Divide by Nought

1. The Basics

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These are the basic pieces that every trader should be aware of. There are a lot of them, I’ll be adding to this list. Each point is discussed below.

  1. Trade length
  2. Prefer alertsavoid stops.
  3. Prefer limit ordersavoid market orders.

Trade Length & Type

The length of a trade is really dependent on the type of trade.  The type of trade is mostly based on the amount of risk a person wants to take on.  For example, and in general, an option seller takes on a fairly high degree of risk while a spread seller takes on a fairly low amount of risk.  This is all just a matter of preference.

I’m a short to medium term trader. For me that means that I’m usually in a trade for no longer than 20 to 40 days; that’s excluding calendar spreads which might go up to 80 or more days. I’m not a day trader, it’s too much work and the risk is higher; I trade to make money, not to work harder.  I also don’t buy many single options, it’s also rather risky and I like to sleep at night.

In general I’m a seller and strive to stay Delta neutral and positive Theta.  However, I take more profits from creating high probability trades that work out than I do from being positive Theta. So being Delta neutral is only a part of my game.  Creating high probability trades is a practice of squeezing as much out of the markets, on as many different levels, as possible. It’s finding statistically probable trades that are diversified across underlyings, markets, time, and volatilities.  But I’ll get into that in a different area.

Suffice it to say that high probability trading is, in most cases all about letting trades work for you. Taking the time to make rational decisions and then trusting that the made judgment was sound even at some later date when it looks like a trade is going against you. One way to look at it is this: You didn’t know the market was going to do when you got in and you don’t know what it’s going to do when you get out. So, unless it’s really clear that there’s no saving a trade, let it ride; that’s part of why I’m always positive Theta.

Alerts vs. Stops

No static stops, trailing stops, or other fancier rules based stops. Market makers know where most people are likely to set stops and can move the market just to force you out. This isn’t conspiracy theory, it’s just a matter of Market Makers using the bit of edge that they do have. Using a stop tends to imply a market order, which is not a good thing; see below.

In the end most high probability trades should never need to be touched. If they do, I will know what to do better than a drone. Which is really a key point since market conditions will have changed if the market has moved to where a stop would be triggered and if that’s true then I need to reassess anyway. That’s where alerts come in. Triggered often the same way a stop would be, but instead they just get my attention so I can decide what to do.

Limit vs. Market Orders

The markets are not a zero sum game, they’re a negative sum game. Why? Commissions, slippage, and bid-ask spreads. You’re going to have to talk to your broker if you want to change your commissions. As for slippage, I suppose market orders can fight slippage by not forcing you to adjust prices to get into a position. Of course, you shouldn’t be adjusting that much, if at all, anyway. Further, the advantage you might gain not chasing, you’ll likely lose on the bid-ask spreads.

For example, if the seller and you’ll be the buyer and you come to me and say “I want [xyz] stock. Here’s my wallet, take whatever you think makes sense”. Then you come back and say “I have [xyz] stock to sell. I’ll take whatever you’re willing to give me for it.” Sound scary and unreasonable, well that’s what a market order does.

But lets look at this, there are 4 possible situations, 3 possible outcomes, and only 1 that benefits you. First and second, if you sold back directly or the market has only moved sideways you would lose moneyvia the bid-ask spread. Third, if the market moved in your favor you would (A) make money (hurray!) or (B) lose money if the bid-ask spread was bigger than the move (ouch, that just hurts!). Fourth, if the market moved against you (and you panicked or worse got stopped out) then you lose money. The third possible outcome for the situations that it makes sense is that you broke even, but don’t count on it; really allocated capital that doesn’t do anything is just as bad as losing it.

Keep in mind that this example is looking at stocks. There is more stacked against you as an option buyer (theta anyone?). Further, because of the leverage involved when dealing with options every penny counts. Giving away a few pennies getting in and out of trades can equate to hundreds or thousands of dollars.

Written by me

Thursday, March 13, 2008 at 2:03 am

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