just ticks. If you have a position
on, however, these ticks take on a life and meaning of their own. They
validate you, or they diminish you. That is not how you want to trade. That
is not an ideal mindset.
FOCUS AND ATTRACT
What we focus on is what we attract. I believe in that, so it is true for me.
The fear we experience causes us to focus on the object of our fear so that
we end up creating the very experience we’re trying to avoid.
I want to give you a simple example of the mind seeking information as a
result of what your focus is on. You bought yourself a new car. It is a yellow
Volkswagen Beetle. As you drive your new car, you begin to notice other
Volkswagen Beetles. You never did that before. Your mind has opened a
filter, allowing information about Beetles into your consciousness.
What we focus on is what we attract. The trader who has a position on in
the market will focus on the price movements (the ticks) that move in his or
her favour because they relieve pain and give pleasure. Movements against
the position create pain.
You might be thinking I am stating the obvious. You are right. My point
was not to state the obvious, but to point out that this state of mind is not
open to other possibilities. The more fear we experience, the less
information the mind will focus on. It will narrow its focus. It will stop you
from perceiving alternative options.
I run a live trading channel, where I trade in real time. When I trade
publicly, one type of scenario I am most proud of is that in which I accept I
have misread the market, and I change my position. For example, I may
have pushed the short side on the Dow Jones Index, and the market is
moving against me. I accept I am wrong. I close my position. I open a trade
in the opposite direction.
It requires a tremendous amount of self-belief to do this when you are
trading big size. What helps me in situations of this type is to recite a
mantra I have created: “Focus on the process. Focus on what you can
control.” I have developed a belief system that allows me to encourage this
kind of flexibility.
This kind of mindset is possible for you too. When I set out, I wanted to
create a mindset that allowed me to perceive information without fear. That
is the ideal mindset. It takes time to create it, but your rewards are directly
correlated to your effort. Don’t expect a eureka moment. Expect to get
better and better gradually.
BELIEFS
Our beliefs determine how we react to information. We were born with a
clean slate, and our beliefs are taught and adopted. We were taught what to
think. We also had experiences that shaped our beliefs.
I will get personal for a second. I felt my mother and father abandoned me
at a young age. They divorced and I became the object of their fighting. I
see now how that shaped my beliefs, which in turn influenced my choices
in life and the decisions I made. The moment I was old enough to take
charge of my own destiny, I saved up as much money as I could so that I
could say goodbye to that toxic environment and leave my home country.
How does this relate to trading? Trading gives us unlimited potential to
express ourselves. We can open a trading account, and away we go. You are
your own boss. There are no rules. There are no limits. Do what you want.
You are no longer influenced or guided by your parents. The world is your
oyster. You have total freedom to do what you want to do, when you want
to do it.
We tend not to want to operate under rules. After all, much of our young
adulthood is spent rebelling against parents giving us rules. Trading is a
rule-free environment. Unfortunately, the result is quite astounding. Traders
have free will, and 90% of them will have a belief system that leads them to
failure.
In order to prosper in trading, we need a combination of being able to
operate under trading rules while not feeling we are being held back,
because ultimately, we want to experience total freedom. Essentially, what
it boils down to is creating a mindset that always acts in your own best
interest. It is a mindset that allows you to see opportunities. It knows your
weaknesses and what to be mindful of. It allows you to receive information
without being threatened by the information.
You can operate from a carefree state of mind. I have created a blueprint for
a carefree trading mind. I have changed my beliefs about trading. That is
the message at the heart of this book – to change how we think, especially
how we think about losing. It is to explain my mindset and teach you the
mindset.
The old way of thinking is still there. It will always be there. It is part of
your personality. But the old belief has no charge anymore. It is faded,
diffused. Just because you have said goodbye to an old belief does not mean
it isn’t still in your memory.
I will give you a childish example. We used to believe in Santa Claus. We
used to believe if we were good, he would come and visit us to leave us
presents. Does it bother you that he is not real? Of course not. You have
diffused the emotional charge of being deceived. Your life is no worse off. I
have the same sentiment about my old trading beliefs. I am not missing out.
I am thriving on a new mindset. I used to think I couldn’t live without a
cigarette after a meal. Now I can’t imagine a life where I stick a cigarette in
my mouth. I eat every day, and I never have an urge to smoke. Once I could
not imagine a life without a smoke. Now I can’t believe I was ever hooked
on it. It took me a little more than a week to re-program my mind. The same
will happen to you as you apply my blueprint for the ideal trading mindset.
My biggest belief I had to overcome in trading was the associations I made
when I was confronted with losses. I had to learn how to disassociate losses
from feelings of failure or feelings of wanting to extract revenge on the
market to create a state of mental equilibrium. Achieving that was a
momentous leap for my trading performance.
THE BOOK OF TRUTHS
I want


rint for the ideal trading mindset.
My biggest belief I had to overcome in trading was the associations I made
when I was confronted with losses. I had to learn how to disassociate losses
from feelings of failure or feelings of wanting to extract revenge on the
market to create a state of mental equilibrium. Achieving that was a
momentous leap for my trading performance.
THE BOOK OF TRUTHS
I want to move the narrative towards the practical element of creating the
right mindset. You can only dance around the fire for so long. Let’s get
down to brass tacks. Let’s get specific.
I once saw a sign that said, “The best views come after the hardest climbs.”
Proverbs have a way of simplifying complex messages, but they are hit-
and-run in their nature. They don’t tell you how to do it.
How do I climb the mountain? Telling us to “Just Do It” might be well
intentioned, but falls disastrously short of a meaningful description of how
to climb the damn mountain. In a similar vein, to be told to just “run your
profits” and “cut your losses” falls disastrously short of providing a
meaningful guide to achieving these noble trading goals.
When I started trading, I had the right credentials. On paper I was
academically destined to do well. Emotionally, though, I was like everyone
else. I was not making money. I should say I wasn’t making meaningful
money. I lost more on bad days than I made on good days. Granted I had
more good days than bad days, but the bad days would set me back
significantly, to the point where I might as well go and get a job. It would
have paid better than my trading did.
I didn’t question what I brought to the game beyond chart preparation. I
showed up. I traded. I studied charts. That was it. I thought that was all
there was to it. If it didn’t go well, then I had to do more of it.
However, I never looked inwards. Then something happened. I read the
research (described earlier in the book) on the 25,000 traders executing 43
million trades, and I thought to myself, I am just like them. They all
believed they would be profitable. Practically none of them were.
It prompted me to start thinking about trading holistically. I had been
obsessed with techniques. I had a belief that more is better when it came to
technical analysis. Yet, I was not seeing the results I wanted.
It got me thinking about thinking and about what I believed. More
importantly, I began to wonder if what I considered to be my beliefs were
actually helping me to become a better trader. So far, they had not.
Your beliefs create your world. How you see the world is a result of what
you believe in. Some beliefs are easy to identify. I believe we should look
after the environment, so I make sure I recycle. That is an example of a
belief. That was an easy example. How are your beliefs shaping your
trading performance? Are you even aware of what your trading beliefs are?
Your trading performance is a function of your belief system, and only by
dissecting your trading performance are you able to uncover what your
belief system is. There is an easy way to discover your trading beliefs.
Although I say it is easy, it is also hard work.
A friend of mine wanted to improve his surfing, so he hired a friend to
video him for a few hours during a surf session. He watched himself surf
and he was able to identify his issues. He needed to strengthen his core
muscles and he needed to trust his wave selection rather than being half
committed, as he often was on many waves.
In a similar way, I decided I needed to relive my trades to truly figure out
what my problem was. So, I downloaded my trading results into an Excel
spreadsheet and went to work. I meticulously went through the trades. I
split my trades up into many different categories, with many of them
appearing in more than one category.
There were trades I held for days. There were trades I held for seconds.
There were trades I executed in the mornings. There were trades I executed
in the afternoons and evenings.
I recommend you read my assessment of my own trading, and you repeat it
on your own trading. It is a vital step in understanding who you are and
how you interact with the markets. Once you have done that, you will create
what I call the Book of Truths.
Above all, be honest with yourself, as I was. If you are not honest with
yourself, you will not be rewarded with consistency in trading. The courage
to be honest with yourself is its own reward.
Here goes:
1. I had periods where my win rate exceeded 85%.
2. My average profitable trade was less than my average losing trade.
3. I was a winning trader, but my big losses were seriously denting my
overall P&L.
4. I traded well in the first half of the day.
5. I traded well in the first three to four days of the week.
6. I often gave away much of my profit from the morning session
when I traded in the afternoon.
7. I often gave away much of my weekly profit on Fridays.
8. I would do very well on range-bound days.
9. I would almost always miss trend days, and I would often fight
them.
10. My biggest losses came from fighting trending moves.
The breakdown of my performance was incredibly cathartic. I took great
pleasure in reviewing my own mistakes, because it felt like I was actually
meaningfully moving towards a better version of myself.
I took a very time-consuming decision to put all of my trades on the
relevant charts. I created a PowerPoint containing every trade to give me
visual imagery of my performance. This is the Book of Truths.
I will argue that this process stood out as the single most beneficial practical
exercise in enhancing my performance. I was, and I am, confronted daily
with all my flaws, and I have a visual representation of those flaws. It
seems as if the act of portraying a loss in a visual representation is a much
more powerful tool for change than merely writing “Don’t trade without a
stop-loss” on a Post-It Note and taping it to your screen.
I use the PowerPoint file to warm up every morning before tradin

eBooks\Tom Hougaard - Best Loser Wins.pdf


ng my performance. I was, and I am, confronted daily
with all my flaws, and I have a visual representation of those flaws. It
seems as if the act of portraying a loss in a visual representation is a much
more powerful tool for change than merely writing “Don’t trade without a
stop-loss” on a Post-It Note and taping it to your screen.
I use the PowerPoint file to warm up every morning before trading begins. I
am reminded of the things I am good at and the things that tend to be my
downfall. It has become an integral part of my process, to ensure I am
acting in my own best self-interest.
When I started the process of visually recalling my old trades, my old hurts,
my old successes, I felt an empowering surge to replicate what I was good
at and avoid what I was bad it. I immediately began to trade differently. I
immediately saw measurable improvements in my trading. The results were
immediate, even if I had to get used to the new way of thinking. I made
more money.
I became much more trusting of the markets. I trusted that I would be given
an opportunity to make money every day. As odd as it sounds, I began to
trade less, and I started to make more money. Sure, I wasn’t perfect from
day one. I am not perfect today either. In fact, one of my beliefs is don’t
insist on perfection in trading.
One truth I came face to face with was less is more. There was a clear
relationship between the time of the day and my profitability. I was
nowhere near as profitable in the afternoons as I was in the mornings.
Would I make more money if I just traded mornings? The statistics said yes.
My heart said no. I wanted to trade, and I felt (or rather my belief dictated) I
had to trade in the afternoons. How else could I call myself a trader if I only
traded part time? It was a process of trial and error.
This was the immediate benefit from the Book of Truths, but I didn’t stop
there. I began to seriously question my motivation for trading. I argue that
in a business like trading, where 90% fail to make a positive return on their
trading account, the only way to separate yourself from the masses is to
acknowledge that your mind is either your best friend or your worst enemy.
If you don’t prepare your mind ahead of the game, and you experience
adversity during the game, your mind will most likely work against your
prime objective. Your prime objective is not to make money. Your prime
objective is to follow the strategy you have developed. More importantly,
your prime objective is to follow the process you have designed for
yourself. If you follow the process, the outcome will take care of itself.
I don’t set goals. I just focus on my process. I am a process-oriented trader.
I don’t think being overtly goal oriented will help you achieve your goals.
Of course, the goal is to win. But a mind subjected to adversity is a mind in
stress. A stressed mind needs structure and process. Otherwise, it will
succumb to feelings of fear, revenge and desperation, and the decisions it
makes will originate from these feelings. Who wants to make decisions
about the wellbeing of their financial health based on fear or stress?
The mind needs guidance. I read about an American football coach who,
during the half-time break, gave specialised talks designed to re-awaken the
imagination of the players on his team. One time his team had taken a
beating in the first half of the game. During the break in the locker room the
coach put on a special video he had prepared. It showed some of the
greatest comebacks in football history.
The purpose of the video was to give the players a path out of their stressed
state. It gave them mental imagery of what was possible. Coupled with the
right kind of motivation, encouraging the players to focus on the process,
staying present in the moment, waiting for the right opportunity and trusting
the process, their minds had gone from being stressed to being prepared.
I want to remind you that the first part of my trading life was spent on a
trading floor, observing traders – thousands of them – go about their daily
lives. I am adamant in my claim that those who were behind at half-time
had no mental tools to help themselves, and as a result tended to dig the
hole they were in deeper and deeper, as the day wore on.
LEAVING THE OLD SELF
Remember how Maximus ritualistically rubs dirt on his hands before
combat in the movie Gladiator? How, through this symbol of mental
preparation, he was leaving his old self behind? Well, I too have to leave
my old self behind. I too have to become someone else for the day. Charlie
Di Francesca, the legendary bond trader in the pits in Chicago, said that
good trading goes against normal human instinct. To succeed you have to
get used to being uncomfortable.
Trading is a battle of the self. Every morning I have to shed my skin and
become someone else. The Book of Truths is key to my transformation. It
arouses a desire to do better than the old pattern of behaviour. I am certain
that had I not taken the steps to focus on my mental game and confront
myself daily with my old behaviour, I would not be where I am today.
I argue this to be the case based on my observations of diaries. One of the
catalysts for my trading transformation came from tidying up my old office
cabinets. I found old trading diaries in which I had meticulously described
my trading day. As I read through the diaries, which spanned a decade, I
saw how desperate I was to make trading work for me.
I saw how day after day I promised myself not to add to losing trades – how
I promised myself not to trade well from Monday to Thursday and then lose
it all on Friday – how I promised myself I would stick to one setup, and so
on.
As I read page after page of trials and tribulations (but mostly trials), I
realised that the Tom whose words I was reading was in real pain, but he
was not transforming. He was repeating the same mistakes day after day.
He might have been increasingly technically competent, as his studies took


Thursday and then lose
it all on Friday – how I promised myself I would stick to one setup, and so
on.
As I read page after page of trials and tribulations (but mostly trials), I
realised that the Tom whose words I was reading was in real pain, but he
was not transforming. He was repeating the same mistakes day after day.
He might have been increasingly technically competent, as his studies took
him deeper and deeper into expert territory of technical analysis, but he kept
making the same mistakes when his mind became stressed.
As I have said before, it was not an epiphany. My change came slowly. It
was a gradual realisation that all my chart studies didn’t move me
meaningfully towards the goals I wanted to accomplish. Rather, they merely
distracted me from the real problem, which was my behaviour when things
did not go to plan. Instead of focusing on the process and having tools to
get me to operate from a stress-free mind, I succumbed to foolish trading,
intending to make back the lost ground. My mind desperately wanted to get
rid of the pain of having lost money, and its solution was to chase every
movement in the market recklessly. And all I did was dig the hole deeper
and deeper.
The Book of Truths will give you up-close, face-to-face time with your own
shortcomings. It made me realise what my faults were. I also started
plotting my good trades. I felt it was necessary not just to remind myself of
the behaviour I wanted to avoid. I should also remind myself of the
behaviour I wanted to strive towards.
The charts I use to prepare for each trading day, to warm up, are my old
trades plotted on a chart. That way I can emotionally relive the trades and
reinforce the behaviour that is good for me and remind myself what my
weak points are.
AN EXAMPLE
Friday 4 March 2022 was an extremely volatile trading day. A colleague
pointed out to me that Brent Oil was soaring. I looked at the chart, shown in
Figure 25, and I thought, “Wow, it really is.”
Figure 25
I bought the first retracement on this ten-minute chart. Now there is nothing
wrong with this entry. I am trading with trend, but as I look back at the
trade, I acknowledge that at that precise moment in time I was not trading
from an emotionally stable point of view. I was eager to get on board a
move, based purely on the opinion of another trader.
So, I just bought it without much thought to it. And I had no stop loss in
mind. I just put an arbitrary stop loss, for safety. See Figure 26.
Figure 26
This is the power of the Book of Truths. I want to remind myself of things
like that. I want to remind myself, in the morning, before the trading starts,
that Tom Hougaard trades best when he is calm and is not caught up in an
emotional whirlpool of excitement and a brain awash with adrenaline and
dopamine.
I looked at my trading monitor and saw my position losing me money. I
reminded myself that, although I got caught up in the emotions of another
trader (one that I respect), I am not him. I am me. I closed the trade, and
then I waited. I had made an impulsive trade – an emotional trade without a
real plan or a real setup. I wasn’t annoyed so much with the losing trade as
much as I was annoyed with suddenly being impulsive and acting without
truly thinking. I could have spent 30 seconds thinking it through and the
outcome would have been very different.
I calmed myself down, and I thoroughly analysed the chart, and I decided
upon a better entry point. I used my process – the tools that work for me.
And then this pattern in Figure 27 showed up. It was late in the day, and I
was prepared for a restful evening after a long trading week. I bought Brent,
and I held it.
Figure 27
The setup is simply a Harmonic Retracement. The first retracement and the
second retracement are identical. It gives razor-sharp entries, where it is
easy to control your risk.
I want to remind myself of the things I do well. I want to remind myself of
the things I can be prone to when I am not calm. I want to do that ahead of
the open. I accept that I will never be perfect. I will at times still make
stupid Brent Oil trades on a Friday afternoon because a friend of mine is
telling me of his success; but I like to think that like a missile I will self-
coordinate as new data becomes apparent, and I like to think that my mental
preparation makes my mistakes short lived.
TRUST
My review of my trades revealed that I didn’t trust myself or the markets.
Profitable trading requires trust. If you don’t believe it can happen, you
should not even start. If you don’t trust, then you will not make money.
Therefore, before you start trading again, you have to work on your beliefs
about yourself and the markets.
As I see it, trust falls into two categories.
TRUST YOURSELF
You have to trust that you already have all the tools you need to make a
living from trading. Yes, you need to acquire a certain competence level in
the field of technical analysis (or whatever edge you use to make trading
decisions).
I continue to study technical analysis, and I do so to improve my
understanding of the ever-changing nature of the markets I trade, but it is
not technical analysis that will make me money. It is trusting that I already
have all the skills I need to make money consistently.
The reason why I was not more successful in my early trading was not
because I didn’t know enough about technical analysis. It was because I
thought the only thing I needed was technical analysis. However, that was,
and is, simply not true.
I had not focused my time and attention on matters outside of technical
analysis. My focus was not on the right things. My technical savvy was not
matched by an emotional maturity, because I had not spent time working on
that side of my game.
You need to trust that you already have all that you need. Otherwise, you
will not bridge the gap between what you know you can achieve and what
you are achieving. You need to believe. The belief comes from doing. I will
address that in a moment


us was not on the right things. My technical savvy was not
matched by an emotional maturity, because I had not spent time working on
that side of my game.
You need to trust that you already have all that you need. Otherwise, you
will not bridge the gap between what you know you can achieve and what
you are achieving. You need to believe. The belief comes from doing. I will
address that in a moment.
TRUST MARKETS
The second trust consideration is the trust in the markets. When I go to
work in the morning, it would be great if the perfect setup manifested itself
before my eyes right at the opening bell. However, it rarely does.
I use a five-minute and a ten-minute chart as my primary trading time
frame. A typical trading session runs over ten hours for me. That means I
will be confronted with a total of 120 candles/bars of five-minute duration.
As a result of my review of my trading performance, I came to a realisation.
I didn’t trust the market would give me the opportunities I needed to make
money. It was a debilitating belief.
I set out to prove that I was wrong in that belief by reviewing ten years’
worth of intra-day data from the handful of products that I traded most
frequently. Now I wasn’t just studying for the sake of identifying patterns. I
studied to prove that the technical analysis setups that served me well
would repeat every day.
I arrived at a new set of beliefs. I came to believe I can trust the market to
give me an opportunity to make money every day. I came to trust the fact
that at least two or three of those five-minute candles would produce a great
trade entry.
I came to trust that the market would give me a perfect entry point, such as
a double top in a higher time frame downtrend or a continuation signal. In
conclusion, I shaped a new belief around the evidence that I laid bare
through my research. I came to accept that I can produce a good living from
trading, from waiting for those ideal setups.
But those ideal setups don’t necessarily materialise when I want them to, in
the time frame I have at my disposal to trade. I need something else beyond
trust.
Trust is a vital part of the journey to making the markets your playground,
but it is not the only component. I needed to work on another part of my
behaviour. I would often tire before the afternoon trading session. I would
often tire as the week progressed. This led to poor decisions, which can be
directly attributed to boredom and impatience.
PATIENCE
I realised that my patience was my weakness. However, there is more than
one kind of patience. For example, a mother teaching her young child to
read may experience a sense of impatience, but the mother will remind
herself that eventually all children learn how to read.
The impatience that a parent may experience is mitigated by the perceived
time horizon to reach the end goal. We know our children will learn basic
reading skills, as long as we persist. We simply have to maintain our
patience as our little ones inch their way towards the desired skill.
You can’t argue that patience is a quality directly transferable from
parenting to trading. As a parent you can tell yourself you will patiently
work towards your child being able to read. However, you can’t say that
you will patiently wait for the market to hit your desired entry point,
because it might not hit your desired entry point.
As a result, you will experience emotions that a parent doesn’t. You will
experience a fear that the market will move without you. You will be fearful
that the market will not give you an opportunity to jump on board. Without
the right kind of conditioning, you will act upon these fear impulses.
Had I not gone through all the data I had, I would not have been so assured
in my decision to wait for the right setup. I accept my process is thorough,
but with that preparation comes significant financial reward.
Without a doubt, one of the greatest flaws I saw traders exhibit during my
decade on a London trading floor was the idea that it is too late to join the
trend. It was a common occurrence during trend days to witness clients
continuously try to find the low of the day.
On those days our clients lost the most. If the market was rallying, they
would either do nothing, or they would try to find a place to sell short. If the
market was falling, they would do nothing; but more likely they would try
to find the low of the day and buy.
Considering the action was so common across such a large group of
individuals, I conclude that there is an inherent trading flaw in our thinking
which makes us want to go against the trend. I have previously mentioned
this supermarket mentality, which compels us to seek value.
Another reason this behaviour is commonplace is because of the prolific use
of chart indicators that display what is technically known as overbought and
oversold price levels. The use of overbought and oversold indicators has a
terrible track record in trending markets.
To my mind patience is a skillset that can make the difference between
being an abject failure or a wizard. I used the word skillset because I believe
that patience can be developed.
I developed my patience in trading using two methods. Both are practical in
nature, but they are very different in their application. One is a proactive
exercise. One is a reflective exercise.
EXPANDING MY FIELD OF
INFORMATION
The proactive exercise evolved around the concept of expanding the field of
information. I print out the charts of my favourite markets every night,
while the trading session is still fresh in my mind. For example, I will print
out the DAX Index chart and the FTSE Index chart on both a five-minute
chart and a ten-minute chart.
The reason I am printing out two time frames is because of perspective. I
found that my use of the five-minute chart prompted overtrading. By
considering the ten-minute chart I am forcing myself to slow down my
decision making. This act of slowing down my time perspective also
strengthens my pat


nt
out the DAX Index chart and the FTSE Index chart on both a five-minute
chart and a ten-minute chart.
The reason I am printing out two time frames is because of perspective. I
found that my use of the five-minute chart prompted overtrading. By
considering the ten-minute chart I am forcing myself to slow down my
decision making. This act of slowing down my time perspective also
strengthens my patience. I see things on a ten-minute chart that give me a
greater clarity than if I had seen them on a five-minute chart alone.
Patience, however, is not a quality that is easy to come by. I am a man in
my 50s. Over my lifespan the world has pandered to the impatient. When I
was a child, if my family ran out of milk on a Sunday afternoon I would
have to wait until Monday morning before I could purchase another bottle.
Everything was shut on a Sunday.
Forgive me if I sound like a relic. I am really not. I love technological
advances. So many wonderful things flow from our advancement of living,
but the flipside of the coin is that we as a species have also become
impatient.
That is important to remember when you set out on a trading journey. Not
long ago, I read about a gentleman called Navinder Sarao, a trader who
became synonymous with the infamous 2010 flash crash. In the book Flash
Crash, by Liam Vaughan, it becomes apparent that some of the primary
skills that Navinder possessed were focus and patience. According to the
book, Navinder Sarao would hide himself away from the other traders he
worked with, so as not to be disturbed. He needed quiet around him to
exercise focus and patience.
The exercise of printing out the specific charts every day instils in me faith
that every day the market will give me an opportunity to make good trades.
The exercise is also an opportunity for me to discover new behaviour in the
market and continuously train my mind and eyes to spot patterns. I happen
to believe that you only see things you have trained your eyes to see.
IMAGERY AND BREATHING
The second exercise is hard to begin with. Some call this exercise
meditation. Some call it visual imagery. I don’t have a name for it, but I
know what I want to achieve. I want to calm down my mind. Depending on
the mood I am in, I will use one of the following tools to keep my mind
trained for the task of being a high-stake day trader.
I sit quietly in a comfortable position, and I observe my breath. I breathe in
for seven seconds, and I breathe out for 11. I repeat. I will do as much or as
little as I need to feel calm coming over me. Sometimes it takes five
minutes. Sometimes it takes 15 minutes.
The purpose of the exercise is simply to calm my mind. Through the use of
breathing exercises I have been able to increase my attention span
significantly. I was hesitant at first. I was even hesitant to write about it. It
has that taste of a new-age fad. The reality is that calming your mind
through breathwork is used extensively by high-performance athletes. I read
extensively on the topic of meditation amongst Formula 1 drivers. It was
both a surprise and a relief that ultra-competitive sportsmen and women,
people I admire and am inspired by, are turning their sight inwards to
improve their edge.
I have to be upfront with you. I have no formal training in meditation or
imagery. I simply trust and let myself be guided by what enters my head.
My mental imagery is designed to place myself in physically dangerous
situations. I may be face to face with an alligator. I may climb a steep rock
face. I may surf a monstrous swell. The exercise is simple. I want to elevate
my pulse through imagery. Then I want to consciously focus on my breath
and simply accept the situation for what it is. The aim is to confront the
imagery and remain calm.
Once I am calm, I see myself trading the absolute biggest stake size I am
allowed by my broker. I see the market move against me, and I visualise my
P&L go deeply into negative. I feel my pulse elevate, and I focus on
calming it down. I repeat this process over and over.
I see myself riding a trend higher and higher. I see my P&L grow larger and
larger. I am waiting for my mind to tell me to take profit. Then I stop the
tape and flip the switch. I calm my mind down, and I see myself looking at
my P&L dispassionately. I calm my breath until I am able to simply observe
my profit grow larger and larger as I trend with the market, higher and
higher. The goal is simply to be, to be an unemotional observer of the
market. The goal is to act without fear, without hope, without anything but
an objective assessment of the price action.
ASK FOR HELP
I believe that beliefs shape our lives. I believe not all my beliefs are
beneficial to the life I want to live. I accept they are there, and as my self-
knowledge evolves I address them to the best of my ability. I have come up
with this back-to-front idea of how to address my beliefs.
It evolves around the old saying, “I will believe it when I see it.” How about
turning it on its head to say, “I will see it when I believe it”? This argues
that you must believe before you can see. Many of our beliefs have been
part of our construct since our formative years. They are not going to go
away without a fight. Of course you might decide not to fight them, but to
accept them.
I call this process Ask for Help. I sit with a blank piece of paper, and I pose
a question. It could be, “Why am I afraid to join a down-trend after it
already started?” I write down everything that appears in my mind. I sit
with my eyes closed and I observe my thoughts. I do not censor myself. I
just sit and ask and listen and write down.
I may write for 10–20 minutes. What often appears on paper are thoughts
straight out of the psych ward. It scares me at times how brutally to the
point and honest the answers can be. It can be quite horrifying to read the
things the subconscious mind brings up. I don’t judge. I accept.
When I am working with my beliefs, fighting those beliefs will not work. I
t


t and ask and listen and write down.
I may write for 10–20 minutes. What often appears on paper are thoughts
straight out of the psych ward. It scares me at times how brutally to the
point and honest the answers can be. It can be quite horrifying to read the
things the subconscious mind brings up. I don’t judge. I accept.
When I am working with my beliefs, fighting those beliefs will not work. I
think giving negative energy to a belief will only cause it to fight for its life.
The only thing that works is complete acceptance. I accept what is there. I
understand it. It allows me to retire it. I diffuse it. If I approach it from a
perspective of “I hate this belief”, it will enforce and entrench itself.
Say I have a belief about trading that suggests I need to make my money
quickly. I need to get in on the move first thing in the morning. If I want to
diffuse this belief, because I have strong evidence to suggest it is
destructive to my trading account, I will ask for help. I will accept the
belief. I will diffuse its negative energy, and I will replace it with positive
energy. I will reinforce a new belief such as “I will wait for the first ten-
minute bar to complete before I make a decision to trade”.
Unfortunately, beliefs do not have the power to dismantle themselves. All
beliefs demand expression. Desire and willingness to ask questions from a
sincere space, with a sincere mindset, will give you answers.
When I use the Ask for Help process, I know it is complete when I can distil
my question into a short one-sentence answer. Then I know I have
condensed the exercise into its lowest common denominator, and I have
diffused whatever belief I had that didn’t serve me. The old memory will
always be there, but the context has changed from negative to positive.
It is important for me to remind you that money is a by-product of the ideal
trading mindset. You are creating a process that will guarantee an optimal
mindset for your trading life. The essence of good trading lies squarely in
how we think and perceive information about the markets. It has everything
to do with how we think and how we live our lives.
Today I spoke to a friend of mine. We had not spoken in a while. I consider
him a very close friend, and it was a joy to reconnect. As he spoke, I
listened intently. You have two ears and one mouth. Use them in that
proportion. He was talking animatedly about his trading and how well it
was going. In between the stream of sentences, I picked up on a sentence
that spoke volumes: “I am still working on increasing my trading size.”
I thought long and hard about that sentence, knowing I was going to write
this final chapter today. My friend first spoke to me about increasing his
trading size back in 2015. Today it is 2022. He has spent seven years talking
about increasing his trading size. What does that tell you about his desire to
increase his trading size? Do you think there might be a misalignment
between what he says he wants, and what he is actually doing to get what
he wants?
I often tell my children this. Do what you have to do, so that you can do
what you want to do. I tell them to make up their minds what they want but
think very long and hard about it first. If you say you want something, and
then you do nothing about it, then you can be damn certain there is a
misalignment between your conscious and your subconscious. When I am
faced with a situation like that, I use the Ask for Help exercise, and I always
get a brutally honest answer. The most common answer I get is: “Actually
you say want it, but you don’t!”
The idea of deciding what you want can undo a lifetime of negative energy
surrounding your beliefs and your belief system. The power of making up
your mind will remove all negative energy surrounding a belief system. I
have come to accept that many people do not want to do that. We fall in
love with our drama. We cling on to our drama because it validates us and
gives us attention.
When I am out of sorts, angry, frustrated, I ask questions and work my way
backwards. I work my way to the source of the problem. Anger is often a
self-defence mechanism. If I am angry, I need to know what the underlying
belief for the anger is. So, I ask.
I am often told I am very disciplined. This is not true. The word itself is an
oxymoron. Discipline implies the use of force and will. My action flows
from a love of what I do. I don’t have to apply will to do what I do. Those
who are self-disciplined don’t think of themselves as self-disciplined. They
are just expressing themselves in harmony with their own dreams and goals
and desires.
When you watch spiritual movies like The Secret and listen to self-help
tapes, you get this sense that the universe is a menu, and you can help
yourself to whatever you want. I find that to be one of the most distressing
aspects of the self-help industry, be it neurolinguistic programming or Law
of Attraction or whatever name the latest fad goes by.
I have stood in an auditorium and listened to motivational speakers make
their audience shout out whatever grievances are holding them back, and
then push the audience towards their private island retreat for untold sums. I
never believed in it. I don’t believe anyone ever achieved anything
spectacular without putting in a massive amount of effort. I know I put in
the effort. I know that everything I do on a daily basis is the result of grit
and determination. I am not talented. I am hard working. I am not gifted. I
am determined. I am not lucky. I am persistent.
TWENTY TRADES
My friend Dr David Paul gave me an exercise, which at its heart is designed
to strengthen the process of your trading. It is as simple as it is difficult.
Your job is to execute 20 trades, as the signals appear.
One by one, you take every trade signal as it comes. The purpose of the
exercise is not actually to make money. You will probably break even, and
that is fine. The purpose of the exercise is to smoke out your internal
conflicts and y


which at its heart is designed
to strengthen the process of your trading. It is as simple as it is difficult.
Your job is to execute 20 trades, as the signals appear.
One by one, you take every trade signal as it comes. The purpose of the
exercise is not actually to make money. You will probably break even, and
that is fine. The purpose of the exercise is to smoke out your internal
conflicts and your unresolved emotions.
It has at its core the idea that if you can execute 20 trades without any kind
of conflict, you are trading from a carefree and fearless frame of mind. This
means you are trading from the perspective that:
1. Anything can happen – and you are emotionally detached from the
outcome.
2. Every moment is unique – and you are no longer drawing
associations between this moment and another moment. You are pain
free.
3. There is a random distribution of wins and losses – you accept the
outcome as if it were a coin-flip exercise.
4. You don’t have to know what will happen next to make money – so
you trust the process, and you focus on controlling the only variable
you truly can control, which is how much you want to risk on this
trade.
The purpose of the exercise is to add energy to your beliefs. Until you can
do that without conflict and unresolved thoughts and conflicting energy
issues, the negative charge will not dissipate.
How do you know when you are successful? When you can trade without
any conflicting or competing thoughts. The results are not important during
the exercise. This a process exercise. You may have to repeat the 20 trades
over and over until you come to a point where you find that you are firing
off trades without fear, without hesitation, without connecting this moment
with a past moment, and you accept the outcome dispassionately. When you
arrive there, you really have arrived!
DISASSOCIATION
A friend called. She had put up a post on a social media outlet, and her post
was very ill received. She endured a torrent of abuse for what was a well-
intentioned post. She called me for help. I read her post and the slew of
abusive comments. To me, however, they were just words. They were
words without energy.
I dispassionately read the posts, and then I explained to her what to do. As
traders we need to work towards being as dispassionate about our trading as
I was about her social media post. The more we work on this, the better we
will trade. Some will argue against me. Remember, I am writing this from
the perspective of what works for me.
How do you do trade dispassionately? How do you disassociate yourself
from feeling anything when you are trading? Well, that is what my exercises
take care of. If you want to be able to receive information from the market,
without feeling threatened, it will not happen by itself. I believe working on
what you think and how you respond and evaluate your responses will
improve your trading in measures you would struggle to appreciate right
now.
I once sped down the autobahn doing 186 miles an hour. Yes, it was
reckless. Whilst doing it, I wasn’t wondering if there was milk in the fridge
or if I had remembered to floss my teeth this morning. I was in the moment.
Focused. That is what I want to bring to my trading every day.
Every moment is unique. That does not mean we have to act like a formless
blob with no memory of the past. There will always be some degree of
correspondence. However, just because I was rejected by a girl the first time
I invited her for a dance does not mean I will be rejected the next time. But
my mind might think so, so I may have an argument with my conscious
thinking and my subconscious beliefs.
My rational mind might say, “The next girl will say yes to a dance.” My
subconscious mind, unbeknownst to me, might say, “No way amigo, give
up, she will never dance with you.” If you have a moment of doubt before
venturing over to ask the lucky lady, you know you are not aligned. When I
experience this in my trading, I will Ask for Help, or I will use imagery to
resolve whatever is going on in my head.
MIND LOOP
My training involves accepting pain and making it part of my existence
through habit and repetition, so that my degree of pain tolerance is
expanded. I also have to train my mind about expectations, and how to deal
with unrealised expectations.
This requires a tenacious effort, through journalling, mental imagery, and
asking for help. You may quite rightly ask, “Does it work?” I think it does.
It has revolutionised my trading. As I type these words, in March 2022, I
have not had a losing day since September 2021. That is nearly seven
months without a single losing day.
I don’t think this should be celebrated. I am not writing this to show off in
any shape or form. The intention is to inspire you to take the mental side of
trading almost as seriously as the technical side. If I were to describe the
beliefs that are the foundation for my trading, they would resemble a
flowchart, one where the entire mindset ecosystem forms a loop.
My trust (in the markets and in myself) supports my patience. My patience
(that a setup will materialise) feeds my confidence. My confidence (that I
will win) dictates my inner dialogue. My inner dialogue (what I tell myself
while I am trading) supports my process-oriented mindset. The process
enables me to stay focused in this moment. I support this loop with my
mental exercises. They feed, nourish and sustain the loop.
I am a process-oriented trader. I do not believe in goal setting. There are no
Post-It Notes on my monitor reminding me how much I want to make today
or this month or year. I have no monetary goals or pip/point goals. I will
take what the market will give me. I never trade with targets.
By being utterly focused on the process as opposed to being outcome
oriented, I ensure that I am staying present. When you are present, you
don’t connect past moments with this moment or future moments. You are
right here, right now.
Being present is what some would call mindfulnes


r. I have no monetary goals or pip/point goals. I will
take what the market will give me. I never trade with targets.
By being utterly focused on the process as opposed to being outcome
oriented, I ensure that I am staying present. When you are present, you
don’t connect past moments with this moment or future moments. You are
right here, right now.
Being present is what some would call mindfulness. I call it focus. I call it
concentration. I call it knowing what I want. I want to win. That is my
overriding motive for trading – to win. I want to win, but I don’t mind
losing.
However, I know that if I forget all about winning, and I focus on the
process, I will win. It is an idiosyncratic conundrum that for a long time I
just could not believe and give into. How can I win if I am not focused on
the goal at all times?
It took me almost a decade to figure out that process is everything. Don’t
focus on the goal. Sure, know what the goal is, but focus on the process.
Trust the process. I built my trading life around this mind loop. How does
the loop look?
I trust. The research underpins the trust. The trust supports the patience. The
patience is underpinned by the mental exercises, and it nourishes my
confidence. My internal dialogue is driven by a process-oriented mindset,
fuelled by my confidence. I focus on what I can control – my mindset, my
risk approach – and I let the market do what it wants to do. Whatever it
does, does not fuel the fearful side of my mind. That has been trained away.
I am not afraid of the market. The only thing I am afraid of is that I do
something stupid in the market. As I trust myself, this does not happen.
I trust that I have the skills to make money, and I trust that the market will
give me opportunities to make money. This trust has been nurtured and
strengthened by my intense study of market charts for the time period I
desire to trade. The trust is further strengthened by continuous dedication to
my vocational skillset.
My patience flows from my trust in the market and in myself. I have built
an emotional connection between trust and patience. I trust the setups will
come, if I am patient. If I am patient, I will win. Winning means more than
anything else to me. If I am not patient, I will not win. I will do anything to
win. Therefore, the trust overrides any emotional impatience that may arise
in my mind, because I trust that if I miss this signal, there will be another
one coming.
My confidence comes from continuously working on my game. I don’t
learn technical analysis once. I learn all the time. Some markets move.
Some markets are dead. Some markets require larger stops. Some require
you to trade with orders because they move so fast. The markets are forever
changing, and I change with them.
My inner dialogue stems from the trust and the patience and the confidence.
Of course, yours truly has bad trading days. I just don’t let it bother me. I
am grounded in this moment. I focus on the process. That is all I can do. I
can’t dictate to the market what it must do. I must be like water, and flow. I
must flow with the market. I don’t fight the market. I flow with the market.
“Just flow,” I tell myself.
This is what lies behind the process. I never expect to be comfortable when
I am trading. If I am comfortable, I know I am not pushing the boundaries
of what I am capable of. I know that to get the best out of myself I need to
be a little uncomfortable. I will give you an example.
I sold short the Dow Index in my Telegram channel (timestamped for
authenticity and verification). I have marked my entry point in Figure 28.
Initially, the market moves against me. Then it turns and trends lower. As it
trends lower, I am mindful of my mind saying, “Take profit.” That voice
used to be much louder. Now I am so focused on the process that the voice
is no longer heard. I focus on the process, not on the outcome.
Figure 28
However, at one point I have 200 points in profit and the market sits at an
old low. I have to accept that there is a real possibility the market will
rebound from there, and much of my 200-point profit will disappear. That is
being uncomfortable. I accept it and decide to let the position ride.
Do you know why I let it ride? Because I know myself well enough to
accept that if I took profit, and the market then continued lower, I would
feel awful. The pain of seeing a market giving you even more profit when
you are not on board is much greater than the pain of seeing some of your
paper profit disappear – to me at least!
This time it worked. Tomorrow it might not work. I have to trust the process
will sustain me over the long run and be less concerned about the outcome
of a single event. Remember, there is complete randomness in the outcome
of one event, but over hundreds of observations there is no randomness.
A trading life is not defined by what we do every now and then, but by what
we do over and over. You will never be able to trade without having losing
trades. The whole purpose for giving this book the title it has, Best Loser
Wins, is to illustrate this point right from the beginning. The one who is best
able to lose will win the game of trading.
The survey of 25,000 traders executing 43 million FX trades over a 15-
month period illustrates this point perfectly. Overall, they had more winning
trades than losing trades. Out of those 43 million trades, up to 61% of them
were winners, depending on what currency pair they traded.
What does that tell you?
It tells you that those 25,000 traders have a good grasp on the markets and
where to place their trades. It tells you that if they were somehow able to
operate with a 1:1 risk-to-reward ratio, they would win 61 out of 100 and
lose 39 out of 100. That is a winning formula. That creates a net positive
trade flow of 22. That is a business model that has an integral foundation.
The problem is that the survey shows that when they win, they win on
average 43 pips. When they lose, they lose on average 83 pi


It tells you that if they were somehow able to
operate with a 1:1 risk-to-reward ratio, they would win 61 out of 100 and
lose 39 out of 100. That is a winning formula. That creates a net positive
trade flow of 22. That is a business model that has an integral foundation.
The problem is that the survey shows that when they win, they win on
average 43 pips. When they lose, they lose on average 83 pips. In other
words, they lose twice as much (almost) on their losing trade than they
make on their winning trades.
Let’s say 100 trades are executed.
61 winners at 43 pips = 2,623 pips
39 losers at 83 pips = 3,237 pips
What does that tell you?
It tells you that they are good at picking winners, but when they are faced
with a losing trade, they don’t have the mental discipline to cut the loss.
What does that tell you?
It tells you that they need to work on their mental game so that they are
better equipped to handle losses. Their minds are most likely wired to
associate pain with taking a loss. The mind has at its core a mandate to
protect you against pain – physical as well as mental pain, perceived pain
and real pain.
FINAL WORDS
Your path to becoming a profitable trader lies not in better understanding
the markets, but in better understanding your mind. Your mind and how you
operate it will dictate the level of success you have as a trader.
I am going to go out on a limb and tell you something about you. People
reading this book could have fallen into one of two categories, but I doubt
it. I doubt that new traders, who have never traded before, will ever
gravitate towards a book like mine.
They are more likely to buy books that have titles like Mastering Trading or
Trade Your Way to Financial Independence. This kind of book will be 300
pages of technical analysis and most likely not contain a single mention of
losing trades. It will contain page after page of perfect chart examples.
This book, I speculate, will be read by the people who previously bought
the sort of book mentioned above, but have come to the realisation that the
gap between where they are now and where they know they can be can only
be bridged by a better mindset.
The advantage I have in writing this book is that I don’t have to establish
my credentials. I have a four-year public track record, timestamped and
readily available for anyone to read. I post my broker trades in Excel format
on my website and in my Telegram channel daily. There are plenty of bad
trades in that track record, I assure you, but somehow I still manage to
make money overall, and quite significantly so.
Therefore, the focus now needs to be on the actual steps I have taken – and
still take – to ensure I stay at the top of my game. That is where you are
headed now.
I want to finish the book on a note which is important to me. I have
described a process that works for me. It is based around my particular
beliefs. Those beliefs are the result of my particular life circumstances.
I believe that beliefs are defined by one’s own desires and needs. As a result
of my desire to be a profitable trader, and my need to create financial
stability in my life, I have acquired beliefs that are consistent with this goal.
That said, I accept that my way is not the only way. I don’t describe the
way. I describe my way. Whatever you decide is right for you is right for
you. Trust it.
I periodically suffer from verbal diarrhoea on the mental aspect of trading. I
post my musings on both www.BestLoserWins.com as well as on my
website www.TraderTom.com
Have a wonderful journey.
With love.
Tom Hougaard
ABOUT THE AUTHOR
TOM HOUGAARD studied economics and finance at two universities in the United
Kingdom, and then went on to work for JPMorgan Chase before spending
the next ten years in the City of London as a chief market strategist for a
CFD broker. He has given thousands of TV and radio interviews on the
state of the market and has educated tens of thousands of clients on trading
strategies. Since 2009 he has traded for himself.
Tom has self-published several works on trading psychology, price action
and product knowledge.
You can follow Tom’s trading via Telegram and YouTube. You can view his
trading results at www.tradertom.com
Table of Contents
Cover
Title
Copyright
Dedication
Contents
Dear Markets
Preface
Introduction
Liar’s Poker
The Trading Floor
Everyone Is a Chart Expert
The Curse of Patterns
Fighting My Humanness
Disgust
The Drifter Mind
Trading Through a Slump
Embracing Failure
Best Loser Wins
The Ideal Mindset
About the Author


Contents Foreword
Preface
Acknowledgments
Part I: The Basics of Option Greeks
Chapter 1: The Basics
Contractual Rights and Obligations
ETFs, Indexes, and HOLDRs
Strategies and At-Expiration Diagrams
Chapter 2: Greek Philosophy
Price vs. Value: How Traders Use Option-Pricing Models
Delta
Gamma
Theta
Vega
Rho
Where to Find Option Greeks
Caveats with Regard to Online Greeks
Thinking Greek
Notes
Chapter 3: Understanding Volatility
Historical Volatility
Implied Volatility
Expected Volatility
Implied Volatility and Direction
Calculating Volatility Data
Volatility Skew
Note
Chapter 4: Option-Specific Risk and Opportunity
Long ATM Call
Long OTM Call
Long ITM Call
Long ATM Put
Finding the Right Risk
It’s All About Volatility
Options and the Fair Game
Note
Chapter 5: An Introduction to Volatility-Selling
Strategies
Profit Potential
Chapter 6: Put-Call Parity and Synthetics
Put-Call Parity Essentials
American-Exercise Options
Synthetic Stock
Synthetic Stock Strategies
Theoretical Value and the Interest Rate
A Call Is a Put
Note
Chapter 7: Rho
Rho and Interest Rates
Rho and Time
Considering Rho When Planning Trades
Trading Rho
Notes
Chapter 8: Dividends and Option Pricing
Dividend Basics
Dividends and Option Pricing
Dividends and Early Exercise
Inputting Dividend Data into the Pricing Model
Part II: Spreads
Chapter 9: Vertical Spreads
Vertical Spreads
Verticals and Volatility
The Interrelations of Credit Spreads and Debit Spreads
Building a Box
Verticals and Beyond
Note
Chapter 10: Wing Spreads
Condors and Butterflies
Taking Flight
Keys to Success
Greeks and Wing Spreads
Directional Butterflies
Constructing Trades to Maximize Profit
The Retail Trader versus the Pro
Notes
Chapter 11: Calendar and Diagonal Spreads
Calendar Spreads
Trading Volatility Term Structure
Diagonals
The Strength of the Calendar
Note
Part III: Volatility
Chapter 12: Delta-Neutral Trading
Direction Neutral versus Direction Indifferent
Delta Neutral
Trading Implied Volatility
Conclusions
Chapter 13: Delta-Neutral Trading
Gamma Scalping
Art and Science
Gamma, Theta, and Volatility
Gamma Hedging
Smileys and Frowns
Chapter 14: Studying Volatility Charts
Nine Volatility Chart Patterns
Note
Part IV: Advanced Option Trading
Chapter 15: Straddles and Strangles
Long Straddle
Short Straddle
Synthetic Straddles
Long Strangle
Short Strangle
Note
Chapter 16: Ratio Spreads and Complex Spreads
Ratio Spreads
How Market Makers Manage Delta-Neutral Positions
Trading Skew
When Delta Neutral Isn’t Direction Indifferent
Managing Multiple-Class Risk
Chapter 17: Putting the Greeks into Action
Trading Option Greeks
Choosing between Strategies
Managing Trades
The HAPI: The Hope and Pray Index
Adjusting
About the Author
Index
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Copyright © 2012 by Dan Passarelli. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
First edition was published in 2008 by Bloomberg Press.
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ark of The NASDAQ Stock
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For general information on our other products and services or for technical
support, please contact our Customer Care Department within the United
States at (800) 762-2974, outside the United States at (317) 572-3993 or fax
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Library of Congress Cataloging-in-Publication Data :
Passarelli, Dan, 1971-
Trading options Greeks : how time, volatility, and other pricing factors
drive profits / Dan Passarelli. – 2nd ed.
p. cm. – (Bloomberg financial series)
Includes index.
ISBN 978-1-118-13316-3 (cloth); ISBN 978-1-118-22512-7 (ebk); ISBN
978-1-118-26322-8 (ebk); ISBN 978-1-118-23861-5 (ebk)
1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title.
HG6024.A3P36 2012
332.64′53—dc23
2012019462

This book is dedicated to Kathleen, Sam, and Isabel. I wouldn’t trade them
for all the money in the world .
Disclaimer
This book is intended to be educational in nature, both theoretically and
practically. It is meant to generally explore the factors that influence option
prices so that the reader may gain an understanding of how options work in
the real world. This book does not prescribe a specific trading system or
method. This book makes no guarantees.
Any strategies discussed, including examples using actual securities and
price data, are strictly for illustrative and educational purposes only and are
not to be construed as an endorsement, recommendation, or solicitation to
buy or sell securities. Examples may or may not be based on factual or
historical data.
In order to simplify the computations, examples may not include
commissions, fees, margin, interest, taxes, or other transaction costs.
Commissions and other costs will impact the outcome of all stock and
options transactions and must be considered prior to entering into any
transactions. Investors should consult their tax adviser about potential tax
consequences. Past performance is not a guarantee of future results.
Options involve risks and are not suitable for everyone. While much of
this book focuses on the risks involved in option trading, there are market
situations and scenarios that involve unique risks that are not discussed.
Prior to buying or selling an option, a person should read Characteristics
and Risks of Standardized Options (ODD) . Copies of the ODD are
available from your broker, by calling 1-888-OPTIONS, or from The
Options Clearing Corporation, One North Wacker Drive, Chicago, Illinois
60606.
Foreword
The past several years have brought about a resurgence in market volatility
and options volume unlike anything that has been seen since the close of the
twentieth century. As markets have become more interdependent,
interrelated, and international, the U.S. listed option markets have solidified
their place as the most liquid and transparent venue for risk management
and hedging activities of the world’s largest economy. Technology,
competition, innovation, and reliability have become the hallmarks of the
industry, and our customer base has benefited tremendously from this
ongoing evolution.
However, these advances can be properly tapped only when the users of
the product continue to expand their knowledge of the options product and
its unique features. Education has always been the driver of growth in our
business, and it will be the steward of the next generation of options traders.
Dan Passarelli’s new and updated book Trading Option Greeks is a
necessity for customers and traders alike to ensure that they possess the
knowledge to succeed and attain their objectives in the high-speed, highly
technical arena that the options market has become.
The retail trader of the past has given way to a new retail trader of the
present—one with an increased level of technology, support, capital
treatment, and product selection. The impact of the staggering growth in
such products as the CBOE Holdings’ VIX options and futures, and the
literally dozens of other products tied to it, have made the volatility asset
class a new, unique, and permanent pillar of today’s option markets.
Dan’s updated book continues his mission of supporting, preparing, and
reinforcing the trader’s understanding of pricing, volatility, market
terminology, and strategy, in a way that few other books have been able.
Using a perspective forged from years as an options market maker,
professional trader, and customer, Dan has once again provided a resource
for those who wish to know best how the option markets behave today, and
how they are likely to continue to behave in the future. It is important to
understand not only what happens in the options space, but also why it
happens. This book is intended to provide those answers. I wish you all the
best in your trading!
William J. Brodsky
Chairman and CEO Chicago Board Options Exchange
Preface
I’ve always been fascinated by trading. When I was young, I’d see traders
on television, in their brightly colored jackets, shouting on the seemingly
chaotic trading floor, and I’d marvel at them. What a wonderful job that
must be! These traders seemed to me to be very different from the rest of
us. It’s all so very esoteric.
It is easy to assume that professional traders have closely kept secrets to
their ways of trading—something that secures success in trading for them,
but is out of reach for everyone else. In fact, nothing could be further from
the truth. If there are any “secrets” of professional traders, this book will
expose them.
True enough, in years past there have been some barriers to entry to
trading success that did indeed make it difficult for nonprofessionals to
succeed. For example, commissions, bid-ask spreads, margin requirements,
and information flow all favored the professional trader. Now, these barriers
are gone. Competi


e truth. If there are any “secrets” of professional traders, this book will
expose them.
True enough, in years past there have been some barriers to entry to
trading success that did indeed make it difficult for nonprofessionals to
succeed. For example, commissions, bid-ask spreads, margin requirements,
and information flow all favored the professional trader. Now, these barriers
are gone. Competition among brokers and exchanges—as well as the
ubiquity of information as propagated on the Internet—has torn down those
walls. The only barrier left between the Average Joe and the options pro is
that of knowledge. Those who have it will succeed; those who do not will
fail.
To be sure, the knowledge held by successful traders is not that of what
will happen in the future; it is the knowledge of how to manage the
uncertainty. No matter what our instincts tell us, we do not know what will
happen in the future with regard to the market. As Socrates put it, “The only
true wisdom is in knowing you know nothing.” The masters of option
trading are masters of managing the risk associated with what they don’t
know—the risk of uncertainty.
As an instructor, I’ve talked to many traders who were new to options
who told me, “I made a trade based on what I thought was going to happen.
I was right, but my position lost money!” Choosing the right strategy makes
all the difference when it comes to mastery of risk management and
ultimate trading success. Knowing which option strategy is the right
strategy for a given situation comes with knowledge and experience.
All option strategies are differentiated by their unique risk characteristics.
Some are more sensitive to directional movement of the underlying asset
than others; some are more affected by time passing than others. The exact
exposure positions have to these market influences determines the success
of individual trades and, indeed, the long-term success of the trader who
knows how to exploit these risk characteristics. These option-value
sensitivities can be controlled when a trader understands the option greeks.
Option greeks are metrics used to measure an option’s sensitivity to
influences on its price. This book will provide the reader with an
understanding of these metrics, to help the reader truly master the risk of
uncertainty associated with option trading.
Successful traders strive to create option positions with risk-reward
profiles that benefit them the most in a given situation. A trader’s objectives
will dictate the right strategy for the right situation. Traders can tailor a
position to fit a specific forecast with respect to the time horizon; the degree
of bullishness, bearishness, neutrality, or volatility in the underlying stock;
and the desired amount of leverage. Furthermore, they can exploit
opportunities unique to options. They can trade option greeks. This opens
the door to many new opportunities.
A New Direction
Traders, both professional and retail, need ways to act on their forecasts
without the constraints of convention. “Get long, or do nothing” is no
longer a viable business model for people active in the market. “Up is good;
down is bad” is burned into traders’ minds from the beginning of their
market education. This concept has its place in the world of investing, but
becoming an active trader in the option market requires thinking in a new
direction.
Market makers and other expert option traders look at the market
differently from other traders. One fundamental difference is that these
traders trade all four directions: up, down, sideways, and volatile.
Trading Strategies
Buying stock is a trading strategy that most people understand. In practical
terms, traders who buy stock are generally not concerned with the literal
ownership stake in a corporation, just the opportunity to profit if the stock
rises. Although it’s important for traders to understand that the price of a
stock is largely tied to the success or failure of the corporation, it’s essential
to keep in mind exactly what the objective tends to be for trading a stock: to
profit from changes in its price. A bullish position can also be taken in the
options market. The most basic example is buying a call.
A bearish position can be taken by trading stock or options, as well. If
traders expect the value of a stock they own to fall, they will sell the stock.
This eliminates the risk of losses from the stock’s falling. If the traders do
not own the stock that they think will decline, they can take a more active
stance and short it. The short-seller borrows the stock from a party that
owns it and then sells the borrowed shares to another party. The goal of
selling stock short is to later repurchase the shares at a lower price before
returning the stock to its owner. It is simply reversing the order of “buy
low/sell high.” The risk is that the stock rises and shares have to be bought
at a higher price than that at which they were sold. Although shorting stock
can lead to profits when the market cooperates, in the options market, there
are alternative ways to profit from falling prices. The most basic example is
buying a put.
A trader can use options to take a bullish or bearish position, given a
directional forecast. Sideways, nontrending stocks and their antithesis,
volatile stocks, can be traded as well. In the later market conditions, profit
or loss can be independent of whether the stock rises or falls. Opportunity
in option trading is not necessarily black and white—not necessarily up and
down. Option trading is nonlinear. Consequently, more opportunities can be
exploited by trading options than by trading stock.
Option traders must consider the time period in question, the volatility
expected during this period, interest rates, and dividends. Along with the
stock price, these factors make up the dynamic components of an option’s
value. These individual factors can be isolated, measured, and exploited.
Incremental changes in any of these elements as measured by opti


y trading options than by trading stock.
Option traders must consider the time period in question, the volatility
expected during this period, interest rates, and dividends. Along with the
stock price, these factors make up the dynamic components of an option’s
value. These individual factors can be isolated, measured, and exploited.
Incremental changes in any of these elements as measured by option greeks
provide opportunity for option traders. Because of these other influences,
direction is not the only tradable element of a forecast. Time, volatility,
interest rates—these can all be traded using option greeks. These factors
and more will all be discussed at great length throughout this book.
This Second Edition of Trading
Option Greeks
This book addresses the complex price behavior of options by discussing
option greeks from both a theoretical and a practical standpoint. There is
some tactical discussion throughout, although the objective of this book is
to provide education to the reader. This book is meant to be less a how-to
manual than a how-come tutorial.
This informative guide will give the retail trader a look inside the mind of
a professional trader. It will help the professional trader better understand
the essential concepts of his craft. Even the novice trader will be able to
apply these concepts to basic options strategies. Comprehensive knowledge
of the greeks can help traders to avoid common pitfalls and increase profit
potential.
Much of this book is broken down into a discussion of individual
strategies. Although the nuances of each specific strategy are not relevant,
presenting the material this way allows for a discussion of very specific
situations in which greeks come into play. Many of the concepts discussed
in a section on one option strategy can be applied to other option strategies.
As in the first edition of Trading Option Greeks , Chapter 1 discusses
basic option concepts and definitions. It was written to be a review of the
basics for the intermediate to advanced trader. For newcomers, it’s essential
to understand these concepts before moving forward.
A detailed explanation of option greeks begins in Chapter 2. Be sure to
leave a bookmark in this chapter, as you will flip to it several times while
reading the rest of the book and while studying the market thereafter.
Chapter 3 introduces volatility. The same bookmark advice can be applied
here, as well. Chapters 4 and 5 explore the minds of option traders. What
are the risks they look out for? What are the opportunities they seek? These
chapters also discuss direction-neutral and direction-indifferent trading. The
remaining chapters take the reader from concept to application, discussing
the strategies for nonlinear trading and the tactical considerations of a
successful options trader.
New material in this edition includes updated examples, with more
current price information throughout many of the chapters. More detailed
discussions are also included to give the reader a deeper understanding of
important topics. For example, Chapter 8 has a more elaborate explanation
of the effect of dividends on option prices. Chapter 17 of this edition has
new material on strategy selection, position management, and adjusting, not
featured in the first edition of the book.
Acknowledgments
A book like Trading Option Greeks is truly a collaboration of the efforts of
many people. In my years as a trader, I had many teachers in the School of
Hard Knocks. I have had the support of friends and family during the trials
and tribulations throughout my trading career, as well as during the time
spent writing this book, both the first edition and now this second edition.
Surely, there are hundreds of people whose influences contributed to the
creation of this book, but there are a few in particular to whom I’d like to
give special thanks.
I’d like to give a very special thanks to my mentor and friend from the
CBOE’s Options Institute, Jim Bittman. Without his help this book would
not have been written. Thanks to Marty Kearney and Joe Troccolo for
looking over the manuscript. Their input was invaluable. Thanks to Debra
Peters for her help during my career at the Options Institute. Thanks to
Steve Fossett and Bob Kirkland for believing in me. Thanks to the staff at
Bloomberg Press, especially Stephen Isaacs and Kevin Commins. Thanks to
my friends at the Chicago Board Options Exchange, the Options Industry
Council, and the CME group. Thanks to John Kmiecik for his diligent
content editing. Thanks to those who contribute to sharing option ideas on
my website, markettaker.com . Thanks to my wife, Kathleen, who has been
more patient and supportive than anyone could reasonably ask for. And
thanks, especially, to my students and those of you reading this book.
PART I
The Basics of Option Greeks
CHAPTER 1
The Basics
To understand how options work, one needs first to understand what an
option is. An option is a contract that gives its owner the right to buy or the
right to sell a fixed quantity of an underlying security at a specific price
within a certain time constraint. There are two types of options: calls and
puts. A call gives the owner of the option the right to buy the underlying
security. A put gives the owner of the option the right to sell the underlying
security. As in any transaction, there are two parties to an option contract—
a buyer and a seller.
Contractual Rights and Obligations
The option buyer is the party who owns the right inherent in the contract.
The buyer is referred to as having a long position and may also be called the
holder, or owner, of the option. The right doesn’t last forever. At some point
the option will expire. At expiration, the owner may exercise the right or, if
the option has no value to the holder, let it expire without exercising it. But
he need not hold the option until expiration. Options are transferable—they
can be traded intraday in much the same way as stock is traded. Because it’s
uncertain


older, or owner, of the option. The right doesn’t last forever. At some point
the option will expire. At expiration, the owner may exercise the right or, if
the option has no value to the holder, let it expire without exercising it. But
he need not hold the option until expiration. Options are transferable—they
can be traded intraday in much the same way as stock is traded. Because it’s
uncertain what the underlying stock price of the option will be at expiration,
much of the time this right has value before it expires. The uncertainty of
stock prices, after all, is the raison d’être of the option market.
A long position in an option contract, however, is fundamentally different
from a long position in a stock. Owning corporate stock affords the
shareholder ownership rights, which may include the right to vote in
corporate affairs and the right to receive dividends. Owning an option
represents strictly the right either to buy the stock or to sell it, depending on
whether it’s a call or a put. Option holders do not receive dividends that
would be paid to the shareholders of the underlying stock, nor do they have
voting rights. The corporation has no knowledge of the parties to the option
contract. The contract is created by the buyer and seller of the option and
made available by being listed on an exchange.
The party to the contract who is referred to as the option seller, also called
the option writer, has a short position in the option. Instead of having a right
to take a position in the underlying stock, as the buyer does, the seller
incurs an obligation to potentially either buy or sell the stock. When a trader
who is long an option exercises, a trader with a short position gets assigned
. Assignment means the trader with the short option position is called on to
fulfill the obligation that was established when the contract was sold.
Shorting an option is fundamentally different from shorting a stock.
Corporations have a quantifiable number of outstanding shares available for
trading, which must be borrowed to create a short position, but establishing
a short position in an option does not require borrowing; the contract is
simply created. The strategy of shorting stock is implemented statistically
far less frequently than simply buying stock, but that is not at all the case
with options. For every open long-option contract, there is an open short-
option contract—they are equally common.
Opening and Closing
Traders’ option orders are either opening or closing transactions. When
traders with no position in a particular option buy the option, they buy to
open. If, in the future, the traders wish to eliminate the position by selling
the option they own, the traders enter a sell to close order—they are closing
the position. Likewise, if traders with no position in a particular option want
to sell an option, thereby creating a short position, the traders execute a sell-
to-open transaction. When the traders cover the short position by buying
back the option, the traders enter a buy-to-close order.
Open Interest and Volume
Traders use many types of market data to make trading decisions. Two
items that are often studied but sometimes misunderstood are volume and
open interest. Volume, as the name implies, is the total number of contracts
traded during a time period. Often, volume is stated on a one-day basis, but
could be stated per week, month, year, or otherwise. Once a new period
(day) begins, volume begins again at zero. Open interest is the number of
contracts that have been created and remain outstanding. Open interest is a
running total.
When an option is first listed, there are no open contracts. If Trader A
opens a long position in a newly listed option by buying a one-lot, or one
contract, from Trader B, who by selling is also opening a position, a
contract is created. One contract traded, so the volume is one. Since both
parties opened a position and one contract was created, the open interest in
this particular option is one contract as well. If, later that day, Trader B
closes his short position by buying one contract from Trader C, who had no
position to start with, the volume is now two contracts for that day, but open
interest is still one. Only one contract exists; it was traded twice. If the next
day, Trader C buys her contract back from Trader A, that day’s volume is
one and the open interest is now zero.
The Options Clearing Corporation
Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday
for a hamburger today.” Did Popeye ever get paid for those burgers? In a
contract, it’s very important for each party to hold up his end of the bargain
—especially when there is money at stake. How does a trader know the
party on the other side of an option contract will in fact do that? That’s
where the Options Clearing Corporation (OCC) comes into play.
The OCC ultimately guarantees every options trade. In 2010, that was
almost 3.9 billion listed-options contracts. The OCC accomplishes this
through many clearing members. Here’s how it works: When Trader X buys
an option through a broker, the broker submits the trade information to its
clearing firm. The trader on the other side of this transaction, Trader Y, who
is probably a market maker, submits the trade to his clearing firm. The two
clearing firms (one representing Trader X’s buy, the other representing
Trader Y’s sell) each submit the trade information to the OCC, which
“matches up” the trade.
If Trader Y buys back the option to close the position, how does that
affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an
intermediary, assigns one of its clearing members with a customer that is
short the option in question to deliver the stock to Trader X’s clearing firm,
which in turn delivers the stock to Trader X. The clearing member then
assigns one of its customers who is short the option. The clearing member
will assign the trader either randomly or first in, first out. Effectively, the
OCC


OCC, acting as an
intermediary, assigns one of its clearing members with a customer that is
short the option in question to deliver the stock to Trader X’s clearing firm,
which in turn delivers the stock to Trader X. The clearing member then
assigns one of its customers who is short the option. The clearing member
will assign the trader either randomly or first in, first out. Effectively, the
OCC is the ultimate counterparty to both the exercise and the assignment.
Standardized Contracts
Exchange-listed options contracts are standardized, meaning the terms of
the contract, or the contract specifications, conform to a customary
structure. Standardization makes the terms of the contracts intuitive to the
experienced user.
To understand the contract specifications in a typical equity option,
consider an example:
Buy 1 IBM December 170 call at 5.00
Quantity
In this example, one contract is being purchased. More could have been
purchased, but not less—options cannot be traded in fractional units.
Option Series, Option Class, and Contract Size
All calls or puts of the same class, the same expiration month, and the same
strike price are called an option series . For example, the IBM December
170 calls are a series. Options series are displayed in an option chain on an
online broker’s user interface. An option chain is a full or partial list of the
options that are listed on an underlying.
Option class means a group of options that represent the same underlying.
Here, the option class is denoted by the symbol IBM—the contract
represents rights on International Business Machines Corp. (IBM) shares.
Buying one contract usually gives the holder the right to buy or to sell 100
shares of the underlying stock. This number is referred to as contract size .
Though this is usually the case, there are times when the contract size is
something other than 100 shares of a stock. This situation may occur after
certain types of stock splits, spin-offs, or stock dividends, for example. In
the minority of cases in which the one contract represents rights on
something besides 100 shares, there may be more than one class of options
listed on a stock.
A fairly unusual example was presented by the Ford Motor Company
options in the summer of 2000. In June 2000, Ford spun off Visteon
Corporation. Then, in August 2000, Ford offered shareholders a choice of
converting their shares into (a) new shares of Ford plus $20 cash per share,
(b) new Ford stock plus fractional shares with an aggregate value of $20, or
(c) new Ford stock plus a combination of more new Ford stock and cash.
There were three classes of options listed on Ford after both of these
changes: F represented 100 shares of the new Ford stock; XFO represented
100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24;
and FOD represented 100 shares of new Ford, 13 shares of Visteon, and
$2,001.24.
Sometimes these changes can get complicated. If there is ever a question
as to what the underlying is for an option class, the authority is the OCC. A
lot of time, money, and stress can be saved by calling the OCC at 888-
OPTIONS and clarifying the matter.
Expiration Month
Options expire on the Saturday following the third Friday of the stated
month, which in this case is December. The final trading day for an option
is commonly the day before expiration—here, the third Friday of
December. There are usually at least four months listed for trading on an
option class. There may be a total of six months if Long-Term Equity
AnticiPation Securities® or LEAPS® are listed on the class. LEAPS can have
one year to about two-and-a-half years until expiration. Some underlyings
have one-week options called WeeklysSM listed on them.
Strike Price
The price at which the option holder owns the right to buy or to sell the
underlying is called the strike price, or exercise price. In this example, the
holder owns the right to buy the stock at $170 per share. There is method to
the madness regarding how strike prices are listed. Strike prices are
generally listed in $1, $2.50, $5, or $10 increments, depending on the value
of the strikes and the liquidity of the options.
The relationship of the strike price to the stock price is important in
pricing options. For calls, if the stock price is above the strike price, the call
is in-the-money (ITM). If the stock and the strike prices are close, the call is
at-the-money (ATM). If the stock price is below the strike price the call is
out-of-the-money (OTM). This relationship is just the opposite for puts. If
the stock price is below the strike price, the put is in-the-money. If the stock
price and the strike price are about the same, the put is at-the-money. And,
if the stock price is above the put strike, it is out-of-the-money.
Option Type
There are two types of options: calls and puts. Calls give the holder the
right to buy the underlying and the writer the obligation to sell the
underlying. Puts give the holder the right to sell the underlying and the
writer the obligation to buy the underlying.
Premium
The price of an option is called its premium. The premium of this option is
$5. Like stock prices, option premiums are stated in dollars and cents per
share. Since the option represents 100 shares of IBM, the buyer of this
option will pay $500 when the transaction occurs. Certain types of spreads
may be quoted in fractions of a penny.
An option’s premium is made up of two parts: intrinsic value and time
value. Intrinsic value is the amount by which the option is in-the-money.
For example, if IBM stock were trading at 171.30, this 170-strike call
would be in-the-money by 1.30. It has 1.30 of intrinsic value. The
remaining 3.70 of its $5 premium would be time value.
Options that are out-of-the-money have no intrinsic value. Their values
consist only of time premium. Sometimes options have no time value left.
Options that consist of only intrinsic value are trading at what traders call
parity . Time value is sometimes called pre