IPTM - Introduction to Professional Level Trading Notes

Video 1 – Professional Traders vs Retail Traders 1

- In investment banks, there is only market making trading going on now thanks to the Volcker rule
in 2014-2015 but they're still allowed to conduct hedging activities, but no more prop trading.
- In market making activities, 80% is no risk/agency business where they simply execute orders on
behalf of HFs and PFs and collect a commission.
- 20% is risk-on business where they sell to the HFs/PFs essentially taking a short position and have
to locate the shares (hopefully at a better price hence risk). They are also still paid commission.
- A risk-on position where the trader buys back higher than the price sold to the client means a net
loss and negative retention metric.
- The total amount of commission retained after closing their risk positions determines the
performance of the trader. The average 'good' rate is 70%.
- Traders would then amass many of these positions where they don't really want them and simply
need to close (aka a 'negative selection portfolio').
- In these days, the unwind is usually left to an algo to do. This is why most prop traders left the IB
sector/industry.

- Hedge funds have a primary function of protecting their clients' investments in both rising and
falling market conditions. Traders in HFs are often called portfolio managers.
- There is no MM activity, and they perform a purely prop trading function.
- Hedge funds are not public companies and deal with the capital provided by private
investors(clients).
- PMs are typically expected to reinvest 50% of their performance fee (20% of profits) back into the
fund. If they lose money, there is no performance fee and as such no bonuses for the PMs nor forced
reinvestment into the fund.
- Typically trade Long/Short portfolios with 1-3 mo time horizon aiming to make money whether the
market goes up or down.
- In both cases, professional traders get paid base salaries regardless of performance as part of the
basic infrastructure of running the business.
- A good Sharpe ratio (reward earned over risk taken) for a professional trader is around 1.8 to 2.2.
- Trading for income does not work because income is never guaranteed in trading, and withdrawing
from the trading account is a terminal mistake as it hampers growth of the fund.
- The trading account should sit on your balance sheet as a human being and be grown over time
with compounding returns

Video 2 - Professional Traders vs Retail Traders 2

- Market return is called Beta, and anything above market return is called Alpha (ie market is up 15%
and your return is 25%, so your alpha is 10%). Alpha can also be negative where you fail to beat
market returns.
- Alpha is very important if your mandate is long only. It's not so important if your mandate is
long/short. For long/short mandates, the Absolute Return is more important.
- This means a long/short portfolio may underperform in comparison to long only portfolios during
bull markets but risk is better hedged against downturns and crashes. What matters is risk-adjusted ,
absolute return in both bull and bear markets.
- The initial goal for retail traders is to trade with a positive Sharpe Ratio. We must seek to perform
better than volatility.
- Decent retail traders have a Sharpe Ratio of 0.1 to 1. Good is larger than 1. Professionals tend to be
1.5 and above but cap out at 2.2 over long term.
- Algos can achieve 1.5 to 3 but have shelf lives.
- Bernie Madoff equity curve is a red flag for any trader because there's no volatility which is an
impossibility
- Time horizon spectrum for volatility sweet spot is between 20-60 days. Any longer (ie 3 months+)
and you begin to be an investor and any shorter and you have to battle HFTs and algos. The
difference between trades and investments are the former looks to take advantage of catalysts and
volatility.
- 80-90% fundamentals 10-20% technicals/price action. Fundamentals are forward looking whereas
charts are backwards looking.
- The cardinal sin in trading is shorting a stock you are fundamentally bullish on -- this gets you
sacked in institutions
- Pre-emptive and Re-active Risk Management, typically 8-12 positions for a retail portfolio
- Fundamentals -> Technicals -> Catalysts -> Risk Management

- For most international retail traders, you are buying CFDs not the underlying asset.
- Revenue stream for brokers is typically spread+commission + financing turn + OTC gain +
data/order flow
- OTC gain is the profit from taking the other side of the trade (by not hedging a CFD for example)
- Financing turn is the interest rate difference between the credit they get from investment banks vs.
the rate they charge users for margin
- The deposit amount from retail traders is then used as collateral against getting bigger loans, which
are often used to take the opposite side of retail trades keeping the difference as 'market making' or
'liquidity provisioning' profit
- As such, brokers are incentivized for retail traders to trade as often as possible with as big size as
possible

- CFDs were banned in the US in 2010 after the GFC

- Retail traders primarily use Options contracts to obtain leverage, or physical cash on equities
through certain brokers for only 2x leverage (ie 50% margin requirement)
- The problem in the US doesn't lie in the cost of overnight (variable) margin but most traders lose
due to the data business and poor trade idea generation
- Most trading educators affiliated with a brokerage have an IB agreement where they receive
kickbacks of spread+commission for clients introduced so there are many charlatan 'educators' who
are essentially brokers' salesmen in disguise
- Charlatans emphasize technicals and psychology because they have no real portfolio
management/hedgefund experience and it sells because it's easy for dumb money to understand
and feel like they've learnt something
- The very definition of 'professional' trader is that you are regulated (taken exams) and trade OTHER
PEOPLE'S MONEY
Video 3 – Realized Volatility 1

- Realized historical volatility and distribution of returns of S&P500

- S&P500 has positive kurtosis and negative skew over the period of 1962-2020 in frequency
distribution of returns (open-close)
- Even a blind squirrel finds a nut eventually (daytrading the index expecting a greater than 2%
return)
- Negative skew means running a purely long bias is risky given that the largest minimum value is
double the size of the largest maximum, meaning that extreme negative outcomes are more likely
than extreme positive
- Daytrading any index is essentially random and days with volatilty great enough for daytrading
opportunities are rare
- EURUSD is more or less the same except with neutral skew, the vast majority of time is between -
0.5% to 0.5% volatility so the expected daytrading return is 0%
- Trade what is PROBABLY, not what is POSSIBLE. 'Daytrading' randomness is not aligned with your
goal of becoming a consistently profitable trader over a long period of time.
- Brokers offer you 'free' trading because they know you have extremely high odds of losing so they
actively take the other side of your trades while selling your order flow/data and charge you
spread/commission. Why else would they offer you so many services for 'free'?
- Megacap >40bln, large 10-40, mid 3-10, small 1-3, micro <1
- DJIA is entirely mega, S&P is mega and large, NDQ is mega and large, Russell 2000 is mid to micro
- Opportunity set/size of samples you can pick when trading an asset class is important because you
want to be exposed to volatility of the class/sector. If your opportunity set is too small you could be
underexposed to volatility over a period of time.
- We concentrate on 1-3 month mid-to-large cap stocks to expose ourselves to a balance of large
opportunity sets AND volatility ('wholesale' opportunity and volatility)
- Overall, equities provide the opportuntiy set AND volatility we need (2200 stocks vs 20-25 currency
pairs vs 10 non-volatile ETF instruments for bonds) for consistently high expected returns over a 1-3
month time horizon

Video 4 - Realized Volatility 2

- Pretty basic spreadsheeting, just refer to previous video for example/template.

- Basically the spreadsheet shows you the probability of certain ranges of returns per asset class.
- Intraday open-close is less volatility than close-close which includes extended hours (as expected).
High-to-low is for the maximum return possible in intraday volatility.
- Important to do this to define our strategy as traders because it illustrates the volatility and thus
opportunities present in asset classes over certain time horizons. We are looking for areas of the
market that present consistent volatility and wholesale opportunities.
- The takeaway is the above exists in 1-3 month horizon of mid-large cap equities.
- As another important benefit, it allows us to *choose* the risk we take on by selecting certain asset
classes.
- We can also apply the same principle across multiple assets simultaneously (aka the risk and
opportunity of a portfolio).
Video 5 – Realized Volatility 3

- Average True Range Percentage is a crude measure to estimate the same measure as DoR analysis
above, usually good enough to get quick answers
- Range = High-Low
- True Range = Largest number from the following dataset over a given time period
> Difference High-Low
> Diffeerence High-Previous Close
> Difference Previous Close-Low
- This takes into account afterhours action so it's more accurate measure of volatility than simply
High-Low difference
- True Range Percentage = True Range/Open, Average True Range Percentage = average over X
period
- ATRP of S&P over 50 years is about 6-7%, NDQ around 8-9%
- When compared against DoR the numbers paint a similar picture but less accurate since it's an
approximation
- The problem with investing in popular megacaps where the opportunity set is very small (ie
FAANMG) is that your opportunity cost is large compared to going for wholesale opportunity; if
opportunity in these few stock dries up then so does your returns
- Another problem with popular megacaps is that they are very 'crowded', and it is impossible to gain
an edge due to how many people and institutions trade them (inc. Wall St)
- The volatility in mid-large caps comes from Earnings as good performing mid caps become large
caps and vice versa
- DoR is more complex than ATRP but more useful because it also allows us to calculate our odds of
certain returns *
- ATRP gives you an additional insight into how volatility has changed for an asset over time which
DoR does not
- Doing the quarterly requires some additional manipulation (1:08:00)

- In general, these analyses are used to understand the volatilty of the asset in question to compare
them against others in the same asset class as well as between different asset classes.
- When comparing, always compare like for like in terms of recency of data and time horizons.
Delete most recent month if it's incomplete.
- tl;dr when you do this you also see that megacaps are generally less volatile than mid-large caps
when compared over long time horizons; volatility and opportunity increase as you increase time
horizon and slide down the market cap scale

Video 6 – Implied Volatility 1

- Implied Volatility is forward-looking and thus can change according to the market's expectations
- Overall Market Volatility is an important concept to understand for risk management
- The VIX is the expected movement in the S&P over the upcoming 30-day period annualized (ie. VIX
of 15 represents an annualized change of 15% over the next 30 days. A VIX of 15 indicates the index
option market expects the SPY to move 15/sqrt12 = 4.33% over the next 30 days.
- The prices of call and put options are used to calculate IV. Higher option premium implies higher
volatility all other things being equal.
- If VIX is high, then that means there are short term trading opportunities. However, we know from
DoR analysis that S&P daily volatility within 1 standard deviation is around 80% of days. This means
we must seek to be PMs 80% of the time focusing on 1-3 months and traders no more than 20% of
the time focusing on shorter term trades.
- As the VIX transitions from rising/falling then we must also switch our focus where opportunities
may present themselves.
- All professional traders are PMs first and traders second (80/20 rule), unlike the narrative sold by
charlatans.
- Volatility is a PM's worst enemy because it increases portfolio risk. As VIX increases, active fund
managers will hedge by buying puts and reducing equities exposure, transitioning from PMs to short
term opportunistic traders.
- If the VIX goes up means the portfolio risk of the entire world goes up, so market participants/PMs
will derisk - institutions are usually slow to do this. We want to do this before them.
- Volatility traffic light system (red - falls 25%, green - rallies 25%, transition - directional)
- Generally - if VIX is in transition and rising, we can reduce positions in portfolio by 50% and reduce
remaining position sizes by 25-50%. Use freed up margin to take directional bets/swing trade. Do the
opposite if volatility reverses.
- The trader is indiscrimnately reducing exposure across the portfolio regardless of idiosyncratic
fundamentals, and increases exposure based on fundamentals when VIX decreases.

- No hard and fast rules, be flexible and consider your own risk tolerance/strategy. At least *think*
about doing something when the VIX moves so you are not a sitting duck to volatility. If you do not
take this approach then you are not maximizing opportunities.

Video 7 – Implied Volatility 2

- Implied Volatility is generally a more accurate measure of volatility compared to historical data as
the market is pricing it in live and forward-looking
- There are 3 worksheets, which one you use depends on the style of options (American, European,
etc)
- We simply aim to obtain the IV by iteratively comparing the option price against the underlying to
see how much the market is 'pricing in' volatility
- American Options are options that can be exercised at any time, European can only be exercised at
expiry
- Must note if there is an ex-dividend date within the period of the option in question
- Pick an expiry that matches your expected trading period as you are trying to find the IV of that
period, and an option that is ATM
- The IV listed with options is generally accurate but it's still worth plugging into the spreadsheet to
take advantage of the analysis tools in it.
- When doing cross-asset analysis for IV, compare like for like (same date and both either ATM or
fixed % OTM)
- Typically take mid price between bid-ask of the option
- The IV value it spits out is an annualized figure, unlike the DoR analyses we've done in the past, so
refer to the table on the RHS of the spreadsheet for different time horizons
- In the summary table in the video, we can see that the IV of midcaps is much larger than of
megacaps which reinforces the idea that opportunity exists in larger amounts further down the
marketcap scale (smaller companies are more sensitive to revenue/earnings)
Video 8 – Portfolio Volatility 1

- VIX increasing and decreasing also increases/decreases risk in your portfolio, but not opportunity
without action by the PM.
- We build long/short portfolios because we want to capture volatility in both directions and also for
diversification (pre-emptive risk management). We want to make sure that when we are wrong that
not one single position can wipe us out.
- We must strike balance between diversification and not being so spread out that we cannot make
high returns. In theoretical finance, this is called the ‘efficient frontier’. We target a level of risk to
get the returns we are seeking.
- We can do a DoR analysis on a portfolio then calculate 1 and 2 std dev moves for the realized
historical risk of the portfolio.
- We can use historical asset prices to calculate expected future volatility by working out the
Variances and Covariances
- This is important so we can model different types of portfolios with different correlations, so that
we can choose what level of risk and volatility we are choosing to take BEFORE going into the
market.
- We aim for correlation of less than 0.6, realistically close to 0. Small positive average correlation is
expected where there is a bias towards longs or shorts.
- We choose the level of annual risk we want to take and target an annual expected return (aka a
high Sharpe Ratio). These are two competing factors obviously as risk and absolute returns are
correlated.
- Typically under 100k margin capital, 8-12 positions, increasing to max of 16 positions for above 1mil
capital.

- The implicit leverage when using options is much higher when using options instead of CFDs.
- There is also risk asymmetry when buying calls and puts (premium spent) versus naked
long/short stock directly.
- There is also gap risk when going long/short stocks when compared to options.
- Generally better risk-return profile when trading options due to above.
Video 9 – Portfolio Volatility 2

- We use standard deviations as measure of volatility in the summary table so that the realized
and implied volatilites are comparable, and it will also be used at the portfolio level.
- You can model backwards portfolio volatility using historical data of the assets but it’s also
possible to calculate expected portfolio volatility using historical data.
- Correlation = Normalized Covariance (both relate to how an asset moves with another)
- What we see is the portfolio volatility is a function of the contents of the variance-covariance
matrix and the weightings of the assets in it, and thus as the number of covariance terms
increase to the square of number of variance terms in the matrix, covariance between assets
becomes a much bigger factor in portfolio volatility than the variance of individual assets.
- Overdiversification hurts portfolio returns and it’s difficult to find many low correlation ideas,
but we also don’t want to expose ourselves too much to the same kind of risk. Sweet spot is still
around 8-12 positions.
- Use weekly close values in the portfolio volatility spreadsheet data.
- Example shows going to mid-large caps has better diversification/lower correlation and higher
volatility which is a win win.
- Even though a long-short portfolio has a smaller volatility/risk profile than a long only portfolio,
the point is that it performs in ALL market conditions including downward trending markets.
- It’s also a hedge against you being wrong as a trader as you have 2 opportunities.
- Covariance is the most important factor in diversification. Overdiversification can lead to
executing many low quality/conviction ideas which hurts returns.
- Although a L/S portfolio might only show a 10-15% annualized volatility of the underlying, the
implicit leverage from using options will often see returns multiples of that volatility without
necessarily increasing downside risk due to the asymmetric risk profile of options.

Video 10 – Final Video

- Literally just a summary of all videos

- A trade idea is not complete without a catalyst that will move the price, and a trade structure is
built around those catalysts. We seek catalysts that are additional to publicly known catalysts
such as earnings.
- Seek consistent returns on a risk adjusted basis (Sharpe Ratio – returns over risk taken)
- We choose what risk we want to take and the expected returns we are targeting
- Realistically targeting 50-100% annual return via equity options (implicit leverage) from 15-30%
of expected annual portfolio volatility
- PTM is Trade Idea Generation, Timing, Trade Structuring, Portfolio Building, Pre-emptive and
Reactive Risk Management and Trader Metrics/Track Record Management
- Take POTM for better ROI