OAP 147: Interview w/ Former CBOE Options Market Maker David Lincoln

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Did you ever wonder what an options market maker is thinking or how they see the markets and regular traders like us? After all, these guys are the ones that are making markets in different securities each week. So, I invited one on the podcast to ask him questions and learn more about the “other side” of the business we rarely see. On today show, I have the opportunity to interview former CBOE options market maker and volatility trader David Lincoln. During our time together we discussed everything from how he went from making $100,000 in a day to losing $300,000 in one session to the lessons retail traders like us can learn from the his decades of trading experience. We also dove deep into volatility trading and pricing structures for VXX and UVXY and the strategies you can use to profit following a rise in market volatility. This is an episode you won’t want to miss!

Key Points from Today's Show:

David Lincoln's Journey

  • Previously, David was a CBOE market maker 
  • David started out as an intern for Shearson Smith Barney where he was assisting a stock broker to find individuals to cold-call.
  • David realized that he did not want to raise money, but work with it instead.
  • Eventually, he went on to work for Merrill Lynch.

Definition of a Market Maker

  • Back in the day, market makers worked with the open outcry system exclusively.
  • This meant that you had to open your mouth to make a trade.
  • The first person with the best offer was always in control of the trade.

David's New Job

  • In his new position, David was in charge of managing 50 options positions to start with. 
  • They had to compete at mock trading in front of a blackboard to get their ticker into the trader/tradee program. 
  • Traders at the firm lived and breathed options trading.

David's Trading Strategy

  • David’s main strategy is to sell options before earnings.
  • He also believes that if things start to go against you when you are short, instead of defending yourself by buying or selling stock, slowly trade options to decrease your position.
  • With every situation and every trade, David takes a much more mechanical approach.

VIX Trading Strategy

  • The VIX is a number based on a formula of a strip of puts in the SPX.
  • The VIX takes a couple of variables out of the way.
  • Most of the time, the VIX only goes between 9 and 20 and it's mean-reverting.
  • With the VIX, if you have enough time it will come back, which is a huge advantage of trading.
  • The VIX is called the "fear indicator" because when the market forecast is not good, traders will buy put options to protect themselves from the downside. 
  • So when more people are nervous by what the market might do, that gets reflected in the put options being bid, and thus the VIX goes up.
  • There is no direct way to trade the VIX — VIX options are based on the individual futures.
  • However, the futures track the VIX very poorly so in that lies another opportunity for traders. 

Example: The VIX is trading 12.30 and the front-month future is trading 14, and the second-month future is trading 15.15. What we look at is the relationship amongst the futures and chart them on a graph called "term structure". Essentially, VIX has exchange-traded products (ETPs) that simulate the VIX that is based on the futures — VXX, UVXY, and SVXY. 


  • As you move out in time, the futures are in a state where the front month future is lower than the next month, which is lower than the next month.
  • The goal and formula for the VIX ETPs is to maintain the VIX 30 days out. 
  • The way this is achieved is by a mixture of the two front-month futures. 
  • The first day after expiration, the second future is exactly 30 days out. 
  • The next day, the future is only 29 days out so you need to mix in another farther out future to get that 30-day horizon.
  • Every day, if there are 30 days in a month, VIX ETPs take 1/30th of their cash value and roll it out to the next future. 
  • This act of rolling every day is called "rebalancing", which is really what creates drag and inefficiency.

Contango Percentage and Decay

  • The Contango Percentage is calculated by tracking the relationship between the first two futures.
  • If contango is 10%, then that represents 10% a month that it will decay.
  • Essentially, if you have a VXX that is $30 and all things are equal, if contango is 10% it will decay $3 a month. 
  • If the VIX is 12.30 now and VXX is $30, then a month from now with contango of 10%, VXX will be $27. 
  • Contango is eating away at these ETFs every day. 

UVX Trading Strategy

  • When trading UVX, the big move you are most afraid of is that it will spike to the upside.
  • This is reflected in the fact that most of these are hard to borrow stocks.
  • Even if you wanted to short shares of it, it can be very difficult to do because there isn't the stock available to short. 
  • Instead, use options.
  • First, wait for a bit of a spike to buy put spreads between 45 to 60 days out.
  • You can pick how aggressive you want to be; if you wanted a higher-risk trade you could pick selling the at-the-money strike and buying a higher strike in a put spread.

Example: UVXY is 8.25, you might pick the November 10, $8 put spread for a risk-reward. Some people will sell a call spread. If you want to be more aggressive you might go a little farther out and pick something like a January 8, $6 put spread or a January 9, $5 put spread where you're buying the higher strike and selling the lower one. This way you know that you have a defined-risk trade where you can't blow out your account in any way. 

Position Sizing

  • The biggest challenge is to remember to stay small in position, even for your best trading ideas. 
  • Maintaining a small position size is something that you have to discipline yourself on. 
  • Anything can happen in the market, so it is better to be prepared and hedge against the worst case scenario than to completely blow out your account.

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
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Option Trader Q&A

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air.

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.