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When I first began as a floor trader my capital account was quite small relative to private trading firms, and especially the well-known brokerage firms who traded their firms' capital rather aggressively by my standards of risk. Being a market maker I either had to trade against and/or facilitate their trades should they place an options market order with any of the five primary stocks traded in my pit. Market makers must do just that, i.e., make markets for their own risk/reward.
This market making process took about a N.Y. minute for me to realize that if I was going to succeed in the pit I had better be able to manage my capital, if for no other reason than to do my job of facilitating my options bids and offers. Doing so in a profitable manner quickly advanced in my mind as being my top priority. However, just above that priority of my critical path to market maker survival was that I had to be adept and profitable enough to maneuver my limited capital. Thus, I had to stay within the discipline and strategic plan of attack that I had so carefully designed prior to taking this rather huge life-changing move from being a cushy-chaired investment advisor to a registered options market maker. The plan was built on the following list of personal rules, listed by most important at the top of this list:
1) Keep risk 100% controlled. All positions were to be completely hedged at all times. Thus only positive gamma for each position was the rule. This rule applied to each position, and thus was not to be considered as a portfolio rule. Positions were not to be considered as commingled as per the total gamma of all positions. In other words, one stock or option position with negative gamma which went the wrong way in price (opposite of that negative gamma) was not going to be allowed to seriously blow up my capital.
2) Capital was to be divided into two equal parts, half being dedicated to long stock positions and half being dedicated to short stock positions. Thus, the capital generated by the short sales would be used to literally capitalize the purchase of the long stock side of the balanced portfolio. Years later I would hear or read of various types of funds that would embrace this strategy. For me, that was a quiet compliment.
3) Total positions were to be right, four from the long side and four from the short side. Thus not only was my strategic plan going to be capital neutral, it was also going to be market neutral. Years later I would also hear or read of various types of funds who embraced this strategy. Once again, that was a quiet compliment.
4) Long stock positions were to be hedged with long, at-the-money puts. Short stock positions were to be hedged with long, at-the-money calls.
5) Which expirations to use for those put and call hedges were to be totally based literally on my feel for the volatilities of the options for each stock. The goal of course would be to buy the premium as close to their cyclical volatility nadir as possible.
6) The cycle of volatility of any underlying stock's options was to be considered secondary to the volatility cycle of the underlying stock. This one rule was the catalyst for my pursuit to find a way to chart a stock's volatility, that quest eventually culminated into becoming my coiling pattern.
7) The puts or calls were always bought before the underlying stock was purchased or shorted. Plenty of times merely getting a short sale executed was a precarious undertaking due to the SEC uptick rule at the time! That element of risk is not a consideration today much to the delight of the high frequency traders who know the fact that trading profits are made much quicker from the short side than the long side. That alone should explain why I cynically refer to these trading firms as the high frequency sellers (as in short sellers).
8) The long stock, long at-the-money put combination is a synthetic call which literally is two-thirds of the combination known as a conversion. The short stock, long at-the-money call combination is a synthetic put which literally is two-thirds of the combination known as the reversal (or conversion reversal). Thus to lock in the synthetic call gain if attained I would sell short the reciprocal at the money call, that call having the same strike price and expiration as the long put that was married to the long stock combination. To lock in the synthetic put gain if attained, I would sell short the reciprocal at the money put. That shorted put was to be of the same strike price and expiration as the long call that was the locked-in hedge for the stock that had been sold short.
9) Profits were taken, positioned either closed or morphed into riskless conversions or reversals, once the unrealized profit reached the 25% level (relative to the actual put's or call's value at the inception of each trading position).
Once a conversion or reversal is executed, the risk to the market maker and his clearing firm is basically 0% as far as monetary risk is concerned because a conversion or reversal at expiration is simply closed out, the stock being out- or in-the-money at expiration. Thus, the options long or short, relative to the stock being long or short, simply expire into stock and cash which would at expiration balance into a dollar-zeroed position. In addition, clearing firms can margin a long synthetic call or a long synthetic put as they would margin the actual call or put respectively (relative to cash they would require to hold the position).
Part two, to be published tomorrow, will focus on the specifics of the portfolio selected. This portfolio will employ the totally hedged market/capital neutral strategy discussed above.
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