Dennis A. Chen - The Option Traders Hedge Fund: A Business Framework for Trading Equity and Index Options

The Option Traders Hedge Fund

A Business Framework for Trading Equity and Index Options

Dennis A. Chen
Mark Sebastian

Vice President, Publisher: Tim Moore
Associate Publisher and Director of Marketing: Amy Neidlinger
Executive Editor: Jim Boyd
Editorial Assistant: Pamela Boland
Operations Manager: Jodi Kemper
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Cover Designer: Chuti Prasertsith
Managing Editor: Kristy Hart
Project Editor: Betsy Harris
Copy Editor: Cheri Clark
Proofreader: Debbie Williams
Indexer: Larry Sweazy
Senior Compositor: Gloria Schurick
Manufacturing Buyer: Dan Uhrig

2012 by Dennis A. Chen and Mark Sebastian

Published by Pearson Education, Inc.
Publishing as FT Press
Upper Saddle River, New Jersey 07458

This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book.

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All rights reserved. No part of this book may be reproduced, in any form or by any means, without
permission in writing from the publisher.

Printed in the United States of America

First Printing May 2012

ISBN-10: 0-13-282340-3
ISBN-13: 978-0-13-282340-1

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Library of Congress Cataloging-in-Publication Data

Chen, Dennis A. (Dennis Anthony), 1970
The option traders hedge fund : a business framework for trading equity and index options / Dennis
A. Chen, Mark Sebastian.
p. cm.
Includes index.
ISBN 978-0-13-282340-1 (hardcover : alk. paper) -- ISBN 0-13-282340-3
1. Options (Finance) 2. Portfolio management. 3. Risk management. I. Sebastian, Mark, 1978- II.
Title.
HG6024.A3C4852 2012
332.64524--dc23
2012007222

For Melinda,
Thank you for encouraging me and standing by me
in all of our endeavors. For my partners at Smart Income Partners, Ltd.,
Thank you for your trust and support. Thank you for believing and
investing in our business. Dennis To Lauren, thank you for putting up with me through thick and thin;
without you all of this is nothing. To my parents, thank you for pushing me to constantly try to exceed
expectations and never settle. To my son, may the road that lies ahead be all you could hope for. To my partner, co-workers, and all of those associated with Option Pit,
thank you for making what I do not seem like work. Mark

Contents

Foreword

As Director of Research and Co-Portfolio Manager of Jim Cramers Charitable Trust, I continuously look for more effective ways to oversee the fund and improve returns. Although it is a long-only equity fund, it is imperative to have a working knowledge of all asset classes and their effects on the broader market and trading psychology. One of the most impactful metrics of managing money in todays market is, without question, volatility.

Volatility as an asset class is a rapidly growing concept in the marketplace. Indexes and products have been introduced to trade, hedge, and use as forecasting mechanisms.

Financial media commonly portrays the VIX, or CBOE Volatility Index, as an indication of fear in the market. Typically, when the VIX is trading higher, stocks are moving lower and the inverse applies. Yet it is far more important than that, as the VIX and volatility-based products have brought the market to its next stage of evolution.

The Chicago Board Options Exchange began its academic work on the VIX in the early 1990s. Todays index has evolved into a product with futures and options contracts based on the S&P 500, which allows for a more accurate view of investors expectations on future market volatility. Following the financial meltdown in the back half of 2008, implied volatility exploded as the market imploded, and that is when market participants embraced volatility as a diversification tool. Other exchanges have now developed their own futures and derivatives products across multiple asset classes and commodities, including currency, gold, and oil.

Mark Sebastian is truly a master of trading options and futures on volatility derivatives. When it comes to the technical subtleties of complicated markets, his analysis and ability to break down the mathematical and quantitative complexities in an intelligent and understandable style is second to none. Mark forces you to think in different ways about the option and futures markets, often in ways that are outside the comfort zone.

For this book, Mark joined forces with his friend Dennis Chen and convinced him to share the framework and processes used when managing his hedge fund. By doing so, they provide you with a real-world perspective to the business of trading options.

Albert Einstein said, Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of geniusand a lot of courageto move in the opposite direction. Mark and Denniss uncanny way to consistently come up with out-of-the-box strategies encourages traders to dig deep and really understand the world of derivative-based products. From my perspective, Mark and Denniss ideas, strategies, framework, and concepts are sophisticated yet easy to understand and implement, which is invaluable when trying to beat the competition and the broader averages.

The Options Traders Hedge Fund is a unique tool that carefully explains how traders can effectively identify and manage positions like the top volatility experts do using key strategies in trend, time, and volatility. As unique as its authors, it encourages investors to embrace their individuality when developing a trading plan and discipline for trading options.

A captivating and masterful read, The Options Traders Hedge Fund is a must-have guide that every professional trader should have in his or her library. The biggest takeaways center on methodology, risk control, and effective use of capitalthe cornerstones for successful money management and trading.

Trade well,

Stephanie Link
Director of Research, Co-Portfolio Manager, & VP of Strategy
The Street

Acknowledgments

This book is the result of a set of experiences that we have collected over the years. Whether knowingly or unknowingly, many people and organizations have directly and indirectly helped shape the content of The Option Traders Hedge Fund . We would like to thank the following people and organizations for sharing with us experiences that helped create this book:

Adam Paris, Cofounder of the OptionPit.comAlexander Elder, Trading Coach and author of Trading for a Living Jim Boyd, Executive Editor, FT PressCheri Clark, Copy Editor, FT PressBetsy Harris, Project Editor, FT PressHarry Strachan, Partner at Bain & Co. and Mesoamerica PartnersJeremy Siegel, Finance Professor at the Wharton School and author of Stocks for the Long Run Kerry Lovvorn, Trading CoachLivevolOptionVuePaul Hayward, Michael Shore, Nina Yoo, and the CME Groups Corportate Communications teamRobbie Garcia, Cofounder, Smart Income Partners, Ltd.Robert Walberg, Stephanie Link, Jill Malandrino, and The StreetShawn and Shelly Howton, Professors at VillanovaThe Chicago Mercantile ExchangeThe Chicago Board Options ExchangeThe Options InstituteThe team at FT Press who assisted in the production of this bookTD Ameritrade and ThinkorSwimNext page