Thanks Sailing. By trading skills here do you mean opportunistically closing out a portion of negative gamma on the side one thinks is most vulnerable to underlying motion or trading its opposite side (e.g. most winning side) by taking profits early to buy blocks of long in the expected direction of motion as we approach expiration? I am still trying to get my teeth into the meat of what you mean by trading skills. As best I can tell you are implying opportunistic trading of risk with loss mitigation or taking profits early. In other words optimizing one's outcome for current market dynamics (e.g. maximizing probability of net win or mitigating probability of net loss) by efficient trading with the least overhead and minimally added risk. Can you help here? Thanks, TS
Murray, When you display your returns on the DD's and calendars, I believe you discuss return on margin. Do you also analyze returns on your overall equity base as well? I seem to consume very little margin (little kahunas) with options so I only analyze my returns on a total account basis. I would appreciate your thoughts as well as any of the other seasoned traders out there. Thanks, Kapil
You can keep your books in any manner that suits you. The return on margin allows you to see how much you earn, compared with money at risk. To me, that's the important number. Because you consider DDs to be too risky for your entire portfolio (a sound judgment!), the return on 'total account' is not as meaningful. Mark
It's not necessary to have true IC positions. Consider any of the following: 1) Fewer call spreads than put spreads 2) Only put spreads 3) Call spreads further OTM than put spreads, even though the credits are smaller 4) Call spreads with strikes closer to each other Mark
Thanks Mark, I guess I am trying to get a handle on what kind of ROE you guys shoot for. I agree we all have different risk tolerances but when you are trying to compare investment alternatives, total return counts. If you don't mind sharing, what is your target for ROM vs. ROE?
Eric, Here is the rub. ATM options are generally the easiest to price. They are the most liquid and there is a generally a consensus agreement on vol. As you go further out, you have less activity and a much wider discrepancy on what vol should be, hence the vol skew. You will also notice the variance of the actual vol on the strips (wings) is much larger then the ATM vols. In other words, the ATM vols stay relatively constant while the deeper strikes move around much more. So here is the deal, the ATM vols are pretty efficient for the most part (think of having a large data sample to analyze). The OTM options are very inefficient (very small data sample). The ATM options are not really underpriced or overpriced per se. You are really just dealing with the vig that goes to the MM. OTM options though are drastically underpriced. Not over any one single strike or option, but over a large range of strikes and options. I stated the reasons for this underbracing earlier. You simply cannot price an unknown event into an option (because it's unknown). Now as to the reason why everyone doesn't just buy these options, this is very simple. For the most part, the hedge fund industry and for the most part, even those people on this thread, live in an instant gratification society. From the hedge funds stand point, they don't have the luxury of having a bad month, or bad quarter in hopes of making the big score down the road. Many hedge funds can lose investors after just a few bad quarters ( and by bad I simply mean underperformance relative to their peers). No one wants to hang around for the "grand finale" so to speak. This is the primary reason this edge cannot be exploited. Think of it this way. Suppose an angel came down from Heaven and told you to stand in the middle of a frozen field outside the city of Chicago in the dead of winter every day for 3 hours. And one day in the future, this angel would return and give you a suitcase with 100 million dollars. So every day you stand in that cold, frozen field waiting for that angel to return. Surely you are ambitious and hopeful and believe the wait will be worth it. But after awhile, you will question your sanity. You will grow tired, You will being to doubt and at some point, you will stop going to the field. Even if you later learned that the Angel eventually showed up, you wouldn't care anymore. Your desire is gone. That is the rub. Now many here will say, how can one possibly profit from such a strategy. Surely no one will want wait forever in the hopes of a 10 sigma event right? And to that end, you would probably be right. But the moral of the story here is not to profit from such an event per se, but rather to make sure this event doesn't profit from YOU! The idea to understand here is we are all vulnerable to this "angel" coming, only not so much in an angelic form, but rather in the form of disaster. All it takes is one event (that no saw coming) to wipe out a lifetime of earnings and hard work. What Taleb was trying to explain is not necessarily how to profit from such event, but how to avoid being hurt from the event. It just so happens that such an event will bring a windfall profit to him. This is simply an ancillary benefit though. The idea is to find ways to profit from the markets while at the same time, not blowing up from the "rare event". Many people seem to miss this point. So it's not a matter of how to trade this strategy but rather an understanding.
Mark, Your statement is not entirely true. Depending on your exit or adjustment strategy, the return on capital might be very important. For example, because I use very active adjustment strategy for DDs, I reserve half of my capital for possible adjustment in the first week. My reserve will decrease as time goes by, and my reserve will increase in the last week when adjustment is needed. To me, I don't think DD is risky when I have reserve for adjustment. However without reserve, DD is very risky to me. So my reserve is actually working for me, and I think it justified to consider the return on capital. I never look at a single spread or diagonal for adjustment. Always consider the overall portfolio to assess my risk and reward.
Kapil, I started using a normalized method when I started spreads and diagonals and it gives me a visual understanding of my return and my drawdown on my capital. All the data values for today are normalized as 100.