Almost Trading For A Living, Part II

  • November 25, 2005
  • TradingMarkets Editors

Welcome to the TradingMarkets Big
Saturday Interview. I’m very pleased to have joining me for the second time, Dr.
Steven Gabriel. In my

first interview with Steve several weeks ago, he
talked about how trading became his passion outside of his work as a doctor and
how he was able achieve consistent results through systematic trading. In this
follow-up interview, Steve takes us more in-depth into his trading strategies
and shows us how he incorporates options into his trading.

Eddie: It’s nice having
you back for the second time on the TradingMarkets Big Saturday
Interview.

Steve: Yes, thanks for inviting me on again.

Eddie: Before you tell us about
your options strategy, can you tell me a little be about your background for the
benefit those who did not read your first interview.

Steve: I am an emergency medical physician, which I love. And the way I got
started in trading was when I as in college I began picking up in an interest in
trading through an my uncle and my godfather. I began to watch them discuss
different stock market trades and strategies that they had which were really
just "buy and hold" in nature. And I began to pick up some magazines on the
markets and began trading my money while I was a college student and in my job
after college. I opened my own brokerage account and just bought a few positions
in a few different stocks and slowly from there my interest grew.

Once I was a medical student, I began taking a more active interest in
trading and I was trading more and more. And I spend a lot of time researching
strategies and the markets.

"…Why can’t the same
kind of rigorous statistical testing that is applied in medicine be applied to
trading systems and strategies?"

Eddie: During that time, what were you initial experiences as a trader?

Steve: When I first started trading during the "roaring 90s," I had a big
interested in computers…so I bought some computer stocks that were performing
very well. Then I started noticing that stocks that were going up fast often
went up even faster as time went on. So I began moving in to a pure momentum
strategy where I would take whatever stocks were performing best and move my
money in to them. With money that I had saved during medical school, I turned a
$10,000 account into a roughly $500,000 which was just wonderful.

Eddie: From there, what happened especially when the markets started
plummeting and the momentum strategies no longer worked?

Steve: Well, in hindsight I realize that I was just naive like everyone else.
Over time, I slowly began to use leverage and I began to use more and more
margin and I began to adopt more options strategies and my account grew
exponentially. And when the market started going down, I really didn’t know any
other strategies I studied was what worked in the 1990s. I knew nothing about
risk management or risk control and it just took me about a year to lose all of
that money.

Eddie: How did you get yourself on the right path and evolve into become a
successful trader? What kinds of things things did you do, what did you read,
what systems our strategies did you acquire?

Steve: The first thing I started doing was I began to approach trading like I
was approaching medicine. I realized that there were people who were successful
at trading and my first inclination was, if other people can be successful
trading, then I can be successful too. The way to start was by gathering
information. The first thing I did was started reading Investors Business Daily,
William O’Neil’s work. That was more because it was readily available than
anything else. I began to read the Market Wizards books to look at and get into
the minds of successful traders. I began to read other books on topics such as
candlestick charting, trading strategies, chart patterns, and fundamental
analysis. From all of this, I tried to develop my own strategy. But what I
really found was I was developing more of a mishmash than anything else.

Eddie: So all of that research was leading you nowhere.

"…My whole theory is
that if I can’t really lose much, I can really only mostly win…"

Steve: In a way, yes. As I read more and more, I began to reach a critical
turning point when I began to contrast what I was learning in medicine with what
I was learning in trading. I would read medical books that would describe
studies in which they tested 10,000 patients and they would tell you the
percentages of successes and the percentage of failures. And they would be
completely truthful about the flaws in their studies. As I read trading books
more and more, I realized that the data they presented was not expressed in the
same way as what I found in the medical books. The trading books would just make
statements like "a head and shoulders pattern works the majority of the time." I
really questioned whether I could use what amounted to subjective guesswork in
my trading. And I began to ask myself why can’t the same kind of rigorous
statistical testing that is applied in medicine be applied to trading systems
and strategies?

Eddie: And how did you get
to a point where you could actually trade using statistically backed methods?

Steve: I was look at the TradingMarkets website and I found some works by
Larry Connors in which he was really expressing his research in terms that I was
familiar with in the field of medicine. From there, I knew that this was
information that I could dig my teeth into, analyze and actually find a strategy
that I could trade confidently. That was really my first step into become a
successful trader.

Eddie: Steve, let’s talk about the strategies you now employ. What kinds of
trading systems have worked and continued to work for you?

Steve: I think the first piece of the puzzle for me was that I look for a
variety of statistically backed systems and data that I put together in one
portfolio and lot of those systems I use are from TradingMarkets. Some of the
things I use have tweaked to a certain extent are R3 System which I use with the
market indices. I use R4s with equities. I also use a derivative system which
you guys have called the Options Income Steam System or  OISS. And I use
the Always Buy Value system. I would say that signals that come from these
systems are the foundation of what I use as a trading style. I’ve gone on and
applied a lot of risk management techniques to these which has enhanced the
performance dramatically. I’ve also done some things using futures and options.
But those systems and the signals from those systems are really what backs up my
trading decisions.

Eddie: That being the
case, let’s get into the nuts and bolts of your trading and how you trade some
of these systems. Can you talk about the systems you use and the kind of unique
approach you use in trading them successfully.

"…Essentially I use
options for just about all my equity trades…"

Steve: The first thing is that I consider myself to be a systematic trader.
The way that I define that is that use systems and I use statistical data to
make my trading decision. But, of course, anyone who trades systems knows that
there’s a discretionary component to all systems trading. What I mean by that is
that you must make decisions about position sizing, how much money you’re
allocating to each system you use. Obviously, there’s times when every system is
firing off buy signals all at the same time and there’s not money to allocate to
all of them. And you have to a plan on place in the even that one of your
systems no long works. All of these decision are more judgment calls than they
mechanical decisions.

Then I look at the average return of each
individual position within each system. The way I put it together is I ask how
well does an average position do in each one of these systems. I basically make
myself a spread sheet and then I know how well each system performs. Based on
that, I can allocate dollars to different systems. Basically I just take the
data that I get from the systems, I list them on a spreadsheet and I notice some
have a bigger drawdown and I notate the profit factors of each systems. That is
how I really developed my position sizing. So I have more money in things that
perform better and draw down less, and I have less money allocated in things
that don’t do as well, but I do still leave those in to make sure I have enough
trades per year.

Eddie: With all of
your risk management and position sizing adjustments, I would imagine that
someone can take the same systems that you trade and get dramatically different
results. Do you think that is the case?

Steve: Yes. My personal bias is that with appropriate position sizing and
risk management, you can make a lot of different types of systems and trading
styles work better. In fact, I believe that you can take trading systems that
are successful for somebody else and with inappropriate position sizing and risk
management, you can make them fail. I think that happens all the time. There is
probably nothing that has changed my trading performance more than how I look at
risk. There is no doubt that every trade I take, I am not basing any decision on
how much money I can make, but on how much money I think I can lose. How much
money I think I can make plays no factor in my position sizing. My whole theory
is that if I can’t really lose much, I can really only mostly win.

Eddie: You mentioned that you use options to
increase leverage and control risk. Can you tell us a little bit more about
that?

Steve: Well, essentially I use options for just about all my equity
trades. If there are options available, I use them. The way I use them is
primarily for risk control. I also use them for leverage in my account, but not
leverage the way people typically think. I don’t increase my position size
because I can afford more options.

For example, let’s say if there is a $50 stock
and based on what I think my position size should be, I think I should buy 200
shares of this stock. In lieu of that, I may buy 2 $40 strike call options.
These calls cost me about $10.10 each, which is $1000 per contract, or $2000. I
would buy the front month call, and it would cost me around $2000, instead of
having to pay the $10,000 that it would cost me to own those same 200 shares.
Now just because I have more buying power because the options cost less, it
doesn’t mean that I go and buy 5 contracts or $10,000 worth of contracts. I
still only buy the same 200 share quantity as if I would have bought the stock.
In terms of leverage, it ties up less cash in my account.

The second thing in terms of options, is that I
use options in lieu of stocks because I can basically get all of the same point
movement in options than I can in stocks. What I’m talking about is buying
options with a high delta. Options with high deltas are options that are deep in
the money. So essentially the delta tells us for every point the stock moves,
how many points does the option move? For the way I trade, I look for a delta
that is as close to one as possible, meaning if the stock goes up one point, I
want my option to go up one point.

So if I go out and buy the option on a $50 stock,
and I buy a call option that has a $40 strike for the front month, meaning its
coming up in the next four weeks, what will happen is that I will be paying
about $10.10 and the option will have a very high delta. In this scenario, if
the stock moves up three points as the trade I am hoping for goes up, then I
will gain roughly three points on the option. What happens if the stock goes
down 5 points, is that the strike price was $40, and the stock is trading at
$45. So now since the stock price is approaching the option price, I start to
gain premium on the option. The fact is, an option has the most premium when the
strike price and the stock price are the same number–an at the money option.

Eddie: Even in the case where you might have an
adverse move, as the stock price approaches the option price the value of the
option wouldn’t go down as much as when you own the stock?

Steve: Correct, so now if the stock goes down 5 points, I only lose 4
points. Obviously, as it gets closer and closer to expiration, it’s worth less
and less, but overall I do believe it protects you. If the stock completely
tanks and has a 40% down move, I really just lose whatever I paid in terms of
the option.

Eddie: When you are using options to trade a
signal–let’s say it’s a TradingMarkets R4 or R5 signal–are you buying the
underlying stock as well?

Steve: I buy the option instead of the stock. I just buy the same number
of shares I would have if I bought the stock. So meaning, if I wanted to buy 200
shares of stock, I would buy 2 option contracts.

Eddie: So basically by trading deep in the money
options, not only do you get the benefit of the delta decreasing as you approach
at the money so you don’t lose as much, but you are also giving yourself the
kind of leverage that you would get from trading a low-price stock.

Steve: Absolutely, but because I look at every trade in my account as an
isolated event, what I can do now is diversify a little bit more. If I have one
stock and I think that one position should risk maybe one percent to
one-and-a-half-percent of my account value, I now may have more money to go into
another signal that may come, or multiple signals that may come, so that the
other individual positions can risk maybe one percent of my account value for
each one of those. So although I am not increasing the amount of the one
position, it allows me to diversify more, which really puts my performance
closer to the true mean of what the performance should be with the system I am
trading.

Eddie: How about if you
walk us through a couple of recent trades that you’ve done. Explain to our our
readers the thought process that goes into determining your position size and
then explain how you use options instead of equities to trade to trade, say, the
TradingMarkets R4 signals.

Steve: Sure. I have a couple of trades
that illustrate what I’m talking about here. They are in HAL an RIO.

Editor’s note: Steve then
uploaded charts of his recent trades and provided explanations which accompany
those charts.
This is an example of an R4 buy that
I took on November 11 in Halliburton (HAL) I looked at the call options
that were trading and I found that the November 50 calls were selling for
6.10 each when the stock was trading at 56. That meant that I was only
paying for .10 of premium and 6.00 of intrinsic value. So, I knew that I
did not have to look at any deeper in the month call options to find what
I wanted.

Next, I needed to determine my position size. Well,
to make things simple, let’s say that my account size is $100,000 dollars.
For the R4 system, I risk 1% of my account value or $1000.00.

From there, I look at the recent volatility of the
stock. I usually look back roughly 3 months and in the case of HAL, the
stock moved from approximately 65 on 11/3/05 to roughly 56 on 11/10/05.
This is about 9 points. To make this conceptually simpler, I round it up
to 10 points. I know that the stock has had recent swings approximately 10
points and I make the assumption that current volatility will be similar
to volatility in the recent past. And that tells me what my potential risk
is and I use this to determine my position size. Well, 1 option contract
is 100 shares, and 10 points x 100 shares is $1000.00. So, I would buy 1
option contract, regardless of the price of the option.

After the preceding process, the actual trade
begins.

  1. I buy 1 November 50 call for 6.10 on November 11.

  2. An exit signal comes on 11/16/05 when the stock
    is trading at 59.50. The November 50 call goes for 9.30. I actually sold
    the contract when the stock was trading at 59.30. Unfortunately, the
    0.10 premium that you pay for the purchase doesn’t come back to you when
    you sell in most cases. This trade was a 52% gain.

 

 
This is another example of an R4
trade, this time in Companhia Vale do Rio Doce
(RIO)

This is a good example of a stock that trades with options but is more
difficult to trade than HAL with options. This is because the spreads were
wide on the RIO options, and I was unable to find a contract that only had
10 cents premium. I chose the October 35 deep-in-the-money calls which had
as little premium as any of the other options I was considering.

For position size, I once again consider that
this is an R4 play. So I risk 1% of my account based on the volatility of
the stock. I looked back a bit on a chart saw the peak of 45 on 9/29 and
the recent pullback of  36.5 on 9/14. Therefore, I estimated the
volatility to be roughly 8 points in a swing. Therefore for a $100,000
dollar account, I would buy 1 contract. 1 contract=100 shares, 100 shares
x 8 points=$800 which is 0.8% of the

account value vs. 1%. We don’t need to be exact, these are all estimates
anyway.

  1. On October 6 in the morning, because I
    had a signal to buy on  October 5th at the close but missed that
    entry, I bought the October 35 Calls for 4.30. The stock opened at
    39.05. I essentially paid .25 in premium. That’s more than the 10 cent
    premium that I ideally want, but that’s where discretion comes in.

  2. At the close of October 6, there was
    another signal to buy, so I bought another position of the same size at
    the close. The stock closed at 38.03, and I bought an equal amount of
    the October 35 for 3.40. This is a .37 premium.

  3. On October 11, there was a signal to
    exit at 41.40. I sold the calls for 6.30 for a nice gain. This was
    actually 0.10 less than what you would expect from the what the
    intrinsic value would be, but when you do these transactions–you are
    actually doing them a little before the market actually closes (or
    opens)–so the stock was actually trading at about 41.30 at the time of
    the sale. Keep in mind that sometimes this works to your advantage.

Eddie: Prior to this interview, we had talked about
your goals and aspirations in managing money and trading at a professional
level. Can you talk a little about that?

Steve: Currently I am working in an emergency department in San Diego.
I’d like to allocate more time later on in my life in doing some free medicine
in more more rural areas and maybe outside countries. Sometimes this can get
frustrating from an administrative standpoint. I’d like to give it some time
because doing medicine has been a wonderful experience and something that I have
really enjoy. But because it is my main livelihood at this time, I have to
allocate most of my time towards that. Hopefully, as I have continued success in
trading, I can build my account through time to have trading support a lot of my
life and what I currently do in my family. I have also been writing a blog–Almost
Trading For A Living–because it helps to keep building upon that. In terms
of managing money, I have already started trading for some of the members of my
family, and I think it is a good way to build experience managing money and
building a base of capital to help accelerate my own capital growth.

Eddie: Could you talk about what your passion about
trading is versus your day to day activity as a doctor?

Steve: One of the real joys of trading is that trying to tackle the
market is a big puzzle. The way I have chosen to go about it is from a
quantitative and statistical approach and others have gone about it in their own
way. Any way you decide to trade, I believe they can all be successful, but even
more importantly, the way we choose to tackle this puzzle relates to who we are
as people. A lot of times, for many of us who have outside jobs, you have to
tackle problems and puzzles at our own work, you are at the mercy of the system,
work environment, rules of government, and the rules of your administration. You
aren’t really at the free will to look at the problems in front of you and
attack it your way. In trading, you get immediate feedback based on your success
and failure, and I think it is incredibly rewarding.

Eddie: Steve, thanks for
being with us once again.

Steve: Thank you.

Editor’s note: I hope
you enjoyed my interview with Steve Gabriel. I welcome your questions or
comments. Please email me at
eddiek@tradingmarkets.com.

Eddie Kwong

Editor-in-Chief

TradingMarkets.com