Katie and the Bat start by looking at her profit and loss (P&L) for the day, getting a portfolio overview in thinkorswim. They begin going over her positions by reviewing delta, which is the expected change in the price of an option for a dollar change in its underlying. Delta can be calculated for a portfolio by adding the delta of each position. Right now, Katie is short delta.

Beta weighting a portfolio allows delta to be calculated for a change in the overall market. Here, $SPY is used to beta weight Katie’s portfolio.

This allows changes in P&L to be quantified for broader market moves. Looking at the beta weighted delta and other metrics, Katie is able to set reasonable expectations for how well her portfolio should be performing at any given time.

Katie wants to minimize directional risk by neutralizing delta. As an example, she looks at her strangle in $DOW, which she wants to adjust the delta in without scaling the position or changing buying power too much. Bat suggests rolling up the untested put, which would result in more positive delta while changing buying power minimally.

He also clarifies how reasonable expectations can be set with the probability of touch calculation, which is roughly 2 times the probability that an option expires in the money. Applying this calculation to a $GDX butterfly, Katie understands how movement in the underlying affected her position.

Transcription Tony: We're back!

Katie: Back to Cool.

Tony: Back to Cool. How are you doing today?

Katie: I'm good. It's arctic in here right now.

Tony: In our studios?

Katie: Yes.

Tony: Little known fun fact. There is only air conditioning in here. There's no heat.

Katie: Wow. I'll have to start wearing mittens and stuff, and then I won't be able to trade.

Tony: Well the lights get so hot, so we usually don't need it.

Katie: That's true. How are you doing? The market's down. (Laughter)

Tony: So, let's take a look. Forget about how I'm doing. Let's go right to your accounts. Let's look at your [monitor 00:00:43] tab when we get a moment, because you have been talking to me, "What am I going to do about this? What am I going to do about that? Look at my DOW position." A moment ago, you're up $66.00 or so in your account, or $69.00 and change as it floats. Everything's dynamic, so it moves in real time. You were up actually in everything you owned. I don't know if you were watching it. Were you watching it about an hour ago? Katie: Um…

Tony: Well you should be. That's a bad answer. You should be. Believe me, with the market down the way it is today, this is going to be just a great show. That's just the way it goes.

Katie: Let's hope that you don't jinx it right now.

Tony: Well, let's take a look. There's no jinx. There's nothing like that. Here, let's look at your overall position for a quick moment and then we'll drill down each one. Because I want to go over your positions, and then we'll put one more position on. Let's go to what's your delta? What's your directional risk?

Katie: It's not weighted right now, but I am short 123 delta unweighted.

Tony: Unweighted, 123 deltas of something, which means we can't do anything with that number. How much money do you make a day in theta decay?

Katie: If the market goes down, I'll make $123.00.

Tony: All things being equal. If once you weight that, not right now, once you weight that…

Katie: In theta decay, if everything stays the same, I'll make $33.00.

Tony: Correct, $33.00 a day in theta decay. If volatility goes lower, that number will actually get a little bit larger. If volatility goes higher, that number will actually get a little bit smaller. It's just a round about number. You should be making $33.00 a day on the risk you have, meaning the buying power reduction you have. It looks like your buying power affects around $9,000 right now, so that $9,000 worth of risk is making $33.00 a day right now in theta decay. It's a great return on capital on a daily basis for your position, but you have risk. That's why when you put money in a bank they pay you very, very little or a very small interest rate, because there's no risk. You're taking a risk, so you're getting paid for it, which is a good thing. Take those arrows away for a minute and let's change not weighted to beta weighted. We're going to take your whole position and we're going to compare it to something. We always like to compare to compare it to SPY, the Standard and Poor's 500. Click enter. Those 120 some odd delta shorts that you had, you actually have 47 shares.

Katie: SPY shares, yes.

Tony: SPY is down, it looks like, what type of percentage? Do you have it up there? It's probably down just about 1%. Let me take a look. SPY is actually down 1.13%.

Katie: Which is considered significant, isn't it?

Tony: Significant in your lifetime of trading, because you've actually never seen a down day, right? You've been trading now for about two and a half months. I don't think there's been a down day in two and a half months. So yes, this would be significant. So if your portfolio is equivalent to 47 short shares, bearish shares of SPY, your account today, all things being equal, should do what? Should make what?

Katie: Should make $47.00.

Tony: That's correct. You're making about $70.00, so it's in line. It's a little bit better, which is good.

Katie: Perfect. Can't complain about that.

Tony: All I'm trying to do is set reasonable expectations. You're making $70.00 today. You should make $47.00. I'll say it's equal, even though it's doing better. At least you know what a reasonable expectation is on your account. Everybody else that's watching the show, if they don't know how to beta weight their position or they've never looked at beta weighting their position and they see, "Oh, I'm making $70.00 today on my account," they have no idea why they're making it, if they should be making it. Maybe they should be making $700 on their account. Maybe they have so much beta weighted risk on that they don't know what they should be making on their account. You can set reasonable expectations here. At least you know that your portfolio is performing as well or better than it should be performing.

Katie: Okay, so I have a question. If the overall goal is to neutralize your delta, then wouldn't your P&L for the day be pretty much unchanged too? That doesn't benefit you.

Tony: Correct. Unless you have a positive theta decay, which is what you have. In a perfect world, listen, is 47 short deltas a lot?

Katie: No.

Tony: Okay. I don't know. There is no answer. You have one contract of each. If you had 10 contracts of each, you'd have 470 short deltas. Is 470 short deltas a lot of risk?

Katie: Yes. For me, I would think so.

Tony: Again, it's exactly the same position that you have, just 10 times the amount of contracts.

Katie: So the risk is the same, then?

Tony: It's pretty much the same. It all depends on your own personal risk tolerance.

Katie: Okay.

Tony: In your world right now this is probably enough risk for you, because you're trying to get delta neutral. Meaning, you don't want to have any directional risk. You will always have directional risk, because soon as a stock moves you have direction risk.

Katie: So you can never have no risk?

Tony: That's correct. Well, you can have no risk. You can be completely out of the market and in a CD. Then you have no risk. You don't get paid anything, but you have no risk.

Katie: Right.

Tony: Your account's up a couple hundred bucks. We'll probably have to do some sort of spreadsheet on how you're doing for it. We'll have to do that in future shows. All right. Let's look at some of the things you had or we'll run out of time here. Let's do the trades and then we'll backtrack and look at your GDX position, which we took off and we'll talk about why. Let's go to DOW. Open up DOW, just the position that you have there. You have a strangle on, you short the 42 call and you short the 37 put. Let's go to a chart of DOW. Do you remember what direction DOW was going?

Katie: It's been going up.

Tony: It's been going up and it was testing your short call. Your short call is 42.

Katie: Which is why were shorted that put, right?

Tony: No, that was GM.

Katie: Silly me. Right.

Tony: Remember, this was just a strangle that we put on from the very beginning. The 37 put and the 42 call. I think we're about equal distance away from it. But now the stock has rallied up in two, three 3 days, to 42. Yesterday we were talking about what are we going to do about this 37 put. Go to the trade page for a moment. This 37 put that you're short was trading for around a quarter and you had a lot of directional risk, meaning your stock had moved up to 42, up to your short strikes, and you had a lot of directional risk. Open up January. So you put this trade on when the stock was trading, let's say, around 39 and change. Now the stock runs up to 42. You put it on when there was no directional risk. All of a sudden, a few short days, you have directional risk. What could you do, being short the 37 put and being short the 42 call, if you wanted to?

Katie: To define my risk more?

Tony: No, not to define your risk. I don't want to change the dynamic of the trade. What I want to do is I want to minimize your risk. Go back to the monitor page for a moment. Your unweight…

Katie: So to minimize it we could tighten it, right?

Tony: Okay. What's your delta in DOW right now, unweighted, just looking at DOW?

Katie: Negative 83.

Tony: Negative 55 shares.

Katie: Oh, duh. Yes.

Tony: What were you looking at? Oh, you were looking at the one short option.

Katie: I was looking at the… Yes.

Tony: The delta is 55. You have 55 short shares of DOW right now. So your directional risk is in which direction, at this moment?

Katie: My risk is to the upside.

Tony: Your risk is to the upside because you're short delta. Go back to the trade page. How could we minimize your risk and not change the trade? The trade is a strangle. Let's keep it as a strangle. How could we minimize your risk?

Katie: Well, we need some positive delta in DOW.

Tony: Correct.

Katie: So that would either be…

Tony: I don't want to add to the trade.

Katie: We don't want to add to the trade.

Tony: Don't want to use any more buying power. I did all that in the beginning when I made this trade. I set how much buying power I wanted, what my risk was going to be.

Katie: We could…

Tony: Change the volume to delta while she's thinking, please.

Katie: I don't know.

Tony: That's good. This is okay. We've talked about it. You obviously didn't listen. I'm just kidding. I'm just kidding. Because everyone says I'm so soft on you. We talked about it. You obviously didn't listen, so here. When a position in trouble, this position is not in trouble, you're actually making money in this position. But when we want to change the position without changing the dynamic of the strategy, we always look at the side that we're not being tested on. The untested side.

Katie: Okay, so the 37 put.

Tony: The 37 put represents, since we're short it, the delta's negative 14, since we're short it that makes it a positive 14, right? If I just sold the 37 puts and I did nothing else, I had no other position, if I sold the 37 puts that's a long position. By selling the 37 puts, you have 14 short deltas which become long deltas, right? Because we're selling it, we're not buying the put. If I rolled that untested side up, since the stock is going higher, my risk is closer, the stock is closer to 42 than it is to 37, I could if I wanted to roll up the 37 put to the 38 put, or the 39 put, or the 40 put, or the 41 put. There's no wrong answer there. Now, to answer the question then, how can I reduce my risk, if I rolled up to the 39 puts, for argument's sake…

Katie: Right, which is 30% probability of being in the money right now.

Tony: Correct, which is a number we like to stick around. I would be changing the trade by how many positive deltas?

Katie: Twenty-eight.

Tony: But I've got to by back my 37 put because I'm not going to change the buying power used, I'm not going to change the dynamic of the trade.

Katie: Oh. Okay, so 14?

Tony: Correct. Correct. Then I have two contracts on. We did this strangle two times, so I'd be changing my delta risk by 28. I had 55. I'd be changing it by almost half, a little bit more.

Katie: Okay.

Tony: Do you want to do that? There's no wrong answer. Right now you have directional risk to the downside. You're still going to have directional risk to the downside if you do this rollup, but you'll be collecting another 40 cents. You'd be changing the spread a little bit. You'll be tightening the probability of success, but you'll be collecting more premium. There's no wrong answer, with 37 days to go.

Katie: Yeah. Let's do it.

Tony: Okay. You sure?

Katie: Yes.

Tony: Sounds good. Okay. To do that we would right click on the 39 puts. We'd go up to sell. Go over the vertical. Left click on vertical and we change one contract to two, since you have two contracts. We've got to change the 38 put to the 37, because that's the one that you're short. So we're buying back the 37 put, selling out the 39 put, making it a little bit tighter, collecting something. It's about 40 cents. Can you move the price up? The stock was around… it got under 41, so let's click a higher credit, like go up to 43 or 44 cents. Stop right there. Let's do 43 cents and that'll bring the stock back down to its low. The market's weak. Everything's weak. The stock has had a run. Let's have them come to us, if we do this. Does this make good sense to you?

Katie: Sure.

Tony: So we'll put that in at 43 cents and we'll let it sit.

Katie: Why is the BP, buying power effect zero? Because we're just rolling it up?

Tony: Yeah, you're not changing the risk by that much. You're changing the risk by $2.00. Does that make sense?

Katie: Yeah, I think so.

Tony: So you're not using any more capital.

Katie: Is there a time when I should really be keeping an eye on this, because we were…

Tony: You should be keeping an eye on it every day.

Katie: Right. We were talking about how DOW was not working out in my favor for a while, and all of a sudden today it started to.

Tony: Correct. When you put this trade on, if we put it on as 30% probability of being out of the money, excuse me, 30% probability of being in the money, 70% that it would be out of the money at expiration, which is 39 days from now. What was your probability of the stock touching 42?

Katie: It was … Wait, did we do a probability of touch for this one?

Tony: You should know what the probability of touch is. The probability of being in the money is 30%; the probability of touch is two times that.

Katie: Oh, so 60%.

Tony: Right. So it touched 42. Is that surprising?

Katie: No.

Tony: No, it had a 60% chance of doing that

Katie: Okay, I didn't know that, that it was twice that.

Tony: Okay, so maybe we didn't talk about that. I don't know. I talk for five hours a day on another show, so sometimes it all blends all together. I am old. You're the young one that's supposed to pick this all up and get it all going, not me.

Katie: Okay, well that's important to know. That's good.

Tony: So here, the probability of being in the money. Change delta to probability of touch. I had so much to talk about, we didn't get to it.

Katie: That's my fault.

Tony: No, it's not your fault. So if you look, and again, I'm just ball-parking it. If you go to the 44 call there's a probability of being in the money of 20%. The probability of touching, in the next 37 days, is 42%. It's about two times the amount. So what I was saying was when we put on your trade, even though the probability of being in the money at expiration for the 42 call is 38.5% right now, 38.4%, there's about two times that amount, about 60 some odd percent, 78%, 76%, sorry, two times the amount, just to ballpark it. Does that makes sense? Even though it says 81 up there, 81 is a more accurate number. I just double it. Make sense?

Katie: Yeah.

Tony: The fact that DOW touched 42 shouldn't mean anything to you.

Katie: So probably of touch is not … it shouldn't be that big of a deciding factor when I'm trading, or…?

Tony: No, but it's like a reasonable expectation, just like beta weighting your position and finding out how much money you're making.

Katie: Okay. This is good.

Tony: It's a reasonable expectation. It's not for sure. It's not absolute, but it's setting a reasonable expectation. What'll happen to people is they'll look at something and they'll say, "Oh, it has a 25% chance of being in the money. I can just put this on, forget it and it's going to be found money and every month I'm going to use this as income. There's only a 25% chance I'm going to have a problem." There's a 50% chance that you're going to be tested.

Katie: Got it.

Tony: Does that make sense to you?

Katie: Yes.

Tony: Since we only have about three minutes left, let's go to your GDX position. Can you go to the monitor tab? You might have to change it and go to account statement. I apologize. What I want to do is I want to look at your GDX position.

Katie: Yes.

Tony: We have so much that you have to do on the break too. We'll talk about it. Open up, click enter and open up the trade history. Okay, so a lot of controversy.

Katie: Lots of twitter conversation going on.

Tony: I know, about why we covered … why we got out of this spread. Now we had the 22, 24, 26 straight line butterfly, meaning equal distance away, $2.00 apart. We paid 62 cents for it. We did this spread when GDX was trading over $22.60. it was trading around $22.80. Go to a chart of GDX for just a moment. GDX got right around $20.00. I actually think it got under $20.00. There you go. Sorry, under 21. It got down to $21.56 The stock has rallied up 6% in the last 10 days. The volatility is still high, meaning 56% or 66%, I can't see it. You had to make a decision. What I decided to do, even though the stock right around 22 when we did it… Go back to the trade page for a moment, the discussion that we had. Open up the December options. The 22, if you look at the 22s, the probably of being in the money on the 22 calls is about 45%.

Katie: Right.

Tony: But your break even was $22.60, so it's in the middle of the 22 and the 23 strike. The probability of being $22.60 was about 55… whatever. Let's say it's a 70% chance that it's going to get there, a 30% chance…

Katie: Of a touch?

Tony: Of a touch. I'm sorry, 70% chance of a touch. But that touch just gets you to break even. Essentially, having the 22, 24, 26 butterfly, if you look at the 24 calls they're eight, nine cents. Really what you had was just long the 22 calls, at a bad price.

Katie: Okay.

Tony: With about a 30% chance of breaking even. Katie: Right.

Tony: For me and you, when we talked about this and the rest of your portfolio, it looked like this was a trade that you had on four times. We might have done it too many times. A four-lot butterfly has been more volatile than a two-lot strangle, which most people will tell you a two-contract strangle is a lot more volatile than a butterfly. We had a four-lot butterfly, so we might have done it too many times. We might have ruined it with our size a little bit. It was about a $170 or $180 loser, which would be four times, three times your largest profit you've ever made on your other accounts. I just wanted to keep everything in line. I think you lost about $70.00 in GDX, which is certainly a manageable number to make back on a trade or two in the future that you're going to do, and the future I mean the trades that you have on now.

Katie: Okay.

Tony: So what we were doing here is portfolio management for you. Go to the monitor tab real quick and then I have to wrap it up. When we go to break after this, we have to look at your GM position. You might have to roll up something there. We have to talk about your SPY position. You might do something in there. You might roll it again to January, but we'll talk about that you'll tweet it out. Your Twitter handle is?

Katie: Traderkatie.

Tony: Who's next?

Katie: Liz and Jenny.

Tony: Peace.

Katie: Goodbye.