Sunday, April 10, 2016

Profitable option trading, thinking on a deeper level

This is going to be a brief and concise post, on the matter of managing option delta or gamma. Over the years I have seen many newbie traders make similar mistakes I myself had experienced starting out; and like most fields, becoming an expert requires critical thinking, at least on a level deeper than those you’re taking your money from.

The core mistakes

Applying textbook theories alone would not likely result in profitable trading, and hedging Greeks blindly to software-default-vols is usually a bad idea. Yet, this is what I’ve noticed a lot of newbies do, despite the subsequent “unexpected” P&L volatility, and no alpha over time for those who don’t engage in market making.

The better process

As you watch the implieds and the underlying change over time, you need to constantly question the motivations behind the transactions. E.g. when you notice big orders lifting the offers/implieds on a number of call options, instead of assuming this is a good spot to fade and “sell expensive vol”, you need to ask yourself “why is a relatively large order willing to buy at increasingly expensive options?, and are they really just giving money away?”

Apply your experience to find the most probable answer, and eventually you’ll realize whether to fade/ride with the changes in direction/vol. This explains why experience in trading offers so much value, and so many newbie quants fail.