Wednesday, March 7, 2012

Day Trading Options - Contest Risk

This is a follow on from the previous post Options and Day Trading.

Firstly, let me define what I mean by contest risk, as it is not a term that is generally used in retail trader land. It is simple the cost of playing the game, in other words, the cost of commission plus the bid/ask spread.

It can be simply quantified by asking the question - what would be my loss if I entered and exited straight away and there was no movement in the underlying. So if the bid/ask spread on a stock was two cents you would lose that two cents in the trade, plus commission. If commission is one cent a share, the total contest risk is four cents a share, or $4.00 per hundred shares traded.

In the aforementioned interchange with my profane friend, he cherry picked a profitable trade where he purportedly made a $3,000 odd profit. Nice when looked at in isolation. But lets dig a bit further:

He told us he traded 27 x 1000 share contracts (the contract size in Australia at the time) = 27,000 shares of underlying, with a delta of approx 0.5 giving a total number of 13,500 deltas.

 The bid ask spread is typically about 5 - 8 cents... lets say 5 cents to be generous. That is 27,000 x $0.05 = $1,350 This means that if the share did not move and he exited, it would have resulted in a $1,350 loss PLUS commission.

It also means that the underlying has to move > 10 cents just to break even (remember our 0.5 delta) That's a massive impost to overcome in a daytrading system. Now compare that to Shares or CFDs, where to gain the same 13500 deltas, we only need 13500 shares with a spread of typically 1 cent.

That's $135 plus commission contest risk. In this instance the options are 10 TIMES more expensive to trade in terms of contest risk. Daytrading sytems, if positively expectant, are not greatly so, because you never get huge outliers. They rely on trade frequency to make money.

Maybe Bill is a good enough trader to overcome 10x contest risk, maybe not, but are the people he teaches?

I know I'm not a good enough day trader to overcome that sort of contest risk over the long term and I would bet London to a brick and Mombasa to a melon that very very few retail traders can overcome this either.

I have had the gamma argument thrown at me which if it moves enough can help, but countering this is theta, which depending on time til expiry and time of day can work against you. Over the great bulk of trades, it's line ball on those arguments in my opinion.

An important point is that our friend operates on the Australian stock exchange where there is much less liquidity and wider spreads than most US tickers. On the American exchanges there are options with much skinnier bid/ask spreads and if feels they must day trade options, that's where I would be looking...

...but for me, I'll just trade the underlying when I'm day trading.