Tag Archives | market neutral

Trading Without an Opinion: Is it Possible? Is it Foolish?

Mark,

I'm bewildered by your reply. I've been reading your
blog for a while, so I think I understand your admonition to consider
one's comfort level when trading. Nevertheless, I find it hard to
believe that you don't have some sort of underlying assumption if not
about market direction, at least about it's relative range when you make
a trade.

I understand adjusting before the underlying gets to a level
that reaches your discomfort point. But short of exiting the position,
when you roll up/down or out, it would seem that you've made an implicit
bet on market direction. That is, you expect the underlying to reverse
before it touches the further out strike.

Maybe you don't look at it
that way. I could imagine that you only look at the risk/reward of the
new position without forecasting market direction. But it would seem to
me that the risk/reward of the new position depends on the probabilities
of the underlying's movement, which still implies some sort of bias.


Even if you don't consider the probabilities, the premium you collect
reflects the market's view of the probabilities, so you're implicitly
betting against the market since you're selling premium.


This isn't a criticism of your method. But as I think more and more
about your suggestions I find it hard to to conceptualize how you get
comfortable with your positions without having some view on market
conditions.

Any insights would be most appreciated.

Burt

***

Hey Burt,

I see your point of view.  Sometimes people use different words to express the same view.  When I tell you that I have no market bias or no expectation for how the underlying stock is going to behave, I mean that from an intellectual point of view.  I have no belief (on which I am willing to wager) that the markets are moving higher or lower or are range-bound.

However, every time I open a position, my account balance is affected by the market action.  By trading iron condors, the bet I choose to make is that the stock price will remain within a range specified by the strike prices of my iron condor. 

I do not believe you are correct when stating that I am betting 'against' the market.  The market has established the odds (when holding the iron condor through expiration).  But those odds apply to both sides.  Why do you think I am against the market?  Why aren't I on the same side as the market?  Oddsmakers go out of their way to make the bet equally attractive from both sides so they can earn the vig (vigorish).

A significant portion of my overall strategy includes: If that price range does not hold, then I wager I can manipulate the trade to hold losses to an acceptable level.  That translates to this: I can make more when things go well than I lose when things go badly.  Every trader makes the same wager: they can earn more when profitable than they lose when unprofitable.

To me that is not a bias.  I am depending on my risk management abilities to keep me out of trouble – despite the fact that they are not 100% reliable.  I choose iron condors because I have no reason to choose bullish or bearish plays.

I adopt a strategy that owns positions that are near neutral in delta and gamma, but which have positive theta and negative vega.  If I am comfortable trading those positions, why should you be bewildered?  I'm always surprised when people believe they can profitably wager on market direction.


My explanation

I believe it's a good idea to open a limited-risk position whenever I 'like my chances.'  If I lack an edge in predictive ability, I must depend on my ability to avoid disasters. 

I must also compromise between safety (how long to wait before exiting a winning trade) and taking advantage when the markets trade within my range.  I decide how long to hold and how much profit to seek.  If I lose when markets are volatile, I must compensate when they are calm.  Risk management precludes holding through expiration (for me) and thus, there is a time to cover.

You are correct.  The premium collected determines the maximum reward.  Risk is more difficult to determine.  I will not allow the trade to move to the worst case scenario, but I also don't know – in advance – at what price I'll exit.  Thus, 'risk' is only estimated.  Options traders estimate future volatility all the time.  I estimate future risk.

If I like the estimated risk/reward for no well-defined reason, does that suggest the trade is 'wrong' or a bad idea?  Not to me. 

Those who use technical analysis, and never trade without a very strong opinion, would disagree.  In fact I had one novice who was incredulous that I traded without using technical analysis.  When I asked how much money he was making by having an opinion, I did not get a satisfactory answer.

I was trained in the 'always be neutral' school, and although I don't strictly adhere to it's teachings, I learned that 'neutral is good' and 'opinions are bad.' 

Question – without trying to get into a philosophical discussion: Is this any different from religion?  As children we are taught to believe that certain things are true.  Most hold those beliefs while others turn away from religion.

There's no 'proof' that the beliefs are true, but people live their lives by those 'truths.' To be a true believer, means that everyone who doesn't think as you do is wrong.  Is that reasonable?  It is how we live.

So I ask: Why is my approach so bewildering?  I don't believe I can accomplish anything with technical analysis.  I don't have a good method for predicting the markets, and believe the vast majority cannot consistently do so.  I choose to trade as a non-believer, i.e., neither the bulls nor bears have an edge. 

I see nothing wrong with remaining faithful to the neutrality idea which tells me that having a market bias is wrong.  I have enough proof that it's wrong for me.

1) I've frequently traded with directional bias in my career, with a dismal track record.

One example: I clearly remember Aug 1982 when I was certain the market had not bottomed.  I was short, stayed short, watched my money disappear (I had made a mint in 1981) and stubbornly refused to change my opinion. When I ran out of money, I conceded defeat.

I've had similar results when opinionated.  I have an opinion right now.  I do not understand why the DJIA is not 5,000 instead of 10,000.  But it is 10,000 and I cannot afford to wager that there will be a huge decline.

If I am a skillful risk manager and don't hold onto positions that are too risky, I do well.  When I get stubborn, I either get lucky and survive, or get clobbered.

I don't want to depend on luck to avoid getting clobbered.  Thus, I learned to control my emotions and opinions when trading.

Is that a good idea for anyone else?  I believe it is, but I'm not adamant.  Each trader goes his own way  I must trade this way.  I proved to myself that I cannot afford the luxury of placing market bets based on my opinion. 

My job is to help people understand options and how to use them.  To that end, I share my philosophy and strongly held views.  But I do not tell people that my way is the truth.  I encourage independent thought.

2) You said: "But it would seem to me that the risk/reward of the new position depends on the probabilities of the underlying's movement, which still implies some sort of bias"

Yes.  It depends on the probability of where the underlying is going.  But I don't know where it is goingThis is where we disagree.

I do not distort that probability with
my opinion.  You believe that if you have a
market opinion, then there is an increased probability that your opinion
will come true.  I know from past experience that my opinion is
not likley to come true. That's why I always ask about a trader's proven
track record when he/she want to bet on market direction.

I suppose I do trade with a bias (if you want to call it that) of sorts.  The volatility skew allows me to sell puts that are farther OTM than calls.  This suits me because I believe a collapse has a higher probability than a melt-up.  It's not a big deal and does not play a huge role in my choice of options to trade.

Rolling

I no longer roll a position unless I want the new position in my portfolio.  The new trade must offer a sufficient reward for accepting risk of being 'wrong.' Wrong in this context does not mean that my expectation does not come to pass.  I have no expectation other than I believe I can make money with the trade.  'Wrong' means that the trade loses money.

I consider trading as a study in probabilities.  I estimate the probability of success (difficult to measure because I don't know exactly how long I will hold the trade) – estimate a reward for that success – and decide if I am willing to accept the risk associated with the trade.  That risk is also difficult to estimate, but if I set a max loss per trade, then I have a very reasonable estimate.

Most traders have strong opinions.  That's great when they have a track record to support that opinion.  I have a track record that screams: don't bet on me.

710

Lessons of a Lifetime: My 33 Years as an Option Trader (Kindle) and e-book versions available.


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What’s so Wonderful About Trading with No Market Bias?

Most traders have a directional bias.  Some have a volatility bias.  Getting either of those right can result in significant profits. And that's especially true when the market undergoes a strong move in either direction or when volatility makes a big move higher or lower.

Regardless, I learned to trade from a market neutral standpoint and have been proud of myself for sticking with that neutral outlook.  However, a question from a reader made me exit my stupor and consider the question:  What's so wonderful about trading without a market bias?

Well – I told myself – I don't care which way the market moves.  I'm in good shape either way (depending on my position and the size of the move).  Who could argue that this isn't the best place to be?  The answer to that question is every trader who makes money by leaning long or short.

But, I'm reconsidering, and looking at different aspects of my neutral bias.  Why is it better?  Why is it safer?  Why is 'neutral' any less of a market bias than long or short?  The sad truth – or at least I'm wavering about it being the truth – is that it isn't any better.  I've been brainwashed my entire career.  Is that possible?

Traders with a market bias hold positions that suit that bias.  I like to
describe my bias as non-existent, but the truth is, adopting an iron
condor strategy is best for traders who believe that the market is not
about to make a big move.  Having no bias, I'm 'hoping' for a
range-bound market, rather than predicting one. That forces me to consider the questions:  Believing that
hope is not a
strategy
, how can I trade iron condors?  How can I choose a strategy that depends on having a range-bound market?  If I am not confident that the market will be trendless, aren't I adopting a strategy of hope?

That is one scary thought.

I must rely on skillful risk management to survive.  Without the possible big win that those with a market bias can score, I trade strategies with limited profit potential.  That's fine because they come with limited loss.  But I am very much dependent on holding losses to modest amounts and managing my positions well.


History

As a market maker (1977 through 2000), it paid to remain neutral.  That allowed me to participate in all order flow (buy bids and sell offers) without being afraid.  When I was caught short and stubbornly refused to buy stock, I was in trouble when more call buyers entered the pit. [This was a problem because every market maker who sold those calls was going to bid for stock, pushing the price higher.  Thus, not being caught long or short had a monetary advantage.  Obviously I had the right direction part of the time, but being neutral left the market maker ready to take advantage of any order that enters (what was then called) the trading pit.]

When I worked for a trading firm, they insisted on traders being as neutral as possible at all times.  Not just delta, but all the other Greeks as well.  That made sense because our goal was to trade for an edge.  Using proprietary models, the idea was to buy Greek neutral spreads with a theoretical edge.

I'm trained to be neutral.  It was drummed into my head since 1977.  But now, 10 years after leaving the trading floor, I'm wondering if there's any advantage to being neutral.  Why can't I choose an iron condor with a bias?  Or adopt a bullish strategy in the first place?  Why should I allow a slow, steady unidirectional bull market be so difficult to trade?  Why don't I open my iron condor by selling extra put spreads or farther OTM calls or do something with a bullish bias (add some call kite spreads)?  I don't have a good answer to any of those questions.

I always believed neutral was the least risky choice.  And it is when you believe the market has an equal chance to move higher or lower on any given day, or over any given short period of time.  But why should I, or anyone else, believe that?

The news is horrible, and the future looks bleak to me – with high unemployment and all signs pointing to a commercial real estate bubble.  Businesses are not growing, real crises loom large (Greece) – but who cares?  Not 'the market,'  It just marches ever onward.

This is a bull market (which may end before this is published) and why shouldn't I trade just a little long?  What's wrong with that idea?  I don't know, but I am unable to do it.

Can anybody answer?  I've traded with no bias for so long, that it just feels right.  As indicated above, If asked, I'd claim to be a bear.  But  I cannot afford to wager on that bias, especially when being long has been the winning move for a year.  Why is it so difficult for me to trade long?  I have no answer.  For now, I rely on the (flawed?) safety of market neutral.

646


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