Traders Edge Blog

Traders Talk:
TEI’s Louis Horkan Interviews Karson Keith

In this monthís Traders Talk weíre chatting once again with Karson Keith, a trader you all know and a mentor to many of you. In the first part of the interview, Karson shared quite a bit about his trading background, as well as insight regarding his straightforward philosophy on how to make money in the market. This second part is more focused on the strategies employed by Karson to consistently bank what can only be characterized as phenomenal returns. Additionally, he offers his views on the fiscal cliff drama and its impact on the economy and market, especially in regards to how that is likely to play out in the coming year. What ís more, he shares the approach he expects to capitalize on in 2013.

TEI: Hey Karson, itís good of you to give us more of your time to complete this multipart discussion. How are you today?

KK: I’m doing fantastic. How about yourself?

TEI: Iím good as well. Getting right to questions and focusing first on market conditions, how much do the broad market conditions play a hand in what strategies you employ?

KK: Well, as with any good trader, you have to trade in whatever market you have. If you’re trying to trade in some imaginary market it usually doesn’t end very well. You have to know what’s going on out there and you have to trade with whatever the market happens to give you. So I’m constantly adjusting to whatever the market conditions might be.

TEI: Do you pay close attention to the key levels on the broad indices in general and specifically when youíre contemplating putting trades on?

KK: I don’t pay close attention to themÖI keep an eye on them. I tend to trade more arbitrage trades, more inefficiency in the options. So it is important to note those certain points, but it’s not really my game. Usually I can take advantage of the pricing inefficiencies in the options, especially in the weekly options. But I do trade always being aware of what’s going on out there with certain prices and support and resistance levels.

TEI: Youíve previously explained that you donít pay attention to most indicators because they simply donít work at this point. That said, do you pay any attention to formations, such as head-n-shoulders, flags/pennants/wedges, double/triple tops or bottoms, etc.?

KK: If itís anything a trader can recognize outside of mine and Jeff Augenís little world, then I don’t use it. I don’t even have them on my screen. If I could delete them off my computer I would, but theyíre built into the platform. I don’t look at them at all.

TEI: Focusing on the Augen Indicators, can you explain what the Augen Indicators are for those who arenít familiar or who havenít witnessed them in action?

KK: Basically Jeff is a trading/programming genius of sorts. Heís actually come up with his own algorithm – his own way of interpreting how a stock moves and determining how much strength is actually behind it. His indicators, which arenít broadly distributed, have worked extremely well for me, even in my option positions. Oftentimes I’ll use the indicators to leg out of trades for even more profit than I already had in the first place.

TEI: What advantage do the Augen indicators give you?

KK: Well, every trader has their days that don’t go so well. For example, say I do a butterfly position or a straddle position that doesn’t work out the way I want. I refer to it as cheating my way out of it. Iíll use the indicators to leg my way out of the position. So what would otherwise be a losing trade, I can turn into a winning trade fairly easily.

TEI: What type of time frame are they most appropriate for?

KK: Jeff originally designed them for longer-term trading. I wouldn’t say long term, but somewhere in the realm of swing trading. As weíve progressed theyíve actually turned out to be fantastic for day trading. So you can apply them to long time frames or really short time frames. It’s quite phenomenal. The most lucrative is just getting in and out within short time frames.

TEI: What types of securities do they work best with?

KK: It’s really simple – if it’s liquid enough to trade, it will work. They seem to work better on things that are super liquid. Apple, the e-minis, any of the more liquid futures, the Euro and a lot of the main currency pairs. It seems like actively traded things work best. I can’t really say they don’t work on things that might be thinly traded because I don’t’ work with such things.

TEI: Does the indicator focus primarily on identifying high frequency or algorithmic trading activity?

KK: It picks up on algorithmic trading typicallyÖbut it also can help you gauge how strong a move is and more particularly when a move is coming to an end. Oftentimes that’s our entry point when a downtrend or uptrend is ending.

TEI: Refocusing on approach, can you briefly explain the absolute importance of trading the markets seeking a statistical advantage?

KK: Well the reason I like to trade these advantages is simply because trading the market by itself, directionally, can be difficult ñ though we do it pretty well with the indicators. But it’s usually in very short time frames. For me to put on an option position that I’m expecting a certain thing to happen over the next two weeks, that’s very difficult. Any piece of news during that two weeks can completely change the dynamics of what I thought when I originally got into the trade. So you have to constantly be in tune with the market if you’re going to do that. But there’s much easier ways in my opinion to make money. You just take advantage of these price inefficiencies. Look at it this way, how do you price an option on Apple? Something that’s going to expire Friday, say four hours from now. An ATM option is almost impossible to price that close to expiration. What’s it’s really worth? Well, no one really knows, right? Is Apple gonna move or not is basically the question. The volatility is priced in at somewhere around 38 percent, give or take. Thatís all they have to go off of. So arbitrages appear because the next week’s option is nowhere near that price. The time decay is four hours and letís say itís going for five bucks. Well, that means it has $1.25 per hour of time decay. The next week’s option doesn’t have $1.25 of time decay per hour, right? So there are all kinds of inefficiencies just because that’s the way the market is. Itís impossible to price fairly. That’s a much easier way in my opinion to make money than to try and guess the direction on stocks.

TEI: You tend to follow market cycle pretty closely, correct?

KK: Well I like to keep a pulse on things – I like to know what’s going on out there. But really my main game is simply these inefficiencies. But you do want to know if weíre having a big Fed meeting or some news thatís about to hit or if a big name is about to report earnings – you want to be aware of these things. You either get out of the way or have a trade structured that takes advantage of it. But as far as the actual trades, for the most part, assuming nothing is going on, it’s almost 100 percent statistical edge trading – inefficiency trading.

TEI: Given the importance of volatility in the markets and particularly in option trading, how closely do you monitor the VIX and how much does it influence your trades at any given point?

KK: Well, without getting into an hour-long discussion on why the VIX doesn’t work, simply put, the volatility that I take advantage of is gonna be within the stock. I previously mentioned Apple’s volatility. Depending on the day, itís somewhere around 38 percentÖthat’s the price of the volatility on Apple.

The VIX is inefficient. People say it’s a measure of risk. Are you kidding me? We’re in the riskiest market that I can recall. Who knows where this thing’s gonna go next. Every single whisper out of Obama or Boehner or anybody. Or whatís coming out of the Fed. Any of that and the market rallies 100 points or it drops 200 points. So why is the VIX down in the dirt? Because the VIX is not what people think it is. It’s not an accurate measure. So to answer your question, the VIX plays almost no role in my trading.

TEI: Weíve had an extended period of low-volatility, range-bound markets for a while now. Whatís your favorite strategy for these kinds of conditions?

KK: I usually do a long or short butterfly, depending on the situation.

TEI: What other strategies have you used in the past year or so?

KK: Earlier in the year I actually did a lot of back spreads – like back spreads for a credit ñ blow-up trades as I like to call them. Basically we’re just looking for a move in the stock. I still do a little bit of that with the short butterflies. But now the market has evolved in a way that the long butterfly position, particularly over the weekend, makes most sense. It ís strictly a statistical trade, offering a statistical advantage. Even if the stock makes a move, which I don’t want to have happen, I still end up getting out of the trade for maybe a small loss, but usually somewhere around break even or in some cases, a small profit. Now that’s without legging out or doing anything fancy. But when I’m right – and I use the term ìrightî loosely – and the stock doesn’t move and it stays within the range over the weekend, you walk away with a nice profit. So it’s strictly just a statistical advantage trade. That’s just the pricing inefficiency of the option due to the fact itís impossible to price that fairly. Over the weekend, at least for the stocks I trade, happens to be the window where this inefficiency takes place. I’ve really milked that to the tune of over a thousand percent return for the year. It sounds ridiculous, I know. You wouldn’t even believe me if I told you that, right? But I have a track record that a third party put together for me. So, itís a phenomenal return playing an advantage like that.

TEI: Whatís your thought on trading longer-term trades, like more traditional option trading?

KK: Longer term, like month-to-month – I would say you’re doing the wrong thing. You have to trade with what the market gives you. It is what it is and right now trading month-to-month, thereís just no way. I mean if you could do it, fantastic and more power to you. But as far as my own personal trading, there’s no way. I have much better ways to make money. Trying to predict what’s going to happen a month from now in this market, there’s no way. One little piece of news can completely change the whole thing.

TEI: You talked last month about the Stock Wiz Kid service. Can you share just a bit about your approach in the service for those who arenít familiar?

KK: Well, basically Stock Wiz Kid is centered on what I’m doing in my own trading. Itís pretty straightforward, pretty simple. Here’s what I’m looking at, here’s what I’m gonna do and these are a few reasons why. It’s a skill that’s acquired over a long time. As for rules, as people would like to call them, they are almost intangible and hard to put into words. I wouldnít say my approach is intuitive, but instead just drawing on experience. The trades I put on there are my actual trades. The people that get it and follow along tend to love it. And I love doing it, so I can’t complain.

TEI: Do you like trading specific known events, such as earnings, stock splits, conferences, etc.?

KK: Absolutely, I love predetermined things. Something that’s set in stone – here’s the time and here’s the date. You want to talk about inefficiencies in pricing. When you know Apple’s going to report earnings or they’re going to release a new iPhone or whatever it might be, the inefficiency is just unbelievable. You can take advantage of things several different ways. Iíve been doing long butterflies going into newsÖjust before the news. Now remember that with a long butterfly you don’t want the stock to move. But I’m doing long butterflies going into an event that will most certainly move the stock. That sounds crazy but it’s a complete arbitrage trade. You have to see itÖmany of my members have seen me actually trade this and made a lot of money along with me. These are ridiculous arbitrage trades where the amount of risk is literally zero and the reward is borderline unlimited. So, any time there is a news event, I absolutely love it. It’s my favorite thing to trade.

TEI: When do you tend to enter these type trades and how long do you hold?

KK: I usually start putting on and taking off positions typically about three days before the event. Not long before the event. That’s when the highest amount of inefficiency occurs. Sometimes, depending on what it is, I’ll hold over and other times just for the period before the announcement happens. It really depends on what’s going on.

TEI: Youíve had a lot of success with Butterflies in this past year. Do you expect it to continue to be a profitable trade strategy?

KK: Yeah, the thing with butterflies is they are really simple. The long butterfly benefits from time decay, while the short butterfly benefits from movement, other than some arbitrage setups, which are fantastic – but you have to wait for news events and things like that. Are they evergreen? Will they work in any market? Sure, because they’re on both ends of the spectrum. So one or the other is gonna be working. It’s either you’re looking for a movement or you’re not looking for movement. Pick one or the other.

TEI: Why do you think youíve had such success trading butterflies and how does your strategy differ from most others?

KK: Most people put on a long butterfly a couple of days to expiration. The option is about to expire and I think it’s going to finish within the range and I’m going to make my money now. Thatís perfectly fine for the standard retail investor who doesn’t really know what they’re doing. The market’s very efficient at pricing that trade though, and for that reason I don’t like that trade. So I do a long butterfly going into the weekend, a week prior to the expiration. In fact, the bad time to do a long butterfly is the last couple of days when most people typically do a long butterfly. On the other end of the spectrum, since thatís a bad time to do a long butterfly, then naturally it’s a good time to do a short butterfly. So that’s usually the window Iím doing short butterflies. Now it’s not every single week, at least with the short butterfly. You need the right circumstances or certainly the right amount of credit on the trade. So I wouldn’t say it’s as consistent an inefficiency as with a long butterfly. Now the long butterfly – I think I’ve done trades every single weekend for seven or eight month now. I don’t think I’ve missed a single one.

TEI: Can you explain your Pinning strategy briefly?

KK: Thereís lots of movement based around strike prices. Apple will move to a strike price and you’ll notice several times it’ll hit that same strike throughout the day and then move to another strike price, especially on an expiration Friday. So, basically there are all kinds of trades you can structure around them. I’ll be honest, I’ve kind of become borderline lazy. I use the indicators now rather than trying to guess when a stock is pinning to a strike price or when it’s about to move to another strike price. I used to do it the hard way, but then I started working with Jeff and using the indicators. Now, using the indicators, it’s extremely clear when the stock is truly pinning or getting ramped up to make a move from a strike price. Long story short, I cheat and use the indicators.

TEI: Do you trade pairs and what can you offer on that strategy?

KK: Pairs trading is fantastic. Especially with the indicators. But even independent of the indicators you can tell when a stock is outperforming or underperforming the market, right? If the DOW is up a hundred points and there’s a stock that’s down a couple percentage points, clearly it’s underperforming the market, right? So you can do pairs trades structured around things like that even independent of the indicators. If you use the indicator, obviously you’ve got a tremendous advantage. It’s kind of a slower-paced way to make returns, but as far as consistency goes, it’s off the scale. The odds are so high in your favor that you’re going to be correct. Itís difficult to compete with the accuracy of a properly structured pairís trade.

TEI: What is as strike force trade?

KK: Really the strike force is just the forces around the strike prices. I’m kind of Star Wars fan so I like to use the force of strike prices to my advantage. But you can structure any trade you’d like around these strike prices, whether it’s a pinning trade or a blow up trade. For example, say Apple moves from one strike halfway to another, it’s usually a pretty good bet that it’ll actually make it all the way to the next strike price.

TEI: Before closing, letís focus a bit on the drama that has everyoneís attention now. As we sit here today, thereís been no resolution on the Fiscal Cliff issue. Youíve talked at length about it with Jeff. Can you share your thoughts on what will occur and how that will effect trading short term?

KK: Well, I’m first in line to short the market. We’re headed for a cliff – one cliff or another. This is not an understatement to say we have analyzed to death the different scenarios that our country can go through. Every single one of them, sooner or later, ends up being a catastrophe and the market falls. Let’s pretend that they raise the debt ceiling to infinity and we buy our own bonds. Essentially we sell bonds and we’re the ones that buy them. Eventually we get downgraded, right? A downgrade is not a good thing for the market. Thatís one scenarioÖkind of the ìpush it out in timeî scenario ñ it gets us a little bit further down the track. Say the tax cuts kick in. They don’t extend the tax cuts; well guess what? Everyone in America sees their paycheck get smaller. Guess what that means? That means less spending. Guess what less spending means? The market is gonna fall, right? Basically any way you slice it, we have to cut a trillion dollars out of the economy. A trillion dollars! Take a trillion dollars out of the economy and the stock market goes down – I don’t know how else to put it.

TEI: What is your outlook for 2013 in terms of the macro picture ñ do you expect more of the same from this past year or do you think trading dynamics are gonna shift and itís gonna be a new game?

KK: Sooner or later we have to pay up and the market’s going to pay the price. It’s going to fall, there’s no doubt in my mind. When that happens just depends on the event. They might push this thing out. It might be six months from now. Or they might just bite the bullet now and let the tax cuts kick in. Everyoneís check is smaller and thereís less spending. Simply put, it’s gonna be a crash. I really think it’s gonna be a strong crash. Where’s the bottom of the crash? Well, I’ll tell you when we’re at the bottom. I’ll cheat and I’ll use the indicators. There’s no way I can tell you when the end of the crash is gonna be. For now though, we’re not in a crash yet. So Iíll keep doing my butterflies and making some money doing that. Once weíre in a crash, it’s gonna be a completely different story.

TEI: Hard to predict obviously, but just gauging on what we do know now, how do you expect to make money in the coming year?

KK: The way I look at it I have one year left of trading. I plan to just short the market to death all of the way down, trading the entire crash. If I do any trading after that point it would be 100 percent because I love to trade, but it definitely won’t be for financial gain.

True to Nature…

Well, one thing you can say bout trends…they are a gift if we listen to them and they remain true to nature.

In the past week the markets have done just so and offered up some pretty easy money for those that read the situation for what it was.
Just as we talked about last week – and many times prior in months recent – the broad equity indices have traded for the most part in range-bound fashion between the upper and lower-ends of well established consolidation zones.

The latter half of last week saw the INDU and SPX seemingly poised for significant breaks to what would have likely been runs at the Sept – Oct triple-top highs. But there was that one little factor standing in the way…those pesky resistance levels at the top of the aforementioned resistance zones…

Now we can attribute it to all of the fiscal cliff shenanigans and light volume and Mayan calendar predictions…yadayadayada… BS…life happens…daily! What’s going on now is catching no one by surprise…the swings and head fakes and various machinations are part of the game…end of story.

Fact is the markets march on and do what they will, oft times regardless of what’s going on. More so the case when the so-called news or events have been anticipated and discounted/reflected in price…certainly the case in this instance.

K, so cutting through the talking-head bull and excuses and everything else and getting to the just of the matter…the broad indices turned tail at resistance. They’ve since traded off a decent clip. Nothing complicated or overly surprising with any of that.

Which leaves us where?

Shouldn’t be surprised to know that at the height of the sell-off today, we traded down and through the lower-end of the consolidation zones for both indices before reversing sharply. The INDU briefly sliced through its 200-dma, which was parked at the bottom of the consolidation zone at roughly the 13k mark. The SPX managed a bounce off its consolidation-zone support at roughly 1,400 – actually managing to remain north of its 200-dma which is parked back at 1,390.

So now we find ourselves at the opposite end of the spectrum from a week ago, with the bears a bit more emboldened than the bulls. That said, we are sitting at the perfect level for a reversal entry on the long side. Aggressive? Maybe! But to ignore the likely possibility of more range-bound activity is to ignore the trend…always a tough way to make a living in this biz….
If the markets head north from here, and today’s sell-off reversal might just be a “tell,” then the obvious targets for trades on the long-side are at the top of the consolidation zones.

Alternatively, if we fail to hold the consolidation support levels breached today before the reversal, then the November lows are gonna act as magnets and you can bet we’ll see them tested.
Which brings me back to what I said at this point last week: “For now it’s pretty straightforward – traders patient enough to listen to the market are looking at a short window with some well-defined targets to shoot for… May not seem like clarity to the average person, but to a price-action purist this is the type of opportunity you’re always seeking.” I’ll stand by that statement any day of the week…and certainly in the coming week(s), as I sense some serious opportunities for profit.

We shall see…

~LH.