Friday, February 28, 2014

So you're a premium seller, huh? 

Just love sellin' that juice. 

I'm guessing you've seen this graph before showing the exponential decay of an option's value at 30 days to expiration:

Let me take another guess: After viewing this curve you immediately rushed out to fund an account and started selling far OTM call and put spreads hand over fist at 30 DTE faster than you can say, "tail risk"?

You might have planned your early retirement next.


However, do you know what the biggest mistake most premium sellers make is?

No? Well, that's obvious because you just made it.

In regards to trading options, the expressway that leads to the divine destination of consistent profitability is a long one filled with roadblocks, speed bumps, frequent pile ups, and many off ramps for those lacking discipline, fortitude, and ice in their veins. That road often starts with a new trader learning about what an option is, how to read an option chain, and the pricing model which typically leads right into two potentially dangerous topics:

1) Probability & The Bell Curve
2) Time Decay

These two topics are dangerous for many reasons, many of which are beyond the scope of this post. However, I will touch on one of those reasons. Back to the point: Anyone that has gone through the basic teachings on these topics typically makes a grave mistake. This sets me up nicely to finally answer the question, "Do you know what the biggest mistake most options premium sellers make is?

They sell far OTM options and expect the time decay to behave like ATM options. 

Classic rookie mistake.

It often sounds something like this, "Why the heck won't these far OTM options decay?! The theta just isn't coming in like the model shows it should. They are just sitting there and the market makers are killing me because they won't fill my order to take them off at $0.05. What the heck?!"

When selling far OTM options be it calls or puts you MUST understand that the time decay is going to behave much differently than your classic ATM 30 DTE exponential time decay graph. Jim Bittman does a superb job at making this point in his classic book Trading Options as a Professional and Mark Sebastian of Option Pit fame reiterates this point in his fantastic book The Option Trader's Hedge Fund on page 94 when he says, "There is a flawed belief that option time premium decays exponentially across all strikes in the final 30 days of an option's life. This is completely flawed; in the final 30 days, studies show, only ATM options decay exponentially."

Far OTM options not only decay much differently but they also tend to hold onto their value as expiration nears. To make it more clear, theta decay for ATM options accelerates exponentially in the final 30 days to expiration but theta decay for far OTM options actually decelerates in the final 30 days to expiration. Time decay for far OTM (around 10 delta) options tends to look more like this:

That is a much different picture than the previous graph and understanding how theta decay is different among various strikes and day to expiration is going to be instrumental in your success as a trader. I cannot stress this enough. If you are going to sell premium, you must understand the differences.

This information is all well and good, but information is absolutely useless without application or action. Let me repeat, INFORMATION IS ABSOLUTELY USELESS WITHOUT APPLICATION OR ACTION.

So, what's the application of this information?

Easy. When selling far OTM options you should be selling them with more than 30 DTE and often closer to 60 DTE or more and you should be taking those positions off by the time you get around 30 DTE. By doing this, you will be taking advantage of the the way far OTM options behave in terms of time decay and all other factors remaining consistent you will be getting the most time premium decay possible on a per day basis.

When I sell far OTM options I tend to sell anywhere between 50-70 DTE and I'm out of those positions by 30-45 DTE. Armed with this new information, next time you are going to sell some far OTM premium check the days to expiration and ask yourself: Is this the optimal position?

It might be, then again - you might just be making a classic rookie mistake.

Friday, February 21, 2014

Analysis Paralysis, Thinking Too Much, and Other Psychological Traps Preventing You From Profits

Are you sabotaging yourself and crushing any chance at consistent trading profitability? 

Not sure? Read on to find out: 

Are you relatively new to trading?

Wait, let me guess: You have put in the time reading books, watching webinars, and learning all the knowledge you can but you just haven't been able to maintain a profitable trading system. 

Even better, you are a veteran trader but your old strategies just aren't working any longer due to market conditions. 

You sit at your computer staring at your Livevol X or Livevol Pro screen, there is a LOT to take in. You have quotes constantly being updated, charts, order flow, a list of positions, etc. Copious amounts of information are overwhelming your senses. You have some free capital and want to trade but instead you sit and stare. You check the charts again, draw in some trend lines and support/resistance points. You add a few more technical studies. You ponder. You check the volume, open interest, and analyze the expiration graph for the 10th time. You say to yourself, "Wait, let me just check the news and upcoming events." 

Sound familiar? We've all been there. From newbie to veteran and even pro traders. We've all had to deal with the psychological trap of analysis paralysis at some point. Sometimes taking that first action step is the absolute hardest part of the journey and this especially true with new traders or traders that haven't had much consistent success in the past. 

As I struggled to come up with the "perfect" topic for my first official blog post I thought about and scratched a long list of otherwise great ideas from theta decay at different deltas to the importance of getting a good fill and how to work the market. Instead, I decided that in the wake of my utter struggle to take the first step and write this post I'd address the elephant in the room and write about how thinking too much can actually be a problem and is a huge hurdle for many traders - especially new traders. 

Early in my trading career, like most, I struggled mightily. I was inconsistent, I jumped from one idea to the next, and I couldn't maintain profitability. I found myself making 10% in one month only to give it all back and then-some in the next month. I'd put on 5 trades in one expiration cycle and 1 or none the next. After struggling with this for a few years I discovered I was literally sabotaging myself by over-thinking, trying to outsmart the market, consistently deviating from my trading plan, and worse of all - freezing up and taking no action at all the wrong times! 

Good news! It's NOT your fault. Let me repeat, it's not your fault. Your brain is wired in this way and unfortunately it will always be this way. Better news: There is something you can do to overcome it. 

The part of your brain responsible for this psychological trap is often referred to as the lizard brain, reptilian brain, or old brain and it's found at the stem of the brain near the top of the spine. This is the part of the responsible for survival, reproduction, and our fight/flight response. This is the part of the brain that tells you to re-think that trade, to look at more indicators before putting anything on. It makes you think you need to read another book or watch another webinar to get just a little more knowledge before taking action. It also makes you think about and focus on losing, which in turn prevent you from taking action and actually trading. 

This part of the brain is also responsible for another concept that paralyzes you at the wrong time: Loss aversion. Loss aversion has been well documented and study after study has proven that we humans want to avoid a loss far more than we want to win. In fact, research shows humans have a loss aversion ratio of anywhere between 1.5-2.5. That means for every $1.00 we lose on a trade, we need to make $1.50 - 2.50 to equally offset the emotion of that loss. Loss aversion can lead to a whole host of problems, but in this context the problem it often causes in traders is an inability to put on trade or adjust a trade according to your trading plan. 

What can you do to overcome analysis paralysis, stay consistent with your trading, maintain profitability, and continuously take action that will lead to success? 

I have a four step process that will put you on the fast-track to profitability. It worked for me and although I'm not providing guarantees because I'm not a car salesman and I'm not selling anything, I can tell you that this system is based on proven research in the field of psychology. 

1. Create a Plan

Create a plan? Seriously, didn't you just say that this crazy part of the brain that is sabotaging my results causes me to go off the plan? What's the deal? 

Yes, I did and that's why this is only step one. A plan is going to remove the element of thinking and lead to instant action which can help in the creation of powerful habits that will help you stay consistently profitable. It removes the guesswork and allows you to take action without over-thinking and ever succumbing to the analysis paralysis problem. 

There are two types of plans as I see it: 

1) An overall macro plan for your account that answers such questions as: How many trades will you put on at any given time? How many contracts or what size are you going to trade? What strategies are you going to put on? When will you look to put on different strategies (60 DTE, 30 DTE, etc.)? How will you fish for trades? 

For example, part of my portfolio plan is a far OTM put spread strategy I put on anywhere from 70-50 DTE. So, at 70 DTE I start looking at the skew and juice in the far OTM put options in the RUT on a daily basis until I find optimal conditions for my put spread strategy. Whenever I see 70 DTE I don't even have to think about what I'm going to do anymore, I just act and I go check the skew and see how much juice is in those far OTM put options for selling. It's a habit now and a good one. 

2) A micro strategy or trade specific plan for entry, management, and exit of a particular position that will answer such questions as: What are optimal conditions for a certain position or strategy? What's a good price? When will you enter? What are you going to do with your position when you are down 10%? What's your profit target? When are you going to exit? Will you let those short options expire or buy them back? What are you going to do if the market open up/down 2 standard deviations tomorrow? 

For example, I have criteria outlined for entry of various strategies and I have a plan written down for the management and exit of the position BEFORE I ever put the trade on. This again, removes any barrier of thinking of too much and if nothing else just keeps me in the game. This is a very powerful technique. Now, when the market opens up or down 1.5-2 standard deviations I don't panic because I already know what I'm going to do. I don't have to look at a dozen indicators, weigh my options, check the charts, etc. I already did those things and I'm prepared to take action so I do it and do without the paralysis of analysis. 

Especially as a new trader, I cannot emphasize this enough: You MUST have a plan in place for these scenarios otherwise you will freeze up and take no action or over-think the situation and take the exact wrong action when it is precisely the time that demands quick, precise, and deliberate action.

2. Add Accountability

What are you going to do if you don't follow your plan from step one? How will you hold yourself accountable and enact consequences for not following through? A trading partner, trading group, or community like the Livevol Community are perfect for accountability. Use them to your advantage to set yourself up for success. Check-in regularly, tell people what you are going to do, then be accountable for your actions. If you didn't put on a weekly SPX Iron Condor like your plan calls for, why not? You better be able to explain. 

If you follow through and stick to the plan, celebrate your success even if the trade is a loser. Give yourself a pat on the back. If you didn't, do NOT pretend it didn't happen and do NOT beat yourself up. We are all human and make mistakes. Admit it and examine why you failed and put in place processes that will help you succeed next time. 

3. Visualize

Visualize yourself taking action and performing the actions you listed in your plan. Michael Phelps, the most decorated Olympian in history would visualize himself swimming his perfect race each night before he went to bed. He also used it to play through scenarios of how he would react and what he would do if things didn't go as planned. For example, Phelps set a world record at the Beijing Olympic games and took home the gold despite the fact his goggles filled with water during the race and he couldn't even see. 

How did he do this? He had already visualized this previously and knew exactly how to handle this situation. It is a technique many very successful people use and attribute to their success. Additionally, visualization has been shown to increase your ability to take action and avoid the analysis paralysis problem. Visualize yourself putting on a trade, going through the mechanics of working the order, getting filled, making that adjustment when the market it down huge, etc. It will increase your odds of sticking to your plan and will allow you to take action instead of staring at your screen with information overload.  

4. Tell yourself it's okay to fail

Lastly and maybe most importantly, you have to understand that failure is going to be part of the process. Even the best strategies with the highest odds of winning occasionally lose. You must understand that a losing trade is not only okay, but actually a good thing! 

Uh, did you just say that putting on a dog of a trade is a good thing? 

Yep. Because it is an opportunity to learn, correct mistakes, and put in place processes or procedures to avoid them in the future. It's a chance to become a better trader! Think about it, how much have to ever learned from a trade in which everything went perfectly according to plan? You put the trade on in the perfect market conditions for the trade, the market acted as expected, you didn't have to adjust, and you took the trade off for your profit target. That experience, while it makes us feel good doesn't really make us a better trader. Anyone can do that. 

What separates the good traders or even the great traders from everyone else is being able to deal with failure, being able to manage the position when things don't go according to plan, and constantly getting better by learning from previous experiences and mistakes. A losing trade is a perfect opportunity for a post-mortem analysis to get better at the craft of options trading. Don't waste those opportunities. Your account balance will thank you.