From Stocks to Options: The Truth No One Tells Systematic Traders

Are you a systematic trader who's curious about options but overwhelmed by all the moving parts and may be worried about the risk of taking a leap into option trading? In this video, I sit down with Gavin McMaster, who's the options trading expert behind Option Trading IQ. And in our discussion, we unpack exactly why the transition from stocks and other instruments to options is so difficult, why people fail, blow up their account and lose spectacularly, and what it takes to win in the options game. We're also going to explore the traps, strategies, and the mindset shifts that it takes to be successful in this really fascinating area of the trading world. So let's jump into the conversation I had with Gavin from Options Trading iq. All right, Gavin, welcome. I've been so excited about this conversation. For some of the people in my audience who haven't seen you before, can you share a little bit about what is your background, how you got into trading, why you chose options, and just give us a bit of a sense for what you're doing now?

Yeah, sure thing. Great to be here. Thanks for the opportunity and great to chat. But, yeah, started trading options in 2004. I was working in the hedge fund industry. So I worked in the hedge fund industry for about a decade. I lived over in the Cayman Islands for 10 years, which was really fun. Got pretty into the finance world over there and then started learning about options. And, yeah, started trading 2004. So I guess we go right back to the beginning. I always knew you could make money with the market going down, but I didn't really know how to do it. Like, I knew you could kind of short stocks and things like that. And then I got this little book from the Wall Street Journal, so just a thin little booklet, and it had information on stocks, bonds, mutual funds, real estate. And then there's this one little section on options. And I just read it and I'm just like, oh, my gosh, this is amazing. This is exactly what I've been looking for. It's one of those moments where you read something and you're just awake all night. Right. Your brain is just going crazy. So, yeah, started trading in 2004, started options trading IQ in 2010. So teaching other traders about options. So, yeah, it's been a long journey, 21 years. I can't sort of believe it. Makes me feel a bit old. But.

Yeah, I love those moments where the pivotal moments, you pick up that book and just captivated. What was it that captivated you?

Just everything about options, just. Yeah. The fact that you could risk a Little to make a lot. You could make money with stocks going down. And I'm just, it was just exactly what I'd been looking for at that time. It's just how do you protect yourself against the big market crash? How do you make money when stocks go down? How do you hedge? And I'm like, oh, options, this is how you do it. So yeah, it was just mind blowing when I first learned about it. This is, the Internet was pretty new back then. Like this is a long time ago, right, like, but there wasn't much information on options. Like it was all books. There was maybe a couple of websites back then on options. So it was really hard to learn. But now you've almost got the opposite problem where there's too much information, you don't know who to trust, you don't know what's real, what's, what's just marketing hype, all that sort of stuff. So it's a lot different now to learn. There's availability is there? But it's almost information overload.

Yeah, it's interesting, isn't it? Because it's still hard to learn. It's still hard to learn what I do as well, but for completely different reasons. It's just there's so much noise. And that noise is part of the reason why I wanted to speak with you because I spent a lot of time looking at different trading styles and what you do really stands out to me in the options space. So that's why in terms of interviewing someone and getting a sense for how to make this work for a systematic stock trader, you're the one that I really wanted to talk to. So we'll get into all of that in a little bit. My biggest stumbling block, if you like, is I come from a purely systematic trading perspective. Everything I do is 100% rules based. It's all back tested with decades of data and I don't make a trade without a back tested model to give me the signal. Yeah, your approach is quite different. You're using some fundamentals, you're using some discretionary technical analysis, you're using some common sense, no doubt. And you've got all of the option strategies wrapped around it. Can you compare and contrast the two approaches a little bit and maybe explain a bit about your process not in specific terms but in more general terms. How do you come up with a trade and how do you know with confidence that's the right decision?

Yeah, just through a bit of back testing as well. I mean it's definitely not as systematic as stock trading. I think getting to your point about the challenges, I think there's just so many more moving parts with options, whereas with stocks it's relatively straightforward. The stock goes up or it goes down, that's it. Whereas with options you've got the Greeks, you've got volatility, you've got delta, you've got theta, your time decay and gamma, which people don't really pay a lot of attention to, but it's important as well. So there's so many moving parts, which is probably why it is harder for someone to come from that stock trading and then get into options. It's probably a little bit harder to be systematic about it, but you can still be systematic. And we've discussed offline, there's a couple of websites where you can back test option strategies and just say, right, what does it look like over the last five years if I sold a 15, Delta, put on spy and you can back test and see how that goes. It doesn't give you the flexibility. I think with options you have to have a bit of flexibility in terms of adjusting trades when they start to move against you. There's a bit of finesse, a bit of art and science with that. And I think that's where options are different to stock trading. There has to be a little bit of discretionary decision making. I mean, personally, I know there would be people out there who use algorithms to trade options. I've never really gone down that route. I may be too much of a control freak, I guess.

I don't want to. I wouldn't just want to let the computer do its thing. I'd prefer to have a little bit of control over what's happening. And the other thing is the bid ask spread as well with options. With stocks, it's very tight, a $0.01 spread or whatever. Whereas that might be the case with Apple, Spy, Nvidia, some of the big options or big stocks. If you start getting outside of those, and particularly with Australian companies, the bid ask spread is a lot wider. And if you're trying to automate an option trademark, you can potentially get a bad fill. So that's a big challenge with automated options trading.

Yeah, I mean, there's a distinction between systematic and automatic automated trading. So the bid ask spread is actually something that, that can really trip people up because you're going from a. Like you said, you're going from a world where spreads are now really tight on the big stocks. But I've looked at some options quotes and you could drive a truck through some of the spreads.

Deal with that. When the trading cost is can be so high, how do you get over that? Or how do you make the decision about when to trade and when not to trade?

Yeah, I mean you've definitely got to look for the stocks that are very liquid. That's number one, Apple in Australia, bhp, that sort of thing. Right. So that's definitely number one. There might be a great stock that is hitting all your parameters based on your system that you've developed. But then you go and look at the option chain and it's just too wide, you have to leave it, you have to move on. So that's number one. Number two is I use what I call resting orders. So let's say I want to sell a put option and the spread is like a $20 to a $40. Right. And the midpoint is a $30. So I could go and put my order in at A$30. Maybe it gets filled straight away, maybe it doesn't. Or I could do a resting order and I'll put the order in at $1.40 and I'll just leave it resting or sitting there in the market. And then maybe during the course of the day the stock drops a little bit, the order gets filled and now I've got a 10 cent better fill than if I had just been impatient and just tried to get filled straight away. So that's definitely a strategy that will help get better fills.

So one of the big questions I get or one of the big challenges with stock trading is that when you're trading directionally, so you know we're buying stocks are going up, selling stocks that are going down, even if you're using a mean reversion strategy or whatever. These strategies don't work all the time. They come in and out of sync with the market. Strategies naturally have drawdowns, they have flat spots. And so one of the things a lot of traders struggle with is the consistency of return, particularly when they're trying to trade for a living. Trading for living is tough for a whole bunch of reasons. Right. But one of them is in order to trade stocks for a living, you need a fair bit of cash because inevitably your account ends up somewhat volatile. My perception is that a lot of people are attracted to options by the promise of smooth, consistent income from the market. What's your perspective on that? Trading for income versus trading building your account and how does options kind of play into that?

I think taking that approach of building your account is the best way to go. So for example, taking a long term approach, you can actually use options to trade. So for income, as you say, or you could use it as what I would call more of a like an enhanced investing strategy. So I'm building my portfolio, I'm increasing my dividend income. Every time I buy a stock, I'm doing a long term investing portion with some of my capital, like half of my capital, right. And then the other half I'll use for more of that trading income style. So with that investing portion, I'm selling put options on BHP for example, there's two things that can happen. BHP can either stay above the strike price of that put, the option expires worthless and I've kept that premium, or the income, right. Or BHP goes down and it goes through the put strike. I have to buy a hundred shares of BHP and then from there I can sell covered calls if I want to or I can just hold the stock, collect the dividend and that just goes into my long term bucket and I'm building my dividend income. So, so with that investing piece I'm really, I try to have the mindset that I'm happy either way. I really don't care what happens if the stock stays above I keep the premium, I'm happy. If the stock goes down, great, I get to buy a quality company. I'm increasing my yearly dividends and I'm happy either way, right. So that's the way I try to view it. And then the income side is a little bit trickier because it's. You're trying to generate that income and the market doesn't always cooperate, right. So being able to judge the market conditions and choose an appropriate option strategy for that condition. The 2008 bear market, you don't want to just be selling puts because you're going to be getting crushed as the market's going down. You're having to buy lots of shares and then your value of your shares is continuing to drop and you're selling more puts and you've got to have some hedges in place or some. We talk a lot about portfolio level Delta. So if the market does go into a bear market, I don't want to have a hundred percent positive Delta trades, right? So positive Delta means they're going to do well when stocks go up. I want to be sprinkling in some negative Delta trades as hedges that are also producing that option premium. So I'm getting two benefits I'm generating and I'm also hedging my long term portfolio and any other positive Delta positions. So that's kind of how you Handle the income side of things.

Yeah, absolutely.

I don't know if that's all that answered your question.

Yeah, I think so. And look, there's two reasons why people, I perceive people are going from stocks to options.

One is to chase that steady income, which I think we've covered. It's not always steady.

Right.

It's, you know, in stocks it's volatile and on the option side, maybe you can have a very high win rate.

Yeah.

Which makes the equity curve appear smooth until it's not.

Right.

Until you have that tail risk sort of event. So how do you, how do you think about that? What would you advise people to be aware of when they go into an option strategy that is a high win rate strategy, but there's a tail risk that is significant.

Yeah. Having those hedges in place and having periods where you try to identify when the hedges are needed and when they're not needed, that's probably going to be the biggest help. Yeah, but that's the risk everybody takes. And I think that's the key with options is trying to avoid those big drawdowns. You see these people who all they're doing is selling puts and it's great when it works and it's consistent and then all of a sudden, bang, the market has a big drop, the tariff drop, Covid, whatever, and people just get blown up. So that's what you've really got to avoid. And that's where having position sizing risk parameters in place, having hedges in place is going to help that.

Yeah. So you've mentioned hedges a few times. How do you think about and how do you use hedging on a portfolio like this? Because you use a bunch of different strategies. And it sounds like the strategies you use vary over time or at least the weighting of those strategies varies over time depending on what's happening in the market. So give us a little bit of a rundown on how you think about hedging.

Yeah, I mean, the really simple way to do it is buying put options. So on the indexes, when volatility is really low, for example, put option prices are quite cheap. So you can buy a really far out of the money put very cheaply, it's not going to impact your portfolio too much if it expires worthless, but you've got that little bit of protection. And then otherwise on the income side that I sort of mentioned, you can have those like a bear call spread, for example, where it's generating option premium, not necessarily profit. Right. Premium and profit are different, but you're Generating premium. But you're also adding some negative delta to your portfolio that are going to. They're going to do well when the stocks drop. So.

Yeah, yeah, perfect. When you say a deep out of the money put for hedge protection, how deep are we talking here? And are you doing this at the portfolio level? So looking at your overall exposures and then hedging at the portfolio level, or are you doing it strategy, kind of by strategy.

Look, the most effective way is to do it underlying by underlying strategy by strategy. But it can be too much. Right. So I would prefer to just do it at a portfolio level. Take 1 to 2% of my account size and that is how much I'm going to spend on those puts.

On the premium of those puts.

Correct? Yeah. Okay. Yeah. And then in terms of the delta or how far out of the money, a low delta. So like a 2 to 5 delta. So. Okay.

That's a long way out of the money.

Long way out of the money. Most of the time those are just going to expire worthless and you're going to lose your money from your hedge. Most of it. It's like insurance. You don't, you don't need it until you need it. Right?

Yeah, absolutely.

Your house burns down, you're glad you've got it.

Yeah, yeah. And are you buying those hedges? So you're buying them in times of low volatility? So you're buying them when you don't need them?

Yeah.

And are you buying them with a long time to expiry so that you maximize the benefit of your timing of getting in when the volatility is low?

Correct. So everything with options is a bit of a trade off. Right? Of course.

So, yeah, Everything in trading is a trade off.

Yeah, yeah. So I'll go out sort of six to nine months to buy those options.

Okay.

And then I'll get rid of them sort of halfway through their life so that you don't suffer that severe time decay Right. At the end of the options life.

Okay. And you more or less always then have a hedge on you. Just, you just kind of replace them when there's a new low volatility period at a new higher strike price if the market keeps moving up.

Yeah. Generally speaking, yeah.

Okay. All right. And 2%, you said 2% of the portfolio value is the premium that you would invest in the hedge.

Correct.

Come up with that number.

How do I come up with that number?

Yeah.

Oh, I don't know. Just did. I can't really remember the specifics. Yeah.

Does it create like Are you looking for a particular outcome or scenario? So if the market tanks 30%, 20% from where it is, your hedge is worth a certain amount to offset other gains or losses, or is it not so scientific?

Yeah, not so much in terms of the profit and loss. I'd more be looking at the Delta and how. What's my overall delta exposure? So I have. One of my risk management rules is the concept of Delta dollars, which is probably getting maybe a little bit too advanced for your.

No, this is cool. I love this.

Yeah. Okay, so Delta dollars is like your notional exposure to the direction of the market.

Perfect.

Yeah. And then you can beta weight that as well. Right. So if you've got lots of Nvidia or pltr, you've got a high beta. So your beta delta dollars is going to be higher. So that kind of tells you your notional directional exposure to the market. And I want to keep that always below one to one with my account size. So then I'm. When I'm adding, so I don't want to take leverage, basically. So then when I'm adding those hedges, I'm looking at the overall Delta dollars and making sure that's in alignment with the market exposure that I want to have at this time. So when we're in a bull market, my exposure might be 80% to 100%, like close to that account size and Delta dollars matching out.

Okay.

Whereas when we start to get a bit more volatile, I'll be dropping that down.

And then if we go into a bear market, I might even have negative delta dollars overall, like an overall bearish exposure. Potentially perfect.

Actually, this is a really great segue because it's the first time we've got it. We've mentioned leverage. And your bomb that you little. Your little value bomb that you just dropped there is that you're looking to not be leveraged. However, I would say the vast majority of people that I speak to that are looking to trade options are looking to do it because of the leverage.

Yeah.

And this leads to all sorts of dramas. I'm sure you've seen more of them in the option space than I have. Tell me a bit about that. You're obviously quite conservative with your trading, which is great. Completely in line with my approach. Talk to me about leverage and options and what people are doing wrong.

Yeah. So I'm definitely conservative. There's people who trade options much more aggressively than I do. I'm much more concerned with capital preservation than generating huge returns. I think where people go wrong is only taking one side of the market getting too much exposure. So I've seen a lot of people, they'll sell put options, but let's say the market goes down and all of those puts get assigned. They don't actually have the capital to cover those assignments. So that's one big mistake. What else? That's probably the biggest one really is just over having too many positions, not having the trading on margin, not having the cash to cover any potential assignment.

So how do you know when you've got too much exposure? Is it the Delta Dollars concept that you mentioned before? Are there. Should they be looking at the worst case scenario for every trade they've got open and making sure that has an acceptable kind of outcome if they're all hit? Should we be thinking about it both?

Yeah, so. So Delta Dollars people think it's their max loss, but it's not. It's actually just their notional exposure at that point in time. So you want to look at that for one. And then your second one is if all of these puts get assigned, how much cash is that going to cost me? And if that's more than you've got on hand, then that's a problem. I mean, you can roll and things like that so you can take extra exposure. But yeah, I'm always concerned about the worst case scenario. If all these puts get assigned, do I have the cash to buy those shares if I need to?

So are you generally writing cash covered puts like you've got all of the cash required to buy the stock if you write the put correct? Yeah, yeah, okay.

But other people will be more aggressive than that and they'll do it without having the cash and try to avoid assignment and things like that by rolling and all that stuff. And stuff.

So let's talk about rolling because again, this is not something you have to worry about in the stock world. It's. And it's always, I've always had this, I guess, concern or thought in the back of my head that in the stock world.

If a trade moves against you, it's generally ill advised to buy more of that stock to like averaging.

Averaging down.

Yeah, because you're just throwing good money after bad.

Correct.

Just take the initial loss call, exit that trade and move on. In the options world, there's a lot of these adjustments to the trades, again, which you've mentioned a few times, there's a few different ways to adjust trade. You can change the strike price, you can change the duration and so on. How much of that is legitimate.

In terms of improving your outcomes versus Just kicking the can down the road and not facing the pain.

Yeah, that's exactly the right term. But yeah, I think there's two different sides. Like if you're trading and you're averaging down, then obviously that's not good. And that's another area where people could get into a lot of problems with options is doubling down. So you've got to be very careful about that. You can increase your exposure on a position if it's moving against you. That is okay with options and that's pretty common. But you don't want to just keep adding to it. Right. You want to have a limit of I'll adjust it once and I'll add size to it and then that's it. If it keeps going against me, then I'm out. So that's one thing. If it's more on that investing side and BHP keeps dropping, I'm generally happy to just keep buying. Right. Because that's my retirement portfolio. I'm just going to keep building that out. So that's slightly different. And then when it comes to rolling, that's not really kicking the can down the road per se because you're still keeping the exposure the same. You're not actually adding to the trade. So let's say bhp is at what, 42. And I've got a put that I've sold at 42.

I could roll that out to November or December and I could even drop the strike price down to 41 and I might actually get paid some premium to make that roll. So rolling is actually really beneficial in situations like that. If you should have. Well, I would have the cash to take assignment if I wanted to. But if I want to try and delay assignment or whatever, or avoid assignment, I can actually get paid to reduce my exposure and roll that strike price down and out in time. So theoretical numbers, maybe I'd buy that initial put back for $2. At that 42 strike, I roll it out a couple of months and down to 41 and I might be able to sell that for $3.

So I've generated an extra dollar in option premium and I've reduced my potential assignment price by a dollar as well. I don't know if that makes sense. It might be easier to see visually.

Okay, cool. So it's not just delaying the inevitable. It's not just throwing good money after bad. It can legitimately improve your position as long as you do it smartly. Presumably you can also do it in a not smart way. So what would that look like? So what should you not do when it comes to rolling and adjusting the strikes and so on.

Yeah, so I guess that example I gave of rolling is simple because we're keeping our exposure the same to that, that one contract if you're rolling and then maybe adding extra contracts, that can be tricky. That's probably something you don't want to do, particularly if you're doing naked options. Because to buy 100 shares of BHP, that's 4,000. If you do two contracts, that's 8,000. If you roll out to three contracts now you're on the hook for 12,000. It's, it's building so you definitely don't want to do that. It's a little bit easier to roll and add with spreads like risk defined spreads like a bull put spread where you might only be risking $500. It's not such a big deal to roll and add an extra contract because I'm only going from 500 to 1000. Whereas those naked options or cash secured puts which have theoretically unlimited risk of the stock if it goes to zero.

Yeah, you want to avoid sort of adding to that. Unless you've got the cash on hand and you're more than happy to buy then 2, 300 shares of BHP and you've been looking to put some money to work in the market, then that's okay in my opinion. So yeah, it's all about your goals and risk tolerance and all that sort of stuff. And your strategy, is it a long term investing strategy or is it more of that trading strategy?

Yeah, makes sense. So one of the things that's fascinating about options is there's so many different strategies that you can deploy and you've mentioned a few by name. I don't want to go into details of all of those, but what I'm interested in is the learning curve to become a great options trader. And so if someone was to come in from say the systematic stock trading world and start trading options, what would you say would be a sequence of things to learn that would make rational sense, that would help keep you out of trouble, that would allow you to learn the ropes without damaging yourself or damaging your account. What would that sort of look like and how long would that take to get to a position where you're kind of comfortable and stable and so you know you'll survive?

Yeah, so definitely a few things. Being a stock trader is going to really help actually because doesn't matter what option strategy you pick, if you can't pick a good stock, it's not going to work. Right. So that's Sort of almost the fundamental thing if it's a bullish or a bearish trade, like obviously you've got neutral trades and stuff as well, but your stock or market analysis is first and foremost the most important thing. So that's a great head start that people have got already if they're successful and good at trading stocks. In terms of starting with options, I would start with the two basic strategies that I would always teach. First are the cash secured puts and covered calls. Because it's not a big step to go for someone who's familiar with owning a stock to just say, hey, take that stock and you just sell a covered call against it. It's a really simple strategy. You're generating some option premium, but you're capping your upside and that's that very simple. And then the cash secured put is kind of similar where you're selling the put. If it goes down, you buy the shares. So that's the easiest one to start with in terms of a learning perspective. And then you would want to move on to risk defined spreads. So you call vertical spreads, credit spreads and debit spreads.

Those are sorts of where the worst case scenario is absolutely defined and limited. You know exactly what it is.

Correct. So yeah, it's weird because in terms of the learning, I would start with cash secured puts and covered calls, but I wouldn't necessarily start trading those strategies.

Oh, interesting. Okay.

Yeah, because they are unlimited risk. I mean, covered calls are okay. Like if you're owning those shares anyway, you've got that risk on the downside. So maybe it's not such a big deal. But if you want to just do option strategies, I would start with, yeah, risk defined vertical spreads that you can risk $500. And if, you know World War Three breaks out, the most you're going to lose is that $500. It's not the end of the world, hopefully. Right. So let's start with that. And then obviously learning the Greeks is going to be important as well. That would be the next thing you're going to want to pick up is learning about Delta, Vega and Theta would be the sort of three main ones. And then Gamma maybe later. I wouldn't worry too much about that one. But yeah, having a good understanding of the Greeks. And I would just start with those strategies, cash puts and vertical spreads. And I'd say six months is a good window of time to. As long as you've committed to being consistent with it and really diving into those strategies and practicing six months is a good window of time to develop Enough knowledge to start to trade on a limited basis. I wouldn't dive in straight away, just that saying you don't know what you don't know, which maybe we talked about last time we chatted, but that's what could, could get you with options is you don't know what you don't know. There'll be something that comes out of the blue and you're just like, what just happened? I didn't even know that was a thing. What's happened here? So that's the thing you want to try to avoid. And that just comes with time and experience. Yeah. There's also some really cool software. Option Omega is one that we've talked about in terms of automated testing of option strategies. There's another one called Option Net Explorer, which is really good for testing single trades. It's almost like rather than back testing, it's more back trading. So you can go back, if I.

Put on this trade on that day, how would it have played out?

Yeah. And you can see it on a five minute interval of how it would play out, or daily interval. And you can just follow that trade along and okay, my trade's getting under pressure here. And then you can try an adjustment strategy and then roll forward and see how that would play out. And rather than waiting, some of these option trades will take a month to play out with live capital. Whereas if you use a back trading or back testing software like that, you could run through a trade, the 30 day trade, in five minutes. So that is something that I would really recommend. And you're not risking any capital. It doesn't matter if the trade doesn't work out. It's just a learning experience. And you're never going to learn as much as you do when you've got live capital in the market. But it will help. And certainly you're not risking any capital. You can get through a bunch of trades in a short space of time rather than waiting one month, two months, six months for these trades to progress. And you can also see how the trades perform in different environments. So you need to be able to understand what can happen to the trades when things like the tariff drop and all that sort of stuff happens. And when you're trading live, you may only get that experience once or twice a year. So that's the challenge.

Yeah, I think one of the biggest advantages in my space of the systematic stock trading and the back testing of that over many decades, because in our world we can code the rules, we've got literally decades of data for every single Stock, we can hit backtest in a couple of seconds. Literally, we have thousands of trades that these rules generated and we can really go and analyze how would that strategy have performed day by day? What were the worst days, what did they look like, what were the best days, what did they look like? And so on. I feel like one of the, really, one of the biggest drivers of success is, yeah, having a strategy that works, but being aware of what could happen with that strategy. So if and when it does happen, you can be emotionally kind of prepared for it. So I think that back trading example, where you take the options trade and you see how it plays out so that you're not waiting to experience that in real life over the next six months as the trade naturally plays out, is a really powerful way to kind of build your psychological fortitude.

Yeah, definitely. I highly recommend it. Like everyone that I talk to or coach, I really recommend getting optioned at Explorer and go back to 2008 and see how the market performed when volatility exploded and stocks were crashing and get a feel for what can happen. Yeah, for sure.

Well, I would say again, we talked about this previously before this video, but trading during 2008 was probably, for me, the best training.

Yeah.

Like I was trading in a way that I was going to survive and actually make money during that market. But seeing it for real and going through it was reassurance for me that, oh, yeah, okay, I've got this thing sorted out. I've got the long side, I've got the short side. I can. My. My system will go in and out of the market at the right time. And, oh, yeah, that's what volatility feels like. Okay. The next best thing is simulating it and really looking. But, yeah, I think there's a gap, right. There's a big gap between simulating it and feeling it.

100%. Yeah.

And that's where the danger lies.

So how do we stay out of that danger zone? Because you can simulate and go, oh, yeah, I could cope with that level of drawdown or oh, yeah, if the trade moves against me, I would just adjust it.

Yeah, it's very different when there's real money on the line.

Right. So how do you make the rational decision when the proverbial is hitting the fan? You need to adjust your position, but your emotion is up and you're stressed about the loss or the potential loss that you're facing. And you've got to make a rational decision about, do I close a trade, do I adjust the trade, what do I do? How do you kind of keep in the zone in that situation?

Yeah, just having risk parameters and a framework of decisions is important. And I think, yeah, as a. Your followers being systematic, they'd probably be really good at that and sort of saying if this level gets hit, I'm out. I think that's crucial having those delta levels or loss levels on a particular trade that once that gets hit you just get out and that's it. Yeah, you've got to have a risk management framework and position sizing it all comes into it, right?

Yeah, absolutely. I think the trick or the trap potentially is in stocks it's pretty obvious what the risk is. Right. You've got the stock price and something crazy can happen to the stock price and you can very easily calculate where your loss is going to be in that first six months. Like you said in options, you don't know what you don't know. And some crazy things can happen in terms of volatility expansion, volatility contraction, movement of an underlying more than you expect. So how do you stay safe in that initial period? What do you recommend in terms of the startup of exposure of risk you're taking so that you can learn what you don't know?

Yeah.

With risk management.

Yeah. I think not going all in with 100% of your portfolio is obviously a smart decision. So start with allocate 10% or 20% to options. I'm going to use this 20% to trade options. I'm going to leave the rest to do my systematic stock trading and I'm just going to try and enhance things with options. And starting small like that is definitely advisable. That's certainly, yeah, rule number one, I would think. And then yeah, sticking to risk defined trades, making sure that absolutely. If World War 3 starts out, what's my worst case scenario? I'll tell you a funny story from trading in 2008. I had all risk defined. Like I knew what my risk was but the market went so crazy then the spreads went so wide. On the day when Bear Stearns and Lehman whatever went bankrupt, my account, my net value of my account was showing us negative. And I'm like, like it was crazy. It was just so volatile and I'm like, and I'm sitting there thinking like no, I've got all risk defined positions. This can. I cannot lose more than I've got. I know I cannot lose more than I've got. But it was wild. It was absolutely wild.

It's like that scenario when crude oil futures go negative.

Yeah.

No, no one I Mean, honestly, no one. Someone probably thought of it, but the vast majority of people never think that was possible. It's like, no, it can't go negative. It's a physical thing. It can't be negative. But it's not about the physical thing. It's about the contract that's sits over the top of it.

Yeah, yeah. That was another crazy one, wasn't it?

And this is again, back to you don't know what you don't know. So, yeah, stick to the areas so you can have defined risk so you can stay in the game. My, my number one rule is no matter what happens, no matter how crazy the world gets, no matter what happens in the financial system, I need to be able to wake up tomorrow and continue to trade and support my family. Yeah, that's my number one rule. So I'll only do things where if something really wild happens, World War 3, massive market crash, October 87 type event, those sorts of things. If that happens, I'm okay.

Yeah, exactly.

I think the challenge is a lot of people don't realize how much risk they're taking on the options side. And so when volatility does have an extreme event in one direction or the other, then people get hurt.

Yeah, exactly. And as you sort of said earlier, you can have all the best intentions in the world of, oh, just roll the position or I'll adjust it. But when things go crazy, sometimes it's not so easy to adjust or roll that position because when the market's really volatile, those bid ask spreads just go crazy. Yeah, yeah.

So the rolling actually becomes very expensive.

Can be expensive or difficult. Yeah. Very hard to do. Yeah, yeah.

I think, I feel like one of the traps, and this is a marketing thing, right?

One of the traps is the belief that you can write premium.

Yeah.

At high levels, generate a big income and survive. Particularly writing out of the money puts with leverage. And I've come across many traders who have been generating their income, their livelihood from writing puts out of the money. And many of them have an extreme event and they blow up, lose everything because they're just taking on leverage and they don't realize the tail risk that can happen.

Yeah.

So I think, what are your thoughts?

Yeah, I think I kind of said it earlier. Premium is not profit. So you see, you see all these people on Twitter. I generated $2,000 in option premium today.

Yeah, that's easy.

Anyway, that's great.

See what happens tomorrow.

That is not a profit. That's not a profit. Until that, you either buy it back to close it out for a lower price or it expires worthless. Like generating premium is not a profit. That's probably the one thing. If people are new to options like get that in your head and never forget that sort of saying premium is not profit.

Yeah, nice.

Okay. I want to come back to a couple of things that are going to help the systematic stock trader if I can. The first one is liquidity. Spreads mark depth of market.

Yeah.

What type of options? Easy to get in and get out of to trade without just getting reamed with spreads. And I want to think about it in terms of index constituency. So like ASX 200, ASX 50, NASDAQ 100s and P 500s and P 100. Russell 3000. Talk to me about where there is sufficient liquidity to really trade options on a regular basis.

Yeah, great question because I think that's absolutely fundamental. As we sort of touched on earlier in the U.S. i'd say there's probably a hundred, maybe 150 stocks and they could. It's not actually that many. They're the only ones that I would touch anyway. Right. Others might have wider spreads and people get into. That's fine. They could be Nasdaq stocks, S P 500 or Dow stocks. It doesn't really. You can't just say, oh, the NASDAQ 100 or the S P100 or whatever. It's going to be some from each index. So I would always scan. I use barchart.com so I actually write a daily options article for them. They're awesome company and website and they have a great scanner where you can scan for option volume. So I would look for anything that has over sort of 5,000 daily contracts traded and that'll give you a list of about 150. And even from there, if you're starting out, you probably want to narrow that down to the top 30 in the US your Apple, Nvidia, Microsoft, PLTR. You could probably name the top 20 or 30 that are the most liquid in Australia. It's definitely more of a challenge. I didn't trade Australian options for a long time. My first trade was an Australian option. I had to call it in on the phone from Cayman to my comsec broker back in the day. And then I didn't trade all the options for a long time until about maybe a year and a half ago. It is definitely better than it was, but the spreads are still pretty wide and it depends a little bit on the strategy you're using. So in the US on those top stocks you can do any strategy, selling puts, vertical spreads, condors, butterflies, whatever, it doesn't really matter. Whereas in Australia the liquidity is not quite there yet for some of the multi leg strategies. So you can only really do covered calls and cash secured puts. Occasionally vertical spreads are going to be okay, but it's pretty much the top 10. I would say top 10 to 15 stocks in Australia are probably the only ones you can do options on.

Okay. And I think I get it. Can you go through the mechanics of the wider spreads and how they multiply through the multi leg strategies and the profit loss payoff of those multi leg strategies to explain why for low liquidity it's really only a single leg strategy that works.

Yeah, I mean I think you touched on it by saying it sort of multiplies that spread. The more legs that you do, the more the spread is going to just get wider and wider based on the more legs that you're trading. So if I'm doing a single leg put sale, I can probably get filled pretty close to the midpoint. If I'm doing two or three or four legs it's going to be much harder to get a good fill price and then you're behind the eight ball from day one and it just makes it much harder to be successful doing that. Yeah.

And many of the multi leg strategies are. Have a maximum profit that the strategy can achieve. Not all of them, but many of them have that.

Yeah, yeah.

Whereas if you. Well I guess if you're long the call and the price the stock goes up, then that is uncapped. But if you're selling a cash secured put, that's capped. Right. It's just the premium you take in. So what is the best strategy for less liquid underlyings if you have a directional view?

Oh, that's a good question. Less liquid underlyings. I mean, I don't like buying options.

Buy the stock.

Yeah, just buy the stock.

Yeah, you don't like buying the options. So as a general rule that's not something you do.

Yeah. Unless it's like a hedge position that we talked about earlier. Don't want to suffer from time decay. So options will decay and they can decay pretty quickly if the. So yeah, unlike stock trading, we only have to be right on the direction. With options you have to be right on the direction and the timing. So you could get the direction right, the stock might go up. But if it doesn't happen quick enough, the option has that you own that call option that you bought has decayed and then you're not Getting the benefit of that upside move in the stock because you've suffered time decay already. So yeah, much trickier to buy options. I always sort of tell people you have to be right on the direction and the timing.

Culminating all of this discussion. The one thing I really want to get to, and there might not be a great answer for this, but I have a lot of stock trading strategies, index trading strategies, so on. So like strategies that might trade a broad portfolio of stocks or strategies that might trade just one etf, like the SPY or the QS or something like that.

Say I have a directional view. Let's take the qqq. Let's say I have a directional view on that because my, one of my systems on that ETF has triggered a buy or a short.

If I wanted to express that view as an options trade rather than a direct trade in the underlying, how would I think about coming up with the best strategy to express that trade with an option instead of the underlying?

Yeah, if you've got a really strong directional view. I know I just said I don't buy options, but leap options are probably okay. So I was sort of forgetting about leap options.

Okay.

LEAP stands for something like long term equity appreciation, something like that. Right. It just made me very long dated.

Options for those long dated options.

Yeah. So most people would say 12 months. Right. So yeah, buying that long term option, I would buy in the money. So like a 70 Delta. And that's going to give you basically 70% of the move in the underlying.

For a much less, much lower capital input than buying the underlying.

Much, much lower. Yep. You are going to suffer a little bit of time decay, but not much. Because it's a long term option, the time decay is very low and very slow. And also because it's in the money, there's more intrinsic value in the option and less time value. So that's the benefit of trading that in the money call. And then you can even turn it into a positive theta or a time decay strategy by doing what's called a poor man's covered call. You might have heard of that. So yeah, you instead of buying the stock, you buy that long term call option, which is basically your stock replacement and then you sell a monthly call option against that position. So out of the money that is going to cap your upside.

Yeah.

So you may not want to do that if you have a huge directional opinion.

Depends on the strategy, right?

Yeah. But if you want to add an income piece to it, you, you could do that and sell that out of the money call. Option and then that's going to turn it into a positive time decay or positive theta trade. So you've got your directional piece which is going to be the main driver of the trade and then you're also getting a bit of time decay from those option premiums that you're selling.

Got it. Let me give you a couple of scenarios. So again, just thinking about the ETF trade because I think this is the easiest one to conceptualize, but also the liquidity is going to be there. Right. So options on the queues or SPY or something more than liquid enough for everyone to trade. Right?

Yeah. Good.

Okay. So let's say I have a mean reversion strategy. I'm going to buy the ETF in a short term panic market where the ETF has dropped suddenly over let's say three or four days and I expect a bounce and the probability of the bounce is pretty high, let's say 70%, something like this. But we're going to get out with a fairly small profit. So on average we might have 1% profit per trade, maybe 1 1/2% profit per trade if we bought the underlying in that pit in that bit of panic. And we're only going to be in the trade for a couple of days.

Yeah. Okay.

On the option side, the problem I see is that we're buying in a panic which spikes premiums.

Yeah.

And when premiums spike.

And we buy them, we're paying a lot to get in. And then over the next couple of days, as the panic subsides, what happens? Well, stock price goes up or the ETF price goes up, but volatility comes down to, premiums are also affected.

Correct? Yeah.

So is there a way to express a very short term strategy like that where we're buying in panic high IV and selling in recovery. How would you express that trade with an option strategy?

So what about just selling a put option? The volatility has gone through the roof, so you're selling that high premium. And then when the market recovers, you've got your directional exposure, which is selling a put is a bullish trade. It's a positive delta and it's also negative vega. So if the market rallies back up, volatility drops. You're benefiting there as well. And it's positive theta. So you're benefiting as the days pass from time decay as well. So I would say that's probably your best strategy.

Okay. The challenge is. Well, depends on how you do it, I guess. The challenge is the risk is much higher than what could Be much higher than just buying the ETF expecting a bounce, but your probability of success could be even higher still if you're selling it out of the money.

Yep.

So in that situation, bull market, short term panic, how far out of the money are we selling the put?

It really depends. Like I said, everything's a trade off. I like 15 Deltas. So basically that has a.

Still a long way out of the money.

It's still quite a long way out. Yep. But basically it's not perfect, but It's a roughly 85% chance that will expire worthless. So if you're more aggressive and you're more confident that the market is going to bounce, you'd go with a higher delta, 25, 35 delta? Something like that? Maybe, yeah.

Okay, nice. Good. All right. And would you do that generally as a cash secured put as well or with that situation, you would take a little more risk?

No, I'd probably still do cash secured puts in that case. Yeah.

Yeah. Okay. So. So the short term panics in a stock or ETF mean reversion strategy where you would be entering in the underlying to appreciate, to profit from the bounce. That would be a timing mechanism for selling the puts.

Yep. But again, you're up, your upside is going to be limited. So it doesn't matter how much the stock bounces. The most you can get is your profit is the premium. So that's the trade off or the downside of that strategy. I mean, you could potentially do what's called a synthetic or a risk reversal where you sell the put and you take the premium that you've received and you then buy a call option with that premium. So that would then give you that unlimited upside and the Theta and the Vega would kind of offset a little bit. So you.

Makes sense. When you sell the put and you're selling 15 Delta, the premium is relatively small. Obviously it depends on what the volatility is. Where would you be buying the call? Are you using that premium to fund a certain number of calls? Like the same number of contracts, but you just go far enough out of the money so that the one covers the other? Like what are you, how are you doing that?

Yeah, you pretty much want to do. Yeah, one covers the other. But the good thing about when there's a panic is the value of the put options go through the roof because everyone compared to the calls because everyone's buying put options because all the big funds are trying to buy protection. So the value of those puts have gone through the roof and there's less Demand for calls, because less people are buying calls. So there should be a bit of a disparity where you could maybe sell a 15 delta put that you could maybe buy, I don't know, 25 Delta call for the same price or something. So you're getting higher directional exposure from the call for the same price, relatively speaking.

Both suffer from the collapse of volatility, though. No, no, because you're selling the foot, so that benefits. But the call would suffer from the declining volatility as the market recovers. But you've got a higher delta.

Correct. And you're. Yeah, your, what we call T +0 line, or how the trade looks as of today would be very similar to stock ownership where it's sort of up and to the left so that you've got volatility exposure, you've got theta exposure, but the delta or the price of the underlying is going to be the main driver of the profit. So, yeah, I'd definitely look at that strategy if you're interested. Okay, cool.

The other scenario I wanted to throw at you is, let's say I have a strategy which holds the top five or ten strongest stocks on the Nasdaq, and it's a rotational strategy. So every week or every month, it buys the strongest stocks, as in the strongest move. And if a stock drops out of that, that, that set of the strongest stocks, you sell it and you buy the next one that pops in. This is one where I feel like, because it's a defined time frame that you're holding each position for, you're basically recycling a portfolio monthly. So you know how the trade is and you know which stocks you're going to be in for that month, and all you're doing is you're buying them and holding them, and then at the end you're just redoing the portfolio. The average profit per trade on those moves is much higher than the example we just had. So let's say 5% could be 10% could be more. Is there a neat way of expressing that with options rather than have it tying up all of the capital to buy the underlying stock?

I think that's going to be pretty tricky by the sounds of it. Yeah, I can't, off the top of my head, think of a elegant way to do that.

I mean, you can definitely tie in the time frame with a monthly option, so that's no issue. But, yeah, how you create that exposure with options. Yeah, it'd be tricky. Yeah.

Okay, so it's. I mean, it would be a strong directional view. It would Be generally a pretty liquid stock. It would generally be a well defined time frame.

My impulse is to think, oh well, let's just replicate the strategy for the exposure of the underlying by buying enough calls that are in the money but not so far in the money. That's super expensive in the money enough to get you say a 70 or 80 delta but reduce the capital requirement to run the strategy. That's kind of where I was thinking of this.

Probably the only way I can think to do it as well.

Yeah, yeah. And if you were, if let's say the trade duration was generally a month, how far out would you buy them so that you don't suffer too much from the time decay?

Yeah, good. That you're thinking about that and good.

Three months, six months or would you buy leaps six months?

I would say yeah, yeah.

Because after less than three months in the time decay is really accelerating. Right.

Starting to. Yeah, it's really that last two weeks, the last month where it really picks up and it's non linear. Right. So it'll be slow to start with and then it'll get faster. But I think six months and if you hold it for one month you're not going to suffer too much time decay at all. Particularly if it's that in the money. 70, 80 Delta. Yeah.

Yes.

It's really going to be the delta that's the big driver.

Yes, absolutely. The trade off is with liquidity because the further out you go, the less liquid they are right now. So.

Correct.

In these top 50 stocks, let's say whatever makes the list, can you really go six 12 months out and get sensible spreads?

I think so, yeah. I think you'd be fine on, on your mag seven or whatever that you're looking at, it's going to be a little bit less liquid than the monthlies or the weeklies. But yeah, I reckon you'd be able to get filled pretty well on those. Yeah, yeah.

So it's interesting in this whole conversation I'm really seeing why options traders in general stick to the indices in a lot of cases or pick the stocks they want to hold long term and do the wheel strategy or those sorts of things because beyond that it really starts to get hurt by the liquidity.

Yeah, definitely. Yeah. It's so important and it's probably maybe beginners overlook that fact. And yeah, hopefully anyone who's watching this and starting out with options know that's kind of one of the first steps is to make sure you've got good liquidity.

Yeah. I mean if you even just Think about stocks, right? If you run a back test in stocks and you ignore slippage and commission, the equity curve of your backtest, if it's a half good system, will look amazing and you just add just a little bit and all of a sudden it can be a really volatile equity curve. In options, I would say that's even more magnified because the liquidity drops away so much. I can buy a penny stock in Australia and as long as I'm careful with how I execute the trade, I can get in and get out at a price that will allow me to profit from the trend that ensues. But there's no options on that end of the market.

No, exactly. Yeah. And that's another point. A lot of low price stocks, they're not really going to work with options as well. So in Australia, things like Telstra agl, not really feasible to do options if you're only.

It's not just about. Sorry, it's not just about liquidity or market cap. It's also about stock price to some extent.

Yeah. So AGL is trading about 850 or whatever. Right. So if you want to sell an out of the money put, you might only generate 10 cents or 15 cents on that option. A lot of that, that 15 or 15 that you're generating is going to be lost in slippage and commission. So it just makes it not really worthwhile.

Yeah, makes a lot of sense. Okay, great.

All right, let's kind of, kind of land this plane, draw this to a close. What are the first steps? If someone is coming in from a systematic trading approach, they trade the underlying, they want to kind of learn options. What are the 1, 2, 3 steps they should really follow and how would you support that?

Yeah, so definitely start with cash secured puts and covered calls and not get too sucked into lots of different complicated strategies. Keep it simple. Learn two to three strategies to start with, which would be cash puts, covered calls, or the wheel and vertical spreads. Keep it really simple and then from there start to learn about the Greeks. And then step three would be back trading. So those are sort of the first three steps I would recommend.

Nice. And the number one book, someone should read the Bible, if you like, of options trading to survive and build wealth long term.

Oh, that is a tricky one. It depends how advanced you want to go. The kind of Bible is by Lawrence McMillan called Option Volatility and Pricing. But it's very heavy, it's a very hard read. So that's kind of the Bible, but I wouldn't necessarily start there.

Okay. Where would you start?

I don't know. Videos. I think videos would be easier now than reading through a heavy text.

So my advice to people is to go to your YouTube channel and just watch everything. That's generally what I say.

Thank you. Yeah, so I've got beginner videos, options 101. That's usually the place where I'd send people to start first. So watch Options 101 will explain a bit about liquidity, bid ask spreads, a little bit on the Greeks, things like that. And then I would. I've got videos on cash secured puts and the wheels and credit spreads. So you could literally go through two, three videos and you a couple of hours commitment and you'd have a pretty good, you know, base to get started.

Perfect. Yeah. And if someone wants to get in contact you with you or wants to learn more from you, what, where do they go to find out more about your work and what should they do?

Yeah, thanks. So obviously the website just optiontradingiq.com and then on YouTube and Twitter options trading IQ as well. So yeah, you can find me there. I'm happy to answer questions on social media or if you want to send me a direct email info options tradingiq.com I'm always happy to help and answer questions.

Awesome. Perfect. Okay, look, I've really enjoyed the discussion. I learned a lot. Kind of cemented a bunch of thoughts that I've had kind of floating around, which is great. One final piece of advice that you would give if you were, if you could say nothing else to someone who was fascinated by options, what one thing would you say?

I've got a few sayings. One is bad things happen in backwardation. So volatility across the option chain, it has like a curve. So generally when the market's in a bull market, short term volatility will be low and as we go further out in time it will be higher. Because with more time there's more chance that something bad can happen. When the market starts to panic, it flips. So the short term options will be really high volatility and the longer term options will be lower. And that'll sort of tell you, hey, there's something really bad happening at the moment. But we think in 30, 60, 90 days time things are going to settle down again.

Keep an eye on the, what's called the VIX term structure contango and backwardation. And when things flip into that backwardation, that's when bad things can happen. That's when you get these big volatility spikes, margin calls, things like that. So that's probably the one thing. And the Greeks, I mean, if you're a beginner, get a decent understanding of the Greeks before you get started.

Okay, good.

That's probably right.

Hey, this has been absolute pleasure. Thank you so much. I've been wanting to do this literally for years, so I'm thrilled that we finally got a chance to have a chat in public for forum. Thanks so much for taking time, Gavin. I appreciate you sharing your wisdom.

Yeah. Really appreciate you organizing the chat. It's been great to chat. And I'll have to pick your brain sometime on some of the more systematic side of stock trading and what you do. So.

Brilliant. Okay, that's all for this video. Bye for now.

See? Yeah. Thanks.

It.