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Introduction to The Option Trader's Hedge Fund: A Business Framework for Trading Equity and Index Options

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Dennis A. Chen and Mark Sebastian introduce their book, which suggests a framework for trading options profitably; this framework has been used by an option trading hedge fund. The book is a road map for anyone wanting to trade options, with guidelines on how to run an option trading business successfully.
This chapter is from the book


The world of investments is very large. You can invest in stocks, bonds, options, real estate, CDs, commodities, or futures. Regardless of where you choose to invest your money and time, it would be very wise to have a framework with which to manage your investments. This book suggests a framework for trading options profitably; this framework has been used by an option trading hedge fund. The book is a road map for anyone wanting to trade options. We provide guidelines on how to run an option trading business successfully. We also provide you with our own experiences, learned along the way as a professional hedge fund manager (Dennis Chen) and a former market maker and trading coach (Mark Sebastian).

If you are reading this book, you already may have experienced trading options. We will not teach you how to set up a hedge fund or how to invest in hedge funds. There are other books to help you set up a hedge fund if you so desire. This book gives you a glimpse of how a particular hedge fund, Smart Income Partners, Ltd., successfully trades options for its partners. Smart Income Partners, Ltd., is an option trading hedge fund managed by Dennis Chen, a co-author of this book.

At his hedge fund, Dennis views trading options in a different light. He thinks of his business not as a hedge fund, but as an insurance company. When asked the question “What do you do for a living?” most hedge fund managers would say, “I manage a hedge fund,” or “I’m a money manager.” When someone asks Dennis what he does for a living, he answers, “I manage risk for a financial insurance company.” Let us introduce to you the concept of “The One Man Insurance Company,” or TOMIC. TOMIC is the business framework Dennis uses to operate and guide his hedge fund. TOMIC is a framework that anyone could use to manage their option portfolio. You too could run The One Man Insurance Company. In the following pages we introduce the concept, explain the framework, and show you how to manage your option trading business like Dennis does at his hedge fund. Also, you will find throughout the book key lessons they have learned during their trading careers.

Part I of the book, “The Framework,” shows you the framework details of TOMIC.

Chapter 1, “The Insurance Business,” provides an overview of the insurance business and compares it to the way the hedge fund thinks about its option trading operations. You will review the value chain of a traditional insurance company and compare it to the value chain of The One Man Insurance Company. You will learn what key success factors are needed to run a successful TOMIC. You will gain a better understating of the business of TOMIC.

Chapter 2, “Trade Selection,” provides you with guidelines of trades chosen for TOMIC. You will learn about market selection, direction, timing, volatility, and pricing. Each of these five factors impact your trade selection, which is the underwriting function at TOMIC. It is the key to making money trading options.

Chapter 3, “Risk Management,” reviews the risks taken at TOMIC and how to manage those risks to avoid a terminal loss of the business. This chapter discusses position sizing, money management, diversification, protection against “black swan” events,1 and trade exits.

Chapter 4, “Trade Execution,” explains how to implement the trades you place. It shows how to get them done efficiently. This chapter gives you a better understanding of the conditions to look for before placing the trade and how to place the trade in order to get better fills.

Chapter 5, “The Trading Plan,” discusses the importance of having a plan, and it reviews the process of creating your trade plan.

Chapter 6, “Trading Infrastructure,” reviews all the tools and services you need in order to be able to run a successful option trading business.

Chapter 7, “Learning Processes,” reviews the importance of a feedback loop. We include suggestions on supporting functions necessary to maintain the edge in the business of trading options.

In Part II of the book, “Implementing the Business,” we give you a taste of how to implement the business. This part of the book shows you specific examples of different trades that are used at the hedge fund that you could implement in your TOMIC. You will see how to trade a vertical spread, an iron condor, a butterfly, a calendar spread, and a ratio spread.

Chapter 8, “Understanding Volatility,” shows you what you need to know about volatility to implement the TOMIC.

Chapter 9, “Most Used Strategies,” shows you in detail the five most frequently used strategies at TOMIC. It provides you with the key criteria for using each strategy.

Chapter 10, “Operating the Business: Putting Together TOMIC 1.0 from A to Z,” provides guidelines for creating TOMIC 1.0. It provides you the answer to how to create your own TOMIC.

Part III, “Lessons from the Trading Floor,” is a selection of blogs written by Mark Sebastian for OptionPit.com, with an occasional guest blog written by Dennis Chen. The section covers lessons learned at the option pits on different topics. You will find words of advice on risk management, volatility, trading and execution, and the Greeks.

Once you have finished reading this book, you will have a good understanding of the insurance company framework used to build a profitable option portfolio. As you build your option trading business, you might decide to read the book again because there are additional insights you will get after you’ve experienced real trading conditions. The markets are constantly changing. We encourage you to continuously learn and seek to improve your trading every day. This book was written to be a guide, but you must walk your own path.

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