C H A P T E R 10
In addition to the numerical evaluation of a potential trade, you should be able to identify and evaluate the reason that implied volatility is priced where it is. This is the point where it is necessary to be on top of recent news stories, sector trends, and behavioral psychology.
Mispriced volatility can only be captured with an efficient and effec- tive hedging strategy. This transforms the options prices from directional bets into a volatility trade. Hedging may superficially look like trading the underlying, but its goal is totally different. We are not trying to make profitable directional trades. We are trying to manage our volatility trade in the cheapest possible way. Hedging makes volatility trading very path de- pendent: It is quite possible to predict volatility correctly and lose money.
This dissonance between being correct and making money makes volatility trading an inherently statistical business.
Trades need to be sized correctly. This means that each trade is evalu- ated according to its projected return and risk, in the overall context of our goals. The same trade will be sized differently by different traders, depend- ing on whether they aim to maximize profits or to achieve a certain specific profit goal each year. We don’t know how each trade will play out, but with experience we can become increasingly confident of the statistical likeli- hood of a trade being a winner. A well-thought-out sizing scheme can turn a string of highly uncertain events (such as individual option trades) into a consistently profitable business.
However, in order to do this you must keep comprehensive, accurate records. You absolutely must know the P/L profile of all your trades. In fact, if you don’t do this, there is really no way you can improve. How can you improve if you don’t even know how well you are doing? Admit- tedly, record keeping isn’t much fun, but having money is fun and keeping records is essential to get it.
This process is necessary but, sadly, doing all of these things is not sufficient. When all things are equal, the trader with more knowledge will do better, but all things are not equal. There are other things that are also essential, and while I cannot really quantify their importance, it is entirely possible that they are even more important than knowledge. What are these things?
EXECUTION ABILITY
Execution ability is the skill that enables us to participate in the trades in which we want to engage. In pit-traded products this could be related to physical proximity to important brokers or even just being a nice guy. The execution edge could also come from speed of technology, connections to important customers, or the considerably less reliable method of reading
a broker, where a trader learns to guess the incoming order from certain physical clues.
In many trading situations, execution ability is the single most impor- tant skill to have. Many traders will have the same rough idea of value.
Those who are best at getting trades will be the ones who make money.
There are some unknowledgeable traders who are especially adept at trade execution, which counteracts many of their other defects.
CONCENTRATION
Concentration is important in trading. Some people are just better at paying attention than others.
Concentration in itself is not enough to turn a nonstudious trader into a winner, but it could be a reason why someone who knows less than you does better than you. Actually, it seems that the more knowledgeable traders tend to be the most defective in concentration.
PRODUCT SELECTION
Product selection is probably the biggest factor in the success of an individ- ual. Are you prepared to move to Singapore because things are busy there?
No? Well someone is. And he will get paid for that willingness. Would you rather be a well-known figure in a complex product or an unknown in corn options? It is common to see ego get in the way of smart, educated traders.
It is far better to be a trader in the sloppiest pit than to grind away in a highly competitive business.
Understanding the pricing model, volatility, hedging, trade sizing, and simple psychology is very important. Technical knowledge must be learned simply because itcanbe learned. It won’t guarantee success, though, be- cause there are other aspects that also need to be present to be successful.
Always remain aware that a model is not a strategy, and a strategy is not a business. Further, be cognizant that a huge part of your success lies in choosing good products to trade. Even the best trader will have a tough time trading a product with little end-user interest, while many mediocre traders have made money by trading busy products. Remember that the aim is to make money, not to show what a great trader you are.
We also need to pay attention to seemingly mundane things like hav- ing good execution software, hardware that is reliable, a comfortable of- fice, and getting enough sleep. However, knowledge is certainly a source of edge. So, all else being equal, the trader with the greater knowledge will be the more successful.
Good luck.
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