moving forward. And what's your take on kind of addressing some of this misconception first about is it riskier and is it hard to learn? And then where do you start?

I think uh one of the misconceptions is that option trading has to be super leveraged. And I think that comes from more of the fact that If you have access to the leverage, because the options themselves are by definition leveraged instruments. And the way the the margin is used, for example, if I wanted to buy. $1,000 worth of stock, right? You have to put out$1,000 of capital, right, to buy those shares. But if I wanted to have an instrument or an option that can give you the same exposure.

as that thousand dollars of stock. Your broker may only require you to put up one fifth or even one tenth of that as margin. And you're not even outlaying any cash, right? It's just like the margin account will be deducted and you'll see the buying power go down. And so first of all, if people don't understand that they're leveraged. Then they can unknowingly leverage a lot higher than they realize. Right. So in this case, if the option is a 10 to 1 leverage instrument,

And I use 50% of my capital thinking, oh, I'm using half my capital. Well, you're actually levered, you know. five times more than you think, right? Because it's it's like um sorry, if it's if it's 10 to one margin, then you're you're leveraged like 500%, right? You're using 50% capital, but your notional exposure is like 500%. So

I think it's more about a not misunderstanding of how the option works in terms of what the broker requires of the capital you put up. And so you can use them super leveraged, but you don't have to, right? Uh another misconception is like uh for so people like I guess in like again like the 2020, 2021, like the Robin Hood and the meme stock phenomena and YOLO call buying where you're only using options to get super crazy gains, right? 500%, thousand percent. And yes.

Options are nonlinear, meaning you can spend a little bit of cash and buy these out-of-the-money options or have a low probability of success, but when they hit they hit huge. But That's not a good thing. The only way. In fact, that's like we don't use options that way. Options are literally

you know, tools. And I think that's one of the reason like people can get lost is because first of all, even the same symbol, right? There's options at different expirations, different maturities, there's different strikes. And so the way to behave, and then there's Greeks, which you know describe how option price moves.

in relationship to the direction of the underlying with relation to the level of implied volatility with and with respect to, you know, time, right? Um And so um again for us, I I think it's just the understanding that you can use options to express Different hypothesis that you have on what the market will do, which direction to go, when it's going to happen.

And I think that's that that's kind of the beauty of it, but also the complexity. Like there's just a lot you can do. And I think really you have to kind of figure out like what your goal is and you can craft a strategy. Um and then lastly it's like

Options are like for degenerates for gambling. Like obviously you can, again, like you can buy these lateral tickets, but like really I think they can and they don't have to be seen as a super exotic thing. And they can really be used in conjunction with kind of more modest and conservative strategies and just kind of more as an enhancement or a way to express different opinions. Right.

And, you know, a lot of the the strategies we talked about and not just here, but in general, people talk more about on the sell side, you know, selling options versus buying options. I feel like there's not enough talk about, you know, when to buy a long put or you're something simple like that as a starting point. When to buy a long put or buy a long call. What do you think about that as kind of starting out like just to learn the basics?

If, you know, coming from maybe like a stock trading background, like you know, when you're trading stocks, you're generally kind of trading directionally, right? And the direction you pick may be based on some Technical analysis, fundamental analysis, whatever it is that gives you a thesis. Now, if you have a direction that you want to bet on, right, options are a tool to again give you leverage.

in a way that's capital efficient and limits your loss. If I pay, you know, 50 bucks on this out-of-the-money call option on this stock. That's the extent of what I can lose, right? But there's that possibility to make a big gain. And so that's kind of the appeal. So if you have An assumption, right? You can buy puts and calls as a way to express that directional opinion. Now, on kind of the more sophisticated side, you know, people might look at um

kind of historical levels of volatility uh versus kind of what's going on in the market. And if they have an opinion that like right now volatility is very high or the the implied levels of volatility, right? Like the option pricing. but they don't believe the the market's gonna actually be that volatile, right? So they believe the implied volatility is higher than what's gonna be realized, what's actually gonna happen.

What I'm trying to get is they believe the options are so-called expensive, right? This is kind of when you want to sell them. And on a vi vice versa, if for some reason They think there's gonna be some kind of vent, there's gonna be volatility, but the market is kind of uh the implied level is very low and kind of believe that it's underpricing the risk that's out there and they believe it's

Relative to what's gonna happen, right? This is when you kind of go around and buy options. So it's the same idea of trying to buy low, sell high, but that's in relationship to what your analysis tells you about the level of volatility. It's like when you think options are price cheap. you can buy them, right? And vice versa. Um, so that's just another another angle.

So far the the strategy that you described with expectancy hacking with adjusting your win size loss. size, risk reward ratio. That's that's a form of um risk management. Yes. And it sounds like you have a very good tight risk management in place. You know, some people they it's drilled into them too is you know, you have to, you gotta have risk management, you know, you gotta have that layer in there.

And that's drilled in my ingrained in me too, to have risk management. But at some point though, you can have so much risk management that you can almost have no edge. And what comes first? What's more important? Risk management and then edge or edge and then risk management or both? If you want to trade and sell options. Firstly, you have a fundamental belief that there is some edge in the mispricing or general overstatement of

options, right? Because if you believe that even the markets efficient, it's hard to well, you can't perfectly price the future, right? The unknown, which is why there's that supposed overstatement of volatility, overpricing of options.

And all the mechanics are like, because even if we believe that the edges there, you you can't just sell options willy-nilly because occasionally the risk is greater than the market thinks, right? And you blow up, right? And that's why you have risk, risk management and mechanics.

But something to consider is that regardless of the how much edge there is, and and this is something that's true for all trading and this is just general kind of bankroll management, you you know that concept that people talk about of like, If you lose 1%, then you only have to make about a percent to catch up, right? If you lose about 10%, you've got to make like 12% or something to catch up. And the extreme example is if you lose 50% 50%.

You have to make 100% to get back to zero, right? You've probably heard that there's like these charts and stuff. And that's the idea of the volatility tax. And it just means When you're talking about compounding your account, right? It's asymmetric, right? It's it's almost faster to compound downwards than it is to compound upwards. So my point is. Regardless of how much edge you think you have or there is in a strategy, if it's not size right.

that nature of the kind of the asymmetric compounding. will basically destroy whatever edge there is because you won't if if we're too volatile, you'll just kind of end up going nowhere if if any one trade or any one, you know, loss kind of wipes out a huge amount of the bankroll. So like The bank role management. That in and of itself needs to be almost considered as a mechanic. Right. And that's why um

focus so much on the credit targeting and using that as a proxy of risk, right? Because I for me, I'm like if I collect this much credit, because I've told myself I'm going to get out at this level. One way I look at it is I look at all of my positions that I have open on the books. And if I have X amount of credit,

of for open positions, I'll know that if they all get stopped out, right, at the level that I I intend, right? That's the caveat, then my realized loss is, you know, twice that, for example. And so I have kind of a a general idea of like my entire book size, if that's lost, what that represents as a percentage of my portfolio. And I can use that to kind of keep the overall level in check.

Right. And then it's always kind of being mindful because, like, regardless of how much edge there is, if you trade too big. you'll still end up going flat or negative, right? Oh, the equity curve will go the wrong way because of that idea of the asymmetric compounding of large drawdowns. Mm-hmm. And this can apply to any kind of trading, not just options.

That's ex exactly. That's just just risk management one on one. You know, that can apply to any kind of you know investment or trading or whatever.

Right. In this current market environment, has just in general, have you had to change your strategy or you're pretty much it doesn't matter what the market's doing. For me, because I've already sized things. In a way that I'm accepting of the potential risk. Uh again, you know backtesting is not perfect. You know, it's not to say if I pack test it and this is I'm gonna always have the exact result, right, every year moving forward. But it gives you context, right? I think.

For one, like you wouldn't necessarily trade a strategy that back test terribly, right? If if all it shows is every year it loses, like why would you trade it? Right. Now, if a back test shows that a strategy always wins. Well, that's great. You you can trade it, just take with a grain of salt, knowing that the result may differ, right? But then if you look at a strategy and you back test, you want to look at like, okay, so

On average, maybe I can make this much percent a year, but then the drawdowns are this percent, right? You're always looking at the past. Um, not just the destination of that strategy. Right. And if in and then once you kind of have a context of the potential path of that strategy. you can size it up and down accordingly based on your risk tolerance and whether or not you're kind of combining that with other strategies.

For those who don't trade options but are interested, you know, this could be a little bit overwhelming, but we all have to start somewhere. And I think In general, I think the simpler you start, the better. Start very simple. I hope that we can continue the conversation of options trading into the chat with traders community.

Thank you so much, David. I know we ran over a little bit, but this has been extremely helpful. How can listeners contact you if they have uh want to get in touch with you? Yeah. Um, so I'm on Twitter. Uh my handle is the Tradebuster, and that's actually the name of my podcast as well. So if you go to any of the typical podcast platforms. Uh you just look for the trade busters, but this is plural. So like the Ghostbusters, but the trade busters. And then my Twitter handle at the TradeBuster.

David, thank you so much for joining me today in this interview. It's really great having you. Yeah, thanks so much for the opportunity. It's it's it's been a blast. You've reached the The end of this episode of Chat with traders. But rest assured. Sure. And zero. and we'd like