Why Does Trade Entry Matter?
Why Does Trade Entry Matter? I have had a lot of my new option mentoring students ask me why I make their life so difficult. "Shouldn't this be easy?" some will say. The answer is no, trading is not an easy business. If it were, every person on the planet would be driving a Rolls Royce. This is why we at Option Pit insist on the strictest most difficult curriculum in the world of option education. We do this not because we are looking for clients, but because we are trying to make confident, knowledgable traders (the clients come because they know what we offer). So what is it that we try to instill in traders? The brains to initiate a trade. Why does this matter? Two reasons:
1. Trading for Edge: What is edge? It is a traderís belief that they are entering a trader at a better price than where the market is currently pricing the spread. Believe it or not, it develops all the time and can produce quick results. It may not be thousands of dollars, but it can be enough to push the trade into a favorable position and often will end up being worth more than the commission on the trade.
One way I like to describe getting a.05 of edge on every butterfly is this: Imagine if you could trade all of your butterflies commission free? Would be nice right? In fact, most traders are profitable or very close to a profitable gross, and then lose big on the net because they pay between.25-2.50 a contract to trade. Trading for a .05 in edge, starts the trader out in theory up 5.00 per spread, certainly enough to cover the commission in, and often enough to cover the out.
2. Predictable Risk: For those that subscribe to risk management being important, trading options for edge will actually make risk management easier. This is because the trader will have greeks that somewhat follow what the model predicts. Here is an example of predictable greeks:
On April 21st, with IV low, and the SPX trading 1330, a trader could buy the 1350 calls, a 33 delta, for 9.20. 5 days later that same call is a 47 delta and the SPX is trading 1347; in theory, the call should have picked up 17 points X the average delta (which is .40) or 6.80 (less the theta which was about 1.50-2.00. Net the calls should be worth about 14.00-15.00 and change. The calls were worth around 13.80, pretty close.
I walked through that calculation to show you something very specific, a pricing model would have worked. Traders sitting in front of OX or TOS would have been able to slide the price bar up to 1347 and come pretty close to knowing what the 1350 calls profit and loss would be. That is a valuable tool that most traders really need-- and almost all lack.
One of the biggest issues we are seeing in this down turn is that IV is not increasing as the market falls. This has to be causing all sorts of problems with pricing models, especially if traders bought puts when they were trading at a nice premium (right around when SPX was in 1360's and WT Crude was around 115). Those traders are not getting the profit they expected because they bought puts, when they were somewhat dollar cheap, but they were not vol cheap.
The facts are, we never know where the greeks will land, but buy buying puts and calls when they are somewhat cheap relative to the puts and calls we sell, traders can put together a position that has 'edge' or if you prefer, a predictable risk. If only they could provide predictable returns, unfortunately the only thing that is predictable is death, taxes, and the critique my Dad will give me about how to better write this blog.
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Mark Sebastian is the Director of Eduction for Option Pit, and a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. He has been published in nationally on Yahoo Finance, quoted in the Wall Street Journal is a featured contributor for TheStreet.com. He also writes regularly for SFO, and OptionsZone, and is the managing editor for Expiring Monthly: The Option Traders Journal.
To learn more about Option Pit and its mentoring services, please visit OptionPit.com
About Mark Sebastian
Mark Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the director of risk for a private hedge fund. He writes a daily blog, the Option Pit blog, formerly Option911. Sebastian has been published nationally on Yahoo Finance, Google finance, Financial Times Alphaville and is a featured contributor for TheStreet.com. He is also published regularly at SFO, the Options Insider, and is one of the Co-Hosts of The Option Block Podcast, a featured Podcast from Options Insider Radio. Mark is the managing editor for Expiring Monthly: The Option Traders Journal. Sebastian has a Bachelor's in Science from Villanova University.
To learn more about Option Pit and their mentoring services, please visit: http://www.optionpit.com
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