Trading Ideas: Matter of EdgeST
One thing that a lot of students falter with during interviews is the trading idea. Im writing this post to help some of the monkeys currently preparing for interviews realize that what they are spewing out as trading ideas are instead sales pitches, and they should be presenting a trading plan to the interviewer instead. This will put you miles ahead of other candidates interviewing and show a bit of understanding of what it means to be a successful trader.
Trading is about edge, you need to have a statistical edge to make money over a longer stretch, otherwise you are gambling. Many students think they understand this but then go and applaud someone like Paulson or Lippman who put billions of dollars on the line on one idea. This type of balls to the wall isn't trading, but rather an all or nothing bet.
A feeling isn't an edge, a lot of the trade ideas that are sort of talked about on this site are based on the idea of some sort of absolute determination.
Philosophical rant over, when you are constructing your idea, make sure to be able to answer the following questions:
1)What is the edge on this trade? Why do you expect to make money?
Let's say company X earnings are being priced in at a 4% move (ie options have an implied vol that is pricing a vol of this magnitude). You look back and find that never has the stock of this company moved more than 2% post earnings, and there aren't any different factors now then other earnings. Therefore going short vol presents a simple form of edge. Now it is true that you are using historical information and extrapolating, but it is much better than telling the interviewer simply that:
"I think the earnings move priced into the options market is too rich"
2) What is your stop loss on this trade and why?
At what point do you get out of the trade? Let's say you went short gamma in the above example, and the stock starts to move heavily as the earnings announcement is moving closer, more than the implied vol you sold gamma at, what point do you decide to get out? (Its a bit simpler with straight stock compared to options because you only have price to look at in terms of a stop, whereas with options you can lose money in many more ways and therefore have to think about various scenarios).
When an interviewer asks this question go through a scenario analysis of situations that could make you lose money and then explain what you would do.
3) How do you get out of the position if it goes against you?
Do you get rid of all at once, in 2 or 3 stages or in small steps? Your answer should be about amount of liquidity, market conditions (ie whether your trade hypothesis has changed or not)
4) How long do you expect to hold the trade on for?
What you went long a stock because you have studied this stock and found that the probability of it being acquired is high, how long until you reverse this hypothesis? Note that holding time does not have to be in terms of days/months, but also in terms of relevant market conditions.
5) What are your main risks?
You want to think about a scenario analysis of possible situations that can make you lose money. Of course you cannot prepare for everything that can happen, but some prep is better than none. Let's say a stock is going to announce a drug test result and you see the following vol schedule (the drug announcement is at the begining of September and it is currently May):
June: 20% vol
September: 18% vol
December: 22% vol
You think the 18 vol is cheap and it should rise to at least 30% leading up to the event (or you think the event will be a large realized move in which case you are planning on making money on gamma, but we will stick with vega and implied vol in this example).
You might think about going short the June vol at 20 to fund the long vol position in the Sep contract to reduce the risk of losing money leading up to the announcement if nothing happens throughout June.
There might also be a strong correlation between vol of the stock and the S&P Index for example. If the drug announcement goes through this will affect the stock's vol but have a muted effect on the index vol, but you only expect the stock vol to drop if the index vol drops as well. In this case going short index vol as a hedge might be a good idea. The event in this case presents a case of a correlation break, and you want to take advantage of these.
Sorry for the long post but I think that these are important things missing from a lot of students trade ideas, and if you do incorporate some of these things you will have a much easier time standing out. I probably missed some things and if anything pops into my head I will add to it.