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5 Lessons To Learn From This SEC Investigation

Shocking news in the option trading world has come out recently.

A well known options trader has been involved in an SEC fraud investigation.

The easiest path to take here is anger, or perhaps to mock the whole situation.

And for those skeptics, a victory lap may be in order.

Yet I'd like to take a step back and see what we can learn from this. If you have any experience in options trading, this will be crucially important to read.

Before we dive into what potentially happened, remember that this is currently an open and ongoing case. Facts and revelations may completely change by the time it is settled.

I'm taking a few guesses here and I'm also pulling from my own experiences to give you crucial lessons if you want to succeed as an options trader.

Enter the Supertrader

A few years ago, a woman from Tennessee came onto a financial show and talked about her strategy. The headline was that "Karen the Supertrader" had earned over $41 million dollars trading this strategy.

She became a kind of a cult figure in the options world, showing how this simple strategy could be used by anyone to earn significant returns in the market.

Since the SEC investigation became public, the videos have been since taken down. However I have looked into the strategy her firm used as to whether it was possible to earn those returns.

Diving Into The Strategy

The way they earn returns is to sell options and profit from the time decay.

What made Karen's technique interesting is the use of margin.

She would "stress test" her positions, figure out how much stretch the market could have, and size up so that the value at risk was her net liquidation value.

So far, nothing out of the ordinary.

The returns she got were $41 million dollars.

Now, the only way to get those returns is by taking outside money.

Which is what they did. Her fund (Hope Investments) took in something to the tune of $90 million dollars. And with that size and the kind of market environment we had from 2009-2013, it was very possible to earn those kinds of returns by selling options.

What the Strategy Looks Like

Here's an example option strategy that would be similar to what Hope Investments would put on.

Sell to open SPX Jul4 1950/2200 strangle @12.00

The risk and reward is pretty simple.

If the S&P 500 trades above 1950 and below 220 going into options expiration, then you keep the credit of $1200.

There's other considerations here like position sizing, scaling in, scaling out and so on.

spx-strangle

This is a "high odds" trade, meaning that you should expect to make money most of the time.

The tricky part is how you manage the trade when it goes wrong.

Where it Turns South

From reading the SEC investigation, it appears that things started to fall apart around the end of 2014.

That makes sense. A lot of option sellers got smoked then.

spx

In case you don't remember the backdrop of this trade...

The ebola scare had started to take hold of the markets. The S&P sold of from 2,000 to 1,825 over the course of a few weeks. It got ugly out there.

That's probably not where things fell apart. It was on the rebound.

After the capitulation in October, the market rallied back to 2,000 just as fast.

And then it continued to squeeze.

Overeager option shorts started selling calls way too early. And too many people got short.

It setup the case for a massive short squeeze.

This happens a lot more than you think. A recent example is March of 2016, where Goldman Sachs put out a note that calls were way too cheap. The S&P rallied another 100 points since that call.

So in late 2014, coming into obvious resistance everyone sold calls too early. And call sellers got ran over.

When you are a net seller of options, the biggest risk is not to the downside... it's to the upside. It's much harder to manage a losing income trade to the upside.

So that's my guess here. They were doing fine, but then sold too many calls in size and got runover on the Ebola trade.

This in and of itself wouldn't be a problem with the SEC.

It's that they got greedy.

Bad Incentives

Once I read how they took a performance fee, I knew that it was the main reason why the SEC went after them.

A normal fund structure is "2 and 20." That means you take 2% of the total assets for overhead and you also get to keep 20% of any gains.

The fee structure for Hope Investments was 20% of realized gains...

Every single month.

When you sell options every single month, you can plan for that cash flow (until things go bad).

If you're trading your own accounts... not a huge deal.

But if you're trading serious size... man you can pull out a massive amount of cash every single month.

Yet if things go wrong, you can end up in a serious drawdown.

One way to manage those losses is to roll the bad options further out in time. You get stuck in the trade for another month, but it allows you to work your basis down in the position.

It's not a terrible strategy.

But when you tell your investors you "realized profits" on that roll... that's where you can screw up.

The monthly performance fee can set you up to be tempted in ways unimaginable when you trade your own accounts.

Consider this scenario...

You get smoked on a bad trade, and it may take 6 months to work back those losses.

That means you won't get that monthly performance paycheck for quite a while. The well has dried up.

But if you just do some fancy accounting, that gravy train can keep going... a very significant amount of money.

What would you do in that situation?

Would you have plenty of integrity and own up to your investors that you screwed up?

Sure it's easy to say sitting behind a keyboard...

Yet the incentive structure makes it an even harder decision to make.

They See Me Rolling...

When you get into a massive drawdown as an option seller, you can get stuck into the rolling trap.

You try and figure out some fancy options technique to get you back to breakeven, even if it takes you months to do.

I've been there. It sucks.

You may get you capital back, but you end up with a massive depletion of your psychological capital.

My guess here is that this is what happened with their fund, and they couldn't keep the numbers game going.

The Major Takeaways

I could go into a lot more detail about this case, but since it's ongoing I don't want to try and speculate too much on this.

Yet I think we have enough to get the lessons we need.

Lesson 1: Protect Your Capital

In terms of capital, I'm not talking about money.

I'm talking about psychological capital.

There are trades you can put on that are losers.

And sure... you can find a way to get it back to breakeven.

You can roll the trade, you can oversell spreads, you can convert a trade into an even more complex option strategy.

Yet there are some times you just need to take the loss and put your capital to more productive trades.

If you try and stick in this trade, you'll end up with blinders. You'll be so focused on working a bad trade to breakeven that you'll miss out on all the other opportunities in the market.

Lesson 2: Don't Blindly Use Odds in Your Trading

This is going to fly in the face of many other "gurus" out there, but I believe that using odds alone for your trading strategy can lead to disaster.

Say you sell an option. Let's say an AAPL Jul 90 put option.

Immediately, you psychologicall anchor onto that level.

And you start to say to yourself...

"There's no way AAPL can break 90."

It doesn't matter your religion, you must understand that the Market Gods exist.

And when you utter that sentence and send it to the universe...

The Market Gods hear.

And they reply:

"Oh yeah? We'll see about that."

At some point you're gonna get smoked on a trade.

How you manage that bad trade will dictate whether you will be successful at this game or not.

Lesson 3: Learn To Manage Risk

Here's the thing... I'm not saying that selling options straight up is a bad strategy.

In fact, I think the strategy they use at Hope Investments is incredibly lucrative and profitable in the long run...

... if you know how to properly cut your risk.

Blindly expecting the odds to eventually be in your favor is bad voodoo. The Market Gods will come after you.

The major risk in selling options is how your directional exposure (delta) can increase as the position moves against you.

Knowing how to manage that delta is half art half science.

But you have to do something.

You can use delta band trading, hedging with futures, buying options, buying complex spreads.

Will it cut into your returns? Of course. It's the cost of doing business.

But you still have to do it. Because once you get stuck into thinking "oh it'll come back..."

The Market Gods will hear.

Lesson 4: Don't Be A Dumbass Accountant

Take a scenario...

Say you sell an SPY 200 put option for .80.

And the market tanks.

So you buy back that put option at 1.20 and then sell another put option further out in time for 1.60.

Did you make money?

No, you didn't.

You have a loss of .40 from the closed option and no p/l from the new contract.

Stop deluding yourself.

If you roll options, treat it as a single position and track your basis on a mark to market pricing.

I've had people who have shown me trades where they got blown out on some put sales with massive losses... and it took them 9 months to get back to any kind of profit.

And they believe that they made money every single month through some BS accounting.

Don't lie to yourself, and especially don't lie to any of your investors.

Lesson 5: Limit Your Risk

I think selling options naked have a time and a place.

Yet if you're looking to create consistent, sustainable income from options while keeping risks low, then you should look to other trading strategies.

My favorite is iron condors. They are simple to manage and easy to understand.

The way we trade iron condors at IWO is a little different... we are much more aggressive in our risk management as we don't want to tempt the market gods.

If you want to learn all about iron condor trading, click here for your free iron condor toolkit.

A Continuation Pattern in IBM

After forming an island bottom back at the beginning of the year, IBM shot off like a rocket, running from 120 to 150.

It has since worked off its overbought condition and looks ready for another move higher.

Watch this video to see my technical take on the stock as well as an option trading strategy to consider.

3 Trading Outcomes for Apple This Summer

how-do-you-like-them-applesWhile the broad based indexes are spitting distance from new all time highs...

Things have not been as good in Apple land.

If you need to "blame" something, well you've got a long list.

Introduction of new competitors.

Poor iWatch sales.

Squeezing margins.

Whatever the case is, the big gap down that the stock saw after its earnings has probably priced in a lot of the bad news.

Yet, you can't just say the market is being completely efficient here.

If you can read the psychology of the market, then you can get a better edge in the stock.

AAPL Is Not A "Stock"

This may seem like a nonsensical idea, but AAPL really isn't a stock anymore.

(At least, you shouldn't treat it like one)

Sure, it represents the underlying shares of a company...

But that's not why many people trade it.

Think about it:

This is the most heavily traded, liquid stock in the world.

It's liquidity rivals many other broad-based markets.

In fact, we can go so far to even call it a mini-index!

AAPL has more in common with gold futures than it does other stocks.

It's more a source of liquidity and a store of value.

Think about it, if you're a fund manager that has a mandate to be invested 95% in stocks...

Meaning you can't hold a cash position...

You can't just park it in anything.

If you want to get in and out of an asset quickly, you don't want to have a bunch of slippage.

So what do you do?

You park it in AAPL... not just because you think the company is good (well, you still think it's good), but also you can sell your shares quickly without dumping the stock.

At some point the company matters... and we see that when the stock gaps around on earnings.

Have I convinced you a little bit?

This matters because the way you trade indexes and commodities is a little different than how you trade individual stocks.

Higher liquidity leads to more mean-reversion.

With that in mind...

A Look At The Chart

aapl

This is a weekly chart of AAPL.

If you could put this chart into a single word or phrase, what would it be?

Optimism? Sure doesn't look like it?

Panic? I don't think so.

When I look at this chart I see "impatience."

This impatience stems from a few areas.

First, we have the true believers in the company. They're invested for the long run and they actually care about the fundamentals.

Well, up to a point. Because if you aren't making money from it, the mood can easily sour.

Those fundamental investors are looking at a nasty gap down on earnings due to disappointing numbers.

And all those people who say they hate technical analysis... they're lying because they've got this exact chart pulled up, watching this level at 93.

The second group are the "liquidity" crowd, who use AAPL as a trading instrument and a way to "store value."

(In fact, I think AAPL and gold have a lot in common. Strong opinions held both in the bull and bear sides, and both assets only trend maybe twice a year. Food for thought...)

This liquidity crowd is growing impatient because AAPL stopped going higher.

I know it sounds stupid simple, but if you're parking your money in an asset, you'd like to see that asset rise.

And when stocks go down, liquidity tends to dry up.

I think the past few months has been an unwind of those who have used AAPL as a trading vehicle.

There's probably another few "profiles" we could build out in terms of who is playing the stock, but no matter what...

Everyone is looking at the 93 support level.

And what happens when everyone looks at the same level?

That's where I get my trade ideas from.

The 3 Trades to Consider

The first trade possibility is the failed breakdown.

aapl1

Because everyone is looking at this support level, it will have a higher initial failure rate.

Think about it...

If you're scared about a breakdown in AAPL, odds are you've already sold. You're not waiting for the actual break.

What ends up happening is the breakdown has no followthrough at all. Once investors and traders start seeing that in the tape, they pile on top of one another to reenter at a "better" price. This takes us back to 93 and probably a swift move to 100.

The second scenario is the all clear fade.

aapl2

In this case, the 93 level holds and we start to head higher.

The sentiment quickly shifts and the earnings gap gets faded. Complacency hits and we head back above 100, which is a big psychological level in and of itself.

If we bounce hard here, there will be a good shorting opportunity into that 100 level.

The third is what I would call a dip buy failure.

aapl2

If we get a clean break under 93 with proper followthrough, we'll find a point where all energy has been spent in the short term.

The first "dip buyers" will come in here, and hope for a bounce.

Odds are the first dip won't be the final move.

We'll need to wait for those dip buyers to get stopped out.

Into that stop out will be a great long term entry point on AAPL. I'd look at selling puts or doing a covered strangle.

It's Like Poker

The way to truly be successful at poker is understanding the motivations of the other players at the table.

The same holds true for stock trading.

Everyone has the same data.

Everyone has the same charts.

The way you win is taking it one step further and learn the motivations of the other participants. From there you can get better reward to the risk you take and build wealth over the long term.

What You Should Do While You Are Waiting For A Market Crash

Here's Where We Sit:

spx

Since the low in 2009, the markets are nearly a triple.

And to be honest...

We've gone nowhere for well over a year.

(With two pretty big corrections in between.)

What's more...

It's been years since we've seen a cyclical bear market.

And it's been years since we've seen a proper recession.

The risks out of China, high yield debt markets, and what the Fed will do next... these are all potential catalysts that could bring further weakness into the markets.

I have a question for you:

Are you truly prepared for what will happen next?

It's not just about expecting downside... are you OK with missing out on any potential returns if you're wrong?

Why It's Amazing To Be A Retail Investor

The beauty of all this is... you don't have any mandate that says you have to own stocks.

Or that you have to own 100% stocks.

And it's not even an all or nothing play. You can easily scale out of some investments and still have skin in the game.

The Catch-22

The biggest risk that permabears rarely talk about is the missed opportunity cost.

Think about all the ugly catalysts we've seen since 2009...

the debt ceiling...

the Eurozone falling apart...

the other shoe to drop in commercial real estate...

It's always going to look ugly out there.

Yet if you've been on the sidelines this whole time, you've missed out on massive upside in the markets, along with returns coming from any dividends that you take in.

The Passive Way to Fix This

As I said before, nobody is forcing you to be 100% invested in stocks.

Let me take an example...

I ran a study a while back that showed the performance of a 60/40 portfolio.

60% S&P 500

40% TLT (long term bonds)

With rebalancing done at regular intervals.

It's not a super optimized portfolio, yet what I found was that after the market crash in 2008...

It was back at its "high water mark" in only 9 months.

Diversification really works.

A No Yield Market

The problem that I'm seeing right now is the inability to find good risk-adjusted returns.

Because treasury yields are so low, it's difficult to get any kind of decent return without being forced into riskier trades.

Yet there's another way...

Potentially a more profitable way...

To keep getting returns while keeping your risk low.

A New Path

There's an asset class that is becoming increasingly popular...

Volatility.

By trading in this asset class, you can potentially get much larger returns than you would in the market without having a ton of risk involved.

I'd like to show you a simple volatility trading strategy known as an iron condor:

This trade makes money if volatility is overpriced in the market.

(And 80% of the time, it is!)

The best part about this trading strategy?

You're only in the market for a month or two at most.

Which means you can get in and out without having to worry about the next market collapse around the corner!

How nice would that be?

How to Get Started With Iron Condor Trading

Iron condors are a complex option spread.

At first it can be overwhelming if you don't know what you're doing.

Wouldn't it be nice if you knew exactly...

- when to enter a trade?

- what option strikes to use?

- exactly how to adjust the trade?

- when to exit for profits?

At IWO, we've worked with thousands of traders on their path to successfuly trading options.

With working closely with clients, we know how difficult it can be starting up.

Because of this, we've launched the IncomeLab, our brand new iron condor trading service.

With this service, you'll get iron condor trading alerts that show you exactly when to enter and exit the trades.

We did a "stealth launch" in 2015, and here's how we did:

returns

Up 60%, not bad.

Get Started for $1

As an introductory offer and to get you trading iron condors as soon as possible...

We've created a "bootstrap" deal.

The membership for IncomeLab is $99 per month.

Yet we know the concern you must have when sending that kind of money out.

With this deal, you only pay $1 for the first month.

That way, we can prove the service and you can potentially reinvest just a small amount of your returns into the cost of the service.

Deal?

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