Option Trading Blog

The hardest thing for an option trader (or investor) is to change is mindset from an emotional one to a more productive logical one. When I started option trading and although I come from a mathematical background, the hardest thing was to think for the long run, not the short run. I wanted to be profitable in every position I make. That would cause me not to leave positions I was in and think a long the lines of “I am sure this is going to change soon and become profitable!”. Although for the novice trader the opposite can also happen. He enters a position and if it doesn’t turn profitable in an instant, he leaves only to see it become profitable again. A vicious cycle that most novices and lay people make.

Changing The Mindset

The proper mindset should be always thinking in the long run. Trading is not a sprint, but a marathon. How good is a trader that is profitable for 1 day before the end of the year and then in the end blowup? Good traders are marathon runners. I’d rather count on a trader that had 10% for 10 years than another with 50% for 3 years.

Thinking With Expectations

What do I mean by thinking with expectation? Here is a simple exercise: Suppose I tell you that I have a method that is NOT profitable 90% of the time. Let’s say when it is not profitable, you’d lose $100. Let’s also say that when it is profitable, you would win $1000. Is this worth while? We can compute it quite easily by what is known as mathematical expectation which is simply a fancy word for a weighted average.

This means that we expect to get on average $10 from this trading strategy. Although some people could reject at first sight this trading strategy, it is actually profitable in the long run.

When People Screw This Up

I am sure this is not the first time you hear about the concept of expectation. But I am sure that you might screwed it up at some point. You have to realize that this works for the long run. It has no meaning in one trade. You can’t actually make $10 in the first trade. It only makes sense in the long run. So if you have analyzed a strategy in the same manner we just analyzed, make sure that you understand this important bit!

When People Have Seriously Screwed This Up - The Case of Naked Puts/Calls

You might think this simple rule is implemented with top traders all the time. But you are wrong. Dead wrong. Even the most experienced traders make the same error again and again. They underestimate the probability of an event happening. Let’s take a look at this simple scenario: suppose John Trader wants to sell naked out-of-the-money calls. He has heard that most of them expire worthless anyway, so why not just get the premium. Easy money? What if I told you that 99% of the time John Trader would make 100$, but in this small 1% he can stand to lose 50,000$? Let’s calculate the expectation:

So even when the chance is slim, he would still on average lose 401$. I know you are probably thinking this doesn’t happen in the real world, but it actually happens more than you think. Traders blowup in this way ALL THE TIME. They underestimate the small 1% I just showed you. That “never going to happen” scenario that happens.

Using Expectation To Your Advantage

It is important for the trader to always think with expectations. When you feel the temptation to start selling out-of-the-money puts/calls as the above example, or you are about to abandon some trading strategy just because the success rate is poor but might be in the long run successful. Check out my post about getting the most bang for the buck technique together with my trend method. This combined can give you in the long run great results.