Establishing Trading Rules: How Much Experience is Needed?


Based on what I learned and thought about over the past few days due to my

  • I would now only buy calls/puts in the front month. The
    odds are more with us [MDW: Us? How did I get involved?]  because of gamma. Is this thinking correct?
  • The
    loss is limited to premium paid, but the upside is huge

  • I would
    never buy otherwise because theta is the enemy

  • I am not sure what I
    would buy though, ATM or 2 levels OTM.


Slightly off-topic: Based on looking at my trades, time decay is not
linear. The more the underlying is at a particular strike, the more the
time decay at that strike.

Is the time decay calculated per day or week
to week?

The time decay graphs given in most literature gloss
over the fact that those decay graphs are concerned with an option which stays
exactly ATM all the time. Why?  The real spot price gyrates?




I get it.  You are an eager student.  You want to trade options right now and make money today.  Every time you see a piece of evidence about a specific strategy, you believe you found the Holy Grail.  I can only tell you that you are making a huge mistake.

You are FAR TOO INEXPERIENCED to make these decisions.

This is learning time.  This is experiment time. 

You cannot make a few trades and reach a permanent-sounding decision such as: 'I would only buy front-month options.'  If you reached this decision, on what is the thought process based?  How many times have you traded 2nd or 3rd month options?  How did the results compare?  Did you make good money by correctly predicting direction, or did something else happen that made the trades profitable.

It is wrong to assume that a profitable trade means you are a genius. 

It is wrong to assume that a losing trade is the result of a mistake.

You must compare the trade with others and discover why the trade was profitable (or not).  The 'why' is how you learn.

NOW is your chance to trade a variety of ideas, analyze the results, keep detailed records, think about the results and make an attempt to get a feel for what works and where to establish risk limits you can handle.

1) No the odds are not with you because of gamma.  The odds are not with you, period.  You have much less time to be right in your prediction.  If it does not happen soon, time decay will eat away at the value of your options.

How can the odds ever be with you when you must predict the direction of the move, the timing of the move, the size of the move?  You must be a very skilled market timer with a PROVEN track record before you can have any expectation of making money when buying options.

I'd hate to see your enthusiasm disappear down a sink hole.  Didn't you try this 'buying options' strategy once before?

2) Yes the Reward to risk ratio is excellent.  But the probability of success is not.

3) I don't understand the 3rd point.  When you buy front-month options, theta is the big enemy.

4) This is your problem in a nutshell.  You want to buy. You think buying and owning positive gamma puts the odds of success on your side.  But you give no consideration to how far the stock must move.  You don't know which options to buy.

It doesn't work that way.  The whole strategy requires knowing which options to buy, or having a method for deciding.  It's not a random selection.  It you cannot estimate the size of the move you should not be buying options.

Buying out of the money options is very much a gamble.  Some players succeed. I have no idea where your talents lie, but if you are excellent (proven track record), you can win this game.  Otherwise, not a chance.  Especially when you buy OTM options.

Off topic:  Time decay is NOT linear.  ATM options have the most time premium and thus, the most rapid time decay.  Time decay of American style options is based on the amount of time remaining until the market closes for trading on expiration Friday. 

The decay can be determined for one week, one day, one second, or any other time period you care to mention.  However, the Greek theta measures the time decay for one day.  Theta tells you how much value the options loses overnight.

Most option analytical tools that measure something specific, such as theta, assume all else is constant.  It MUST be this way.  If you want to know about theta, then if anything is not constant, that item will also affect the option price, and you will NOT be able to tell what part of the option price change is due to theta.  Please tell me that you understand this is true.

One of my basic tenets is that it is very foolish to trade when you don't understand the rules.  Some rules (automatic exercise) can come as quite a surprise to the novice. Other properties of options (how quickly they decay as expiration nears; or the sale of options is not free money) may not be immediately obvious.  But it makes no sense to use tools  when you don't know how to use them.

What's your hurry?  You have the rest of your life to trade. 

Practice in a paper-trading account or trade small size in your real account.  But don't go jumping to conclusions based on one or two trades.


July 2010 Expiring Monthly.  Table of Contents:


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5 Responses to Establishing Trading Rules: How Much Experience is Needed?

  1. amit 07/22/2010 at 12:34 PM #

    Please read my next comment which is right after I posted the above mentioned comment. It’s here
    I don’t buy options and I won’t, unless and until the odds are heavily in my favor. Since the odds are in favor of the house I won’t buy.
    I was just reacting to your insight when you pointed out that the gamma swings so much in last few days, if the prudent thing is NOT to write but then obviously the prudent thing is to buy.
    I am just trying to understand options.

  2. Mark Wolfinger 07/22/2010 at 12:44 PM #

    I did read it, but did not comprehend what you were trying to say.
    I want to help you understand.
    The following may feel strange, but it’s true:
    If strategy A is a bad idea because it is far too risky or because people don’t know how to handle the trade – that is not a reason to conclude that ‘doing the opposite’ is a good idea.
    Buying straddles: This is a very difficult proposition. It’s costly, you need a good-sized move in the stock – you need that move to occur quickly and be large enough. You must be certain not to overpay for the options or your chances of success are tiny.
    But, selling straddles is a high risk play. You win most of the time, but occasionally, the seller can get hurt badly. That’s the risk that comes with selling naked or unhedged options.
    IMHO, using straddles is not a good idea, unless the trader is experienced and knows how to handle positions with positive or negative gamma.

  3. amit 07/22/2010 at 1:02 PM #

    Ok, I stand corrected. I won’t assume next time. No straddles done yet, and not until I get comfortable.

  4. Jason 07/22/2010 at 11:48 PM #

    Just a quick point, in theory the delta of an option indicates how likely the model thinks an option will end ITM, thus ATM call is 50 delta, OTM call < 50 delta, ITM call > 50 delta. Also, sometimes the most prudent thing is to do nothing at all. Sometimes its the trades you don’t make that save you the most money.
    My general experience with Straddles is that unless I have a large enough size that I can scalp the delta using futures, I just stick to butterflies. I’m not comfortable enough with stop losses, especially given some of the size of the bid-ask spreads, to run straddles/ strangles naked (the flash crash didn’t help much in that regard). Also in the case of short straddles/strangles, the margin required is prohibitive.
    On the OTM/ATM/ITM option debate, my own approach is that if I am trying to make a bet on market direction, I stick with deep ITM options with a long expiry. The time decay isn’t bad, delta is high, and I don’t have as many ancillary risks. Of course, that’s just really another way of levering up.
    Outside of IC’s, Mark’s concept of the kite spread on the upside has saved me several times, and I like the idea of occasionally buying front month deep OTM puts just to hedge a crash (in this recent market environment, I’ve found put kite spreads to be prohibitively expensive).

  5. Mark Wolfinger 07/23/2010 at 7:24 AM #

    Hi Jason,
    Appreciate the information.
    If buying options, I also prefer ITM. Not too DITM or else downside risk is high.
    Kites are costly when IV is elevated. I don’t own any right now, but feel the need.