When buying options, you're not only betting that you are right directionally, but you're also betting that you are right on the time-frame of it. IMO it's a loser's game, unless you are privy to some nonpublic info. You're fighting time-decay, and it is a losing battle.
Use Kelly Criterion and you won’t bleed to death, especially if you truly have positive expectation. Taleb Fund never bled to death. Also, you can sell vol to fund the strategy, but takes a lot of work. Peace, Amahrix
Actually if you do the math with Kelly on a function where you have rare large pay offs, you end up betting far to little to make a huge impact when the rare event actually happens. Thats why guys bleed out, they have to bet larger to make it worth while when the event happens. The other thing is how can you use the Kelly if you do not know the distribution of the event? On a side note, cheap gamma is way to valuable to be left un-noticed. It's (unfortunately) usually over priced, hence another reason for the slow bleed.
Well, you might have a positive expectation on a rare event but you need to keep the investors money for that event to arrive. Indeed, his main thesis (having actually spoken to him in person years ago before he became a celebrity) was that gamma is overpriced and kurtosis is underpriced. While I can see the reasoning for it, it's a hard trade - you don't make money most of the time, you lose money on small adverse moves and you only make up for all of it when the shit really hits the fan. For an institutional trader, if your best years coincide with everyone else's worst years, you never get paid for that convexity. I myself have a tendency to be long(ish) risk premium, even in my relative value strategies. Made a ton of money in 2008, made a chunk in 2011, did ok in August 2015 and this Feb. However, on a personal level it did not work out quite as well - i.e. I am still not rich The only people that seem to have done well in that regard are guys with a strong gift for self-promotion (oh, and yes, Empirica did shut down due to poor returns). For a private trader, where your risk horizon and tolerances are not dictated by the management, there is no reason to restrict yourself to that modus operandi. You should think in relative value terms most of the time anyways.
There are a lot of guys posting in this thread that know a whole lot more than me but here is my 2 cents worth. I have had very good success this year trading the ETF Optionss for the four major futures. Oil CL with etf USO: stocks ES with etf SPY: Bonds ZB with TLT and Gold GC with etf GLD. Looking only at 4 charts simplifies things considerably. I look only at the daily charts for futures and never the ETF chart. I only buy puts or calls in the last 30 minutes of the trading session and look for reversals or rejection of support areas on the daily futures chart. If it is not profitable the next day I cut it loose and if it is profitable I let it run for 2 or 3 days or take a predefined profit, ie. if my option has 150% profit I generally just feed the ducks. If you sell into market strength you get more extrinsic value. I buy the weekly option with 5 to 7 days left and a delta of .65 to .70. I generally get the mid point of Bid/Ask but the MM in USO is hard to get along with. I will generally have only 6 to 10 trades per month in all four ETFs combined. I keep my risk level to less than 20% of my option account balance at any one time. There you have it: A successful trading system. (that works for me anyway)
The time to expiration I choose depends heavily on the tactic I trade. For my trend-following swing trades, I will typically choose contracts with about 2 months left to expiration. This allows for an acceptable amount of theta (for me) to burn off if the instrument doesn't take off right away after entry. For shorter term trades where I expect to close the trade in one or two days, I often choose a month out (again to spare me some theta loss). My most successful trades are swing trades. Because they may run days to weeks, I typically buy the initial option to go in the direction of the trend and then leg into a vertical spread after the underlying instrument has progressed nicely into the trade. Once I'm in a vertical spread, theta cancels out so it's no longer an issue. If either the set up breaks down or the price doesn't take off in about a week, I will close the long contract if I couldn't get into a spread. In cases where the volatility is caused by a very rapid pull back in an upward trend or a second test of some major support, I have either opted to trade the underlying or to go long an option with a very far out expiration. I would also consider trading a synthetic long stock/index to possibly cancel out the effects of volatility on pricing. What I am looking to avoid is a volatility crush. I most often trade options on indices (e.g. SPX, NDX) and occasionally trade the options of very liquid stocks with pretty liquid options. I follow the indices daily, so I know those pretty well. I've read lots of books on trading options from McMillan to the more typical get-rich-trading-options garbage. If you are new to option trading (or trading in general), I would recommend reading the second edition of "Trade Your Way to Financial Freedom" by Van K. Tharp. The second edition, in particular, includes examples of a (fictitious) trader who trades set-ups with options in a matter that I would later emulate. What I learned from that book has paid for itself many (many) times over.
How do you deal with a large adverse move? Do you just let them expire? If so, do you position size the 20% with that in mind? What do you do with the rest 80%? Hope it's not too much prying.
No, I NEVER let an option position expire worthless. If the set up does not work the next day I am out. That said anyone who invests in options has to understand that it is possible to lose the entire amount invested in the event of something catastrophic that might happen overnight. I have never experienced that but that is why it is necessary to keep 80% safe at all times. A 20% loss can be recovered easily but a 100% loss not so much. The diversification is important as well. A catastrophic event might mean a total loss in SPY but a windfall in USO should the setups have you with a position in both. I do not usually have the full 20% committed to options at any one time but my rules do permit it. The other 80% sits in the brokerage account as available funds.
Not that my opinion matters but I actually agree with Amahrix. Like in Blackjack, change your bet size when the odds are in your favor.