How to Sell the High or Better!!

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In an article I wrote for the VTI Weekly Newsletter (April 8, 2020) entitled "Same Trades, Different Views. Improve Your Results with Positive Reversion" I introduced the concept of the Excursion Ratio, which I now call the Capture Rate. The Capture Rate uses two different inputs:​ The first is what we call the maximum favorable excursion,and the maximum favorable excursion is a The furthest the trade went in your favor during the life of your trade, and then the second number is the actual profit. We take the profit and we divide it by the maximum favorable excursion we get the capture rate. What the capture rate does is it actually measures how effective you were in capturing the move that benefited your trade. It takes advantage of what we call positive reversion entries and positive reversion exits, that help you to dramatically improve your capture rate.

What is a positive reversion entry or positive reversion exit? Well, positive reversion entry is buying low. Positive reversion exit is selling high, it's basically buying low when you get in and selling high when you get out or selling high when you get in and buying low when you get out.

The capture rate is measuring how effective you were at capturing the move that went in your favor, and one of the key aspects of being able to capture, that that high capture rate, is using positive reversion.

Now, let's talk about the fantasy of every trader. The fantasy of every trader, the dream revolves around the perfect trade, in which you get long, you take no heat to trade, it really goes in your direction, and then you exit the high tick of the move, watching the trend implode after you exited. We all know that's not possible, though, right? There's no way to sell the high tick with any regularity. You might get it once in a while be lucky, but you know, we can't do that. What if I could show you the way that you could sell a high tick or even better than the high tick? What if I could show you how to get a capture rate greater than 100% of the move? You probably want to grab the proverbial bullshit flag and throw it because you know I cannot be telling the truth. Well, let's see.

How do we get capture rates greater than one?
By using options! One of the vans core principles is that you need to have large wins to be a great trader, and Van used to preach that, Dr. Van Tharp used to preach that the threshold for a big winning trade was a minimum of 3R, three times of reward, three times your risk. It needed to be a minimum of 3R or greater.

One of the things I preach is that large winning trades are the secret sauce of great trading. Everybody goes for win rate. It's not about win rate. It's about big wins. This is one of my all time favorite quotes, and I studied Paul Tudor Jones a lot. He's actually a friend of mine. I had conversations with him about this, and I know people who have worked with him extremely closely. Not only do I know, Paul, but I know people that have been involved in Paul's trading on an intimate level, and one of Paul's fundamental principles, which I borrowed from him is this idea of five to one. Paul would say "Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.” ​Think about what Paul's saying if he's right, and he makes five and he's wrong and he loses one, he has an 80% win rate. He's actually going to be up 1R. In other words, he lose fourR, four losses times one and he make fiveR in one time he's right. Even though he's wrong 80% of the time, he would still be money.

Now, we built this table, and this table to me just tells the whole story beautifully. What this table does is it shows a matrix of win rate versus reward to risk ratio and what does your win rate need to be to break even at different reward to risk ratios. What we can see is we have this concept called expectancy. Expectancy is also the average R the average reward or average realized R.

One of the things we see here is that everybody goes for high win rate systems. I view the minimum threshold for a good system is expectancy of 25 cents. If you're under 25 cents, it's really just not worth your time. What's interesting is that if I set up a system where if I'm right, I make 50 cents, and if I'm wrong, I lose $1. My breakeven rate is 67%, I have to be right two thirds of the time breakeven. At 50%, I'm down 25 cents, which is an awful system, and I want you to notice, even if I'm right, 80% of the time my expectancy is 20 cents, which is not even the minimum for an acceptable expectancy.

Now, if we move over to 1:1, which everybody is like, 1:1 would be great, okay, well, one to one, if you're right half the time you breakeven, you don't make any money. If you're right, 60% of the time, you make 20 cents, which is not even a minimum threshold. It's not to get over 60%, that you actually, it's really about 63%, that you actually get to what we would consider the minimum threshold for a good system, but if we look at what Paul does, if we go all the way to the right to five to one, what we see is that for the breakeven rate is 15%, and if we could be right half the time, with a five to one payout, our expectancy would be $2.

I want you to step back for a second. Because in the one to one system, if I make $1, if I'm right, I lose $1 if I'm wrong, which most traders are totally good with that. The best I could do, the best expectancy I could have perfection would be $1 expectancy. If I was right 100% of the time, my expectancy would be $1. I want you to notice the way Paul does it at a 50% win rate, the expectancy is $2. It's double perfection, which is insane.

If we looked at what Van teaches us to do it three to one at 50 cents our expectancies $1. It's perfection, it's the same as perfection at one to one. That's how powerful this is, and you can see the table this we heat map this and you can see as you go to bigger and bigger wins, it just changes everything.

Large R winning trades have a massive, massive implications for your trading. It is the secret sauce. If we believe that large wins are the secret sauce, then options are the ingredients of the secret sauce. In addition, by creating large R winners using options, we can develop trades where the capture rate is greater than one. In addition to focusing on large R winners Van would preach two key concepts.

One know your objectives. Options give you the ability to trade with much greater precision, then trading underlying which supports you to create positions in alignment with your objectives. This is in a way that's not possible with stock or futures alone.

The second thing Van would say is you have to know your market type, I call it the market environment. Well options gives you the ability to maximize the six market types by creating positions that make money when the market doesn't move. You can put positions on to make more money when the market rally slowly than long stock or futures alone. If we were in bullish quiet, you could option trades on to do better than just being long stock, and you can put option trades on that make more money when the market rallies fast, which would be bullish instead of being long stock or futures alone.

This concept is vital. Because when you can anticipate direction and volatility, you can pick pick an option structure that massively outperforms underlying alone. The combination of these concepts leads to a powerful schematic that creates trades that have capture rates greater than one.

Let me show you an example. This is in Tesla. This is in one of our systems called the REED$TRADER mechanical system. If we just did the follow the rules by buying stock and Tesla, we could buy 100 shares of Tesla, we'd risk one weekly average true range for our stop, and if we did that we'd be going long at 622.77. The 554.48 stop and we'd be exiting on January 15 at 826.16. This trade would be a 2.9 R winner. It's a nice trade, it would make $20,339 and the capture rate, which is excellent is 77.7%.

Couple things are noteworthy here too, is it cost you $62,277 to put this Tesla trade on, and your return on capital is 32.66%. Now, we could instead buy four of the January 640/780 call spreads, and Tesla, they would both be equal to 100 shares exposure is normalized. They both had equal directional exposure at the time of initiation. Here we're buying the call spread at $35.87. Our stop is at $18.80, and our target is $140. This trade goes out fully in the money. It goes out at 140. It generates a p&l $41,652 or 6.1R the capture rate 159%. I want you to think about that. We'll work through the numbers here.

It's 59% better than perfection. That's what the 159% capture rate tells us. We go ahead and break it down, we can take our $41,652 from our Tesla call spreads, and we can take this and divided it by $100, by 100 shares. This gives us a total profit of $416.52 per share, we're going to add 416.52 to our entry price of 622.77. The entry price is where if we had bought Tesla, so we bought Tesla at 622.77, we're going to take this unit of profit $416.52 and add it to it, this is going to give us an exit price of $1,039.29. This is what we're going to use to calculate our capture rate. The capture rate is the exit price minus the entry price divided by The MFE minus the entry price. So the exit price is $1,039.29. The entry price is $622.77 divided by the MFE of 884.49 minus the entry of 622.77. This gives us 159% capture rate. By making this conversion, we can see that we exit our Tesla 159% better than MFE of the trade. We not only sold synthetically at the top, we actually sold 59% better, than the high. This happens all the time.

In our matrix workshops, we teach options strategies in the context of the implementation to create trades with Capture Rates greater than one, one of the things we do is we help you understand how to define your objectives, and structure your trades in alignment with those objectives. If you spend the time to master these strategies, they will have massive implications on your future trading success.

Here's just some examples. We'll go through these quickly, but these are four different examples of an underlying trade that could have been substituted with an options trade in its place. The first example is we sell 100 shares of spy, this trade is excellent trade, it makes 3.84R but if we actually did a calendar spread and options, instead, we would have made 11.79R. Our second example we buy 100 shares of Google this trade makes 3.12R we could buy 10 Google butterflies and you would have had an R of 11. Then, in a short call spread we could have sold 100,000 shares of the TLT ETF or we could have sold 40 call spreads, while the the ETF trade is a winner by .23R. Rhe call spreads or .18R winner, and then finally we could buy DocuSign or instead of buying DocuSign we could buy what we call long synthetic calls. DocuSign makes 6.67R it's an excellent trade but if we did the calls that have been up 12.54R.

The other thing is all these trades have a limited risk profile. The other underlying trade has unlimited risk. Yes, you have a stop, yes, but you could have a gap. All of these have a maximum risk point. Our psychology is an essential aspect of our trading success. I love what Van used to say, said we just trade our beliefs. What I find so interesting is how many people see these concepts repeatedly but still have resistance to embracing the concept that will ensure their success.

How about you? Ask yourself, honestly, are you embracing the concept of hunting large R winning trades? Are you? It starts there? Then do you clearly understand your objectives for each trade? Saying, "Well, I'm thinking it's gonna go up", Is not enough. Are you willing to embrace using options structures to create trades with, with Capture Rates greater than perfection? Are you? That's freaking amazing. I don't know why you wouldn't.

This is your wake up call. It is it's a wake up call. What are you doing? This is your opportunity to adopt these concepts and improve your trading radically. We have what we call the red pill challenge. It's a free challenge that you can take. It introduces you to options and starts to educate you on these concepts so you can start to understand them and embed them in your trading.

There's a link right here for the 10 day Red Pill challenge. If you want to give it a go. It's amazing. Well worth your time.

That's it for today. Stay tuned every Tuesday for additional webinars, where I'll continue to teach you different ways to take your trading to an elite level. Have a great week. Have a Merry Christmas. God bless all of you! See you next week. Bye.