Yeah that makes a lot of sense actually, to be honest most of my futures trading is mean reversion/spread trading these days. But can see how options are good for directionals. What percentage of your trades would you say you can turn what would have otherwise been a loser into a break even in the options? Is that normally done by putting on another credit spread further out?
These verticals are hard to adjust because there is no profit in them until near expiration, when it becomes expensive to adjust. For directional trades, it's best to make your decisions based on what you think about the UL.
I been trading futures since mid 80s and stocks before this, except for trend trading, I think many start a trade with reversion to the mean when many are buying dips but they don't see it as such. I started learning how to trade options as an investment at same time of learning more in depth of spread trading 3.5 years ago to help my best buddy. I been using options long time as a hedge in stocks/commodities so am deep in knowledge on how not to hurt myself. If I said the percentage to the world of how I redeem bad trades, 99% think BS, so I won't. But 7 years ago something happened to me as almost lost my life and changed how I trade now. So I think in terms of risk first and never profit, it has change the bottom line incredible for me. I even hedge my spreads.
Handle, I have until now mainly traded long or short options. A lot of options books I read (e.g. Get Rich With Options by Lee Lowell was one) claimed spreads were the best options trading strategy and were the "bread and butter" trades of professional traders. You are saying to be successful it is still a directional trade? With spread, it is not easy to work out the probability outcome, especially the combination of changes in direction, volatility and time decay. Do you have any suggestions? I welcome others to chime in. Thanks
I'm not sure when that book was written, but I'd bet 90%+ of professional option flow is in the following forms: - market making which is done delta neutral - volatility arbitrage: computing a vol surface and trading reversion towards the mean in volatility space. Delta hedging is done here as well - volatility dispersion: basically a stat arb between two correlated underlyings and their respective volatility. Also delta neutral. I would find it odd for a pro desk to think in terms of credit spreads because it's unlikely that a trade involves vol reversion just between two options in the chain. However, I know there are hedge funds and banks that have taken large, direction plays in options, but this is in the realm of betas.
Your calculations as stated would make this seem to be a horrible trade. It's the approximations which are making it look so bad. You are using max risk and max reward when a very likely scenario is a payout of < 11 or a loss of < 100. Adding those together gets the trade back to a net positive expectancy as long as realized vol <= implied vol. Overall, I don't think it's a great time to be selling vol.
I'm not at all sure that, over time, credit spreads have positive expectancy. However, if you have some reliable (better than chance) way of predicting the direction of the underlying, then you can make them have positive expectancy.
Can a retail mom and pop trader do volatility arbitrage and dispersion? What do I have to do to learn that? Regards,
While these trades tend to happen in high frequency, I think there may be a sort of pairs trade on vol that retail traders can take advantage of. It would involve finding a pair of correlated instruments (say for example SPY and IWM) and then computing whether the difference in normalized volatility is close to zero. If not, you sell vol for the overpriced option and buy the cheaper vol. imagine a sort of iron condor with short legs in the overpriced product and long legs in the underpriced one. The valuation details would need to be worked out
No they don't, at least not in general. Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss) You have to mathematically work out the expectancy for every candidate trade. If the IV smile is flat then credit spreads work more in your favor. If the IV smile makes the long put relatively more expensive then it takes away profitability. Don't confuse high probability with positive expectancy. Probability is only one factor in expectancy.