Trading options - How to have an edge?

C

crayon851

Hi, I'm still new to trading. I basically broke even in my first year of trading options, made a little profit, but nothing to celebrate over.

What I've read online:

1) low vol = you should buy spreads, high vol = sell spreads

2) options/market movements are based on probability (normally distributed - with a slight skew)

3) you should sell credit spreads when IV rank is above 50%.

My questions:

1) assumption, option pricing is based on supply and demand. If this is true, if everyone is applying rule number #1, then shouldn't there be no edge/benefit to buying or selling spreads based off the current levels of vol since everyone is doing the same thing? So, there should be no edge in pricing.


2) Assuming the market is probability based, shouldn't your minor gains from credit spreads be offset by the tail risk?

3) has it been definitively proven that the market is purely random? Aren't there instances where the news affects the price positively?
 
Celebrate - that might be a good result.

very briefly...
1) not everyone applies rule number 1. Option prices are relative to other option prices --- that is usually where an 'edge' is.
2) which is why the expression picking pennies up in front of a steam roller came about.
3) keep reading :)

Options are about transferring risk....sometimes the risk is not worth it no matter the price, other times as you have increasing risk, you should be paid for that...but you are often not. ....even if the market is random can you manage to get enough of an edge to compensate for that, and if its not random can you get paid enough - and survive when wrong - for taking on the risk when required.
 
SIUYA said:
Celebrate - that might be a good result.

very briefly...
1) not everyone applies rule number 1. Option prices are relative to other option prices --- that is usually where an 'edge' is.
2) which is why the expression picking pennies up in front of a steam roller came about.
3) keep reading :)

Options are about transferring risk....sometimes the risk is not worth it no matter the price, other times as you have increasing risk, you should be paid for that...but you are often not. ....even if the market is random can you manage to get enough of an edge to compensate for that, and if its not random can you get paid enough - and survive when wrong - for taking on the risk when required.
More...
 
If edge is about direction then it does not matter about all the other factors so much... you simply pick the instrument that will give you the most bang for your buck.
I have said it before, and repeat.....edge when talking about options is often incorrectly/poorly used. Option pricing edge v trading strategy edge are 2 completely different things. You can trade volatility without trading price and vice versa...if your egde comes from picking direction, then Q 1, 2, and 3 are arguably irrelevant.

Keeping it simple.....Once put call parity is understood and that risk can be synthetically replicated using various options and underlying combinations then its a simple matter of saying --- which is the cheapest way for me to replicate my directional view, that over the long term will give me the risk return profile I want.
 
SIUYA said:
Celebrate - that might be a good result.

very briefly...
1) not everyone applies rule number 1. Option prices are relative to other option prices --- that is usually where an 'edge' is.
2) which is why the expression picking pennies up in front of a steam roller came about.
3) keep reading :)

Options are about transferring risk....sometimes the risk is not worth it no matter the price, other times as you have increasing risk, you should be paid for that...but you are often not. ....even if the market is random can you manage to get enough of an edge to compensate for that, and if its not random can you get paid enough - and survive when wrong - for taking on the risk when required.
More...


do you have any recommended readings?
 
I just trade stocks and etf's but recently started with options, Still learning so a long way to go...But have been doing really well this current quarter..im in the room called pristine method trading room, so there is a moderator in there who does options for swing trades, so learnt a lot from him
 
readings for what - there is a lot of ground you want to cover?
random markets, option pricing theory, market supply and demand dynamics for market markers.....

There are plenty of books recommended by others....but there is no substitute for making your own notes and scenario testing with option portfolios using a good system. There is also plenty of info on the web.....but I would take with a grain of salt when people say things like - only buy this or do that when this occurs. rules of thumb exist but you want to understand why they exist and understand they are generalisations and that is all.
A lot of this is about really understandng the basics and then being able to see how others apply it, and understanding mostly when it does not work. Options are great in that someone can sell you an option and make money and you can buy that option and make money.....this is about risk transference
 
I think daniel is correct.

Edge comes from superior knowledge, be it fundamental, insider or technical. You need to come up with a fair value first for the instrument, even if you're just trading volatility. With a pricing model, after you figured out the fair value, you can then sell or buy an option that is over or undervalued respectively, and hope for a mean reversion or you keep delta hedging to expiration to capture all the volatility premium.

But, you can still get destroyed if the instrument moves quickly against you. So ultimately you need to get the price movement of the underlying correct too because there is no such thing as perfect continuous delta hedging, especially not for gap moves and the fact options market only trade during market hours but the underlying can continue to trade in extended markets and often gaps.

Also, your pricing model can be wrong so the real trick is the part about figuring out fair value. Sometimes, options are high implied volatility for a reason. Its maybe because someone with superior knowledge are buying those options that may raise its volatility and you the seller using your pricing model may end up losing.

Case in point, HLF one day prior to Ackman's presentation that caused a huge end of day sell off. Something was going fishy with the options premium already. An options seller might think some of those options were overvalued and were willing to sell. But because whoever was buying puts might be the ones off loading the underlying too, they had superior knowledge of what they were gonna do and their actions on the price, so sellers would have gotten destroyed as HLF started tanking heavily towards the close.
 
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crayon851,
your best recommended read at this point may be your own "book"
if you have a years worth of trading, have you been doing a journal or keeping notes or a log?

when doing option trades I keep track of the following main items, (note that I mainly trade stocks using options, i don't usually "trade options" as some of the purists here insist is the only way to use options)

what strategy is being used, spread, long or short call or put, etc
what underlying is being used
what is the plan, ie, buy 3 mo. delta 20 call on HPQ, expect 3% rise in stock, 80% gain in option
what is my edge, have I used this strat or underly before? do I have a good entry based on T/A?,
what is the trade management, watch for chance for profit taking, close if option drops 30%
what was the result, win, lose, or learn

your book should point you in the direction of what works for you,
what strategies and underlyings are best for you

in my years of option trading I have found that what works changes and simple is better
and bull markets let everybody think they are a genius, unless they are a bear and then they think they are just early and everyone else is a fool.
 
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