Tony Battista: Best Practices, Sosnoff!
Tom Sosnoff: There's a rat in the kitchen and I don't want to do.
Tony Battista: There's Slim's balls, you can call them Slim's balls
Tom Sosnoff: I already know more about those than I need to, thank you. I saw one picture…
Tony Battista: I don't want to know how you know, you saw a picture, whatever, its your friends pot, I got it. It doesn't make a difference.
Tom Sosnoff: I saw one picture one time, that's all I needed. I'm done.
Tony Battista: Slim's balls. You can call them Slim's balls and I'm the one you worry about.
Tom Sosnoff: I'll never forget, one of my first experiences with email and internet was Slim sent a picture to the office, like as his Christmas card of him in an inner tube, with no clothes on. We're like "Okay, we've seen enough of this. My eyes! My eyes! Destroy this picture."
Tony Battista: Everyone is calling you rain man. "I'm an excellent driver, I'm an excellent driver."
Tom Sosnoff: I am an excellent driver, I can't help it if I can't get through the alley.
Tony Battista: "I'm an excellent driver."
Tom Sosnoff: Oh my God.
Tony Battista: Two minutes to Whopner.
Tom Sosnoff: At least my dogs like the snow. My dogs love that snow. They were just out there running and charging around. What a mess. What?
Tony Battista: Your dogs love the snow, running, charging around. Where? Your compound is all with that radiant heat, even outside. Where? Where were they frolicking in the snow?
Tom Sosnoff: No I got an area with snow.
Tony Battista: You're such a freaking liar.
Tom Sosnoff: I do.
Tony Battista: You're such a freaking liar.
Tom Sosnoff: I got an area with snow. I need one of these things, thank you. No, they run around. You know.
Tony Battista: That hurt your hand? My rifle?
Tom Sosnoff: No, I'm okay. S&P is up six bucks, NASDAQ is up ten bucks. Man, we got a lot to do this morning. Well, let's see.
Tony Battista: Everything is up about the same, namely the S&P, NASDAQ, Russell, and the DOW. DOW up 55.
Tom Sosnoff: Can you believe Exxon is unchanged?
Tony Battista: Bond is down 16 now. 150-25
Tom Sosnoff: Can you believe Exxon is unchanged?
Tony Battista: I can not believe Exxon is unchanged, even with oil up now by a dollar fourteen. So, oil has been the big, volatile mover this morning.
Tom Sosnoff: Oh my god, yeah. Its 49-30, I have an offer in at like 50. I haven't done anything yet today. Did you want to trade that…
Tony Battista: Oh you haven't done anything yet today, I feel like the US Army. I've done more before seven o'clock this morning than most people do all day.
Tom Sosnoff: Oh my god, that is so the thing, broken back almost had a heart attack.
Tony Battista: How, seriously be honest, you got stuck in your alleyway. How painful, how many times did you look at your phone to call me for help and then go "no, I got to do this myself."
Tom Sosnoff: I wasn't calling you for help, okay, I was…
Tony Battista: Hold on one second.
Tom Sosnoff: I needed a ride to work.
Tony Battista:
Tom Sosnoff: Okay. My biggest fear was my dogs.
Tony Battista: "Bat, Bat Bat Bat, I don't know what to do I'm stuck in the alley…"
Tom Sosnoff: I never said "I don't know what to do."
Tony Battista: "You have to come and get me," That is a cry for help. You didn't abandon your car and walk down the street and get your way to work. That would be doing it yourself. You needed saving!
Tom Sosnoff: I don't abandon, I'm not going to abandon my car.
Tony Battista: I was like "Saving Private Ryan" I had to go through, I was already here, I was 15 minutes earlier than I normally am here. So was Jules.
Tom Sosnoff: I'm not going to abandon my car. In the alley.
Tony Battista: Okay
Tom Sosnoff: Plus, I had my dogs in there, it was a free-for-all. Okay, just…
Tony Battista: You needed saving. Say it.
Tom Sosnoff: I needed somebody to push.
Tony Battista: You needed saving.
Tom Sosnoff: I needed somebody to push.
Tony Battista: You needed saving.
Tom Sosnoff: And I didn't realize how pathetic you and Jules are.
Tony Battista: "Bat, Bat, Bat, Bat, Bat I almost had two heart attacks before you got here."
Tom Sosnoff:
Tony Battista: I do not feel sorry for you. "I almost had two heart attacks. I'm on my second heart attack now." That's what you said to me.
Tom Sosnoff: When you fell down in the…
Tony Battista: Oh and then when you got in the car, we had everything done, the first thing out of your mouth was, "Well I bet people are really going to be happy that I won 500 dollars in the square pool." Like, oh yeah they're going to be real happy about you.
Tom Sosnoff: When you fell down.
Tony Battista: I did fall down. Pushing your fat ass in the car.
Tom Sosnoff:
Tony Battista: Yes, it was slippery. I was nice and dry and cozy in my car. While you, the prince with his clothes on, the Emperor's New Clothes, sitting in his car. You didn't even have it in park or reverse, I mean you didn't have it in reverse and neutral to drive, you had it in park!
Tom Sosnoff: When you fell down.
Tony Battista: I was so pissed at you!
Tom Sosnoff: All I wanted to do was laugh, but I was like "I can't laugh."
Tony Battista: I'd leave your fat ass right there, you know I would.
Tom Sosnoff: Because then he's going to walk off the job.
Tony Battista: I'd walk off the job is right. You were sincere, "Bat, Bat, you okay?" I looked at you like "Shut the…"
Tom Sosnoff:
Tony Battista: "Bat, you okay?"
Tom Sosnoff: You had you and your trusty sidekick.
Tony Battista: Mundo. "Lean into it Mundo, lean into it. God bless it. Lean into it."
Tom Sosnoff: Oh my god. They woke up every neighbor. Their cursing…
Tony Battista: Who cared about your neighbors. They got to hate you anyway. How happy are they that the guy in the big house is stuck in the alleyway? Look at that jerk. Everybody, every common-folk knows you can't get through there.
Tom Sosnoff: Oh my god. That was, you bring your helper.
Tony Battista: My trusty sidekick, my Robin.
Tom Sosnoff: Oh my god.
Tony Battista: All right, he let himself go a little bit, but he'll be okay.
Tom Sosnoff: I can't stop, I'm sorry. I was just watching like…
Tony Battista: Then your case's dog is sitting in the front seat. Dude is just like "How do I get in the car?"
"I don't know Jules, move the dog."
Then, I should have taken a picture, I didn't. Three, seriously let's think about how much weight was in the back seat, let's see.
Tom Sosnoff: Oh my god.
Tony Battista: Two, three, four, five, seven hundred and fifty pounds.
Tom Sosnoff:
Tony Battista: 750 pounds of beef and dog. In the back seat. I'm not going to the front with Jules in there.
Tom Sosnoff: Oh my god. All right, I can't….
Tony Battista: We had a ton! We weren't getting stopped.
Tom Sosnoff: Oh my god. I can't take it. All right getting back together. S&P is up 8. Did you want to trade last night at all? Because I couldn't find anything to do.
Tony Battista: I couldn't find anything to do. Oil down a dollar and a half, I mean I'm like "I'm not putting my toe in that."
Tom Sosnoff: I mean you could have bought it but who's going to… after the three point rally on Friday, the only thing I saw that was kind of a way up last night was buying oil, but I'm thinking to myself, "Really?" When you're already long lot.
Tony Battista: Bonds were up, I mean, I guess, you know.
Tom Sosnoff: They were uh…
Tony Battista: I know, listen, after a bad day on Friday in the Market, I mean we had a nice trading day but a bad day in the overall market. Yeah, I got you. I hear you. Tough one.
Tom Sosnoff: All right. We got to get our act together here.
Tony Battista: USO up 72 cents. I'm liking that.
Tom Sosnoff: Yeah that's a nice, another nice rally in there.
Tony Battista: Oil up a dollar forty.
Tom Sosnoff: Yeah, can they just screw everybody here?
Tony Battista: Its about time.
Tom Sosnoff: Could they just do this, and just mess with everybody?
Tony Battista: Welcome to the party. Let's do this! XOP up a buck
Tom Sosnoff: These February 45 puts, they were still short couple of them, they're down to 76 cents.
Tony Battista: You're talking about the future puts on CL correct?
Tom Sosnoff: Yeah the, we're short, hang on I got to… yeah I'm going to put a 75 bid in, because…
Tony Battista: Those 45 puts you sold…
Tom Sosnoff: Well we didn't sell them at 75 cents that's for sure.
Tony Battista: No, a buck 90, buck 98, two dollars and change, 2.14.
Tom Sosnoff: You know, it is so funny because its hard to make money trading the futures, but the options have been great.
Tony Battista: Yeah, that's a thousand a point on that also.
Tom Sosnoff: Yeah we've got some… all right let's keep going. Anyway, so POP and ROC, we haven't covered this in a while. Probability of Profit and Return on Capital. And why this is important for today is because we've been going back and forth with Robin and Robin's trade of the week coming up and we're going to actually cover return on capital this week on Robin's trade of the week, so lots and lots of stuff, you know, I don't know if the show is going to be great or suck this week, whatever it is, but we're going to give you content like you can't believe. The one thing I need to say first before we start is the live show tonight with Dylan, myself- canceled. Because all the flights from New York to Chicago were canceled. So we can't get him here. Its not a question of, we don't mind staying but we just can't get him here. His flight was supposed to come in this morning and it was canceled. So we're probably going to reschedule for tomorrow if we can get him out here.
Tony Battista: Can't fight with Mother Nature.
Tom Sosnoff: No, you can not mess with Mother Nature.
What is probability of profit? So this just kind of like, best practice would be we just go back over a little bit of a refresher, just so you're ready for all of this stuff we're going to throw at you this week. So what is probability of profit? We call it POP, it can be interpreted as the chance of a trade, or the portfolio whatever you're looking at, being profitable by at least one penny. That means break even or better. It is determined by looking at the probabilities of closing within the trade's break-evens. It is kind of the backbone of the, a lot of the logic that is built into dough. So when you look at the visuals in dough, its all based on what we call POP, probability of profit, which is just staying inside of your break even.
So how do we calculate for the following? Naked puts, covered calls, vertical spread, short strangle, iron condors, whatever it is. Let's take you on a little bit of a walk through this. So for a naked put, and we put all of the definitions in here. Oops, let's go back for a second. So just as an example, and I'll stop at naked put, it is the strike price minus the premium equals the break even. And then you take 100 minus the probability of break even and that's your probability of profit. It is very simple, straightforward logic. This is the simplest part about…
Tony Battista: This is the math behind how dough gets it, but yes.
Tom Sosnoff: But the simplest explanation we can throw out there. This is standard, its pretty universal throughout the whole… you can substitute it to a certain extent for almost delta. I mean, that kind of thing. It throws it out there. But for the most part, this is just kind of your go-to, your fundamental guide, this is your cheat-sheet. Just explaining how we get to each one. There's iron condors and short strangles, and essentially, its all pretty self-explanatory.
Tony Battista: We've gone over this a lot.
Tom Sosnoff: Now, what we do is in dough we can see our probability immediately as soon as we set up a trade. This way we can adjust our strikes and find the trades with the probabilities to suite our portfolio. One of the longer-term visions we have about trading and managing our own money is you're just going to need to see the overall picture and not necessarily all the little pieces. Because as we make this more and more, as we make the technology simpler and we make the logic that much easier to understand, really all that is going to matter is "hey what do I need to make, what do I need to tweak here?" Its kind of funny, we've always thought, "My car runs, I don't need to know every single little thing about my car except that its runs, and when its broken-"
Tony Battista: [inaudible 11:15]
Tom Sosnoff: I understand that, "but when it's broken, I just need to make a minor adjustment, whatever, just tweak it, fix it, and move on."
Tony Battista: Sure.
Tom Sosnoff: I hope it's the same thing for our portfolios going forward, in the sense that we'll understand it all but we don't have to break - we can just tweak a number here.
Tony Battista: It's six of one, half dozen of another. There's no better strike than another strike, you just assess your probability of profit and then assess your risk to the amount of money that you're using.
Tom Sosnoff: In order to be a great trader, it's almost like you have to be a great- remember when we were kids we played a lot of pool? And the reason for the pool was,
Tony Battista: Golden cue and Queens? Yes! What'd you play? In somebody's basement?
Tom Sosnoff: Probably.
Tony Battista: And they you played ping pong afterwards? Like, it doubled as ping pong, it wasn't even a regulation table.
Tom Sosnoff: Yes. And then their mom would make us chocolate milk and everything would be cool
Tony Battista: Chocolate milk and grilled cheese!
Tom Sosnoff: Grilled cheese.
Tony Battista: Chocolate milk and grilled cheese!
Tom Sosnoff: That's right. So-
Tony Battista: And then you would hide your Mad magazines.
Tom Sosnoff: Great pool players were always three or four moves ahead just like great chess players, whatever it was. And I think trading is almost the same way. We're getting to the point where great traders are- all you can do is put your position on, and where we used to put our position on and worry about our position, now we're just putting our trades on and looking at the next trade. Which is very different than we've ever looked at investing and trading before. So anyway, that's the dough.
So, what is return on capital? Return on capital is a metric that allows us to analyze our profits as they compare to the capital risks on the trade. So for example, if we make one hundred dollars on a trade that requires a thousand dollars of capital, the return on capital for that trade would be 10%. The reason this is so important is because there is a mathematical formula, and I'll discuss more when Robin does her trades this week. But if you make 1% per day on your portfolio, 1% per day. That's 360% a year, which is obviously a huge number. But if you make 1% per day on 1% of your portfolio, that's 3.6% per year. Now remember, we're taking about an era where risk-free capital is 4/10ths or 3/10ths or 2/10ths of 1%. So if you're able to make 1% a day, on 1% of your portfolio, over the course of a year, it's eight times better, or nine times better, or ten times better- whatever rate you want to use, than risk-free returns. That's why this stuff is so important. And then if you were only to do that let's say, I don't know, 1/6th of the year? It's still 50% better than short term rates. So again, if you were able to make 1% a day on 1% of your portfolio, for any period of time, it would only take about 30 days to equal the return on your entire portfolio for risk-free returns.
Tony Battista: And if you got that, you could sit in cash with no risk, allegedly, and have the same type of return you would have for one year's worth of risk.
Tom Sosnoff: Now that's an extreme, but I need you to understand that's why return on capital is so important. Now let me say it again. If you make 1% on 1% of your capital, per day, it's a 3.6% return. If you do that for one month a year, it's the same as risk-free capital. So if you found one put to sell, just as an example, that would deliver a very small amount of money, tiny. It still beats what you would make on risk-free returns over the course of a year. And that's doing one trade for thirty days for the entire year. Now what's so important about that, because people are going to be like, "that's all this is?" Yeah, that's it. That's it!
Tony Battista: And it's not that simple, but that's the mechanics behind it.
Tom Sosnoff: That's it. That is the mechanics behind it. That's why it pisses me off when everybody says "oh, my god, this is too risky." Really? It's not. It's too risky because we do things because we're not satisfied in making 3.6%. We want to make 360%, and then all of a sudden that's how the system falls apart. Because that's an unrealistic expectation
What's the relationship between POP and ROC? Well typically, an increase in probability of profit requires a reduction for return on capital which we can demonstrate with an example study.
So what we did is we went to Spider. So we looked at four years, first trading day of every month, we sold the 69% At The Money and the 84% On The Money put. We held it to expiration of 45 days. And the reason we wanted to show you this, is because we wanted to share the relationship between probability of profit and return on capital. So again, the At the Money puts you can see the percent winners, high IV, low IV and you can see how much more important, how much greater the opportunity is in the high IV. And then you can also see how much greater the return on capital is in the high IV. So you understand why we're so implied volatility conscious. Listen. This isn't rocket science. But what it is is hey, make smart decisions and your business will be smart. Your business will do well. It's the same thing in any business, make smart decisions at the right time, take advantage of what you know, and you'll be successful. It's not- it's so much common sense, but yet we don't always act that way.
How does ROC of a defined risk trade compare to that of undefined risk trade? Defined risk strategies generally have a higher return on capital than undefined risk trades. And the reason that is- it sounds like it's backwards, but it's not. The reason that is is just because you're using less capital. I mean, you increase your probability of profit by taking undefined risk and you increase your return on capital by taking defined risk. It's a little bit misleading, so that's why sometimes return on capital- be careful, okay? Because you've got to stay small. This is demonstrated in a study where we sold monthly iron condors for five years in underlyings, and what you can see here is it's the same thing, your 1 point wides, 2 point wides and 5 point wides, 5 point wides are there more to simulate…
Tony Battista: The strangle type trade, although it doesn't completely-
Tom Sosnoff: That's right. And we just put all the numbers up there so you can kind of see it. So, the 1 point wide, the 2 point wide and the 5 point wide iron condor. You see the 2 point wide iron condor actually has the highest return on capital.
Tony Battista: Yes, and to bang that home again, if you're doing more than one contract of a 1 point wide iron condor, it totally makes sense doing just one contract with a 2 dollar wide iron condor or a half the amount iron condor.
Tom Sosnoff: Yeah, we actually did a great study on this the other day, and what we showed was that- we did this last week and you can go back in the archives and see it. And what we showed was that there is a point of diminishing returns. What that means is you can get to a certain spread-width and it doesn't make sense to do the naked option. So I think it's like in low IV it's 5 points wide and high IV it's 10 points wide. I'm sorry. In high IV it's 5 points wide in low IV it's 10 points wide, but there's a little bit of… there's a couple of factors that go into that. But generally speaking it's 5 points wide on high IV, it's 10 points wide on low IV and again don't confuse return on capital with probability of profit. Higher return on capital, usually lower capital. Higher return on capital, less capital required. Higher probability of profit, usually undefined risk, more capital required. So generally speaking, the relationship is between capital required and probability of profit versus capital required and return on capital.
Tony Battista: A naked put is going to have a low return on capital, a clear call spread is going to have a high return on capital. Less probability of profit.
Tom Sosnoff: That's correct. And if you use cash securities, it's going to be even less, so don't get all hung up on this, just remember that your portfolio needs to have a nice combination of return on capital along with a high probability of success. It is a complex fundamental understanding, but as soon as you get it, you're like, "okay this makes sense."
Tony Battista: Take a quick break, we'll come back, we've got the opening bell next. We'll take a look at Exxon-Mobil as one of our earnings plays. This is tastylive live.