Friday, July 27, 2012

Adding to Winning Directional Bets

Having seen many documentaries of professional (directional) traders talking about adding to winning positions, I had a little brainstorm of why this helps with profitability of trades. Here’re some reasons I’ve come up. 

So the basic idea is to only add to a winning position, and reduce position size as it moves negatively. We can already see how this replicates option delta, where the trade becomes essentially long Gamma, without risks around Vega, Theta, and other Greek uncertainties.

1)      It gives a convex payoff; it creates monster winning trades with respect to average losing trade size. (Convexity vs. Concavity)

2)      Having a convex payoff requires much lower win-rate for a trading strategy to be net profitable i.e. maintain a positive EV.  

3)      The trade would have a significantly reduced probability of taking relatively large losses. We’ve all heard stories of people blowing out from short Gamma trades, such as adding to losing positions, selling naked options.

4)     Counter-Intuitive, and we know going against the crowd is usually a GOOD thing in this industry.

0 Reflections: