How I Diagnosed and Cured A Trading Disease!

Discussion in 'Trading' started by riskfreetrading, Feb 1, 2008.

  1. A fellow (with years of experience in trading) asked me to see if I can help him in potentially improving upon his trading (in the sense of learning, doing better, etc). He has had (to various degrees) some of the problems that some traders experience. I suspected that if there is any problem, it would be hidden somewhere in the knowledge layers of a trader's mind.

    I asked to review some of his trading history. I noticed that he bought some option calls here and there. That lead to the detection of various "diseases" in his trading approach and how to cure them in regular trading not involving options at all.

    One of them was simply that he did not understand the implications of how he calculates breakevens!

    He showed me many of the well-known books where it is shown how to calculate breakevens (which is take strike price + premium paid), and he was sure of what he was doing that we even had a heated argument. At that point, I knew exactly what went wrong with some of his trading, which opened the road to curing them.

    Many of the bad trading habits that were hard to remove/realize were mainly rooted in not grasping the implications of how one thinks of breakevens and calculate them!

    Before I tell (for those who may not know) how to really calculate/think of breakevens, and how that can fundamentally change someone's trading, I wanted to ask ET members (particularly the newbies and those with potential trading problems) how do you calculate your breakevens?

    Consider a 100 day 90 strike call (with delta around 0.20), with underlying around 80 when call is bought. The cost of the call option is around 1.25.

    If you were to determine the breakeven for buying the above call and holding until expiration, what would the breakeven be? (you can skip commissions, etc, for the sake of learning and ease of calculations).

    If you do not trade options and/or never did/will, do not underestimate the lesson you may learn if you were to calculate the breakevens!
     
  2. Well I seem to be infected with the disease, but this is how I determined my break even:

    100 day 90 strike call, delta around 0.20, under lier around 80, cost is around 1.25.

    Strike Price + Premium

    90+1.25

    The stock would need to break the $91.25 mark.
     
  3. It is not your fault, and as per your other thread you seem to have sensed that something is wrong. I thought to wait a little to allow for others to give their answers, and then I will post my answer.

    Maybe someone will step in and give another answer that addresses the issue.

    If you need it urgently just PM me and I will PMit to you.
     
  4. Sashe

    Sashe

    Could you please give me the exact definition of breakeven as YOU perceive it?
     
  5. lar

    lar

    "RiskFreeTrading", eh?

    One problem with 90 + 1.25 is that it doesnt take contest costs into concideration. Both getting into and out of a position. So, even if the initial cost was 1.25, it doesn't concider the slippage and commissions of getting out.

    Also, one must do better than the uh, "risk free" alternatives to make it worth taking on additonal risk(s).
     

  6. How do you calculate anything in this world now?

    Computers, soft wares, more computers , more soft wares. No one who is serious trader uses antique pen and paper analysis of options. Professional traders use soft wares that work in real time while you trade and they do a series of complex analysis of multiple legged spreads in nanoseconds

    Start using option trading soft wares, there are many available for a reasonable investment, it will help you keep your positions profitable and you will see midas touch in your option trading.
     
  7. I will wait until others have the chance to think about this.
    Any definition of breakeven is welcome. The most important point will be learned when one understands the implications of breakeven analysis.

    What is your definition or the commonly accepted definition accordin to you and how do you perceive it?
     
  8. Computers do the calculations, they do not do the thinking--humans do! The problem is in the formula used and its implications, not in the labor to run numbers. It is true that running numbers is a job done well and accurately by computers.
     
  9. He's exactly right. Breakeven is defined as where your net P&L on the trade is $0. And that is where the cost of the option is equal to the proceeds from exercising at expiration. For a call, that equals the strike price + the total cost of the option. In your example, that's 91.25 (ignoring transactions and funding costs).

    Perhaps you are thinking of the 1:1 risk/reward point, where your profit would be equal to how much you would lose if it expires out-the-money? The 1:1 point for a call = (2 x cost) + strike. In this case, 92.50.

    But you asked about the breakeven point, not about the 1:1 point.
     
  10. jem

    jem

    I am now concerned the teacher underestimated the experience of the class. (by the way I am talking about cutten not myself -I claim no expertise in options)

    resolved -
    the "risk free trading point" is not the breakeven point.
     
    #10     Feb 1, 2008