To Trade or Not To Trade

Options trading between two parties is, by design, a zero-sum game. To initiate a trade, you should ask what you have more than the party on the other side of the trade.  If you trade for personal liquidity (liquidity trader), you do what you have to do regardless of the rest of the world.

On the other hand, in most cases, asset prices are driven by arrival of new information. Discretionary investors (information traders) only trade when they think they have either more information, or they have better analysis on the same information, than their counterparts.  As both the speed of information transfer and the awesome power of computing have increased exponentially through internet, the advantage on information has quickly disappeared between average investors.

Even institutional and professional investors lose their edge quicker than they would like to.  The so-called “high frequency traders (HFTs)” of large hedge funds, trading in 1/1000 of a second, have got to the point of “just picking up pennies from the sidewalk.”  Nowadays, there are proposed regulations that disallow hedge fund HFTs from putting their computer servers on the exchange floors to gain that 1/100 of a second advantage over average investors.

Most of us should also be wary about “first finder biases.”  Just because you just heard of some supposed “breaking news” from CNBC, we often have the illusion that we are the only one or the first one to know it.  It will be dangerous to act on it as the market almost always overreacts in the short run.

As most futures markets, especially metals, energy, commodities, and financial futures, the underlying asset prices are known to follow long momentum cycles, e.g., 3-5 years.  The obvious implications to momentum futures traders are (1) timing to get in is not that critical, and (2) once in, stay in for the long haul.  Both suggest not to over trade.

Even for a mean-reverting market with volatility increasing when approaching the release of important public news events, novice investors with no advantage are doomed to “buy high and sell low.”  The market volatility can easily “whipsaw” you out of 2-3% a day.

Even if you have a legitimate trade in mind, you have to consider the expected return net of all execution cost.  In addition to the standard commission cost, options investors will need to pay the bid-ask spread to the other side.  Even for the liquid Apple Jan 2017 105 call, the bid premium is $7.90, and the ask premium is $8.05.  Adding a $2-3 round-trip commission cost, the execution cost is around 2-3% (= ($2.5/100 + $0.15)/8) just to get in and out, excluding any significant market impact against you large traders.

How often does Apple stock move 2% a day to your favor?


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s