Every trader dreams of finding the secret formula for making consistent profits in the market. And while it may seem counterintuitive, many successful traders are willing to share their strategies with others. So why would they do that?
One important concept to understand in the context of trading strategies is the difference between beta and alpha. Beta refers to the return on an asset attributable to market movements, while alpha refers to the excess return on an asset above what the market provides. In other words, beta is the return you would get simply by investing in the market, while alpha is the return you would get by making smart investment decisions that beat the market.
Some strategies have capacity constraints. In these cases, traders may be more likely to keep their strategies to themselves to maintain their edge in the market.
However, other strategies have a high capacity, meaning many traders can adopt them without losing effectiveness. These high-capacity strategies are more likely to be shared, as there is little risk of oversaturation in the market.
So, what would someone authentically share when it comes to trading strategies? Generally speaking, traders are likelier to share high-capacity beta strategies that many can adopt without losing effectiveness.
On the other hand, traders are less likely to share low-capacity alpha strategies, which may only be profitable for a short time. Some shills may tout these strategies as the secret to making a fortune, but they are often exaggerated or fraudulent.
It’s extremely important that traders can identify which trades are scams and which are viable to implement. We can begin by understanding which strategies people might be willing to share: strategies likely to persist.
Some strategies last a long time because they are risky
Risk premium harvesting describes how traders can be compensated for doing something risky that is useful to the market. The most common examples of risk premia are stocks and bonds. The investor provides equity or debt capital to companies who need it, carries the risk of market crashes, and receives a return on capital as compensation.
Options, on the other hand, are typically used as hedges or a cheap way to speculate. Because options have a limited loss and unlimited profit, investors prefer to hold options rather than sell them. With options, traders can harvest other forms of risk premium.
The most common time options are trades around earnings events. Institutional funds need to hedge their investments, hedge funds and retail traders alike want to speculate on the direction of the stock price, and market makers don’t want to sell that many options right before a volatile event. As a result, there’s a lot of demand but a limited supply of options.
Selling options right before an earnings announcement is profitable on average. You could further improve the profitability of this strategy by identifying which stocks are more likely to have more expensive options. For example, stocks with much retail attention might have expensive options since these traders are not price sensitive. Whether an option has an IV of 65% or 85% does not matter to a punter who wants to bet on the direction of the stock price.
Is it possible that too many people sell options before earnings and removes this earnings risk premium? Sure. But good traders don’t hold risks for free. When profitability declines, many traders will naturally pursue different strategies. Others stop trading because they can’t handle the variance. Demand for options may also increase if they become cheaper over time.
Sometimes, there just aren’t enough traders
Aside from the fact that some strategies are risky, there are situations where traders cannot trade as much as they’d like. These strategies are especially common in commodity options markets where much of the flow is producers and consumers trying to hedge their exposure.
I analyzed a corn meal skew trade posted on r/options by a commodity options market maker a few years ago. Long story short, there was so much put volume one day that the skew flipped. The implied volatility of the puts continued to be mispriced for several days because other market makers didn’t have the margin to sell more puts.
In a research paper, Professor Ing-Haw Cheng explores the relationship between hedging pressure and commodity option prices. Cheng’s research found that hedging pressure pushed prices around so much that traders could build a profitable trading strategy inversing the trades in COT (Commitment of Traders) reports. More importantly, this strategy is most profitable when selling puts, likely because they require more margin.
The volume from commodity hedgers is so large that there weren’t enough people to meet their demand. Imagine how much capital you need to stop billion-dollar corporations from pushing prices around when they hedge.
Some trading strategies are just too hard for most traders
For retail traders, market-making as a strategy is practically impossible. This is because retail traders lack the capital and technology to do so. Market making is also really difficult.
When I was a Finance undergrad, one of the classes I most looked forward to was Financial Trading Strategies. We had a market maker trading simulation where we tried to post bids and ask prices for just three stocks. I attended a decent school, so I assumed my classmates were smart. Even then, most of our market-making algos were terrible.
Some strategies just aren’t possible as retail traders.
Benn Eifert, Founder of QVR Advisors, talks a lot about QVR’s trading strategies on podcasts and Twitter. One of the concepts he discusses on Twitter is implied correlation.
Implied correlation measures the market’s expectation of correlations between stocks within an ETF. This can be calculated by comparing the ETF’s implied volatility to the implied volatility of the individual stocks.
For example, imagine an ETF with two stocks, and both stocks have an implied volatility of 30%. If both stocks were perfectly correlated, the ETF would also have an implied volatility of 30%. However, if the stocks were uncorrelated, the ETF would benefit from some diversification and realize less volatility. The ETF would have almost no volatility if the two stocks were inversely correlated.
Similar to how implied volatility tends to be higher than realized volatility, implied correlation tends to be higher than realized correlation. A strategy that buys ETF options and hedges with individual stock options makes money over time. However, this is impossible to execute for retail options traders. How can we enter orders for hundreds of stocks and adjust them as the price moves around to trade at the right implied volatilities? How can we execute everything simultaneously so we’re not too exposed to only one side of the trade?
As retail traders, however, we have some advantages. If we find an ETF with an expensive implied correlation, we can just sell the ETF’s options. Unless the individual stock options are underpriced, we’ll have to endure more variance but won’t lose EV (expected value).
Another advantage is that we’re not obligated to put any trades on. Many investment funds are like private ETFs: they are mandated to trade a certain way. A long volatility fund, for example, has to be long vol. Retail traders have no such limitations. We can be pickier about our trades and only trade when opportunities are big.
We can also trade ETFs with less liquidity because our account sizes are small.
Some Strategies Require Data
Trading based on public information (such as past prices, many technical indicators, or fundamental data) is extremely difficult. Retail traders trying to make sense of public information probably aren’t doing a better job analyzing data than the big hedge funds looking at the same things. Many good trading strategies need you to look deeper than what’s on the surface, requiring data that is either expensive or hard to understand.
Relative value strategies involve buying cheap exposures and selling expensive exposures simultaneously. This hedges out the main directional market risks that would otherwise be present in a traditional investment portfolio. This strategy works for similar assets that should have a stable relationship. For example, Visa and Mastercard are similar companies. They should be affected by the same macroeconomic events, are in the same sector, and are generally similar stocks. It makes sense to assume that the volatility of Visa and Mastercard have a stable relationship; Visa volatility rises when Mastercard volatility does, and vice versa. If Visa options are suddenly overpriced compared to Mastercard’s, a trader could sell Voptions and buy MA options as a hedge. This would insulate the trader from broader market movements, isolating the relative prices between the two stocks.
However, even the simplest relative value trading strategies require some way to compare the volatility data of two different stocks. This would require a subscription to historical data, a lot of time, and data analysis skills that not everyone has. This strategy is tradable but would require much time and effort to implement.
Conclusion
While traders may be hesitant to share their trading strategies due to concerns about losing their edge in the market, there are several reasons why some successful traders are willing to do so. High-capacity beta strategies that many can adopt without losing effectiveness are more likely to be shared. Some strategies may be too risky or hard for most traders to execute, while others require data and analysis skills. Understanding which strategies are viable and which are scams is crucial for traders.
In contrast, low-capacity alpha strategies that are only profitable for a short time will likely be kept secret. By understanding which strategies are persistent, traders can better identify opportunities and avoid scams.
Are you feeling stuck in your options trading? You aren’t alone. That’s why I’ve been teaching traders how to run data-driven strategies. If you are interested in my one on one coaching (which comes with access to data and a library of learning materials) then use this link to book a free call with me!