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Establishing Trading Rules: How Much Experience is Needed?

Mark,

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

  • 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?

Thanks

Amit

***

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.

746

July 2010 Expiring Monthly.  Table of Contents:

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