I'm a discretionary trader and have built up over many years a good level of expertise in technical analysis focused around classical charting techniques. After working with stocks, then warrants, I started trading single leg options as a way to express directional views. I've done enough of this to know through experimentation that option pricing is too efficent at my typical trading timeframe of up to 3mths to be profitable. Any edge I have in picking direction disappears in buying single legs, over muliple trades. Where I have been successful though is in longer times out to 18mths. I've read somewhere that option pricing models such as black-scholes cant account for trends. I also cant understand how a market maker could effectively price volatility as you go futher out in time given the degree of movement that can occur in an individual stock. My thinking is that buying single leg stock options (moreso than index) on say 5month to 18mth timeframes and maybe 5% OTM (subject to a view on strength of trend) should more genuinely reflect any edge I may have in directional trades. I.e. that pricing of volatility doesn't properly discount my directional view the further out in duration you go. The trouble is that this takes years to test through experimentation and so I'm interested in understanding a theorectical or practical basis of how market makers account for longer dated options? It may that they don't price trends and simply hedge their risks on longer duration, which is fine by me. It would mean that there actually is some optimum timeframe(s) for buying single leg options, subject of course to one's ability to determine direction. Any thoughts.
Thanks, this is a really interesting post. I think that you may be right when you say that the market has priced short term single options quite efficiently, meaning that an edge is hard to get. However, I agree that inn the longer term it is harder for the market to price an option so, if you are fortunate enough to pick a stock that is trending, you can do well. Would this not be a case for using LEAPS rather than normal vanilla options? Also, I suppose that the trick is finding stocks that will trend.
Maybe, your friend thinks you're a special case! I am also not to sure why you are quoting SJ Options. Options are traded on an open market like all other products. The problem is 95% of people think options are used for leverage and or should be used for high probability trades.
On average, for the past several months, I noticed for typical equity options @ 18 month out IV were much higher than IV @ near term (e.g., 30 days). Perhaps, that is the MM's way of pricing in drift/trend? I just don't believe MM are nice enough to give you free money for longer term options.
I should rephrase and say 95% of retail. I can't speak for all 5%. But most of the successful option traders I have come across, look at options as a way to get exposure to different risks that are not possible in delta 1 space.
So where does it leave the retailers? I've been thinking about this ... Let's put hedging and leverage aside, the only thing that I can come up with is using part of your profits to enter into lottery type of trades around turning points. Obviously, we can't predict turning points with high degree of accuracy, hence the lottery reference.
Ironchef, yes options further out are priced at a premium. But a higher IV has a marginal impact on price and doesn't appear to compensate the MM for the much greater movement in price that can occur on longer timeframes. Of course further out may be harder to correctly guess the likely future price, but still there may be a timeframe where it's optimal to buy single legs.
This is actually not the case. Long dated calls are actually quite expensive. You can plot an RND function and you will see that as you go really far out, the probability implied by the options for an upside move are actually quite high. This is not for all underlying's and expiration's of course, but for a few of the large cap names and etfs I have taken a look at. What is more exciting in my opinion is finding stocks that are in bi-modal situations. Ie. In 2 years, the stock will either be bankrupt or will completely recover. A ticker that rings a bell is FTR. There may be ways to trade options you might not have thought about! Take a look at some of the posts on NuclearPhynance.com Just to get the juices flowing.