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. During our time together, David Lincoln and I discuss 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 his decades of trading experience. We also dive 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.
David Lincoln's Journey
- David was a CBOE market maker for many years.
- David started out as an intern for Shearson Smith Barney where he was assisting a stockbroker in finding individuals to cold-call.
- David realized that he did not want to raise money, but wanted to work with it instead.
- Eventually, he went on to work for Merrill Lynch as a runner and then took a job with another broker matching trade tickets after the close each day.
What is a Market Maker?
- Back in the day, market makers worked under 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 and could decide how many contracts he or she wanted to do at that level.
- As a market maker, he was in charge of making a bid and ask market in every strike.
David's Journey Continued
- Moving on from the runner job, David was now in San Francisco and 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 ticket into the trader training program.
- Traders at the firm lived and breathed options trading and the gamesmanship of the trading pit.
David's Trading Strategy
- David’s primary strategy then was to sell options before earnings.
- He learned many lessons from the ups and downs of selling options before earnings. One takeaway is 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 exposure.
- With every situation and every trade, David now takes a much more mechanical approach.
VIX Trading Strategy
- The VIX is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. The VIX basically looks at the pricing of put options on the SPX.
- Most of the time, the VIX only goes between 9 and 20 and is mean-reverting. So, compared to individual stocks, a couple variables are out of the way due to most of the time the VIX being range-bound.
- With trading the VIX, if you have enough time, the trade will come back in range, which is a huge advantage in 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 downside exposure.
- So, when more people are nervous about what the market might do, that gets reflected in the put options being bid up, and thus the VIX goes up.
- VIX options are based on individual monthly futures.
- However, the futures track the VIX very poorly. So that provides another opportunity for traders.
Example: The VIX is trading 12.30 and the front-month futures contract is trading at 14, and the second-month futures contract is trading at 15.15. What we look at is the relationship between the futures and chart them on a graph called "term structure". The VIX has exchange-traded products (ETFs) that simulate the VIX that is based on the futures — VXX, UVXY, and SVXY.
Contango
- Contango refers to the fact that as you move out in time, the futures are in a state where the front-month futures contract is lower than the next month, which is lower than the next month.
- The goal and formula for the VIX ETFs, such as VXX, 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 futures contract to get to that 30-day horizon.
- Every day, if there are 30 days in a month, VIX ETFs 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 at $30 and all things are equal, if contango is 10%, it will decay $3 a month.
- If the VIX is trading at 12.30 and VXX is trading at $30, then a month from now, with a contango of 10%, VXX will be $27.
- Contango is eating away at these ETFs every day.
UVXY Trading Strategy
- When trading UVXY, 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 ETFs 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 vertical 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 trading at 8.25. You might pick the November $10 / $8 put spread. 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 reone. 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.
- Start with the worst-case scenario. 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.
