Wednesday, September 30, 2009

The Trader Development Stage Model and the Jump from Stocks to Options

First, thanks to all who commented or wrote to me about the trader development stage model, I was quite surprised and heartened by the response.

When I was in the process of assembling my initial draft of the trader stage development model, I had in mind a novice trader that was focusing primarily on stocks, but perhaps occasionally trading ETFs. With respect to options, my sense is that for the most part, novice traders avoid options entirely or take an occasional gamble on a potential big winner by buying out of the money calls or puts.

Looking at the model, however, it quickly dawned on me why so many traders have trouble making the transition from trading stocks to trading options. I asked myself two questions:

    1. What is the motivation for a stock trader for jumping into trading options?
    2. How far has the trader progressed in terms of the stage development model at the time he or she decides to trade options?
I suspect quite a few beginning traders get frustrated with some of the stage one issues associated with entries, leverage and position sizing and before coming to terms with these issues, they decide that stocks just aren’t the right trading vehicle for getting rich in a hurry. Attracted by the leverage potential of options, these traders make the jump from stocks to options and in so doing, simply magnify the cost of their mistakes. Of course, this is absolutely the worst way to approach options. Almost without exception, traders who follow this course of action succeed only in accelerating the time it takes to blow out their account.

The situation is only marginally better for traders who make the jump to options after advancing to stage two and are grappling with how to cut losses while letting winners run. With options positions much more volatile than stocks and spreads much wider, many of the exit strategies that work well for stocks do not work as well with options. Further, some traders become confused about whether to use the options, the underlying or both as their cues for when to exit. On a personal level, while I think mastering the art of exiting positions is a critical success factor for anyone who trades stocks, I found that porting the lessons I learned about stock exit strategies to options was nowhere near as easy as I had hoped.

Even for those traders who have reached stage three of the development model, options will be difficult to trade profitably, but these traders should understand most of the hurdles to success and what it takes to overcome them. Still, edges that work for stocks don’t necessarily work for options and risk management becomes much more complicated and difficult.

The bottom line is that for those stage three stock traders who are interested in augmenting their trading with options, their time and effort will likely be rewarded. On the other hand, for those traders who are still mired in stage one and stage two of their development process, options are almost certain to be a disaster and result in large losses.

If you are thinking about making the jump to options, make sure you undertake an honest self-assessment before diving in and be sure to make risk management your number one priority.

For some related posts, readers should check out:

5 comments:

Patrick said...

While I thought your model was interesting I'd say a lot of caution professionals may express toward heavily using options is that counter-party risk is an increasingly real specter over these trades. What happens if major broker/dealers are exposed to gross amounts of short risk on gamma positions and get hit with 100-year-flood type losses, rendering them bankrupt? Who can you trust to not be vulnerable to the rest of the financial system?

Personally I'm looking forward to when CDS contracts start being exchange traded.

keithpiccirillo said...

You sure play to the level of your competition Mr. Luby.
LOL.
This second post is the higher level most of need to see, similar to a Dr. Steenbarger blog. Most of your Vix blogs are quite complicated, but then you impressed me greatly with the YUM/swine flu analysis a while back.
I'll stick with stocks for now and gradually pile on the Gladwellian 10,000 hours and wait for a real bull market before I enter the options foray.
Thanks.

Mark Wolfinger said...

"edges that work for stocks don’t necessarily work for options and risk management becomes much more complicated and difficult."

This is an interesting point of view, worth discussing.

I agree that risk management becomes much more complicated. After all, when you own stock, there is only one variable to manage, and that's delta.

The beauty of options is that risk can be quantified by using the "Greeks." The question becomes: does the ability to sue the Greeks to measure risk make things more or less difficult to manage?

Can something be complicated, yet not difficult? I believe it can. Option traders can manage time decay, volatility risk, delta risk. And they can go further and manage second derivatives such as gamma.

Risk is easily reduce with options. Bill, I agree it's more complicated that stocks, and it's more difficult because there's more to learn. On the other hand, does the ability to manage risk on several levels make it less difficult to be profitable?

Patrick said...

@Mark: I respectfully disagree. Black Scholes is an intellectual albatross and is regularly arbitraged whenever an option can be bought from a dealer pricing with the model and then sold into the open market based on actual demand. The quantitative risks of options only hold true most of the time, but when you get these tail events that seem to happen quarterly but are only supposed to happen every 100 years, then you can get burned very badly, especially if you are short and your hedges don´t work all of the sudden.

Bill Luby said...

Thanks for all the comments.

Mark, I am inclined to agree that using the Greeks actually makes options easier to manage in terms of risk, particularly at a portfolio level. I suspect, however, that most beginners do not get much farther than delta, if they even get that far. Of course there are options positions with defined or limited risk, as well as positions with unlimited risk. Some options traders make sure they always have defined risk positions, so their risks are better managed than a stock trader who fails to put in an automated stop loss order. This is clearly a subject that needs to be explored further. As a matter of fact, I am going to make the Greeks a more important part of this blog going forward...

Regarding Black Scholes and the risks associated with the fat tails, this is a critical point, but one that can be taken out of the equation with defined risk positions.

Cheers,

-Bill

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