Option Trading Blog

Archive for May, 2007

The Right Mindset For The Option Trader

Published May 31st, 2007 in Making Money With Options. 0 Comments

The hardest thing for an option trader (or investor) is to change is mindset from an emotional one to a more productive logical one. When I started option trading and although I come from a mathematical background, the hardest thing was to think for the long run, not the short run. I wanted to be profitable in every position I make. That would cause me not to leave positions I was in and think a long the lines of “I am sure this is going to change soon and become profitable!”. Although for the novice trader the opposite can also happen. He enters a position and if it doesn’t turn profitable in an instant, he leaves only to see it become profitable again. A vicious cycle that most novices and lay people make.

Changing The Mindset

The proper mindset should be always thinking in the long run. Trading is not a sprint, but a marathon. How good is a trader that is profitable for 1 day before the end of the year and then in the end blowup? Good traders are marathon runners. I’d rather count on a trader that had 10% for 10 years than another with 50% for 3 years.

Thinking With Expectations

What do I mean by thinking with expectation? Here is a simple exercise: Suppose I tell you that I have a method that is NOT profitable 90% of the time. Let’s say when it is not profitable, you’d lose $100. Let’s also say that when it is profitable, you would win $1000. Is this worth while? We can compute it quite easily by what is known as mathematical expectation which is simply a fancy word for a weighted average.

-90%\cdot100 + 10%\cdot 1000 = 10

This means that we expect to get on average $10 from this trading strategy. Although some people could reject at first sight this trading strategy, it is actually profitable in the long run.

When People Screw This Up

I am sure this is not the first time you hear about the concept of expectation. But I am sure that you might screwed it up at some point. You have to realize that this works for the long run. It has no meaning in one trade. You can’t actually make $10 in the first trade. It only makes sense in the long run. So if you have analyzed a strategy in the same manner we just analyzed, make sure that you understand this important bit!

When People Have Seriously Screwed This Up - The Case of Naked Puts/Calls

You might think this simple rule is implemented with top traders all the time. But you are wrong. Dead wrong. Even the most experienced traders make the same error again and again. They underestimate the probability of an event happening. Let’s take a look at this simple scenario: suppose John Trader wants to sell naked out-of-the-money calls. He has heard that most of them expire worthless anyway, so why not just get the premium. Easy money? What if I told you that 99% of the time John Trader would make 100$, but in this small 1% he can stand to lose 50,000$? Let’s calculate the expectation:

99.9%\cdot 100 - 0.1%\cdot 50,000 = -401

So even when the chance is slim, he would still on average lose 401$. I know you are probably thinking this doesn’t happen in the real world, but it actually happens more than you think. Traders blowup in this way ALL THE TIME. They underestimate the small 1% I just showed you. That “never going to happen” scenario that happens.

Using Expectation To Your Advantage

It is important for the trader to always think with expectations. When you feel the temptation to start selling out-of-the-money puts/calls as the above example, or you are about to abandon some trading strategy just because the success rate is poor but might be in the long run successful. Check out my post about getting the most bang for the buck technique together with my trend method. This combined can give you in the long run great results.

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The Variance Ratio Method - a Powerful Trend Indicator

Published May 30th, 2007 in Making Money With Options. 0 Comments

In the last post, I discussed the use of the Parkinson number as an indicator. In this post I will discuss a simple trend indicator you can use. Please read my volatility estimation post before attempting to read this post so it would make sense.

Background

In one of my posts, I discussed the method of sampling volatility (I recommend reading it now if you haven’t) . We assumed that there isn’t a problem in choosing an interval because we can then scale the sample to any interval we like. For example, if the daily volatility sampled was 1%, we can scale to figure out what would be the 20 day volatility by multiplying 1% by the square root of 20. This is the square root law. This results in 4.47% volatility. What happens now if instead of sampling on a daily basis, we sample on a monthly basis? Would the monthly sample yield the same calibrated result (4.47%) ? what does it mean if not?

The Method

If the volatility on an hourly sampled basis turns out to be higher than the volatility on a daily sampled basis, the market can be considered as not having a trend. If the hourly volatility was lower than the daily volatility, we can assume there is a trend.

An Example

Download this excel file to see the example. The first column are 30 samples of hourly prices of a stock, with the last price that is known is in the last row. The second column automatically computes the log returns of the stock and then scales it to daily volatility. The third column has a sample of daily prices of the stock. The 4th column then computes the daily volatility. We can now compare the volatilities.

The scaled daily volatility equals 0.0003 while the daily volatility equals 0.0001. This means that according to our rule of thumb, this is a mean-reverting market and hence no trend is present.

You can use this excel file to plug in different prices to suit your need. It will automatically compute all the other prices.

Final Note

This powerful tool can help you make a better decision towards determining trends. It adds a powerful tool to your trend indicators. For another trend indicator method see this trend indicator post.

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How To Estimate Volatility - Importance For The Option Trader - Part I

Published May 28th, 2007 in Option Trading. 1 Comment

One of the most important tools for the option trader are the Parkinson number and the Variance Ratio Method. The Parkinson number, named after physicist Michael Parkinson, is an estimator of the volatility of returns presupposing that returns follow a geometric random walk (If that last bit doesn’t tell you anything, don’t worry).

If you take a look at the last post when we estimated volatility, we needed to take a sample of each day/week/month we wanted to estimate. The Parkinson method estimates the volatility only by the high and low of any particular period. Following is the formula. Don’t worry if it looks scary, I’ll walk you through it:

P = \sqrt{\frac{1}{n} \sum_{i=1}^{n}\frac{1}{4log2}\left(log\frac{S_h}{S_l}\right)^2}

Where S_h and S_l are the High and Low for that period respectively.

The meaning

If this number is supposed to give us the estimated volatility, we can compare it to the sampling formula we derived in the post about volatility estimation. This gives us the following relation:

P = 1.67\cdot \sigma

Where \sigma is the sampled volatility we estimate.

This last equation tells us that the Parkinson number will be 1.67 times bigger than the sampled volatility.

Why Should You Care

Who cares really you ask? We are interested in the cases when the Parkinson number is either bigger or lower than 1.67 times the volatility. When The Parkinson Number is higher than 1.67 times the volatility, it means that the markets are volatile and one should follow a trend. This is just one application. You can think of many more applications when you know volatility is high.

Another application is with hedging. If the Parkinson Number is lower, than we can assume the market is less volatile and hence, perhaps not re-balance our hedge to keep ourselves market neutral.

I’ll soon add an excel file so you could implement this on your own. I’ll also add some application with the Parkinson number so you could see how good of an indicator it is. Also, in the next post, I’ll discuss the Variance-Ratio Method and how it can help you profit in your trades.

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