Article Summary
- Beginner traders often dive straight into the technical aspects of trading and burn out. The most important thing when first starting out is having fun and discovering what you like to do.
- After traders find a niche that is both profitable and enjoyable, traders (driven by curiosity) will naturally want to learn everything about trading.
- Advanced traders love doing the things that make them successful.
Introduction
When a new trader asks for advice on how to start trading, we often become too focused on a new trader’s technical skills. We try to teach traders how to enter and exit positions, options theory, and risk management. However, this is not always a practical approach.
If you’ve read psychologist Dr. Brett Steenbarger’s book Enhancing Trader Performance, he compares the novice trader to a young couple on a first date. Imagine expecting a couple on a first date to get married—wouldn’t they need more time to get to know each other and prepare for such a commitment? The same could be said for traders; expecting them to master everything about trading without giving them enough time for development can overwhelm them.
The Phases of Learning
Research has shown that expertise is a process that develops over time and progresses in stages. For example, a University of Chicago study found that superior performance in athletes emerge across three distinct stages.
The early phase of expertise is characterized by play and exploration for fun, with someone being initiated into the activity in a social context. During this stage, performers are encouraged and supported by family members, instructors, and peers, with success offering a feeling of specialness that sustains motivation. At this point, teachers or coaches provide positive feedback and structure learning in a supportive manner.
The middle phase focuses on developing competence and learning new techniques. Again, coaches and teachers are vital here, providing feedback and creating an environment for the student to practice. During this period, individuals develop competence and pride in their development as they begin to excel.
The final phase of mastery involves a commitment to self-development beyond just competence, often working with a mentor who specializes in working with elite performers. Intensive practice occupies a large part of each day, intending to internalize complex skills so that high performance levels become routine. At this point, the pursuit of excellence has become an intrinsic motivation for the performer.
The Importance of Having Fun
The idea of this study is that traders must begin exploring and having fun before they can achieve elite performance – experiencing trading without pressure or expectations. By allowing themselves to explore, traders can determine whether or not they should move forward with dedicating themselves fully to trading. Unfortunately, this concept is often looked over or forgotten within the trading world, where people are expected to dive right into things without taking the time to establish a connection with what they’re doing beforehand.
Two factors were crucial to the earliest initiation phase of performance development: (1) having fun and (2) obtaining support from the social environment. Without the initial fun factor, we would never be motivated to do the “grunt work” required to get good at trading. Part of the fun is also the praise and attention from family members, friends, or teachers. The combination of early success and early encouragement provides the motivation for future development.
How to Learn Trading
1. The Exploration Phrase
Before getting to the grind, traders must experiment and explore what they’re good at. Beginner traders are mostly motivated by the novelty of the capital markets and want to find out the possibilities of options trading. Of course, this assumes that these traders are testing profitable trading strategies and not betting on stocks based on the RSI or something. SSRN is an excellent source for potential trade ideas, as many academic publications document tradable market phenomena. There are many ways to trade options, but popular ways include directionally trading options and volatility trading.
Options Strategy #1: Using Options for Directional Trades
Suppose you are pursuing a strategy that relies on options to express directional views. In that case, most of your effort should go into researching and gathering data before you even consider implementing option trades.
After your research has uncovered a trading opportunity, you could start by betting purely on the direction of stock prices with single calls or puts and even debit or credit spreads. You could also bet on the distribution of stock prices; for example, OTM SPY puts tend to be more expensive since stocks generally rise slowly but crash downwards. If you were only slightly bearish, you could buy a put debit spread, taking advantage of the fact that you’re buying cheaper ATM puts and selling expensive OTM ones. If you expect a binary event where the stock will move in either direction, an ATM butterfly or iron fly might be a good trade.
Directional trading strategies can include using debit or credit spread to trade the “Post Earnings Announcement Drift,” a phenomenon where stocks that make a large move after earnings announcements tend to continue trending in the same direction for days or even weeks after the event.
Options Strategy #2: Volatility Trading
Volatility trading involves trading implied volatility levels rather than the underlying stock’s direction. There are a lot of different trades in this category. Some volatility traders look for stocks with elevated levels of implied volatility relative to their forecast of future volatility. By selling delta-neutral straddles, for example, they know they will (on average) collect more in premium than it costs to delta-hedge. This is known as “reverse gamma scalping.”
Other volatility traders take this to the next level by trading the relative levels of implied volatility between different stocks. For example, perhaps one energy company has a much higher IV than its competitors. Buying the cheap options and selling the expensive ones allows traders to capture the relative price differences and helps hedge against the broader market.
Volatility Trading strategies include selling straddles before earnings announcements, where they tend to be overpriced on average. An advanced strategy might include trading straddles on an ETF based on its implied volatility relative to its constituent stocks.
The 2 Types of Retail Trading Strategies
No matter what successful strategies retail traders use, they typically have one of two different return drivers; risk premia and price inefficiencies.
Return Driver #1: Risk Premia Harvesting
Risk Premia Harvesting is an investing strategy that seeks to generate returns by taking on certain risks that are typically rewarded. The premise of this technique is to expose one’s portfolio to a diverse range of risk sources and prudently manage these risks. An example is the 60/40 stock/bond portfolio, where the investor is compensated over time for bearing market and interest rate risk. Remember that not all risks are rewarded; the investor, in this case, is compensated for providing equity and debt capital to corporations. Daytrading 0 DTE options are unlikely to be compensated, no matter how risky.
Risk premia harvesting should be the core of every trading business since this is the most reliable form of edge. Options traders, for example, can harvest the volatility risk premia – the tendency for implied volatility to be too high to compensate sellers for bearing gamma risk. Likewise, selling options before earnings announcements fall under this category – traders are bearing the risk of an earnings blowout on behalf of option buyers willing to overpay for insurance.
Return Driver #2: Inefficiencies
Inefficiencies often occur due to various behavioral or structural factors that cause them to be too cheap or expensive at certain times. Inefficiencies can pop up during special events like IPOs and earnings announcements. Other trading strategies, such as statistical arbitrage, look for inefficiencies at all times.
Because these inefficiencies tend to have a lot of variance, these trades must be analyzed over a large sample size. This can be difficult for novice traders with little experience. For these edges to be traded effectively, it is essential to understand why the inefficiency exists, metrics that quickly recognize when the inefficiency has disappeared, and patience and discipline when dealing with small, noisy edges over long periods of time.
Post-earnings announcement drift is an example of a price inefficiency – where the information of earnings announcements takes some time to be fully priced into the stock price.
2. The Learning Phase
After the trader has discovered what they like to do and what they’re good at, they can dive deeper into the techniques and theory of why their strategies can be profitable. Traders are here when they are motivated to learn more out of curiosity and are proud of their development.
While novice traders may trade options simply based on their belief that the stock will trade within or past their breakeven prices, intermediate traders may want to learn more about the mechanics of how options work; namely, the Greeks and how option values are affected by stock prices, implied volatility, and time to expiration. In addition, traders may also want to study concepts such as the implied volatility skew, term structure, and implied correlation to better understand how options are priced relative to each other.
Books such as Natenburg’s Option Volatility and Pricing, and Hull’s Options, Futures, and Other Derivatives are well-regarded textbooks that educate traders and business students alike. In addition, Euan Sinclair’s books Option Trading, Volatility Trading, and Positional Options Trading are also excellent resources.
3. Mastery
Advanced options traders are obsessed with improving their skills. After gaining a basic understanding of profitable options strategies, advanced options traders work on improving them. For example, while selling options over earnings is profitable on average, some data analysis might show that we should focus on a certain subset of profitable stocks. We could also discover that the best time to sell options is not 3-5 days before the earnings announcement (as outlined in several academic papers) but the day before. They might also apply a proven strategy (earnings trading) differently (selling before commodity reports?).
Traders can also develop their own trading strategies. This typically requires a good understanding of the capital markets and at least one programming language. By backtesting theories about the market (do pension funds affect options skew by systematically selling covered calls?), they can support their intuition with data analysis. The advanced trader never stops improving, as some strategies lose their profitability over time. By constantly developing new ideas, they transition from a hobbyist trader to one that puts food on the table.
The most important characteristic of advanced options traders is that they love what they do. They like research, data analysis, and statistics. The routines that create successful traders are the routines that these experts love doing.
Conclusion
The path to expertise is a long, rewarding, enjoyable journey. By understanding the three stages of this process—play, competence, and mastery—you can create an environment where individuals passionate about their craft can reach their full potential. With the right guidance from mentors, teachers, coaches, and peers, you can unlock your inner expert and truly excel at whatever you’re pursuing. So if you want to become an expert in something new or brush up on existing skill sets – start playing today!