Sunday, April 30, 2006

Long Options: The Realm of High-Multiple Return

I've been talking more about long options lately. Maybe it's because the vol is so knocked down that short premium is tougher to find (at the same time I am a firm believer that as long as options exist there will be a reason to sell them) but more likely it is that the long side of options has that unbeatable advantage: high-multiple return.

To avoid any confusion, let me immediately state that when I talk about long options I always talk about naked calls or naked puts and I always put that into the context of directional trading. Other well-known ways to trade the long side exist, such as long gamma and long vol. Those are rich with their own merits (sometimes long gamma is such a good trader that I shun any other method) but in retrospect, from both personal and historical perspectives, the most money on the long side was made betting on direction.

Admittedly, the most money lost was the same way.

There is a lot to be said about playing direction. One thing I won't do is go into details of a winning strategy (I made a foray into that a few weeks earlier and found it to be a non-rewarding experience. Giving someone a fish really is a fruitless exercise.) and would rather talk about the necessary ingredients of coming up with and executing a successful one.

Generally speaking, a trader is very rarely right. If you don't believe me then you haven't traded seriously or long enough. You may also have been incredibly lucky (long runs of being "right on the money" indeed happen and are completely in line with randomness, given enough of a sample space - something that we certainly have if one considers the number of financial deaths paving the steps to greatness). Now, since successful traders do exist, being right obviously isn't a necessary requirement.

So, being wrong is acceptable but it bears to consider how wrong a trader is allowed to be. Let's consider a standard cost-averaging strategy where being wrong is allowed (and in some cases even encouraged - yours truly is a practitioner of one such case): some amount of an asset is purchased at some cost with the outlook of further prices rising. The expected rise does not occur and the prices drop instead. An additional amount of assets is purchased. Shortly thereafter the tape prints a limited rally and then leads even further. A third lot is purchased. Another decline. The asset is now showing a sizeable unrealized loss.

Immediate observation: If you haven't been in this situation, you probably haven't traded enough and certainly have not made any serious money. Reason below.

Necessary question: What does a trader do?

The answer is not simple and it depends on two things:
  1. The percentage of total capital in jeopardy.
  2. The integrity of the existing trading context.
It's really a balance of these two. Other factors such as fear, heart palpitations, dry mouth and visions of doom don't enter the picture. If they somehow do, please get a lot more money and continue trading. It makes my (non-writing) job a hell of a lot easier. And if this suggestion upset you (because you think I am a pompous asshole) then financial world has a better place for you - behind a desk as a stock analyst.

My "black book" says that the amount of total capital in jeopardy should not exceed 25%. To most of you this is going to sound crazy since we're taught to never risk more than 2-5% of our accounts. The reason 25% is my choice is that this number factors in the fact that a strategy (consistently executed) loses very rarely (this is a trivial function of mathematical expectation based on frequency of wins vs. losses and average dollar amounts won or lost). So for my strategy an occasional 25% loss isn't at all terrible. However, it should be rare that a 25% unrealized loss is even a reality - mainly because of the second point - the integrity of trading context.

This point is fundamental. As you buy into a situation you must be absolutely assured that the context leading you to buy has not been compromised. The minute it is, you will blow out of the trade and move on. To make sure the context has not been compromised you must have it defined as concretely as possible. This is never an easy task and it is very often extremely subjective. So, test your strategies well. The main point here is that your trading context should dictate whether to get out of the trade or stay in (or get bigger) way before your money does. So, if you're seeing a 15% loss of your equity it is well if your definition of a proper trade is compromised by the market. That way you know you're getting out for the right reasons and not because your bank account can't stand it anymore.

From the above it follows that if you trade on the long side, be prepared to withstand substantial swings in your unrealized P&L. If you trade a $100K account, you should have no problem in seeing a $10-15K unrealized loss and staying with the trade - so that you can make the expected amount. Obviously, the bigger the swings the more you'll make. Again, this is a function of your strategy.

As a parting thought, as you progress always be respectful of ruin (study it and understand it), but don't be afraid of it (put your money on the line like you mean it).



At 6:11 PM, Anonymous Anonymous said...

the heart pounding & the dry mouth have certainly happened to me....i think this is the right apporach, defining how much pain you can take before you make the trade

At 8:38 PM, Anonymous free trading tip said...

Interesting reading... Keep up the good work...

Stock Trading Guru
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