When trading options, it is always important to use your capital in the most efficient way as possible. This can be measured in a number of ways such as delta, theta, product and volatility efficiency. Delta Efficiency refers to the amount of delta you can receive per $1 of capital. Theta Efficiency is similar in the fact that it is the amount of theta you can expect each day per $1 of capital used. Product Efficiency is the comparison of liquidity and the bid ask spread between cash settled indices and their corresponding ETFs. Finally, Volatility Efficiency is that increase amount of premium you are able to collect when Implied Volatility is high.

Today, Tom Sosnoff and Tony Battista break down all of these different metrics and explain how you can use these when trading options. The guys make everything really easy to understand and show specific examples of each type of efficiency metric. Being able to apply these different strategies will allow you to use your capital more efficiently so that you can increase your number of occurrences and increase your probability of success!

Tom Sosnoff: Tom Sosnoff is back my friend, Best Practices. EMNsEP down 575 NASDAQ down 8. All I've got. Wish I had more.
Tony Battista: It's down, um … The NASDAQ level between …
Tom Sosnoff: NASDAQ traded under 42.
Tony Battista: Did it really?
Tom Sosnoff: 41.98.75
Tony Battista: The level between, like, 04 and 14 has been kind of this little, you know… it hasn't really broken, man, it broke a little last night over night. And the SMPs can get under 20.20, something good can happen.
Tom Sosnoff: Yeah. Get 20.25
Tony Battista: Yeah, we're just being conservative here and keeping kind of our core position on, but not jumping all over anything else. We've got plenty of short deltas in plenty of other places. We're a little short twitter now after that rally on Friday, but it hasn't been bad for us. We're a little long on oil still, we're definitely short SMPs and we're long on all these currencies. The Ns and the Euro, they're both up last night. So, we could use a little turn around.
Tom Sosnoff: Yes.
Tony Battista: In some of those underlyings. And we're looking to get short … I want to get short bonds over 143, but that's a point away.
Tom Sosnoff: Yeah, that's a full point away.
Tony Battista: I'm impatiently waiting. And that's it. You know, I'm looking through all the positions right now. You know, we could definitely use a sell off in Apple.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: No question about it. And a sell off in stupid Yahoo.
Tom Sosnoff: Yeah, Apple's up 35 cents.
Tony Battista: Yeah, Apple's up, Yahoo's up. It's the same old garbage, same old companies.
Tom Sosnoff: Never thought I'd be putting Yahoo up in "same old garbage, same old companies."
Tony Battista: It is, look at that.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: Well, whatever. We'll see … Listen, maybe we'll get a little more aggressive today. We definitely haven't added a single contract to our positions. So we've just been sitting …
Tom Sosnoff: Scalping great.
Tony Battista: Scalping good, haven't added a contract, and we'll see what happens.
Tom Sosnoff: Plays have been nice.
Tony Battista: Yeah. So we're gonna run our ring plays though.
Tom Sosnoff: Yes.
Tony Battista: So that's it. All right, tons of content this week. Like I said, we're gonna be here for all week, next week we go dark. So, you pretty much miss 3 days of tastylive.
Tom Sosnoff: Right.
Tony Battista: But it's only fair.
Tom Sosnoff: Thanksgiving is a slow week.
Tony Battista: Thanksgiving, it's a slow week, and we've got to get people off. And we're actually going to work Christmas, so we're going to take off for Thanksgiving, which will be nice. Give everyone here a break, we haven't given anyone here a break all year. We've given a couple of days after holidays, but we've killed the tastylive team here.
Tom Sosnoff: Yes, yes.
Tony Battista: In order for them to show up for 2015, we've got to give some people a little bit of a vacation.
Tom Sosnoff: We've gotta give them 3 days.
Tony Battista: Yes. So …
Tom Sosnoff: Synthetic Week.
Tony Battista: Yes. But, Friday night we'll be in Vegas, if you want to come out and … I always have fun at the Vegas show, we're actually doing a … pretty much a brand new show for Friday. I'm working on it with Paul this week and we'll have some fun segments. Vegas is always, to me, the most fun, because you can say anything.
Tom Sosnoff: Sure, it's a lively crowd.
Tony Battista: Yeah, yeah, yeah, yeah. You can curse and do anything you want, you don't have to … There's no compliance people, it's a whole different fun. So 6:45, it only goes about an hour and a half, and hour and 45 minutes or whatever. They're early, but we start at 6:45 or whatever. We don't have unlimited space like we do at other ones … It's free! And you don't have to sign up or anything. But, it's confusing to get to, so if you go to Ceasers' it's up on the … It's in the convention area, but you have to … It's like a maze.
Tom Sosnoff: It's big.
Tony Battista: Yeah, it's Ceasers' Mansion.
Tom Sosnoff: It's big.
Tony Battista: But the room itself's not that big, it only holds, you know, maybe 4, 5, … I don't know what it holds total.
Tom Sosnoff: Yeah, but to get through all the …
Tony Battista: It's a maze.
Tom Sosnoff: It's a maze.
Tony Battista: But if you get there, like last year we ran out of space, so get there early and it'll be fun.
Tom Sosnoff: Cool.
Tony Battista: Like, 6:15, 6:30. I think there's somebody else who speaks until 6:00, whatever. And 6:15, or so, and then you'll have plenty of room.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: It'll be fun.
Tom Sosnoff: So I heard. Gonna get the nod. It's alright
Tony Battista: So then I'm gonna disappear for a couple days. And relax and get ready to come back in the first of December.
Tom Sosnoff: Gonna be good.
Tony Battista: Yeah. It's gonna be great. All right. Let's do this. Best Practices. You ready?
Tom Sosnoff: I'm ready sir.
Tony Battista: So the guys put together something. A lot of people have asked us about this in the past, I'm going to … Because we did a couple of market measures and things like that, on efficiency. And what we call delta efficiency. And what it means is just that, hey, if I use a certain instrument, and I'm right, what are the chances that I'm going to make money? That's kind of what efficiency is.
Tom Sosnoff: Sure.
Tony Battista: If I do something, I mean, I don't want to do something, be right, and not make any money. Because if I'm wrong, I always lose money.
Tom Sosnoff: Correct.
Tony Battista: And sometimes if I'm right I lose money. So I want to know what my delta efficiency is, just meaning that if I guess right, I want to make some money. So what is delta efficiency? Delta efficiency refers to the amount of directional exposure gained for every dollar of buying power we use. So it's a little bit different from delta by itself. This way, we're just talking about how it relates to buying power use. Which is not the way most people look at any one of the option creeks. The beautiful thing about tastylives is that we do things that are completely different from the way everybody else looks at the world. And delta efficiency is kind of a term that we pretty much created here. The research team did. Esentially, we want our delta's to be as cheap as possible, especially when hedging existing positions, but other times we want our deltas to be actually more efficient when we place something directional. A neat little distinction. Let's keep going. So what we did here, is we … and we'll archive all this, so you can see, but this is kinda cool. We looked at December SPY prices, and we talked about a short Put, a short 99 Put, 93 Put, a short Put spread, a long call spread, long stock. You know, of course, long stock is going to have a … Or course long stock is going to be efficient to move tick for tick, but how does it move relative to … How much capital do you have to use?
Tom Sosnoff: Mm-hmm (affirmative), sure.
Tony Battista: Because that's kind of where, with respect to buying power …
Tom Sosnoff: The higher the number for efficiency …
Tony Battista: Yeah.
Tom Sosnoff: The more efficient it is, meaning more correlation 1 to 1 it has.
Tony Battista: Yeah. I mean, you look at the long /ES, the delta efficiency of long /ES here, the delta efficiency is .99.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: That's about as tight as you can get.
Tom Sosnoff: Sure.
Tony Battista: But it's funny, because most people think "Well, long stock has credible delta efficiency." And the answer is, not relative to, for example, a long call spread.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: You know, just depends on how you want to use your capital. And I think this really puts perspective.
And again, we show efficiency equals delta divided by buying power times 10. But again, if you look at everything on this page, we tried to cover all our bases. So a short, out of the money Put, is 69% of the money. We looked at the delta efficiency, and in that case, you want the option to expire worthless. So you're just thinking "Okay, so the efficiency is relatively low, that's good." All right?
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: Because you're not looking for something that's highly correlated, but you want to see relative to your buying power reduction. All we're doing here is saying "Hey, relative to buying power reduction." And this is a really cool way to look at the markets. Relative to buying power reduction, how efficient is this trade?
Tom Sosnoff: Sure.
Tony Battista: You know, obviously, then, if you want to be long spiders and take a lot less, what we call "efficient risk", you're gonna use a lot more capital to have a less potential profits than you are futures. That will show you the difference between futures and stock and how much more "notional risk" there is in futures. But, at the same time, it shows you how much more efficient they are if you're looking for tic for tic.
Tom Sosnoff: I think if you look at number 1 and number 3 here, you're looking a short Put. That's the example that you gave, and then a short Put spread. You're collecting 87 cents, let's just say about half of what you would collect for the short Put, but you're using significantly less money. So the efficiency is better.
Tony Battista: Yeah. The efficiency's better. It doesn't meant that your risk … What we didn't put on here is probability profit. So this is just efficiency, not probability profit.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: But we did this so that you'll have a cheat sheet for efficiency. So because a lot times people talk about this business, they don't really understand. Okay so, you know, how inefficient your use … how inefficient use of capital is for long stock.
Tom Sosnoff: Correct.
Tony Battista: Like, it drives me crazy. People go "I don't use futures because they're too risky." I understand the risky, they have a big notional equivalent. But if you understand that, okay, and you want to trade in the equivalent of 100,000 dollars worth of stock, all right. There is no better way to do it, because your delta efficiency there is 99. It's way different if you want to trade 1,000 … if you want to trade 500 shares of stock and you want to use just straight long stock, you're talking about an extraordinary amount of capital. It's a much less efficient use of capital. Now, we're not talking about anything else.
Tom Sosnoff: I understand.
Tony Battista: So it's cool here, you get to see kind of "Hey, you want to sell out of a money Put? Your delta efficiency is far greater if you use the futures options, in this particular case, than if you use lifted options.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: That's how we talk about, kind of, delta efficiency. Anyway, very cool slide, you should definitely use it.
So what's theta efficiency? Theta efficiency refers to our daily decay relative to the buying power required to put the position on. This is really cool, because nobody covers this.
Tom Sosnoff: Right.
Tony Battista: So here, on the left hand side, we talk about low theta efficiency. 1 standard deviation strangles, you know Apple, IWM, and Google. Those are … You can see the credit received, you can see the margin required, you can see the data efficiency and you can see the return on capital. On the left hand side of the page, which is obviously all volatile related, but GoPro, HLF, and GDX, which all have high IVR, which all have a return on capital and then you talk about theta efficiency. This is just, again, this is just so you become more … This is to raise the level of intelligence and confidence among the Tasty nation. What's so cool about this is that this improves your level of articulation dramatically. Understanding the difference between a delta efficiency and not and a theta efficiency, and as a reply to return on capital, it's just really cool.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: That's it, that's it. You don't need to take it 100 steps beyond this. How much is the margin required? How much is credit received, the margin required, what's my return on capital? That's your theta efficiency. It's extremely cool. So for selling garbage, trangle, and Apple vs. a garbage, trangle, and something else. Listen, I want to understand it. If I'm going to take unlimited risk, maybe 5.7% in IWM is not nearly the same … I have a different risk tolerance for GDX. So maybe I'd rather collect the same amount of money, let's just say in GDX, and have 5 times the return on capital.
So, let's got to product efficiency. Product efficiency has to do with the liquid counterpart of very similar underlyings. This specific measure usually refers to cash-settled indices and their ETF components. This is, again, really cool, because we don't see this disseminated the way we're doing it right here.
Tom Sosnoff: Okay, good feedback on it already.
Tony Battista: It's almost unbelievable.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: This is a great segment, it should be archived. This is one of the first things they teach everybody. But we don't think about the business like this because listen, what's in it? Who's to gain?
Tom Sosnoff: Right.
Tony Battista: Why would some exchange teach you this? They don't care. Why would somebody else? It doesn't matter. The December SPX options, just take a look ad the bid ask and then look at the SPY options below that. And there you can just see the rut options and the IWM options. And again, this is just another case of kind of product efficiency. Sometimes, we don't think about it. You know how many questions we get a month on product efficiency? When people don't even realize that's what they're asking about?
Tom Sosnoff: Sure.
Tony Battista: "Tom, do you use SPX, or should I use SPY when I'm trading?" "Should you bait a way against SPX of should you bait a way against SPY?" "I'm thinking about trading away this rut strangle, do you think I should use IWM instead?" I mean we always … We are …
Tom Sosnoff: It's always being effected and you don't even think about it.
Tony Battista: Yeah. I mean, we talk about oil or something and they say like "Look, should I use OIH, or should I use USO because it's more liquid?" "What do you think about using CL options vs. whatever else it is?"
Tom Sosnoff: Sure.
Tony Battista: Vs. XLE. It's just, you know, we have to start thinking about efficient use of capital. Because again, you can't stay small enough without understanding the efficiency of the products.
Tom Sosnoff: Good point.
Tony Battista: So, what is implied volatility efficiency? So IV efficiency refers to the advantage that is realized edge that we receive by waiting for high implied volatility. This allows us to collect a greater amount of premium at the same strike or collect the same amount of premium at strikes further away. Consider the following: This is neat.
So. So we did this, a market measure on 6.3.14, entry level IV rank. And what you see here, is if the IV rank … Okay. IV rank, 0 to 24, 25 to 50, 50 to 75, 75 to 100. And all we're doing here, and again, is showing you efficiency of implied volatility.
Which, delta efficiency? What's your directioncy relative to your return on capital? Theta efficiency, what's your buying power reduction relative to how much premium you're going to collect, again, to your return on capital? And then we get in to product efficiency, is there enough liquidity in the underlying. And then probably, again, among the most important, is volatility efficiency. Which just has to do with, you know, IV rank and the current relationship between implied volatility and implied volatility as it's measured against itself.
So, we can put context around it. Here look, this is really simple. If your average P and L trade is a negative number, on 138 occurrences, and this is, this in spiders I think. But on 138 occurrences between 0 and 24, you're a net loser, even after collecting a dollar 15.
Tom Sosnoff: Sure.
Tony Battista: On the same, 20 occurrences at a dollar 80, you're up 123 dollars between 75 and 100. This … In each case, people go "How can I be right 78% of the time and not make money?" Well, it happens if you don't have good IV efficiency. If you have great IV efficiency, if you're patient, then 85% of the time you make a fortune.
Listen. So, we can't answer every question. It's really hard for us. We can't explain sometimes why we did a great anatomy of an account the other day on a customer that sent in …
Tom Sosnoff: A bunch of emails.
Tony Battista: A ton. Hundreds and hundreds, if not thousands of emails, discussing that segment. We're gonna do another one. We've got great responses from our customer base and a couple people have sent in some really complex, or some really interesting studies of their own accounts. It takes a lot of freakin' work.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: So we appreciate the stuff that's been sent in. And based on what's been sent in to us, we're gonna try to put in another one of two segments on that. Which are very similar, but have their own perspective. And you'll see, and a lot of mistake people make is, we're getting it down to where "Hey, if I want to be right 70%, 80% of the time, I can be. But now I need to understand that volatility … "
Tom Sosnoff: There's more than that.
Tony Battista: It's more than just being right, it's being right and making money.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: And the way to do that is to make sure that we're in situations where the IV rank is high, and so, if we're gonna be right 85% of the time, there's a possible P and L takeaway from it. This isn't easy, and we're learning ourselves. And e have no motive. Other than you guys figure it out.
Tom Sosnoff: Sure.
Tony Battista: You know, you can't … I just spent a whole weekend at this entrepreneurial conference, which I again, I don't think everyone was an "entrepreneur" in the same sense, there was a lot of big companies. But the theme is pretty consistent. The theme amongst entrepreneurs everywhere is pretty consistent, and in order to … And my take away was that there's … There are a lot of really genuine special companies out there that are on a mission. The missions are all different kinds of missions.
Tom Sosnoff: Sure.
Tony Battista: They're great companies, everyone's on this mission, but in the world of finance, I just gotta tell you this, in the world of finance, do you know one of the categories they had was finance. Do you know one?
Tom Sosnoff: No.
Tony Battista: In finance. It was a bank, and it was a bank that somebody had saved from bankruptcy to create just a stable bank.
Tom Sosnoff: Mm-hmm (affirmative)
Tony Battista: What I thought was really interesting about that was there was not a single consumer financial product in the entire … This is the biggest competition in the world.
Tom Sosnoff: Financial space.
Tony Battista: In the financial space. The biggest competition in the world, there's not a single consumer product or brokerage product, or anything that has to managing your own money except for us. It's crazy, when you think about it.
Tom Sosnoff: You want the public's money, but you don't really care what happens to the public.
Tony Battista: The entrepreneur space makes up, meaning that the … The self employed space, the mom and pop stores, make up almost, what is it, almost 50% of the GDP? 50% of the GDP. Self employed.
Tom Sosnoff: Okay
Tony Battista: Okay. I think it's 50% GDP. If that's the case, and there's nobody in finance, that's scary.
Tom Sosnoff: Let's take a quick break, we'll be right back. We've got The Opening Bell next. This is tastylive live.