Options Trade Initiation: Why Patience Pays Off

When   developing   traders  enter into  income options strategies,  there is   a   tendency to  become  impatient  when   executing the opening trade.   The    trader   will   typically  put  an  order  in at  or around the mid-price but  often finds that the market  is  not  biting on that   price immediately.   This can create anxiety and a feeling of impatience in the trader,   arising   from the belief that,   since  almost   all income strategies  are  “theta negative” at initiation (i.e. all other things being equal, the passage of  time improves the P and L of  income  trades)  that we are in a  hurry  to get the trade placed to “catch the theta”.    But   what   the developing trader often misses is that, in the majority of expiration cycles, the trade will   go   negative at the outset of the trade only to turn positive later as time decay picks up.   So a delay in placing the trade until the market “comes to us”, more often than not works well. Whereas if we negotiate the price too easily, we often find ourselves regretting having negotiated the   price so heavily , when, if we had simply been more patient, we would have gotten our price or even an improvement  upon our original  price  goal.

Here’s   a   simple   example   from   a   few   days   ago.  Last  Wednesday we initiated a 5-lot  March call side butterfly in  CAT .  The   market   mid-price for this spread   was   a   debit  of  $2,495.  As often is the case, the market was not filling our price at the mid and an impatient trader would have caved and paid a higher debit to get this done.

We took a look at the options  risk  analysis software that we use and noted that a  1.30   point   upward move in the price of CAT, assuming a 1 point drop in implied volatility,   would   have   moved   the   mid-price debit on the trade  down 2%, or $50.  If we held our price during a move like that, we certainly would have gotten filled at one point.

By the same token, a   1.30   point   downward move in the same stock, assuming a 1 point increase in   implied volatility, would move the debit down $50  as well.

It   is   pretty   reasonable   to expect  CAT,   a  $100.  stock     to make  a  1.3  point move  in either direction over the course of a  trading day.  And even if it does not, a slightly larger  move  over  2 days  would  cause  the  same  reduction  in  debit.  As it turns out, and of course this will not always be the case, CAT made a   3.05 point  move  above the original entry price of the trade the very next day  and the total debit dropped 15% by the end of the next trading day!

Trade initiation is the ideal point in a trade  to  practice execution  patience, because no capital is at risk that point in the trade.  Most of the time, with a little bit of patience, we can get at least mid-price and perhaps better.

One Comment on “Options Trade Initiation: Why Patience Pays Off”

  1. Good article Seth. These are important but frequently overlooked issues. Execution, especially in the options markets, is like a chess game and if it is done well, it can effect the P&L significantly. There are a lot of blog posts and articles about strategy (and that’s great), but few about these types of mechanics. This is such important stuff. Thanks Seth.

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