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Defining Your Edge

Discussion in 'Options' started by AKJ, Dec 29, 2015.

  1. AKJ

    AKJ Well-Known Member

    Hi all,

    I just read Ron's post about the need to more community participation to improve the quality of discussions and learning, and felt compelled to initiate a discussion about "Defining Your Edge" as it relates to the common campaign style strategies that many people in this community trade. Not sure what the etiquette is as it relates to these types of discussions, so please excuse me if I am delving into secret sauce territory that people prefer to be hush-hush about.

    So to begin, I am a big believer in needing to thoroughly understand and have the ability to define your edge to be a successful trader. Otherwise, you run the risk of continuing a particular trade or style once your edge is gone. Maybe a particular trade works in a high skew regime but not when the skews are flatter. If you know this, you can scale back or adjust the trade when the skews flatten, as opposed to continuing to trade through the regime change none the wiser as to the reasons for your lower profitability.

    With that said, I'm hoping to solicit some input or have someone point me in the right direction regarding the edge in a Bearish Butterfly campaign. I could spend many hours thinking this through on my own, but am hopeful that others may share their insights. Below are my initial thoughts on the edge in such a strategy:

    (1) IV historically trades at a premium to realized volatility. This would seem to be a source of edge for any premium selling strategy.

    (2) Short-Term Mean Reverting tendency of markets. Being negative gamma, short-term mean reversion helps you capture the theta in the trade if in fact the mean-reversion materializes. Also, the martingale nature of the campaign also benefits from mean reversion.

    (3) Skew. I haven't quite worked this out completely, but I suspect that the skewness of the markets contributes to your edge in such a strategy. You are buying an ITM put at a lower IV than the puts your are selling (good!) but also buying an OTM put at a higher IV (bad, but how bad?). I need to think more about the how the slope and curvature of the Vol term structure would affect your profitability in this trade.

    Some natural extensions of this discussion would revolve around how to identify similar conditions in other markets that would tip you off to a trading opportunity. If you can define your edge, you can fold in more markets where the same edge exists, and remove markets as the edge disappears.

    Is there reason to believe that the Vol term structure, IV v. HV relationship, or mean-reverting tendency of RUT versus SPX would cause it to be a better market to trade? What about other markets that have experienced prolonged trends and where the future risk/return profile looks asymmetric? Just some food for thought to kick off a discussion.

    Sorry for the long-winded post and all the digressions.
    Timo likes this.
  2. Trader G

    Trader G Well-Known Member

    This skewness in the puts is definitely a big part of the reason a lot of us here trade some type of bearish butterfly structure. You are right that the far wing does have a higher IV typically then the body of the fly, however it will typically decay at a slower rate then what you have sold (a 5$ wing bought can only drop so far vs. a 20$ body sold). One thing I have always found, is that the modeling of option pricing typically miscalculates further out of the money options (the theta decay is usually way overstated as one example).
  3. ACS

    ACS Well-Known Member

    It is my belief that the edge in options trading comes from discretion in how/when the trade is put on, adjusted and exited. I suspect there is no strategy that can be blindly used from entry to expiration without management that will produce profits on a consistent basis. That said, there are types of trades that will do better under certain underlying conditions and may even be a disaster under others so understanding how option trades generate edge is a great topic. I spend a lot of time watching the ES futures ( in effect, the SPX) and the RUT on a 5 minute chart and their behavior is often quite different. The RUT will sometimes strongly trend while the SPX is in a weak trend or even a trading range and other times the RUT will lag the SPX trend and then suddenly play catch up. Compare the two charts. Over the past year IV has been above HV more often in the RUT than the SPX which argues for using that index. View attachment 775 View attachment 776

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  4. AKJ

    AKJ Well-Known Member

    Thanks for the input ACS. I agree with you that position management is a key to maintaining +EV positions in your option trading.

    My goal is (was) to initiate a discussion around WHY certain decisions, and extension, the timing of those decisions, are +EV.

    Take adjustments as an example. I see adjustments generally serving one of two motives: Opportunistic Adjustments or Risk Management Adjustments (more accurately, Risk Reduction).

    Under Risk Management Adjustments, you may adjust your position to manage your Delta, Gamma, and/or Vega, if any gets out of hand.

    Under Opportunistic Adjustments, you may adjust your position to take advantage of some condition in the market that you feel will change with some asymmetric likelihood. An example may be high/low Vols or high/low skews that you feel will revert, and your risk profile of betting on this reversion is +EV.

    My sense is that in Options trading, these Asymmetric opportunities are what drive most of the returns. But I'm hoping to hear the opinion of others regarding this.
  5. DavidF

    DavidF Well-Known Member

    Hi Andrew, I may be misunderstanding your post but I think it´s difficult to define a trading "edge" unless you´re specific in what you´re comparing the trade with. Otherwise you end up with a list of generic factors (e.g., historic IV vs implied IV) that could apply to almost all positive theta trades.

    With respect to the edge with a BB (disclaimer, don´t trade it), it´s edge is that you can take a short position that, due to the fact that it bleeds theta over time, is much more forgiving than a straight short position of comparable delta. The latter only wins if the market tanks right through your BB which is statistically speaking improbable. The bleeding theta allows you to utilise the roll sequence in the BB without incurring the same losses as compared to a straight short. I could go on but these are edges the BB has over a short position. The edge (or lack of) versus an M3 or rhino or any other trade as different.

    I´ve heard round table discussions where BB traders have said people misunderstand the BB as a theta trade, it should be viewed as a delta trade. I´d respectfully disagree, if it was just a delta trade you could just go short. It´s beauty lies in it´s forgiveness which in turn is based on the bleeding theta. I know you know all this, just saying that it´s hard to identify a generic edge without specific parameters.

    I´ve also heard that iron condors are great for high IV conditions that worked really well (before QE), then conditions changed and they stopped working. I´d also disagree with this line of thinking, even in high IV conditions it´s pretty poor compared to what John Locke and other developed. Hence my belief that you have to be careful when you try to identify market conditions that are best for certain trades, "conditions" are dynamic and it can end up as market timing.
  6. AKJ

    AKJ Well-Known Member

    Great point David! I agree that the details are necessary to truly define the edge that you gain by implementing a specific trade or adjustment.

    You mention round-table discussions on BB; where can I find these discussions? Most of what I'm reading is people discussing the mechanics of trades and generally following guidelines.

    This approach is fine as long as conditions are right for the specific trade, but market conditions change, regime changes occur, and I am hoping to develop the skills and knowledge so that I can respond to regime changes with modifications to trade designs that will protect against or take advantage of the new market conditions. Your mention of the Iron Condor is a perfect example. If (more likely, WHEN) the alpha of John Locke's trading systems begin to decay, it would be great to have the ability to made changes on the fly, and not continue trading a system that is not designed to handle changes in the markets.

    I'm sure some of the more advanced traders on this board could write a thesis around the pros/cons of their trade entry requirements, adjustments, etc. and I'm hoping to pick those brains to improve my own skillset.
  7. ACS

    ACS Well-Known Member

    Both the M3 and BB derive edge from both Theta and Delta but the emphasis in the BB is much more Delta. The BB carries much higher Delta limits than the M3 and that is why it can max loss on a relentless rally where Theta never contributes enough to counteract Delta while the M3 will break even or have a small loss. The BB however is capable of producing profits on a big early move down on Delta while the M3 will struggle because Theta has not had enough time to inflate the tent. Conditions are always changing but you can look at a chart of the underlying and the price and Delta of the butterflies and get some pretty good hints on trade planning; that after all is what the M21 program is all about.
  8. DavidF

    DavidF Well-Known Member

    Hi Andrew, I think it´s either the 15th or the 22nd of Oct round table, both are well worth listening to.
    ACS makes some good points, underlines what I mean that an edge is only specific to what you compare it with, e.g., BB vs straight short is theta, BB vs M3 is delta (and scaling in).
    As you know price on entry is key and you get a great price if vol. is high. But if vol is high there´s also a higher chance you´re putting it on at worst possible time, i.e, when price is at a trough. Hence newer BB/M3 trade variations now going further out to 70 days to get cheaper price without necessarily the associated vol. Makes me wonder if the cheap price you get on a BF for taking time risk is more favourable than an identical cheap price you´d get for taking volatility risk.
    Last edited: Dec 31, 2015
    Timo likes this.
  9. Chuck

    Chuck Active Member

    I like the risk management and adjustments of the BB. It is adjusted to win; so many other trades are adjusted/managed based on playing defense.

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