Trading financial markets successfully is a very difficult line of work. Most of the methodology presented to the retail trader has little chance of producing consistent profits over the long run. But like many things in life with high potential rewards, many try but few succeed. In this article I will explain one method that might help to improve the odds on the side of the retail trader.
It is important to have a realistic sense of what the market is all about, and to not accept at face value what is promoted by trading educators, chat rooms, and vendors selling trading methods. Most of what is promoted for sale is useless and will put the trader a further distance from the goal of trading success. Most traders that have been in the business for any length of time will not fall victim to the hype, but many new traders are seduced by what seems to be an easy road to wealth. Even frustrated veteran traders can fall into the lure of the hype.
Most trading methodologies presented in chat rooms and so called trading schools try to predict the future by looking at past data, that is data to the left of the current price bar. These traders will spend their time facing backward on the chart, with their analysis looking over the past data, trying to find inflection points where they can draw their trendlines or fibonacci retracement levels, or their indicators and moving averages, often optimized from the very past data they are analyzing. They try to draw conclusions about the future from what happened in the past.
I contend that those market participants that have the financial means to actually move prices directionally are not that concerned about price data from the past, as the reason for those old prices are no longer influencing the current price. These traders are looking forward on the price chart, with their eyes on the current data, and with their backs to the past price data. The movement of prices that seem random to many are caused by traders trying to find areas of accepted value where trade can be facilitated. When new information enters the market prices will move to another level to find a new area of value. Whether that information is correct is not the point. Traders are still reacting to the information at hand and testing the market up and down to find value at that moment. The up and down movement creates a bell curve that can more easily be seen on a market profile chart, and will graphically display areas of price acceptance and price rejection. By facing backward on the chart and looking at price activity at some point in the past, caused by conditions that are no longer relevant, the trader is not listening to what the market is trying to communicate. Viewing a trend on a chart does require looking at past data only as a reference point to the current price, but doing so does not necessarily have any implication for future prices.
So is it possible to forecast future prices, and to make a living trading on those forecasts? Certainly in the very long term there have been some very successful investors who have benefited from the long term direction of the markets and by being able to find the best values within the various sectors. But there can be very long periods of time without adequate upward price movement to be able to make a living from such an activity, apart from taking fees. If one tries to actually earn a living from the market, apart from commissions or fees charged, then trading must be considered, rather than investing. However, the odds of trading success are not great. The very best traders and funds, with very deep pockets, access to information, and with sophisticated proprietary trading models and computer power, most often underperform a benchmark such as the S&P 500. The very best trading systems and indicators have a difficult time getting over 30% winning trades when using any sensible form of profit objective and risk control. Systems that tout very high winning percentages usually are optimized over a very short sample period, or they take very small profits on each trade, and let the losses run. It is very difficult to devise a directional trading strategy that can produce more than 30% winning trades and still be profitable after slippage and commissions. Many are advertised, but few that I’ve seen can pass the test of a large sample size. So if 30% is the figure of winning trades that is possible or probable using a directional methodology, is it not better to just flip a coin and have 50% odds. It would seem so. However, by looking forward on the chart instead of backwards the trader at least has some clue of the direction the market is trying to go, and I believe with practice and experience a trader can improve on those dismal odds. But it can still seem like a futile task to rely on having to correctly predict market direction.
Another point to consider is that the market has three possible directions: it can trend up, it can trend down, and it can trend sideways. Trying to call market direction therefore seems to have about a one in three chance of success, which is close to the 30% odds of a trading system or strategy. Taking that into account it seems any analysis on a market would be about the same as random selection. It would seem, with these dismal statistics, that it is not possible to trade by calling market direction. It is certainly compelling to see perfect examples of indicator or pattern set-ups with positive outcomes. A quick look at a chart with a perfect pattern or indicator set-up would make it look like a piece of cake to trade such a pattern every time it appears. Successful indicator or pattern trades tend to jump out from the charts. But be careful of the well-chosen example when viewing trading methods for sale or in chat room hype. Usually when you analyze these perfect set-ups by looking at more data and apply the same rules, without the benefit of seeing the eventual successful outcome, you’ll find many more identical set-up that didn’t work out. The eye has a tendency to gloss over the unsuccessful outcomes, and only seeks those that work out. The trader wants to see success, not failure. However, the usual outcome once real money is committed to these set-ups is quite the opposite of what is promised.
Trading directional seems an obvious choice when someone first wants to become a trader, but for a trader who wants to take consistent profits out of the market in order to make a living, it can be a very difficult and stressful occupation, with very low odds of success. Many traders will even further reduce these odds by buying options. It is difficult enough to call market direction, but buying an option with its inevitable time decay will decrease the odds further. And since most novice traders prefer to trade from the long side of the market, doing so via a long call option can make the odds even worse as option premiums tend to decline due to declining implied volatility during uptrending markets. Add all of these ingredients together and you must conclude that the odds of trading success by calling market direction, and then using leverage such as puts and calls, will leave the trader with a very slim chance of a winning trade.
But these low odds of success can possibly be turned around be doing just the opposite. Regarding my earlier point that the market can trend in one of three directions, it would seem that one could improve the odds by not picking the direction the trader thinks the market will go, but by picking the direction that the market may be least likely to go. That would seem to improve the odds from a one in three chance, to a two in three chance, which is closer to a standard deviation. A good, tested trading approach should help to pick a direction the market is least likely to go, especially if one were to use a forward looking approach such as that offered by the market profile. Even a simple moving average and oscillator approach with money management should be able to help the trader avoid the wrong side of the market at least some of the time. It doesn’t have to be perfect. The market might still go the wrong way and adjustments might need to be made, but there are at least better then even odds that the market will either stay the same or move in the desired direction.
But how does one profit if the market does not move directionally? This is difficult if one is taking net long or short positions. But one logical approach is to use the inevitable decay of options. One can easily sell option premium instead of buying. It is like using gravity, or having the wind at your back. All option time value decays to zero at expiration. Of course, if the option is in the money then that option will have intrinsic value, but the time premium will be gone. The time decay of an option is referred as theta. Purchasing an option would be a theta negative trade whereas selling an option to benefit from the decay in time value would be a theta positive trade. Trading option positions that are theta positive can greatly improve the odds of a successful trade, but money management must still be used, and all the short options should have a long hedge.
Many traders that survive in the pits for many years are not necessarily trading directionally, but employ strategies that are hedged and not dependent on directional market movement. An option trader might spread front month options against back month options, or hedge a position against the cash underlying. A futures trader might trade small discrepancies between similar markets, or trade the same market between different exchanges. Many of these techniques are difficult to employ by the retail trader, however the concept of a hedge can be helpful if one is considering profiting from option decay. Some theta positive traders will sell option contracts short, thus being naked short an option. This is a very risky trade and not recommended. It is highly advisable to have a long option to hedge the short option. This also greatly reduces the margin requirement of the position.
If the trader has a bullish bias, or at least the belief based on his trading approach that the market will at least not go down, that trader could use a bull put credit spread. This spread is constructed by selling a put and then simultaneously buying a cheaper put at a lower strike price. The put that is sold can be at the money, or the trade can be given a little more room by selling it a bit further out the money. If the trader is correct the spread will decline in value over time and that becomes the profit that will accrue to the trader. The maximum gain can be achieved if the market goes up, stays flat, or even goes down a bit. If the market goes down past a certain point the maximum loss is known in advance. One downside of this trade is that the profit potential is limited, but so is the loss. If the trader is very bullish a long call could be purchased using part of the credit received from the spread. This would allow a greater profit if the bullish move did indeed occur, but would still allow the credit spread to produce some profit if the market only moved sideways. A profit might still be had if the market moved down if the short put was placed a bit under the market. Of course the short put could be placed a little in the money to receive more dollars, but there would be less actual time premium, or extrinsic value received, and there would be more risk. If the trader had a bearish perspective, the same strategy could be applied using call credit spreads sold above the current price.
Other spread opportunities using theta positive trades would include doing a butterfly or a calendar spread. A butterfly is simply doing a credit in both directions, so there would be two short options, either puts or calls or both, and then a long option higher to protect one of the shorts, and another long option lower, to protect the other short option. A calendar is simply a short option in the near month hedged with a long option in a later month. Both of these spreads benefit from time decay. The main difference between them is that a calendar spread works better when the trend of implied volatility is increasing, and a butterfly benefits in the near term from a decline in volatility, but near expiration is can still work out regardless of the direction of volatility. The butterfly uses four options per spread, so commissions and slippage can be a bit higher. These spreads can be put on with the short strikes near the current price if the outlook is for the market to trend sideways. If there is a directional forecast the short strike can be placed at the objective or target price, that is above the current price if bullish, or below if bearish. If the butterfly is employed the wings, or long options, can be spread out to give a wider breakeven range. That way the current price could be included in the range of the expiration breakeven so if prices remain stable or move toward the direction of the short strike the trade would become profitable, with the most profit occurring with the price at the short strikes. One downside of the butterfly or calendar spread is that the price can overshoot the expiration range, so a loss could result if price moves too far too fast. The vertical credit spread described previously is not affected if the price moves too far in the favored direction, however the credit spread usually does not have as favorable a risk reward ratio. There is always a give and take when considering various option strategies. There are many adjustments that can be made to keep price within the expiration breakeven range of the various option spread strategies. The subject of adjustments and money management is beyond the scope of this article.
What can discourage traders from doing theta positive spread trades is that the profit potential is often limited and less that what a trader would want to accept for the risk taken. Novice traders who think they have the ability to accurately call market direction often view each trade as having the potential to hit a home run, and therefore view each trade in terms of how much can be made if the forecast turns out correct. But if a trader constantly swings for the fences, the odds of success will be very low. A more successful approach might be to accept trying for singles, with a much higher win rate, and then employing the power of compounding to build the account. It can be very satisfying profiting from a very large market move, but these large moves are very difficult to find in real time, and difficult to profit from on a consistent basis. The smaller moves are more accessible and frequent, and one might build up an account faster by accepting the smaller moves, and then simply repeating the process over and over. And of course it is vital to use good money management at all times so the inevitable bad trades don’t become larger that the winning trades. The probability distribution, or standard deviation, favors this approach rather than always trying to hit the home run, which is actually trying to trade far outside of the normal distribution of prices.
This article is not meant to be a complete trading methodology. Rather it is just an introduction to an alternate approach to trading that might have a better chance of success that the methods used by most retail traders. There are many more theta positive spreads available to research in addition to what is presented here. There is a wealth of free information available in the learning center on the CBOE website. If this methodology is of interest it would be wise to study the various methods of making adjustments when prices do not cooperate with what is expected. Of course strict loss control and use of realistic profit targets is essential. It is best to create a detailed trading plan in writing, and to paper trade for a time by practicing entering trades in a simulated trading platform. Entering spread trade can be a bit tricky at first if one only has experience placing orders for net long or short positions.
For another related article click the following: Trading Methods – What Works and What Doesn’t