Almost Trading For A Living, Part II

Welcome to the TradingMarkets Big Saturday Interview. I'm very pleased to have joining me for the second time, Dr. Steven Gabriel. In my first interview with Steve several weeks ago, he talked about how trading became his passion outside of his work as a doctor and how he was able achieve consistent results through systematic trading. In this follow-up interview, Steve takes us more in-depth into his trading strategies and shows us how he incorporates options into his trading.

Eddie: It's nice having you back for the second time on the TradingMarkets Big Saturday Interview.

Steve: Yes, thanks for inviting me on again.

Eddie: Before you tell us about your options strategy, can you tell me a little be about your background for the benefit those who did not read your first interview.

Steve: I am an emergency medical physician, which I love. And the way I got started in trading was when I as in college I began picking up in an interest in trading through an my uncle and my godfather. I began to watch them discuss different stock market trades and strategies that they had which were really just "buy and hold" in nature. And I began to pick up some magazines on the markets and began trading my money while I was a college student and in my job after college. I opened my own brokerage account and just bought a few positions in a few different stocks and slowly from there my interest grew.

Once I was a medical student, I began taking a more active interest in trading and I was trading more and more. And I spend a lot of time researching strategies and the markets.

"...Why can't the same kind of rigorous statistical testing that is applied in medicine be applied to trading systems and strategies?"

Eddie: During that time, what were you initial experiences as a trader?

Steve: When I first started trading during the "roaring 90s," I had a big interested in computers...so I bought some computer stocks that were performing very well. Then I started noticing that stocks that were going up fast often went up even faster as time went on. So I began moving in to a pure momentum strategy where I would take whatever stocks were performing best and move my money in to them. With money that I had saved during medical school, I turned a $10,000 account into a roughly $500,000 which was just wonderful.

Eddie: From there, what happened especially when the markets started plummeting and the momentum strategies no longer worked?

Steve: Well, in hindsight I realize that I was just naive like everyone else. Over time, I slowly began to use leverage and I began to use more and more margin and I began to adopt more options strategies and my account grew exponentially. And when the market started going down, I really didn't know any other strategies I studied was what worked in the 1990s. I knew nothing about risk management or risk control and it just took me about a year to lose all of that money.

Eddie: How did you get yourself on the right path and evolve into become a successful trader? What kinds of things things did you do, what did you read, what systems our strategies did you acquire?

Steve: The first thing I started doing was I began to approach trading like I was approaching medicine. I realized that there were people who were successful at trading and my first inclination was, if other people can be successful trading, then I can be successful too. The way to start was by gathering information. The first thing I did was started reading Investors Business Daily, William O'Neil's work. That was more because it was readily available than anything else. I began to read the Market Wizards books to look at and get into the minds of successful traders. I began to read other books on topics such as candlestick charting, trading strategies, chart patterns, and fundamental analysis. From all of this, I tried to develop my own strategy. But what I really found was I was developing more of a mishmash than anything else.

Eddie: So all of that research was leading you nowhere.

"...My whole theory is that if I can't really lose much, I can really only mostly win..."

Steve: In a way, yes. As I read more and more, I began to reach a critical turning point when I began to contrast what I was learning in medicine with what I was learning in trading. I would read medical books that would describe studies in which they tested 10,000 patients and they would tell you the percentages of successes and the percentage of failures. And they would be completely truthful about the flaws in their studies. As I read trading books more and more, I realized that the data they presented was not expressed in the same way as what I found in the medical books. The trading books would just make statements like "a head and shoulders pattern works the majority of the time." I really questioned whether I could use what amounted to subjective guesswork in my trading. And I began to ask myself why can't the same kind of rigorous statistical testing that is applied in medicine be applied to trading systems and strategies?

Eddie: And how did you get to a point where you could actually trade using statistically backed methods?

Steve: I was look at the TradingMarkets website and I found some works by Larry Connors in which he was really expressing his research in terms that I was familiar with in the field of medicine. From there, I knew that this was information that I could dig my teeth into, analyze and actually find a strategy that I could trade confidently. That was really my first step into become a successful trader.

Eddie: Steve, let's talk about the strategies you now employ. What kinds of trading systems have worked and continued to work for you?

Steve: I think the first piece of the puzzle for me was that I look for a variety of statistically backed systems and data that I put together in one portfolio and lot of those systems I use are from TradingMarkets. Some of the things I use have tweaked to a certain extent are R3 System which I use with the market indices. I use R4s with equities. I also use a derivative system which you guys have called the Options Income Steam System or  OISS. And I use the Always Buy Value system. I would say that signals that come from these systems are the foundation of what I use as a trading style. I've gone on and applied a lot of risk management techniques to these which has enhanced the performance dramatically. I've also done some things using futures and options. But those systems and the signals from those systems are really what backs up my trading decisions.

Eddie: That being the case, let's get into the nuts and bolts of your trading and how you trade some of these systems. Can you talk about the systems you use and the kind of unique approach you use in trading them successfully.

"...Essentially I use options for just about all my equity trades..."

Steve: The first thing is that I consider myself to be a systematic trader. The way that I define that is that use systems and I use statistical data to make my trading decision. But, of course, anyone who trades systems knows that there's a discretionary component to all systems trading. What I mean by that is that you must make decisions about position sizing, how much money you're allocating to each system you use. Obviously, there's times when every system is firing off buy signals all at the same time and there's not money to allocate to all of them. And you have to a plan on place in the even that one of your systems no long works. All of these decision are more judgment calls than they mechanical decisions.

Then I look at the average return of each individual position within each system. The way I put it together is I ask how well does an average position do in each one of these systems. I basically make myself a spread sheet and then I know how well each system performs. Based on that, I can allocate dollars to different systems. Basically I just take the data that I get from the systems, I list them on a spreadsheet and I notice some have a bigger drawdown and I notate the profit factors of each systems. That is how I really developed my position sizing. So I have more money in things that perform better and draw down less, and I have less money allocated in things that don’t do as well, but I do still leave those in to make sure I have enough trades per year.

Eddie: With all of your risk management and position sizing adjustments, I would imagine that someone can take the same systems that you trade and get dramatically different results. Do you think that is the case?

Steve: Yes. My personal bias is that with appropriate position sizing and risk management, you can make a lot of different types of systems and trading styles work better. In fact, I believe that you can take trading systems that are successful for somebody else and with inappropriate position sizing and risk management, you can make them fail. I think that happens all the time. There is probably nothing that has changed my trading performance more than how I look at risk. There is no doubt that every trade I take, I am not basing any decision on how much money I can make, but on how much money I think I can lose. How much money I think I can make plays no factor in my position sizing. My whole theory is that if I can't really lose much, I can really only mostly win.

Eddie: You mentioned that you use options to increase leverage and control risk. Can you tell us a little bit more about that?

Steve: Well, essentially I use options for just about all my equity trades. If there are options available, I use them. The way I use them is primarily for risk control. I also use them for leverage in my account, but not leverage the way people typically think. I don’t increase my position size because I can afford more options.

For example, let's say if there is a $50 stock and based on what I think my position size should be, I think I should buy 200 shares of this stock. In lieu of that, I may buy 2 $40 strike call options. These calls cost me about $10.10 each, which is $1000 per contract, or $2000. I would buy the front month call, and it would cost me around $2000, instead of having to pay the $10,000 that it would cost me to own those same 200 shares. Now just because I have more buying power because the options cost less, it doesn’t mean that I go and buy 5 contracts or $10,000 worth of contracts. I still only buy the same 200 share quantity as if I would have bought the stock. In terms of leverage, it ties up less cash in my account.

The second thing in terms of options, is that I use options in lieu of stocks because I can basically get all of the same point movement in options than I can in stocks. What I'm talking about is buying options with a high delta. Options with high deltas are options that are deep in the money. So essentially the delta tells us for every point the stock moves, how many points does the option move? For the way I trade, I look for a delta that is as close to one as possible, meaning if the stock goes up one point, I want my option to go up one point.

So if I go out and buy the option on a $50 stock, and I buy a call option that has a $40 strike for the front month, meaning its coming up in the next four weeks, what will happen is that I will be paying about $10.10 and the option will have a very high delta. In this scenario, if the stock moves up three points as the trade I am hoping for goes up, then I will gain roughly three points on the option. What happens if the stock goes down 5 points, is that the strike price was $40, and the stock is trading at $45. So now since the stock price is approaching the option price, I start to gain premium on the option. The fact is, an option has the most premium when the strike price and the stock price are the same number--an at the money option.

Eddie: Even in the case where you might have an adverse move, as the stock price approaches the option price the value of the option wouldn’t go down as much as when you own the stock?

Steve: Correct, so now if the stock goes down 5 points, I only lose 4 points. Obviously, as it gets closer and closer to expiration, it's worth less and less, but overall I do believe it protects you. If the stock completely tanks and has a 40% down move, I really just lose whatever I paid in terms of the option.

Eddie: When you are using options to trade a signal--let's say it's a TradingMarkets R4 or R5 signal--are you buying the underlying stock as well?

Steve: I buy the option instead of the stock. I just buy the same number of shares I would have if I bought the stock. So meaning, if I wanted to buy 200 shares of stock, I would buy 2 option contracts.

Eddie: So basically by trading deep in the money options, not only do you get the benefit of the delta decreasing as you approach at the money so you don’t lose as much, but you are also giving yourself the kind of leverage that you would get from trading a low-price stock.

Steve: Absolutely, but because I look at every trade in my account as an isolated event, what I can do now is diversify a little bit more. If I have one stock and I think that one position should risk maybe one percent to one-and-a-half-percent of my account value, I now may have more money to go into another signal that may come, or multiple signals that may come, so that the other individual positions can risk maybe one percent of my account value for each one of those. So although I am not increasing the amount of the one position, it allows me to diversify more, which really puts my performance closer to the true mean of what the performance should be with the system I am trading.

Eddie: How about if you walk us through a couple of recent trades that you've done. Explain to our our readers the thought process that goes into determining your position size and then explain how you use options instead of equities to trade to trade, say, the TradingMarkets R4 signals.

Steve: Sure. I have a couple of trades that illustrate what I'm talking about here. They are in HAL an RIO.

Editor's note: Steve then uploaded charts of his recent trades and provided explanations which accompany those charts.

This is an example of an R4 buy that I took on November 11 in Halliburton (HAL) I looked at the call options that were trading and I found that the November 50 calls were selling for 6.10 each when the stock was trading at 56. That meant that I was only paying for .10 of premium and 6.00 of intrinsic value. So, I knew that I did not have to look at any deeper in the month call options to find what I wanted. Next, I needed to determine my position size. Well, to make things simple, let's say that my account size is $100,000 dollars. For the R4 system, I risk 1% of my account value or $1000.00. From there, I look at the recent volatility of the stock. I usually look back roughly 3 months and in the case of HAL, the stock moved from approximately 65 on 11/3/05 to roughly 56 on 11/10/05. This is about 9 points. To make this conceptually simpler, I round it up to 10 points. I know that the stock has had recent swings approximately 10 points and I make the assumption that current volatility will be similar to volatility in the recent past. And that tells me what my potential risk is and I use this to determine my position size. Well, 1 option contract is 100 shares, and 10 points x 100 shares is $1000.00. So, I would buy 1 option contract, regardless of the price of the option. After the preceding process, the actual trade begins. I buy 1 November 50 call for 6.10 on November 11. An exit signal comes on 11/16/05 when the stock is trading at 59.50. The November 50 call goes for 9.30. I actually sold the contract when the stock was trading at 59.30. Unfortunately, the 0.10 premium that you pay for the purchase doesn't come back to you when you sell in most cases. This trade was a 52% gain.

This is another example of an R4 trade, this time in Companhia Vale do Rio Doce (RIO) This is a good example of a stock that trades with options but is more difficult to trade than HAL with options. This is because the spreads were wide on the RIO options, and I was unable to find a contract that only had 10 cents premium. I chose the October 35 deep-in-the-money calls which had as little premium as any of the other options I was considering. For position size, I once again consider that this is an R4 play. So I risk 1% of my account based on the volatility of the stock. I looked back a bit on a chart saw the peak of 45 on 9/29 and the recent pullback of  36.5 on 9/14. Therefore, I estimated the volatility to be roughly 8 points in a swing. Therefore for a $100,000 dollar account, I would buy 1 contract. 1 contract=100 shares, 100 shares x 8 points=$800 which is 0.8% of the account value vs. 1%. We don't need to be exact, these are all estimates anyway. On October 6 in the morning, because I had a signal to buy on  October 5th at the close but missed that entry, I bought the October 35 Calls for 4.30. The stock opened at 39.05. I essentially paid .25 in premium. That's more than the 10 cent premium that I ideally want, but that's where discretion comes in. At the close of October 6, there was another signal to buy, so I bought another position of the same size at the close. The stock closed at 38.03, and I bought an equal amount of the October 35 for 3.40. This is a .37 premium. On October 11, there was a signal to exit at 41.40. I sold the calls for 6.30 for a nice gain. This was actually 0.10 less than what you would expect from the what the intrinsic value would be, but when you do these transactions--you are actually doing them a little before the market actually closes (or opens)--so the stock was actually trading at about 41.30 at the time of the sale. Keep in mind that sometimes this works to your advantage.

Eddie: Prior to this interview, we had talked about your goals and aspirations in managing money and trading at a professional level. Can you talk a little about that?

Steve: Currently I am working in an emergency department in San Diego. I'd like to allocate more time later on in my life in doing some free medicine in more more rural areas and maybe outside countries. Sometimes this can get frustrating from an administrative standpoint. I'd like to give it some time because doing medicine has been a wonderful experience and something that I have really enjoy. But because it is my main livelihood at this time, I have to allocate most of my time towards that. Hopefully, as I have continued success in trading, I can build my account through time to have trading support a lot of my life and what I currently do in my family. I have also been writing a blog--Almost Trading For A Living--because it helps to keep building upon that. In terms of managing money, I have already started trading for some of the members of my family, and I think it is a good way to build experience managing money and building a base of capital to help accelerate my own capital growth.

Eddie: Could you talk about what your passion about trading is versus your day to day activity as a doctor?

Steve: One of the real joys of trading is that trying to tackle the market is a big puzzle. The way I have chosen to go about it is from a quantitative and statistical approach and others have gone about it in their own way. Any way you decide to trade, I believe they can all be successful, but even more importantly, the way we choose to tackle this puzzle relates to who we are as people. A lot of times, for many of us who have outside jobs, you have to tackle problems and puzzles at our own work, you are at the mercy of the system, work environment, rules of government, and the rules of your administration. You aren’t really at the free will to look at the problems in front of you and attack it your way. In trading, you get immediate feedback based on your success and failure, and I think it is incredibly rewarding.

Eddie: Steve, thanks for being with us once again.

Steve: Thank you.

Editor's note: I hope you enjoyed my interview with Steve Gabriel. I welcome your questions or comments. Please email me at eddiek@tradingmarkets.com.

Eddie Kwong
Editor-in-Chief
TradingMarkets.com