This is a mobile optimized page that loads fast, if you want to load the real page, click this text.

The idiots way to options riches

Jump to new
Hello Ducati,


You raise some really interesting points here, very elegantly.

Thanks for that, you covered some very relevant ground I didn’t have space to cover in my post. Together, both posts present a very full coverage of the issue at hand.


Regards


Magdoran
 
Magdoran

We have an excellent example already posted, that we can use.


Now this as you will recognise, is, enzo's FRX trade.


In the first instance, is the choice of instrument, common stock, CFD, Option contract the best choice?. The choice, as it turns out would have had a rather dramatic impact on the resulting outcome, as the common gapped overnight by some $5.00 or 16% on the underlying http://finance.yahoo.com/q/ta?s=FRX&t=3m&l=on&z=m&q=c&p=&a=&c=

Now assuming the wrong play, Options without a doubt provided the best of a bad outcome, as to some degree the position is hedged.

My query, and related to the topic under discussion is this;
How was the risk of an adverse outcome within the legal liability priced?
Was the useage of Historical/Implied Volatilities the correct measure of risk?
Sails identified the greek vega as being underpriced.


The vega pricing model assumes a change in the Option price caused by a change in volatility, which, of course with the legal liability pending decision, was the fly in the ointment.


I'm not sure I agree that the mistake, even if rectified from the inputs would have provided the correct pricing for an adverse decision in the legal liability on the position, as historic volatility does not look to be high enough;
http://finance.yahoo.com/q/ta?s=FRX&t=my&l=on&z=m&q=c&p=&a=&c=

However be that as it may, in a CFD, the adverse move could well have on a 5% margin position ended the traders game............... permanently.

Therefore, the question really becomes, in regards to the following;
*Recognition of Risk
*Pricing of Risk
*Assumption of Risk
*Management of Risk

How successful was the preceeding example within the decision tree?
Which instrument was the best risk adjusted for reward ?
What is the key component to have in place?

jog on
d998
 
And another example;


To my understanding, it is fairly easy to summarize: it is the dividends that are causing the disparity you have found and you can usually only win on a trade like this IF the underlying falls below the sold call strike by the day before ex-dividend.
Click to expand...

Again, the initial step in the process was missed.
*Recognition of Risk
*Pricing of Risk
*Assumption of Risk
*Management of Risk

There are no free lunches in the market.

jog on
d998
 
Interesting approach Ducati.

This is where having knowledge and experience in evaluating derivatives is critical. The FRX example is quite unique since the volatility conditions offered a range of opportunities to employ major skews, but the approach ventured by Wayne was quite complex. Comparing this kind of approach to CFDs, Futures, or common stock would require a detailed understanding of each instrument, and the capacity to evaluate the probabilities of a very volatile market.

The FRX trade was an unusual approach because it was a diagonal ratio back spread which had the sold strikes expiring before the bought strikes. Part of the problem with this kind of approach is that it is difficult to calculate the effects when volatility changes at different rates for the bought and the sold strikes.

The risks are that the sold leg moves deep ITM and that there is a prospect of being assigned especially the closer the sold leg moves towards expiry.

The other risk is that the volatility in the bought leg falls significantly hurting the value of the longer term strike.

The objective is for the volatility to drop harder for the sold strike, and for the underlying to really move up sufficiently to put the bought strikes deep enough in the money to outweigh the increase in value for the short strike.

The problem with conventional graphs is that it is difficult to simulate the divergent effects of volatility, and also to take into account the earlier expiry of the sold position.

Ratio back spreads have an area of risk with break evens slightly above and below the bought strike price level (which is where the maximum risk is located), and it is in this area that the diagonal version is even more exposed since all the underlying has to do to incur a loss nearing expiry of the sold strike is to stay within the break evens.

Essentially this strategy needs the underlying to break up or down away from the bought strike as far as possible, preferably below the sold strike, or as far as possible above the bought strike (certainly above the upper break even). And it needs to do this before the sold position gets too close to expiry, or moves too much in the money too close to expiry.


Comparing Strategies:

Now, how do we compare this approach to CFDs, stock and futures?

This is a process of assessing the probability of where and when the stock may move, and looking at the relative leverage in each case, assessing the net profit or loss both in probable outcomes (including time frames), and also taking into account less probable extremes, again assessing probable profit and loss models (specifically for CFDs, Futures, and option strategies, and common stock).

Using a range of modelling packages would allow an examination of the areas and magnitudes of risk for options strategies, and a manual calculation based on futures and CFD margins could then be compared looking at:

• Maximum profit and loss in the worst case scenario to determine position size and risk mitigation approaches.
• Estimated profit and loss based on the more probable outcomes to assist in selecting the best balanced strategy in line with the individuals trading approach.

This is where the devil is in the detail. Talk to 10 different derivative traders and you’ll get 10 different answers. A lot is determined by ability, preference, and risk profile. Some people opt to use very risky strategies in order to make large profits (which may result in losses), and some opt to make small but probable profits with capped risks… Some use a mix of the two, and employ one approach or another depending on their view of the market.

In essence Ari Kiev in “Trading in the Zone” talks about getting bigger (or increasing risk) in specific situations that the trader views as being high probability, and reducing risk or position size in situation where the probability is lower (but within tradeable parameters). This is perhaps an approach to consider, but again depends on the individual.

Also, it is possible to use a mix of instruments if the individual has the capacity to determine an effective approach using a co-ordinated strategy using different instruments.

So, as you can see, a lot will depend in the individual psychology of the trader as much as their market analysis capability and their capacity to evaluation derivative strategies. Certainly not for the inexperienced, hence my earlier comment about people contemplating using any kind of derivative should be fully aware of a range of instruments, and fully conversant with the risks involved.


Regards


Magdoran
 
Bear in mind the FRX trade was ####ed up from the beginning. Sans the mistake in analysing vega risk, it would have been done completely differently, or possibly not at all.

As I pointed out in the thread, I have given myself a very low score for the implementation. So sure, use it as an example, but only for an example sake.

Cheers
 
Hello Wayne,


I actually thought the FRX trade looked good too (certainly on my graph), and I suspect that it yielded a guaranteed profit at one point (albeit a small one).

It was also a great working example highlighting all sorts of Greeks all at once, and all sorts of aspects such as using diagonal approaches and using ratios.

I thought it was great stuff and a really good exercise. I think we all learned a lot from it, so I congratulate you on posting it.

Even now it is a powerful model for this discussion.


Regards


Magdoran
 
enzo


As it happens it is only being used as an example.
It is a useful example, as I have a variation on standard Options to run by you guy's [Options traders]

I am not particularly interested in whether it failed or succeeded, more in the way that it is initially constructed.

The bolluxed vega input while definitely changing the pricing, was not the most important initial consideration, rather, the legal liability, or lack thereof, was the critical component

Therefore, initial risk assessment should have had this parametre in the mix.
That it was ignored, placed the trade on a non-risk adjusted basis immediately, and thus all the price calculations were understated.

Thus due to a failure in;
*Recognition of Risk
*Pricing of Risk was incorrect. This is the stage that I would look at. The greeks......if you like are equivalent to TECHNICAL PRICING of risk
I would introduce the concept of a double check on price risk by, calculating shall we call it FUNDAMENTAL PRICING of the Option.

Therefore we end up with two calculations of fair value for the Option.
The first calculated via a standard Technical methodology;
The second as a cross-check utilizing a Fundamental methodology.
The Fundamental methodology pays more attention to contingent risks.......or, the Recognition of Risks and places a price on them, cross-referenced with the standard greeks, or Technical pricing model.

Magdoran


Correct.
The fly in the ointment was the realization of an incorrectly priced risk.
One that had not been contingently priced into the Option.
When that risk eventuated, the model collapsed.
It was only the strength of the;
*initial strategy
*rational management........that saved the trade deteriorating into a total debacle. Had a pure directional strategy been utilized with CFD's, untold mischief could have been the result.

jog on
d998
 
dubiousinfo said:
In cases where the option was not the best alternative, would there be any reason you could'nt use the CFD & look to reduce the risk by using some options as well. I don't have a particular stratergy in mind, just considering possibilities.
Click to expand...
Hello Dubiousinfo,


Apologies for not answering your question sooner – you have a remarkable talent of asking what at first appears to be a straight forward question, that is actually quite tricky when you think about it!

Ok, so let’s look at this logically. In a condition where there is not a viable option to suit a specific market view, in what cases should we also NOT use CFDs, even with the prospect of reducing risk by using supporting options.

Simple answer – you need to assess each situation and consider firstly all the possibilities (determine maximum risk to maximum reward), then secondly assess the probability of what is likely to happen based on your analysis, and consider the likely outcome of the strategy you are considering.

Complex answer: a lot depends on your capacity to analyse the nature of the trend, and how effective your forecasting ability is.

From here you then need to determine your view of the market – is it bullish, bearish, trading sideways, is it in a blow off trend, or is it creeping up/down, or is it trending in an orderly way. This will in part determine the time frame and type of strategy you will consider using based on this market view.

Then you would need to assess the available instruments and the associated strengths and weaknesses of each, and evaluate the potential risk to reward within a framework of probabilities.

Now to answer your specific question given that you have considered the above variables, you could use options to mitigate risk in a CFD if anyone transacts with your order. But, this may not be to your advantage depending on your overall approach.

Problems may be wide spreads, liquidity -in that if you enter some options series, it may be so illiquid that there is a real risk that the position may work adversely – whether short or long the option, or a strategy.

For example, you may well deem it reasonable to sacrifice capital on buying a put for protection for a heavily leveraged long CFD position, and commit to purchasing these understanding that the capital outlaid is like a 100% paid insurance premium.

If the CFD position size is too large, interest alone can hurt your position, and a long option may just lose value through theta decay.

Maybe the available strikes in the options may not be suitable. Maybe the volatility is too high.

These are just some examples off the top of my head, but I’m attempting to give some examples of what you need to consider. I’m sure others may be able to give lots of other examples, but the key here is having the requisite knowledge of derivatives to make these assessments.


Hope that helps! Phew!


Regards


Magdoran
 
Magdoran

Prior to running a second [cross-check] valuation, it might be of interest to examine some of the thinking process involved.

There would seem to be a fairly loose general agreement, on this and other forums, that, emotions within a trading, or investment methodology are negatives to be eliminated.

I would disagree that in the first instance that emotions are a negative, and in the second, that they can be somehow switched off.

It is this initial error in attempting an emotionless state, that the first rule is violated; viz. Recognition of Risk

Again using psychological experiments, what has been demonstrated are;
the physiological responses to negative stimuli are correlated to;
*the expectation about the intensity
*not the probability of receiving the noxious stimuli.

The result, is thus that we as humans cannot weigh decisions without emotional filters. Pure cognition [emotionless] cannot trigger a decision in humans. These emotional markers that accompany every decision, are responsible for the mobilization of motivational states that preceed action.

The capacity to plan cognitively, evaluate the merits and consequences of a decision and construct imaginable outcomes are inseparable. When they are separated via surgical techniques [frontal lobotomy] the results generated in exclusion of anticipatory emotional filters are uniformly poor.
In games of probabilities & uncertainity, the inability results in bankruptcy every time.

Emotions therefore are necessary and highly important. What however is also important is the weighting of a decision based on cognitive & emotional inputs. This brings us directly back to the original point;

*Recognition of Risk and finding the balance between the facts, as knowable, and uncertainity, or possible future outcomes.

jog on
d998
 
As a direct example, we can again utilize the FRX trade.
First, we have the trade identified, and some of the surrounding circumstances;


The relevent area to this example lies within the highlighted sentence.
That it is identified, and then categorically dismissed, immediately struck me as odd, and why I followed the trade through the time-period.
This is the area of the emotional filter that must be balanced with an analysis based on quantifiable criteria;

The *numbers* are summarized in the last paragraph;


The Risk was recognised, and dismissed, therefore in actuality, never recognised, as it was not recognised, it could not be comparatively priced.
The contingent risk would have needed to be priced on an emotional pricing methodology, as, we have imperfect knowledge of an unknowable future outcome, and when compared with market pricing, via a technical pricing model we see the risk in terms of a price based on *intangible elements*

jog on
d998
 
Hello Ducati,

Great post Duc, I think you’re onto something here, but in part it is something that I think Mark Douglas has made a concerted effort to address in both “The Disciplined Trader” and in “Trading in the Zone”.

Interestingly I have been considering the conclusion that a key element in the process of effectively exercising judgement is learning how to compensate for your own bias.

Firstly recognising emotions on several levels (conscious/subconscious) – in effect recognising your own “matrix” of bias and preferences, and then working out how to effectively filter these potentially disruptive emotions in a specific way to enhance decision making capability, while simultaneously focusing the individual on freeing their mind to react to what is actually happening – for instance not having to be right all the time, thinking in probabilities, recognising when the reason they first took an earlier decision has changed in a way that requires a reappraisal or (corrective) action to be taken.

This is not easy. Soros talks about not being worried about making mistakes, but focuses on first recognising them, then working out how to correct them. He actively looks for flaws in his thinking (from “Soros on Soros). I think this is the crux of the problem – how to become as objective as possible, but without impairing the key emotional capabilities that empower individuals to be decisive.

I think you have made an excellent point, we need feelings to invest and trade – we use emotions to make decisions, that’s how we’re wired. The trick is to have the right mindset, on two levels. One is a methodical decision making process at a strategic level, where we develop detailed knowledge over time, and reflect on this away “from the action”. The other level is not unlike panic management in fluid situations (not unlike making command decisions under pressure in a combat zone).

So I agree, it’s not about turning off emotions, it’s more about filtering the potentially disruptive ones out and focusing on fluid decision making capabilities when required in tandem with the cooler more strategic thinking. Fully agree with your point that the cognitive and emotional aspects are inseparable (and if they are they impair the individual). I think Douglas really addressed this well in “Trading in the Zone”, which I think can help people to pull the trigger, and exit when the situation requires it.


Regards


Magdoran
 
Magdoran

Interestingly I have been considering the conclusion that a key element in the process of effectively exercising judgement is learning how to compensate for your own bias.
Click to expand...

Agreed.
This again is an example of the evolutionary process that has modified our neural functionality. These are the heuristics that tend to be mentioned in psychological texts and are examined within Behavioural Finance studies. They are simply the result of the requirement of reaching fast and instinctive decisions. However, in the post-industrial world, they are less of a positive factor in the decision making process.

Heuristics circumvent the solving and studying of problems through a long-hand and labour intensive process that makes a significant call upon the available processing power of the cognitive apparatus.


Absolutely agree.
I have highlighted the area that relates to the topic under discussion; viz.
*Recognition of Risk

Within the FRX trade, the assessment of risk, was completed in two stages.
The first was via a heuristic, which resulted in the ignoring of the litigation in process, and that was to have a material effect, and second, within the technical method of an analysis of [some] all of the greeks.

As the Black, Scholes model [for example] assumes;
*an efficient market
*due to information flow
*rationality
This model, is an example of, albeit, elegant heuristic.
The premises are all open to serious questions however as regards the validity and accuracy of their valuations in a non-linear outcome.
Hence the advantage to be found in adding a further layer [where applicable] to an Options pricing model such as B/S.


Again agreed.
Cognitive bias + emotions = problem.
Remove cognitive bias by eliminating the heuristic evolution and returning to a longer more quantitative based analysis [for example] will almost automatically result in a modification of the emotional input to helpful, as opposed to detrimental.


Again agreed.
Therefore, what actually remains is to build an analytical model for Options traders that accomplishes the requirements discussed.

jog on
d998
 

Duc

Notwithstanding that the analysis was heuristic, (whatever that is, I'm yet to look it up) that the litigation was ignored is not quite correct. The litigation was material in analysizing the IV's and IV skews, and in projecting change in same (vega)

The issue with the vega was that there was a mistake in the calculation due to a misunderstanding in the workings of the software. Had this not been the case, the strategy would have looked quite different and perhaps even non-existent. If there was no way to mitigate the above risk within the goal of the trade (i.e. to tade the difference in theta) I wouldn't have put it on, full stop.


ducati916 said:
Therefore, what actually remains is to build an analytical model for Options traders that accomplishes the requirements discussed.

jog on
d998
Click to expand...

Therefore the analytical models are contained within works of BS/CRR et al, but one had better get the sums right.

Of course, further exploration is always welcome.

Cheers
 
enzo


Well we can agree to disagree. The reason that I am arguing for the materiality of the litigation being ignored is as follows;

The reason for this decline, apart from a general market decline in the same time period, is that FRX is involved in a court case regarding one of its pharmeceutical lines. The exact details are not important to us.
Click to expand...

I would argue that the details in this example should be important, and that ignoring even a rudimentary analysis caused risk to be underpriced.


This seems to be the crux of the analysis.
That the selling of high volatility and purchase of low volatility is the basis of the trade being placed.

I previously addressed the point of the incorrectly inputed vega.
I felt, from the historical volatility both from a visual inspection, and from additional calculations performed by sails that the vega would not have caused a material difference in the analysis;


In response to this calculation, and based on the previous post;


And in response to sails on the previous discussion we see the dichotomy of retroactive analysis, these are the very real difficulties in attribution of past events; viz. the contradiction in post trade analysis.



The combination of the various points presented suggests that the initial cognitive bias..........or heuristic was so embedded, that even on acknowledged evidence to the contrary, the evidence was rationalised away.
This is common, and a major finding within any number of the better quality studies. The point of pursuing the point is......how to avoid it in the first place?


This is the area under discission with Magdoran
As can be seen from the later comment; how is this high probability ascertained?
We have just identified a mistake in the original analysis.....and.....it is still a high probability trade?

This is pure cognitive bias in action.
A heuristic decision is reached, and irrespective of contrary evidence, the initial decision far from being questioned is reinforced

The first step in a cure, is a correct diagnosis.
With a correct diagnosis, we can create a patient management plan
We can then monitor the patient, adjusting as we go, based on objective, quantitative criteria.
The result, should then be positive, if it is not.........
Back to step #1

jog on
d998
 
Any beginner reading this thread for education purposes might actually get the idea that one has to be extremely intelligent to trade options successfully. However, the most successful traders I know personally get to the point where they only trade up to a handful of stocks or patterns continuously and at key times. Decisions and trades are made and executed rapidly. From my own experiences and observations of colleagues, limited selection, key times and quick decisions seem to be defining characteristics.

Cheers
Happytrader
 
Hello happytrader,


You raise a really good point – and that is to try to keep everything simple (this thread for example too, point taken). I certainly agree that you don’t need a degree to be a successful options trader, but you do need the right knowledge and attributes.

Unfortunately to try to explain all the known attributes on a written forum like this for others to understand is actually really difficult to get the message over. I know that we get tied up in beginner unfriendly terms sometimes, sorry… but to try to explain the aspects that have been recognised is quite involved and not easy to put simply.

Interestingly your description of traders who trade selected stocks or patterns that they know continuously and at key times about sums up my core “position trading” style. I’m not sure that the decisions in all aspects are rapid – certainly the quick “command” style decision to enter and exit is, but as described in my earlier post, this is done in the context of broader strategic thinking, and within a system where there are a series of steps in the decision making tree.

So this is what the recent discussion was about – how do you assess risk using different options strategies, and even though experienced options traders make this look easy (because they do it all the time), it is actually not as easy as it looks.

In a trending market, it becomes much easier to just enter single series at the money directional trades, and if volatility is fairly consistent, some people can have a great run in options, even for months. It is when these conditions change that can catch a lot of traders out, especially when volatility has rapid significant changes.

But the style described is mainly swing/position trading, usually directional, often using single series options (some will use slightly ITM, many ATM, and some OTM) where this ability to make quick decisions is used. But behind this process there needs to be the ability in knowing when to enter and exit, and which options to use.

Personally, I actually do the hard yards away from the market, looking for potential opportunities and considering the volatility, and think through which strategies may work best. Then I do the due diligence rapidly when the opportunity arrives, and that decision making is certainly executed rapidly when looking to get set.

The discussion above was really getting to the core of how to assess risks. Experienced traders either consciously think this process through, while others develop the ability to do this intuitively. The message here is to identify that risk assessment however you do it is a cornerstone of options trading.


Regards


Magdoran
 
Magdoran & enzo


Agreed.
To progress the model we need to;
*ask enzo to reconstruct the initial valuation model [with amended vega]
*or, take a new, real time example, and provide a dual analysis & valuation.

If option #2 is undertaken, we will need an example that includes a non-linear event that will provide a similar scenario for valuation as the previous litigation in the FRX example.

Anyone interested?

jog on
d998
 
Hello Ducati,


While I understand where you are coming from, and while the issue you raise is certainly of interest at the fine tuning end of options trading approaches, it maybe getting to the level where the majority will see this as splitting hairs, and will not really benefit from the discussion.

Certainly not beginners, or for that matter even at the intermediate level.

The FRX example is great for those wanting to play around with complex spreads, and to see the impact of ratio and diagonal variations, and it certainly highlights just how involved the Greeks can get.

But I wouldn’t see this as the “pin up” idol to interest new options traders. I can almost hear happytrader thinking, what’s this Frankenstein’s monster of an options position got to do with straight calls and puts? And if he is, he’d have a valid point at that level.

In fact, I suspect that the majority are either snoring or “changing the channel” (clicking on to another thread).

The original topic was about the pros and cons of a strategy, then briefly raised the notion of options vs CFDs, then the mental state behind assessing risk came to the fore. While all this is relevant, aren’t we losing track of the basic option mechanics at the start?

Perhaps you could start a new thread Duc and frame a discussion there? What do you think?


Regards


Magdoran
 
Magdoran


Oh,Oh!
The model that I was proposing is a completely different model that is utilized to value non-linear events. That Options, in essence, provide a very similar framework, this model could be used as a cross-reference to the standard greeks in a valuation.



I think that in the light of the lowest common denominator, I'll just drop the subject.

jog on
d998
 
Oh, Ducati,


I think I missed something then, can you expand on what you mean the term "non-linear events" please - I may have a different interpretation...

Also how would the model (can you please summarise this in simple terms please?) be used as a “cross-reference” to the “Greeks” we’re currently using?

Don’t forget if this approach is to have value, it needs to be compatible with actual options traders and their style, and I know Ducati that you are still studying options in theory (hence you may have more of an objective viewpoint in theory, but then there’s nothing like experiencing the “real thing” either!).

I still think setting up a separate thread for this would be worthwhile for the advanced options traders if you’d care to do it. I’d also be interested in Wayne and Margaret’s perspectives here too.


Regards


Magdoran
 
You must log in or register to reply here.

Similar threads

August 2025 DDD
2 3
Replies
54
Views
7K
ducati916
J
The 'plan'
Replies
5
Views
2K
ducati916
Risk Management
2 3
Replies
44
Views
7K
basilio
All trading needs to cease for 14 days prior to Monday open in Sydney
2 3 4
Replies
75
Views
15K
divs4ever
R
21 Lessons in Investing
Replies
6
Views
4K
divs4ever
Menu
Log in
Register
Cookies are required to use this site. You must accept them to continue using the site. Learn more...