Article Summary:

• It is important to ensure you have an edge before trading options. Edges can be either model or event-driven.
• There are many trade structures you can put on, so it’s important to find the best one given your forecast of the market.
• Size your trades according to how large your edge is. When your edge disappears (either from your forecast becoming true or realizing your forecast is wrong), close your trades.

Introduction

When it comes to gauging your trading capabilities, there are two approaches: evaluating them by the results of your trades or by assessing your methodology.

It is essential to understand that there is a lot of variance in each trade, no matter how experienced you might be. Therefore, evaluating yourself based on results, especially in the short run, might not reflect the quality of trades you take. The win rates of some of the most successful traders barely hover over 50%, but they can still generate huge returns over time. These traders understand that if they consistently maintain and take advantage of their edge in each transaction, their overall successes will show up in the long run.

You can evaluate your trading methodology by forcing yourself to think through every trade and articulate the exact details of everything you’re considering. By doing so, you’ll be able to stay in control of each trade, know what to do in any situation, and be confident that your trade has a positive expected value. This article covers all the details you need to consider before taking any trade.

Breaking down your trade

Every good trade requires four components: mispricing, due diligence, the trade itself, and position management. Sharp traders will notice that the trade and position management are only some things on this list. Instead, the trade itself and position management come as a result of finding mispricing in the markets.

Finding the mispricing

The first part of every trade is finding a mispriced asset, whether an option, a stock, or anything else.  You must be able to identify what the mispricing is to correctly and confidently enter the trade.

For options traders, one of the best ways to do this is to search for mispriced implied volatility.

“Recap:

Implied volatility (IV) measures the expected volatility of an asset’s price over a given period and is often used to gauge the uncertainty surrounding the price movement. Traders also use it to determine whether an option contract is priced correctly or not.”

If there is a divergence between the current IV and what traders consider “fair” value, then there may be an opportunity for a profitable trade. Traders can look to sell options with higher-than-expected IVs and buy those with lower-than-expected IVs.

According to Euan Sinclair, there are two ways to find mispriced volatility: model-driven and event-driven.

Model Driven Trades

Model-driven trades are precise trades driven by your model of options prices. For example, market makers have a model describing every option’s prices. So if they see the 30 Delta calls are a couple of vol points higher than the rest, they can sell them and hedge with 20 or 40 Delta calls.

For us retail traders, trading the overall level of volatility is more straightforward than finding relative mispricing within a stock’s options chain. By building a volatility forecast, we can identify stocks whose options are much more expensive than we think they will be. Our model-driven trades have an edge because options prices differ from what we believe to be fair value.

Event Driven trades

Event-driven trades come from mispricing that stems from earnings announcements, Fed meetings, or other fundamental market movers. Unlike model-driven trades — where we know exactly how big our edge is every time— we don’t necessarily know how big our edge is. What we do know, however, is that these trades tend to make money over time. For example, previous research has shown that options straddle tend to be 2% more expensive than “fair value” the day before an earnings announcement, which means selling them makes money over time.

Of course, just because we’re not using a model doesn’t mean we can’t use data analysis to identify which subset of options are more expensive before earnings – whether that be large-cap stocks, high IV stocks, or meme stocks.

Due Diligence

To accurately assess whether an option’s price is fair, traders need access to a wide range of data to ensure they make the correct decisions.

Implied and Historical Volatility Data helps traders understand whether the current levels of implied volatility match or exceed previous levels of volatility. This data is essential for forecasting future volatility. While the past doesn’t predict future stock price movements, this is not the case for volatility. Volatility tends to cluster in the short term and revert to the mean in the long term.

Current News helps traders identify if there are any special events (such as earnings, upcoming acquisitions, or lawsuits) that could explain the elevated (or depressed) levels of implied volatility.  Similarly, sentiment data helps traders identify if retail sentiment is causing the mispriced implied volatility. A high level of retail sentiment is generally a good sign as they bid up implied volatility when speculating on stock direction. Sentiment data can come from sources such as StockTwits’ measure of sentiment.

By properly analyzing this data, traders can ensure that they have an edge trading mispriced options.

Trade Structure

Once we find a mispriced option, we need to find the right trade to put on – one with the best payoff when our volatility forecast comes true. For example, if we believe AAPL volatility is 5 points too high compared to the rest of the market, we could use many different trade structures.

The most straightforward trade would be to sell a straddle, giving us a trade that profits when volatility falls. However, selling a straddle has an undefined loss, which some traders would be uncomfortable with. The iron condor could be another option – selling a straddle but buying a far OTM strangle to protect against a significant crash in either direction.

Another consideration is hedging, which applies to every type of trading. Let me tell you a story.

While doing my Finance undergrad, I had a trading class that had simulated trading sessions. In one class, my job was to arbitrage* oil prices between Cushing and New York.

Whenever oil was relatively expensive in New York, I could buy oil in Cushing and make a profit by transporting (Piping? Pipelining?) the oil to New York. While this strategy was profitable overall, I was surprised that some of my trades lost money despite buying oil in Cushing for cheaper than oil prices in New York.

After taking a deeper look into my PnL, I realized something: Even though the oil in New York was always more expensive than in Cushing, sometimes oil prices would fall worldwide. This is because I was exposed to the overall price movements of the oil markets.

*not a pure/true arb

If we sell an AAPL straddle, we’re exposed to both the volatility of the stock and the market’s overall volatility. If SPY crashes while we’re short AAPL vol, we will lose money even if AAPL was relatively stable compared to the rest of the market. We could hedge this risk by buying SPY straddles as a hedge.

Our resulting trade (long SPY straddle, short AAPL straddle) would capture the relative mispricing, and we would profit no matter the market conditions.

Position Management

Position Sizing

Traders size their positions according to how big their edge is. For example, the average “beta” trade generally has a small edge, so traders should size small so that any loss doesn’t materially impact their portfolio.

On the other hand, when traders find a big “alpha” trade, they know these opportunities don’t last long. So when we find a trade where we can place a hedged trade with huge payoffs, we have to size our positions as big as we can.

When to close your trade for a profit

Traders must understand that there comes the point when expected profit has been fully realized, and further exposure to the market carries additional risk without any reward. With model-driven trades, we can say, “our edge has come in” when the market value of our options has converged with our estimate of fair value. For event-driven trades, there’s no longer any reason to have open positions after the event has happened. At this point, holding the option (either long or short) no longer has a positive expected value, so we should close our trade.

Closing your trade for a loss

There comes a time when a trader has to admit that they’re wrong – and close the trade for a loss. Similar to how trades no longer have a positive expected value when options return to fair value, sometimes we realize that we missed some critical piece of information, and now we realize that our trade doesn’t have a positive expected value.

For example, if a stock we’re selling options on starts to see greater volatility than we expected for several days in a row, that could indicate that we’ve missed something and options may not be mispriced. A beginner mistake is selling options on a stock and then finding out that a stock is announcing earnings in the next week. If a trader understands that there’s an explanation for why the stock’s implied volatility differs from their initial forecast of future volatility, they should close the trade.

Conclusion

If you want to evaluate your trading methodology effectively, it’s important to make sure you are consciously thinking through every single step of the process. Try to be specific and articulate all of the details, objectives, and parameters that you are considering. Then, by identifying mispricing, performing due diligence, properly structuring trades, and having a plan for position management, you remain firmly in control of each trade and can place trades confidently.

Interested in 1-on-1 coaching for your options trading? Click here to book a free session with me!