By: Steve Smith
In options trading, depending on the strategy there are multiple outcomes that can occur over different time frames, even for the same movement in the underlying security.
An outright purchase of options will outperform a spread if the shares move quickly to the same price target. Both will lag a credit spread if the movement in the underlying remains muted for a period of time.
One downside of owning options is the way they leak value through time decay. It’s this concept that inspired the title of this article “Leaking Faucets and Trading”, which describes the various stages of the options trading process.
It’s a short, but valuable read for this Friday afternoon. Read on.
Drop by drop the river is formed.
This morning I realised that the kitchen faucet is leaking. Have you ever experienced one of those moments when something small from your daily lives brings memories or helps you come up with a new idea or visions?
Have you ever thought of how close the elements of life are to trading?
This morning I was mesmerised when I realised how similar leaking faucets and profitable trading are.
Rain falling on to a virgin landscape eventually organises itself into streams and eventually a river. After a river is formed, it goes to the sea.
In a very similar way, trading ideas can sometimes organize themselves into an outcome. Sometimes, two “rivers” form and there is a double outcome. Traders then need to choose between the two.
But which one is the right one? We, as traders, do very seldom ask ourselves those questions. Impatient, greedy, fearful and willing to get rich quick are all terms defining the average trader… the losing trader.
Options trading may have more than one outcome.
In one-stage trading we go from a field of possibilities to a single outcome.
In two-stage trading, we go from a pool of possibilities to a few alternatives and then possibly to a couple of outcomes.
In three-stage trading, we might first build our own trading theory, then discover a pool of possibilities and then choose from a few alternatives.
There is no such need to categorise so many outcomes and alternatives, as long as you do realise that you cannot go straight to the right outcome. You cannot be a profitable trader by just looking for the “right answer”.
Traders often aim at reaching a single conclusion, but they forget that what makes a trader profitable is the process of trying to extract maximum value from both sides of any contradiction and not a blindfolded coin toss.
And so, the faucet keeps on leaking…
And so, profitable trading takes time to form a “river”.
Then the student of the markets thought… if only I could have the persistence of a leaking faucet.
Drop by drop…
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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