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.
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.