Tuesday, July 24, 2012

Intraday Trading Options Instead of Underlying Products

I have grown to prefer intraday trading options instead of underlying stocks/futures because of the theoretically superior risk management; this allow us to circumvent need for Stop Loss Orders . While the math for options valuations remain somewhat complex, I believe options markets are close enough to “efficient” that a robust edge purely in direction (1 of many Option Greek uncertainties) would be good enough to make money. 

Trading Strategy
Long only ATM (At The Money)/OTM (Out of The Money) options, this gives the trades a limited downside while leaving the trader open for potentially much higher reward. Pretty simple right? Well there’s a bit more to it as risk management still depends on the core logic of the trade. Viability still depends on several risk-related areas. 

Risk Management- Theta
Off actual trading experience, I’ve noticed that theta does not kick in like clockwork as academic theory implies; in the short span within the trading hours option prices are very much dependent on supply/demand within the exchanges, i.e. Market Microstructure. So what does this mean for practical trading?
Trade logic of shorter average position would have a greater advantage. Don’t worry about it in the short run. On some days time value would go in your favor, and some days it wouldn’t. In the long run, the near-efficiency would equal to a pretty small negatively Statistically Expected Value (EV) of roughly the expected Theta * Average Position Time (hours) / 24.
Therefore, the directional edge must overcome Theta + other transaction costs. A theoretical edge that takes your attention is likely to have a much higher EV than the expected damage off Theta.  If not, move on and develop another trade.

Risk Management- Liquidity
If the options are relatively illiquid (such as the ASX200 Index Options), bid/offer spreads tend to be significantly wide, and if the underlying volatility remains relatively low, the inherent transaction cost could sky rocket and make the trade negative EV . Trade the Limit Order Books, blindly putting in Market Orders puts the trader in additional, undesirable risks. 

Risk Management- Time Value
Of course we want to buy the cheapest options possible and work the gamma. We can simply buy the ATM/OTM option(s) at the lowest points off the Volatility Smile.

0 Reflections: