Abandoning your favorite option strategy? Reconsider

An excellent post by Jared at Condor Options was also picked up by Abnormal Returns. [If you are not familiar with the work of Tadas at Abnormal Returns, it's worth the visit.  He finds the best blog posts, and it's more than I can find time to read.]

Jared suggests treating a strategy as you would a favorite stock: Buy on dips:

"If you’re trading a strategy with a long-term record of solid
performance… a great time to increase
your exposure to that strategy is after the strategy has suffered a
losing period.

In other words, given a strong and consistent strategy,
you should buy that strategy on the dips."

That is an interesting suggestion based on mean-reversion.

When investing, and more often when trading, we tend to buy on dips.  We remember price levels at which we had previous success when buying a certain stock. Technical analysts consider this practice to be 'buying at support.'  It makes sense.

However, I confess that I've never done that.  When a strategy is not working well, I tend to cut back, rather than expand position size. 

"A strategy that has performed well over the long run should never be
abandoned after a decline, unless there is overwhelming evidence that
something about markets or the strategy has changed so fundamentally
that the strategy will never work again."

When there is a solid, fundamental reason for abandoning a strategy, then do it.  But when the decision to change strategies is based on an expectation of further losses (with no solid basis for reaching that decision), that's an emotional decision.  Jared goes on to say:

"Based on my own experiences mentoring and educating option traders, I
think that the most important factor differentiating unsuccessful
novices from those who survive long enough to become experts isn’t that
the latter group knows more about the option Greeks, or is better able
to analyze implied volatility, or anything like that. The decisive
factor, as trite as it sounds, is that successful traders are willing to
base decisions on information rather than emotion


Visit the new Options for Rookies Home Page, with links to new material, including my thoughts on an options education.

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17 Responses to Abandoning your favorite option strategy? Reconsider

  1. Tim 09/24/2010 at 7:34 AM #

    Is there software or calculator or a method to determine about what an option will be selling for should a stock fall or rise to a certain level. For example. If I want to figure what a 600 RUT put would be priced at (approx.) should the index fall from 650 to 630 and enter a limit order prior to the fall but contingent upon it falling to that level. Or stock XYZ is a volatile stock and I’m not available to watch the monitor so I enter a contingent order to buy an option at a limit should the stock move $5 one way or the other. Is there a common method people use for this?

  2. Mark Wolfinger 09/24/2010 at 8:38 AM #

    Yes. Calculators are readily available. Here’s one, but your broker should have a good one.
    1)Choose European options
    2)Set the price to 630 and dividends to zero
    3)Choose a date and remember to change your bid frequently because the date is important
    4) Guess how much higher the implied volatility will be
    5) Read the ‘fair value’ and determine how much to bid.
    I don’t know of a common method used, but your broker will tell you their system for entering such orders. Just remember that the contingent order will be a limit order, and there is no guarantee you will get filled. I believe it is far to dangerous to use a market order, unless you would have some significant loss exposure and ‘must’ make the trade.

  3. Larry 09/24/2010 at 1:12 PM #

    Mark, when is Delta not really Delta? I am watching a $310 LEAP call in January 2012 for AAPL and it has a Delta of 50%. I thought Delta was the change in the option related to the change in stock. In watching the stock and option the movement today it is more 1 to 1. What gives? Is that because of low open interest? (There are well over 1300)or is there something else I need to understand.

  4. Mark Wolfinger 09/24/2010 at 2:18 PM #

    Delta is ALWAYS delta. But option prices do not always move as predicted by delta. There are other factors to consider.
    1) It is a LEAPS call, not a LEAP call
    2) Delta is as you described it.
    3) But these are markets. The bid and offers are determined by people (who enter specific parameters into their option pricing computers). There is no promise that they will move their bids higher when the stock moves higher. there is no promise that a 50 delta option will move with a delta of 50. Other factors affect he rice of an option.
    4) Open interest has absolutely nothing to do with the price of an option.
    5) What do you mean that they move 1: 1?
    a) Do you mean that you are keeping an eye on the bid/ask spread for this option and that the bid rises point for point with the stock?
    That is not happening and this option is NOT moving 1:1 with the stock.
    b) Do you mean that this option is up as much as the stock is today? If yes, that is not a valid comparison
    The option price change today is measured from yesterday’s CLOSING PRICE. That closing price is worse than worthless. I mean that literally. The closing price of an option means NOTHING. If the stock were to rally 100 points, and the option does not trade that day, the closing price would be UNCHANGED from the previous day. Closing price is based on trades, not changes in bid/ask quotes.
    Ignore ‘price changes’ for options. They mean nothing.
    6) Yes. There is this to understand: Watch the option’s bid and ask prices to determine the true option price. For the sake of discussion, choose the mid-point between the bid and offer as the true price for comparisons. You probably cannot trade at that price, but it is the ‘price’ for discussion purposes.
    Keep this in mind. As the stock rises, it’s likely that the option implied volatility is declining. LEAPS options have lots of vega. That means, I would not be surprised if the option moved only 25% of the expected (from delta) rise – due to a big drop in price due to vega (exposure to volatility.
    Does that answer the question?

  5. Steve B 09/24/2010 at 2:58 PM #

    It is interesting how many different opinions there are. William O’Niel (Investors Business Daily) actually disagrees with this. He insists that you buy stocks based on their potential for increase. So he never buys on a dip, but waits for a stock to gain momentum through a new high and rides that wave. (That is an extremely over simplification of his CAN SLIM theory).
    Two imperative factors for buying on dips is position sizing and confirmation. If you think you have reached the end of a draw down and dump a good majority of your capital into that strategy and another drawdown occurs, you could wipe out your account before the rebound. Yes, the odds and history are in your favor that it will revert to the mean, but when it chooses to do that is a whole other issue.

  6. Peter 09/24/2010 at 3:12 PM #

    If you think it’s still a winning system, there’s no need to double up. Your edge will eventually work itself out, assuming you’re applying good money management.
    Doubling up could be dangerous (unless this was a forethought plan with corresponding money management included). Even if there was no fundamental change to the system and that an edge is still present, the mean reversion time is unknown. Volatility is known to mean revert, yet it could stay depressed for a very long period.

  7. Mark Wolfinger 09/24/2010 at 3:12 PM #

    Steve B,
    One opinion per person.
    True, one group of traders use new highs as breakout signals. And another buys at support. Technical analysis can be used any way one wants (or not at all).
    I spent almost my entire career as a CBOE trader on the short side of the market – which explains why I’m not wealthy today. With that history, buying on breakouts is foreign to me.
    Steve B – I would not load the boat on dips. I was assuming that the trader has no position and that would make buying at support attractive.

  8. Mark Wolfinger 09/24/2010 at 3:16 PM #

    I don’t disagree with anything you said here. Nor was I referring to doubling position size.
    Most of us have a standard position size for ‘normal’ trades. The suggestion here (as I read it) is to consider boosting size by 10 to 20% – just as you would usually do if you find a trade to be especially attractive.
    Agree totally. Money management and risk management remain top priorities and can never be abandoned.

  9. Larry 09/24/2010 at 3:29 PM #

    Thanks Mark, that answers the question. The stock price and option price (using the ask price)were changing in concert. For every dollar of stock appreciation the option was moving up by at least that amount. I had thought Delta was a hard rule that predicted the change in the option but it sounds like the market is still the market and therefore there are other factors to consider; especially with LEAPS.
    Thanks again

  10. lance.barnette@gmail.com 09/24/2010 at 3:41 PM #

    I think part of what is counter intuitive about AAPL the past few days is that call IV’s have been going up as the stock ran up. I commend Larry for his desire to learn and his ability to notice the impact of vega on option prices. Most people learn about vega through the scenario that you pointed out. They own that 310 call when when the market moves up and IV tanks. Then they have to figure out why they lost money while the stock went up.

  11. Peter 09/24/2010 at 4:16 PM #

    Mark, I’m not sure where I got the idea of doubling up either. I still wouldn’t add to the position – I might bring it down slightly because you might not know, at that point in time, whether there was some fundamental change which could have removed your edge in the system for a long period of time, if not permanently.

  12. Mark Wolfinger 09/24/2010 at 4:44 PM #

    Hi Lance, Welcome
    I had not realized that AAPL IV was on the rise.
    But sadly, too many beginners buy OTM options, get their rally, and still lose.

  13. Mark Wolfinger 09/24/2010 at 4:46 PM #

    In practice, I do cut back in this situation.
    But Jared’s idea is new to me, sounds reasonable, and is worth the discussion.
    Thanks for participating

  14. Mark Wolfinger 09/24/2010 at 4:50 PM #

    If the ask prices were moving higher, 1:1 with the stock that’s unusual. As Lance pointed out, those calls moved MORE than would have expected becasue of the increasing IV.
    Under more common circumstances, the delta is about 50 and describes part of the option price change. When stocks rally, IV tends to fall. Not in this case. That’s the reason for the option moving so rapidly.
    I don’t want to confuse you: Delta is nearly a HARD RULE: But other factors can be so large as to overwhelm delta.

  15. Larry 09/24/2010 at 8:29 PM #

    Thanks Mark; I got it, and I actually learned something today. I even went back and re-read your chapter on the Greeks in your Options for Rookies book.
    Thanks to Lance for his assistance as well.

  16. Dave 09/26/2010 at 7:38 PM #

    This strategy sounds to me a lot like heads has been flipped 4 times so tails is coming up…
    Reversion to the mean? Big Question: What time frame?
    Overwhelming evidence? It’s not working, right? So keep trying until it REALLY doesn’t work– and then it becomes overwhelming”?
    This article is vague and suffers greatly from lack of examples or specifics.

  17. Mark Wolfinger 09/27/2010 at 12:26 AM #

    My feeling is that Jared’s emphasis is on the fact hat this is a time-tested strategy, not something that has worked for a year or two.
    I appreciate the feedback. Not agreeing with everything you read – without overwhelming proof – is the sign of a thinking mind.
    Appreciate the conversation.