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Friday Q&A: Brad Thomas – Professional Trader

|Includes:AMZN, FB, TSLA, Twitter, Inc. (TWTR)

By: Brad Thomas and Chris Tell at http://capitalistexploits.at/

Recently, while corresponding with our friend Chris Mayer from the simply outstanding Mayer's Special Situations, Chris shared with me the GMO quarterly newsletter. For those of you who are thinking GMO is something to do with crops that promise to make you sterile, or grow you another finger you'd be wrong. GMO in our world (the world of finance) stands for Grantham Mayo Van Otterloo, the asset management firm headed by Jeremy Grantham.

The quarterly Chris shared with me discusses bubbles. Not a surprising topic really given the fact that Greenspan, Bernanke, Yellen, Draghi, Karudo, and Carney, to name but a few, have been juicing the markets in much the same way GMO is today juicing agriculture to be "better". So too our economy is being forced by a group of ignorant, arrogant crazy scientists to be "better".

Central bankers throughout the "developed" world, like purveyors of Viagra, view every economy as a limp appendage in need of "fixing". Rise oh mighty one!

Risk is now underwritten by central banks, whose balance sheet liabilities have exploded. What could possibly go wrong? Haven't I read this story before?

Artwork "Balloon Dog (Orange)" by artist Jeff Koons is seen during a media preview at Christie

$58.4 Million. A steal….really!
This stupid piece of "art" wasn't even hand made. Nope…built in a factory

Bubbles are relatively easy to identify, especially when there exists something to compare and contrast them to - a benchmark.

For instance, you can tell if a 10 year old kid is unusually tall when standing amongst his peers. What happens when increasingly so many markets are overvalued? Our benchmark itself becomes overvalued, bubble like. Is this how market participants justify absurdity?

Picture a room full of 10 year olds raised from birth on absurd amounts of human growth hormone and steroids. It becomes difficult to identify the outliers, not least because they're all a head taller than you. This is what the market increasingly looks like today. It is why a ridiculous dog "art" piece sells for $58 million. It is why US profit margins are currently at peak levels and the profit share of GDP in the US is more than two standard deviations from its long term mean (going back to the 1920′s).

Now, I'll be the first to say I know little about art. I do know that I can pick up unbelievably beautiful art pieces in places like Cambodia, Myanmar, Mongolia, or throughout Africa for the price of a half decent bottle of wine, yet in the developed world poorer quality, ugly as sin works, sell for thousands of dollars… or millions!

The normal metrics and associations seem to have broken down. Or have they just been put on ice?

Interest rates no longer reflect fundamentals in any way. Junk bonds trade for ridiculous values, stocks, real estate, antiques, art, even classic cars which Mark and I were recently pitched on, seem to be trading at either all time highs or close to. The one consistent when digging into the interplay of the financial markets is a market driven by artificially low interest rates. When the price of capital is manipulated is it any surprise that we see this reflected in asset prices?

As prices move higher underwritten by central bankers, investors become less and less cautious. The age old valuation anchor, income, is no longer tied to asset prices. Take a look at Tesla which I wrote about here, Facebook, and Whatsapp, where I asked readers if they may want to buy an entire country instead. A country that has been growing, an emerging market rather than a submerging market…the new definition I intend to copyright. Let's not forget Netflix and Twitter. Or Amazon, a company enjoying continually deteriorating margins, and yet it has soared 60% in the last year.

Presidential elections are rolling around so don't expect the market to give up just yet. There is a lot at stake for our Masters.

If like me you're a glutton for information, you can read the whole GMO report here.

Navigating this environment is not easy, and quite frankly a key reason that we turn to our friend Brad Thomas. Brad's mantra is finding deep value situations globally where he can achieve an asymmetric payoff.

With that not so brief introduction let's get into this weeks Q&A session. If you have any questions for Brad, you can ask them here.

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Question:

Hi Brad/Chris. Thanks for these Q&A transcripts. Really great for generating ideas. My question is on the type of options you trade Brad. How can I get access to options on FOREX and index futures which are 4 to 5 years before expiry? I know that one can trade LEAPs on single stocks but I'm nor sure how I can enter into longer dated options?

Many thanks,

Faizul

Answer (Brad):

In the US options on stocks go out as far as two years - at the current point January 2016 expiry. You can get options on the S&P and Dow that go out to December 2016. But that is as far as they go. These options can be traded via any US option broker.

For FX options the only option broker worth considering is Saxobank. You can go out as far as 12 months to expiry on a wide range of FX options.

For Stock indexes in Europe both Saxobank or Interactive Brokers are your best bet. You can get options going out as far as December 2018 on the Eurostoxx 50 and Amsterdam Index (AEX). Most other European indexes have options going out to at least 2017.

For European stocks there are about 20 large cap stocks for which you can get options going out to December 2017/18. The best broker here is Interactive Brokers. However, Saxobank will soon offer options on these stocks.

Chris' note: Saxobank are rolling out stock options in June of this year.

Question:

Do you feel the potential profit in options is more in a volatile market, or in a less volatile market, as we seem to have at the present time? It seems that call option prices would be higher (or lower for puts) in a more volatile market and adjust accordingly to that volatility.

Is their any kind of science to option pricing or just a bidder and seller (demand/supply) typical pricing? I personally have found a rather wide percentage range from stock to stock in the same category or industry which suggest someone is making judgments along the way.

Ron

Answer (Brad):

When the volatility of the market is higher so to will be the cost of the options, of course the opposite also applies. The trick is to try to anticipate what volatility is going to be and compare that to what is actually being priced in.

One of the big behavioral traits of humans is to extrapolate the recent past into the future. So when volatility has been low in the the market for a couple of years option writers tend to extrapolate this into the future and usually volatility is under-priced (this in essence is what we try to capitalise on). Is there any science to this? I guess there is somewhere, but I think it is more of an art to try and identify these time periods.

What determines the level of implied volatility on an option? It's good old fashioned demand and supply. Right now it seems that there is an excess of supply over demand with the result that long term volatility on many stocks are trading at 20 year lows! I'm guessing that its largely due to the popularity of the buy-write/covered call thing. This is pushing implied volatility way below where it should be.

Question:

Hi Brad and Chris,

After watching for a while I finally decided to subscribe to the Capex Asymmetric Trader. Why did I hesitate so far? First of all there are so many comparable services being offered that it takes time to separate the wheat from the chaff. Secondly, in one of my accounts I am already trading on similar principles as Brad: looking for deep value situations with chances of asymmetric payoffs through long dated options.

As I intend to slow down my trading over years ahead I thought I should give it a try and start parallel trading Capex AT and compare results with those of my own trading first. If satisfactory I may well decide later on to have a look at Brad's forthcoming fund or even consider a managed account for high net worth individuals (I wonder which amount would qualify?).

In this context your new idea of auto trade subscriber accounts sounds tempting and fits in well for me. There are, however, a few questions that come to my mind immediately:

  1. Who is the broker?
  2. I guess that in case I would join now I would only participate in future trades, not the existing open ones, correct?
  3. If I would invest, for example $100,000, could I determine such parameters like:
  • Minimum cash balance in the account at time of new trade must be e.g. min. 40% of account value - otherwise abstain.
  • Can I interfere and by-pass the auto trading by closing a position (e.g. in the event that my cash balance falls below 40%)?
  • Amount invested per trade: e.g. 1% (of account value rounded) if option expiry is in more than 18 months, 0.6% if in 10-18 months, 0.3% if in 3-10 months.

And finally, a general question for Brad: do you keep a minimum cash balance in your "asymmetric account" and if "Yes", how much?

Please advise what to do to subscribe to Capex Asymmetric Trader.

Cheers,

Thorsten

Answer (Chris):

All good questions. Let me try hit them one by one. Firstly, we are in the process of setting up the fund infrastructure and will let readers know when it is ready for prime time. The minimums will be $50,000.

  1. The broker is eOption, a low cost specialist options broker. You can check them out here.
  2. Correct, you'd only be able to participate in future trades.
  3. Parameters can be set with the broker. Including the ability to override. This needs to naturally be discussed with them. Here is what they've told us:

"When your request to auto trade the (Capex Asymmetric Trader) service is made, eOption will first verify you are a paying subscriber and will then proceed to add you to the auto trade system. Once verified, they will activate your account under the CAT service to begin auto trading.

You will have the ability to set your auto trade allocation amount to a specific dollar amount, a percentage of account value, or a set number of contracts per alert. When eOption receive an alert, they input the parameters into their proprietary auto trade system. The system is constantly scanning balances and positions so that when an alert comes in, they can quickly determine who should participate and at what level. They will then enter one order to the market for all active auto traders. Once filled, they allocate the options to each account at the executed average price. They do it this way to keep it fair and equitable for all participants. It also allows them to move quickly to execute the order. The order entry process literally takes just seconds to execute."

Brad here: In answer to the question - how much cash to keep in the account? This depends on time frame, if you are only investing in options with two years to expiry then I would say keep about 50% in cash. However, if you have options expiring 4-5 yrs to expiry as well, then one could go down to 25% cash.

Lastly, if you want to give it a try you can sign up to the Capex Asymmetric Trader here.

The following is a string of questions from a member:

Question:

A couple questions regarding the auto trade. Do these forms work for an LLC also? And also, I assume you would check margin and shorting? I mean, why not?

Paul

Answer (Chris):

Yes, you can trade via an LLC.

As for the margin and shorting, personally, I'd check it even though for the service you won't be using it. It will allow you to use it for other trades should you wish to at a further date. Think of it like having a large big ass gun. Nice to have in the cupboard even though you will probably never use it. Easier to ask for forgiveness than permission right?

Question:

If you were starting with $25,000 or $50,000 in the account, would you select a dollar amount per trade or a percentage, or is this determined by Brad at each trade? I mean, if you allocated 1%, or limited yourself to that wouldn't that hinder something bigger if it comes along? And, obviously 1% of $25,000 is $250, but going forward it would be less if that money is tied up in a trade for a while, if that makes sense.

Answer (Chris):

Percentage. And, yes it does make sense. Personally, and this isn't advice, I just up the % allocation for a smaller account size. I've been known to run as high as 5%. So for example instead of 1% you run a 2% and now you're at $500 instead of $250 on a $25,000 one. If a particular trade is a big ticket item you can always sit it out. For example the last trade in MIB is quite costly in comparison to the others (largely because the sucker runs for 5 years which is awesome for what we can buy it for). You can also have the ability to override the auto trade at any time I believe. Check this with eoption though.

Question:

I guess it's asking for a maximum amount per trade, so just looking for some input, since you guys have a better idea of timing on these things, etc. From what I have seen it looks like most of these trades seem to be long dated?

Thx

Answer (Chris):

Yes long dated is the strategy since you're using options, time value erosion is your enemy and buying deep fundamental value long dated is an awesome strategy Brad has been using for 30 years. I'm not sure you need a maximum amount per trade if you're choosing a % per trade? Maybe I'm missing something. I think its just a standard form and that particular question becomes redundant based on choosing a percentage.

Question:

Hi Brad,

I am a founding member of CapEx/Seraph and have been following your trades although I haven't executed any thus far. I like the idea of the auto trade function and am filling out the paperwork to set up an account.

There is a section for "Maximum Amount per Trade", quantity of shares, dollar amount or percentage. I'm looking for a little guidance here. I assume if I open the account with $25,000 or $50,000, that this is enough to allocate? I mean, how much would you put on a normal trade, as in, should there be a minimum amount to make the trade worth it?

Also, if I select a 5% maximum, would that be high enough if something good comes along? I assume that all trades would not be made at maximum as it looks like a lot of your ideas are 1% of portfolio? And, it looks like most of your trades are long dated. When you close these out I assume the Auto Trade function works on that as well? So, when you would close your trade out it works the same as when the trade is initiated?

I would appreciated any clarity you could offer. I'm not asking for specific advice, but since you are the expert in the room, I would certainly like to hear your thoughts on setting this up so I can do it right the first time. Please feel free to let me know if a higher qty to open is better, etc.

And lastly, would you put any of the recent trades on once this is set up?

Please feel free to call if that is easier.

Thank you,

Paul

Answer (Brad):

Hello Paul,

Let me try and provide some guidance.

Size of ones portfolio? $25,000 would be plenty. What I am going to be doing is one or two trades each week of $300 - $500 per trade. First of all, I have no idea as to which trade is going to better than the others so I would equally weight all positions (more or less).

How much to allocate to each trade? An amount that you have no emotional attachment to. So if that is $500 then you would select quantity max $ amount of 500.

Note it is important that you gain an understanding of the strategy and the risks and eventually you "buy" into the investment process. This will come with time,so start off small and work your way up slowly.

When to get rid of the option? Well the great thing about options is that you can only ever have a pleasant surprise because the upside is "unlimited" and the downside is capped so you can never get yourself in trouble and you can afford to "walk away" from the trade and revisit it in 6-12 months time. All the options I have talked about so far are at least for January 2016 expiry. What I will do is sit down at the end of this year and decide what to with each trade, whether to roll to a January 2017, hold or close out the trade.

All the trades I have talked about over the last 6 months are as applicable today as when I first talked about them, but of course the prices of the options would have changed somewhat.

Hopefully this makes sense. If you need further clarification I am happy to give you a call.

Brad

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Thank you for joining us and we'll have another full week for you next week. In the meantime, take a look at what trades are on Brad's plate HERE.

- Chris

"Think how weird profit margins are: We've got high unemployment and financial crises - and world record profit margins. People think the American market is very cheap. We don't. The market quite incorrectly gives full credit to today's earnings." - Jeremy Grantham

Stocks: TWTR, FB, AMZN, TSLA