Continuing the discussion on whether delta neutral trading is truly as 'ideal' as its adherents claim it to be.
If I recall correctly, there's some empirical research out there
suggesting that being short volatility on the index has an
edge, I would think that staying (roughly) market neutral is the
simplest way to express that edge without introducing too many
variables. Trading long I think would mean abandoning that edge, maybe
that's what makes you uncomfortable?
Over the years, implied volatility on indexes has been higher than realized volatility. There is no way to know if that
will continue to be true. However, being short index volatility has resulted in the seller having an edge.
Some try to exploit that edge and still remain vega neutral. They buy individual stock options (obviously choosing appropriate, lower IV vs. realized volatility stocks), and short index volatility.
I don't see how taking a lean of a few hundred deltas equates into giving up that edge. If I choose, I can remain fairly Greek neutral, except for that small delta 'lean.' At this point, it's merely a discussion, not something I plan to do.
Do you truly believe that being just a little long (or short) delta removes the edge gained by being short index vega? I don't see why that should be true, and remain unconvinced.
From a more personal experience, a couple of folks I know who trade with
a directional bias very very well tell me that entry is a key
determinant in making money. I'm absolutely terrible at timing these
things, and every time I've tried I've lost money. I don't seem to have
any edge in that area, and no real reason to think I will develop a
sustainable one anytime soon.
I am confident that while having to
constantly adjust/roll my positions is painful, I think I have an edge
that I can focus on.
It may also be a time-frame thing, most directional traders I've seen
seem to operate on shorter time frame (daily, hourly, sometimes even
minutes) than I'm comfortable with outside of having a machine do it for
Goodness knows that if I were smarter/more skilled I'd be swinging
directionally, but as Clint Eastwood said, a man's got to know his
Very appropriate quote. Suitable for anyone who participates in the markets. Know your limitations.
Traders who trade with a directional bias tend to be very short-term traders for good reason. The bias tends to be short-lived. They see a chart pattern or some other data that suggests the next mini-wave of trading will be on the buy or sell side. They play it, and it ends quickly. In that scenario, the timing of an entry is critical.
Do you remember that old Merrill Lynch adage: 'I'm bullish on America'? That's for investors. No trader can have a multi-year opinion and expect to use it profitably.
Other directional traders may have a longer-term horizon and follow the trend. Trend following is an entirely different approach that I do not discuss at Options for Rookies because it pays to be 100% long or short when playing the trend. As has been pointed out, most of the time the trend is too short to be profitable.
The big decision when 'trending' is understanding when the trend has ended – and not stubbornly holding onto directional trades.
I agree that I have no edge in the area of timing an entry, and don't pay a lot of attention to that aspect of trading. I know that's heresy to those who follow charts and use technical analysis.
A trade either does, or does not, meet my requirements. If it does, I enter the order and must rely on money management skills to protect my assets. That's certainly less fun that making a trade, taking the profits and looking for the next trade opportunity. But you and I know our limitations, and make no serious effort to time entry points.
Eric Falkenstein at Falkenblog has a theory that risk is
actually relative, and the biggest risk is not that we underperform our
markets, but we underperform relative to others (or even worse, people
we think less of). Do most of the folks you talk to trade directionally
or market neutral? When markets are one way like this, I always think
about going directional, and when markets are stuck, the trend traders
all think about going market neutral.
This is a key psychological factor. Perhaps the only factor. As a market maker, I always said that all I want to do is make my share of the money. I wanted to earn a living and it doesn't matter how well any other traders in the pit perform. But I'm very competitive, and when I did not make the most money every year (and possibly I didn't in any year, despite a couple of good ones), something was missing. That's a bad attitude!
But I get it. Bull markets are enjoyable for the vast majority of traders, yet for my entire trading career (as a market maker), I prospered in bear markets (1987 being an exception) and lost money during bull markets. That's sad. But, it's one good reason for being market neutral, now that I'm an individual, trading from home.
But I look at the recent huge bear market, followed by a large bull market and I took advantage of neither. How can that be a good result? When RUT moves 34 points in two days (Mon and Tues), a 200 delta lean may not be big money, but it represents about $6,800. And, if not stubborn, the potential loss is far less. At some point, I'd give up those 200 deltas.
Don't get me wrong, I would not have been in at the bottom and may have even sold out most of those extra deltas along the way. But why struggle with iron condors when it's easy to take a lean? When the upside already looks risky for my portfolio, an extra few deltas is cheap insurance.
Buying a kite spread or extra call option gives me positive gamma and negative theta, but it does provide a good upside boost over most price ranges – at little cost. What's so bad about that?
To me this entire discussion evolves abound a situation without a good solution. So neutral I remain.
PS Outside this blog, I don't have
detailed conversations with many traders, so cannot answer.