Creating Positive Expectancy in Trading Options

Discussion in 'Risk Management' started by blk, Oct 28, 2006.

  1. blk


    Dear option traders,

    I understand the definition of "expectancy". And that any given option strategy has a less than zero expectancy over the long term.

    How does one go about creating positve expectancy in trading?

    Some strategies that Mo has pointed to recently are morphing into a (iron) butterfly after an initial position (like vertical spread, ratio spread etc) is profitable.

    In other words, is positive expectancy (automatically) created when a profitable initial position is morphed into another position (at less than fair value) and this new position also wins?

    I would appreciate opinions / views from experienced option traders on this topic please.

    Thank you.
  2. Honestly it is your skill in risk management and in selecting underlying stocks/indexes and applying the right strategy that gives you positive expectancy over the long-term.

    I make money trading credit spreads. On their own they have no positive expectancy, it comes down to the way I have managed my portfolio.

    Match the right strategy with your own risk tolerance and trade management skills and learn how to cut losses and you can make money. the strategy does not matter really.

  3. This is a highly contentious topic and has partisanship on par with religious debates.

    The two main schools of thought are:

    1) If you have gains on a position, you can take the profits on the position and bank it. You can then open up a new position which starts from scratch and has zero expectancy.

    2) If you have gains on a position, you can adjust into the new position for less than fair value resulting in positive expectancy on the new position. The amount by which you have the new position for less than fair value is equal to the gains on the initial position.

    It's arguably minor but the benefit of adjusting into the new position rather than liquidating and then initiating the new position is a matter of leveraging your existing inventory and thus cutting down on the burden of b/a spreads and commissions. Depending on your volume/size, this is not insignificant.

    It's the options equivalent of moving your stop up, or setting a trailing stop.

    It's probably best not to think of it in terms of expectancy at all to avoid the contention. A positive expectancy position can still obviously lose! It's recommended to only adjust into a position that is consistent with your outlook and not just for the sake of positive expectancy.

    You can approach it like chess. If you can think a couple of moves ahead then you can take advantage of moves in your favor to build your position or manage your risk when there are moves against you.

    FYI. Earlier discussion and debate on positive expectancy in the now infamous and imortal Writing options for a living thread.

  4. Good summary MoMoney, regards,

  5. To me, it's all about risk. You can test and trade something like short puts, credit spreads, whatever, for years and *think* you have a positive expectation system/method.

    But LOOK at your risk graphs. Expand your scale out to see what would happen if your underlying moved 5% - 10% ...20%! the wrong way.

    What's that? You have stops? What if it blew through your stops by 10%?

    You will simply hedge with something else? What if you can't get through?

    What is your unhedged total risk for that position? Do you still have a positive expectation system?


    Sorry for the rambling. I just see too many people taking on too much risk. I know what will happen, sooner or later...

    Good trading to all. :cool:
  6. blk


    Good summary by Mo. Bank profits or morph? Hmm.. Will check out the "Writing options for a living" thread...

    OC is successful with his style of FOTM verticals. Agree its all about managing risk.

    And yes, we need to watch out for market crashes like Oct '87. Unless someone is just short delta looks like no one can plan for events like those - so comes back to managing risk - position sizing, I guess.

    Thanks for your thoughts folks. Appreciate it.