What is Bill Lipschutz's trading framework?

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Integrating ideas

Once a trade has a certain view of the future market, it must integrate the relevant ideas into a trade. If you expect the market to rise, the simplest way is to buy the underlying asset. However, depending on your view of the market, other complex strategies may have better performance.

"Next is the framework of the trade. There are countless ways to structure a trade, and the details are even more numerous. You may be completely right about the market, but the result is a loss. If the timing is slightly inaccurate, you may lose. Structuring a trade must increase the probability and potential of profit and reduce the possibility of loss. This is the essence of the trading game, constantly making such decisions." How does Jon Najarian conduct high-probability trades?

For example, if you are bullish on the yen, you can do the yen in many different ways. You can buy yen, buy call options, or sell put options. If you want to go long on the yen, and the yen exchange rate volatility is low, you may consider buying a long position in options.

If the exchange rate volatility is high, you may consider selling put options. However, if the exchange rate volatility is very high, selling put options may not be ideal, and you may want to buy the underlying yen directly. Therefore, to build a trade, you must grasp all the favorable factors as much as possible and accumulate the odds as much as possible. How to conduct high-probability trades?

"For example, suppose you buy a premium call option spread, where the premium on the buy side is 2%, and the premium on the sell side is 5%. If you are right about the direction of the market, the call option on the buy side will then enter the parity state, and the price volatility will change relatively because the option enters the parity state."

"In other words, when you first buy the spread trade, the implied price volatility on both sides of the long and short is higher than the average implied price volatility of the option. Now, the call option on the buy side enters the parity state, and you know that this part has some losses, because the parity option now implies the price volatility of the parity."

"Therefore, you have to understand the dynamic relationship, especially when using the ratio spread strategy. If you are right about the direction of the market, you may want to cover the short side of the strategy, because the short side may continue to maintain a high value."

However, please note that the more complex the structure of the strategy, the more money it does not mean.

"My boss at Solomon, Gil Rineydek, used to say that there is smart money and stupid money in the market. But at the end of the day, money is money. In other words, no matter how you make money, the source doesn't matter."

"For example, if you lose money by buying IBM stock, many young people always want to get justice in IBM stock. This is irrelevant. Even if you lose money in IBM stock, you don't have to force yourself to trade IBM. The market doesn't care, and the bank account doesn't mind where the money comes from. Gil once said to me: 'Why don't we just buy and sell money and make money? Why do we trade options or other complex things?' He meant 'smart money is money, stupid money is money'. Sometimes, you can say 'buy', and after the price rises, you can say 'sell, thank you'."

Evaluating profit potential and potential losses

In addition to trying to grasp the profit potential, the structure of a trade must also consider risk protection. How to perceive trading risk and how to understand the nature and management of risk?

"When you first establish a position, of course, you will set profit-taking and stop-loss exit targets. These targets should be determined by your trading ideas. The size of the position depends on the maximum amount of loss you can accept. For example, suppose the current exchange rate is 1 US dollar = 124 yen.

In addition, suppose you think that the result of the latest round of trade talks between Japan and the United States should make the yen depreciate to 130, but based on technical considerations, the yen may also appreciate 122.50.

After evaluating the pricing structure of the yen options, you decide that the best position is to directly short the yen/buy the US dollar in the spot market. How big should the position be? This depends on the size of the trading account and the maximum loss you are willing to accept.

If the trading account has a capital of 10 million US dollars, and you only accept a loss of 3%, then you should short 15 million US dollars worth of yen (by 300,000 US dollars × [125/2.5] = 15 million US dollars). In case of a wrong judgment, the loss is 300,000 US dollars. If you judge correctly and smoothly cover the yen at 130, the profit is 600,000 US dollars."

"It looks simple, doesn't it? But this is just a static analysis in a dynamic environment. After establishing a position, new information keeps happening. You have to constantly re-evaluate the status of the position based on new information and adjust the target price.

Of course, if the market moves in an unfavorable direction, but you insist that you are right, you may keep lowering the stop-loss point. This is certainly dangerous, but it is not the reasonable adjustment I am discussing now. You have to interpret the new information correctly. In short, you can't bargain with yourself, and the maximum amount of loss must be very clear."

Therefore, how to use the target price? How to re-evaluate based on new information? These are the key aspects of the trading framework. One of the effective ways to prevent losses is to make the profit potential several times the potential loss.

"For any trade, the profit potential should be several times the potential loss. But what should be the ratio between the two? Generally speaking, in short-term trading - in other words, trades that are ready to end within 48 hours - the ratio should be 3:1. For long-term trades, especially those involving many option positions and requiring capital, I set the return/loss ratio to at least 5:1."

Traders often use options to hedge against adverse price movements. For example, if a trader expects the market to rise, he may buy call options. However, to hedge against the risk of falling prices, he may also buy some put options, or sell call options with different strike prices or expiration dates.

"I think that professional traders regard options as insurance tools, which seems inappropriate. If the liquidity of a market position is not high, or the trading often stops, it may be worth considering the option insurance strategy."

"But the aforementioned two situations obviously will not happen in the foreign exchange market. Professional traders should always track the market as long as they hold open positions, and they can always end the position or admit defeat. Only in very rare cases, if the position size is too large and may significantly affect the market, I will consider using options as insurance tools."

In addition to setting loss protection for any single trade, you also need to guard against continuous losses.

"Regarding returns and risks, I think the mentality should not be symmetrical. To maintain long-term success, you must focus on losses, continuous losses, or related issues. It's simple, just know how much you are prepared to lose."

"No matter how big or small your position is, or whether you are right or wrong, it is the same. You have to know the extent of your loss. I'm not talking about psychological preparation; every time you make a trade, you have to set the maximum amount of loss, naked data. You are not allowed to strike out, you have to maintain the ability to re-enter the market - tomorrow, the day after tomorrow, the day after tomorrow... it is the same. Manage risk well, and profit will take care of itself."

Focusing on loss risk, there is a question involved "When to end the position?"

"I think there are two reasons to end a loss position. First, if the scenario or scenario evolution that should happen in the expectation obviously cannot happen."

"For example, if you expect a left-wing political leader to win the election, but he loses. The second reason is that the price reaches the predetermined stop-loss level, regardless of whether your expected scenario is correct or not. Once this happens, there is no room for bargaining, and you exit immediately."

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