Which is more important win-rate or risk-reward ratio ?

Every traders must have come across this epic question of which one to give more value, high winrates or high risk-reward, winrate is – how many of your % trades tend to come out profitable, you can have a 60% winrate which is considered decent, for many experienced traders with 70-80% win rates are not uncommon, on the other side risk-to-reward ratio, is basically how much typically you make against your losers, a 1:1 of risk-reward works well most of the time, the higher the better.

When we design a strategy, algorithmic or price pattern, it will have a characteristic winrates and risk-reward, some strategy have high winrate and low risk/reward, and reverse is also true, by evaluating these we can either discard or accept that particular strategy, because it must have acceptable winrate and reward ratio both, note that a high winrate with very poor risk-reward is not useful similarly a high risk-reward but loses quite often is equally bad, therefore when we say high winrates that means, risk-reward is also fixed, typically 1:1.

This article is for day traders and not a investing or positional trading material, for investing or any long term trading clearly the focus must be towards high reward/risk ratio. you maybe losing 7 out of 10 traders but those 3 winner will make up for all losses. Warren buffet will tell you how much he loves high reward to risk and lots of buffet folks will advice you the same, but is it one fit for all? is it good for everyone, not so simple.

As we know, winrate and risk-reward runs contrary to each others, you can’t have both in favour, means for a higher profits one has to give up some portion of from winrates and vice versa, so again the same question arise, which one is more valuable – winrate or reward to risk? Let me again clarify this guidance is only for day trading. and for day trading winrates are more important than risk to reward ratio.

Why it is so, to figure out this we must understand significance if both, winrate and risk-reward, a lower winrates simply means you are doing something wrong in your analysis or make mistakes, perhaps your market knowledge is not up to the level or you lack psychological robustness, whereas a consistently high winrates means you are right path. Second the higher risk-reward means you as a trader have been able to develop a stable mind and patience. so reality is both are important but not equally for everyone, typically in the beginning of your trading career you must focus on high winrates, combined with at least 1:1 risk-reward, later when you have mastered trades, you should be improving on reward to risk, because your experience has already made you the master of trades and don’t make mistakes.

To sum up, aiming for high risk-reward comes later in the trader learning phase, and don’t fall for anyone who is giving you a black and white answers.

Why is it hard to day trade options ?

Most experienced traders play options for expiry, they buy options on events when high volatility is expected. Both are positional style trades, for our day trading we can either buy or sell options, as said earlier it is not recommended to buy options on a daily basis unless high volatility is expected. Therefore we are left with options selling, let us instigate further in this.

Note hedging stocks using options is not the scope of this writing.

options day trading

First thing will come in mind is, best way to day trade will be, price-action trading, here use of “Options Strategies” is out of question as that again is for positional trading, by price action I mean, using technical things like support & resistance, candlestick patterns, trend analysis, risk-reward knowledge etc to carry out trades.

So basically we are asking, is it possible to trade options like stocks? and not use traditional “options strategies” and too much rely on news analysis etc which are main tools for any positional option trader. How we use price-actions?  obviously they will be used on underlying instrument and using that we put options trade.

Now let’s discuss what are the major issues with approach, first options prices tend to drop little earlier than underlying so you will always get the late entry making risk reward worse for you, when second selling options will have very awful risk-to-reward ratio, what this means is, if you get 2 point drop for some fall of underlying will get 3 point rise when underlying recovers, so selling options will force you to wait longer as you get stuck in a losing position, and perhaps convert your your trade to positional.

Third issue is options price will rarely be match their fair value. Fair value of options are calculated using Black scholes model. What this effectively may do to your trade entry is, you get under priced options sold or over priced bought.

Together all these factors makes up the returns limited even if you correctly predicted underlying movements, and unfortunately that’s a proven way to become loser in long term!

Why is options selling difficult ?

Options have evolved in ways that they works in favor of sellers, but wait its not for every seller, you have to have mastery in smelling market sentiments and then only you can use options to make trading robust. We will discuss more on options behavior without which one cannot become an option champion.

Options are hedging instrument, but in standalone trading, why are sometimes options preferred over stocks ? this is because options give you more time, as opposed to stocks where a losing position, necessarily create a emergency situation where one has to decide and act hast-fully, which means run stop loss before it becomes too large.

This emergency situation is eliminated from options trading which is a huge advantage, temporarily your position may come under loss but you are not really a loser unless the underlying price crosses the option strike on expiry day.

options selling
Options are used by variety of traders for different reasons

Day trading is chewing iron bullets – the style which option value change with underlying price, creates a very poor risk-to-reward ratio for sellers, this is due to the fact that when underlying price drops, corresponding option drops by logarithmic function and during rise its exponential rise, this makes them difficult to use for day trading, as when you lose its manifold than what you get in winning trades. Look at the diagram below which shows how option price adjust.

options price with underlying

Historically Oom ( out of the money) options selling wins 90% of the times, so its only 10% trades are loser, now the tricky thing to understand in losses in an option trade are never small, it cannot be small, why?

This is because when selling you earn only small option premium, but when lose you always shell out the difference between underlying price and strike price which is completely in a different scale. Therefore those 10% trades have enough capacity to eat up all profits generated from 90% winners, sounds ironical…isn’t it !!

Another thing is options price do not drop during days when an important news is about to be released, so even if you get the direction right don’t expect options to generate profit for you.

A frustrating thing about options are, they do not carry one-to-one correlation with underlying value, and anyone who trades options by watching spot price will have disappointments, this is because underlying and options are abide by only strike and expiry date. in between options can behave like an independent instrument.

Are, open interest data helpful in F&O trading ?

Open interest data in F&O trading is touted as a magic ball by some stock traders using which they determine market direction that are otherwise behaved like a random shock always. When you are repeatedly told that using OI, you can pursue an successful trading career, you jump into that appeal without actually knowing the reality.

In this article we will discuss, the value of “open interest” as an indicator, first of all get this basic clear that, open interest does not carry any great deal of value in them for predicting stock moves, although it’s not entirely useless too but they are heavily lagging indicator. That’s what we are going to see.

Debunking hypes around open interest

Open interest is just like volume in equity, but with some difference. A rise in price may see build up in OI, and vice versa. so if you are looking at OI, ask yourself, does it give you anything more insight than price is already showing you ?

Open interest gets you little help in options trading and in swing trading ( position carry over days), as they mark the probable resistance and support area, which can be entry or exits areas for your trades. But trick is those levels are known to most traders without even looking OI table, as these levels are chosen with laymen picks, most stock traders will have the same level for shorting options.

Beyond that it’s useless, at least for intraday trades its barely of any help, if you look at that in live market, you end up adding confusion to your actions.

A rational peek into traders mind

trading psychologyA trader is someone who is expected to act on rational decision, that are based on facts and logic, that’s at the very core for being a trader, this also means following discipline. Let me be also be clear about rationalism, a rational action, is one that is first evaluated in terms of good or bad outcome it may bring, how we know that, is by experience and logic? A learned trader is supposed to already have gained that knowledge and could apply without failing, that’s what I call rational trading, but this easier said than done.

Rationalism is not limited to trading, it spans across almost everything in life. unless we explore and discuss those as well, it may not be help us much,

Many scholars and psychologist like Sigmund Freud had findings. that human beings are not rational animal, in ways that, what they want to do is already preconceived in mind and later they merely look for some-kind of justification or confirmation to do that, take for example, if anyone wants to commit a crime they will prepare a thought process like potential target is a corrupt person, or in modern world everybody does that etc. Its in the experience of all of us, we tend to start hating or loving a newly met person without knowing much about him/her.

So, without these justification a person will not be able to act upon thought structure, now that also means once they have decided and found some support, they will not be going to deviate from path no matter what may come. Basically here the order is changed, logic and facts that should have come first followed by decision making, now come towards theend and what needs to be done is already fixated by – god know what !

If you figured out above, it will not be difficult to see same thing happens daily with traders, A trader, once taken bullish or bearish view for a market, is unable to see otherwise, also it applies to trading style which persist for lifetime, traders that are pertinent, contra or trend followers, find them unable to change their trade style even if the market is clearly telling exactly opposite of that.

All kinds of indicators we use also end up working like that, we would have our preset ideas to “short” or “buy” that particular stock, and with these indicators we merely look for justification, in fact at times we ignore if the indicator telling exactly reverse story, this is blinding of mind by its own powers.

Preconceived ideas are not bad thing, in fact that’s the very basis which a trader has to hold on, but that such idea must be based on facts, and by reading the cumulative brain of market. Once we learn to do that it starts to work in our favor, until then its always against.

How to trade with algorithmic signals

I am going to discuss here, the basics and correct procedure to follow when you have buy/sell signals software to assist you in trading, many people’s will have this question, whether you use Windicator signals or any other algorithms the procedure is same, it draws little similarity from indicator based trading, like RSI, MACD etc, in that information produced by these signal only makes up for a part of trading opportunity that may arise..so they are just one input and finally what to do is decided entirely by trader.

Unfortunately when trading with signals, many people tend to think that, the
signals are trading decisions on their own, which is not valid concept. These peoples then make losses and end up believing that, algorithmic trading is unworkable, or there must be utopian self driven algorithm out there, only when you have that, it can be make profit. Nothing is far from truth but this. By believing like this you are depriving yourself from the leverage and edge a computer assisted trading can give you, computers have helped and improved our efficiency in every fields, and trading is not an exception.

First ask a question to yourself, if there exist such a algorithm able to profit on it’s own, what will be the use of human traders? Those algorithms can be run by mom/dad, your neighbor buddy etc and they will generate huge profit without doing anything not knowing single thing about market. This sounds impossible right? Why I given this example is to never underestimate your role as a trader, no matter what kind of signal system you have, role of a trader is always above everything else.

In the following passage I am going to describe common tactics that can be used to improve trading with a mechanical system. Remember you may choose to run trading in a complete automated environment, but again it must have parameters configured for that manually.

In a nutshell, once you have decided to trade a certain stock, for rest of the day you must fix the trading style ( Long only, Short only or both) and second, assign the correct type of strategy. Remember these steps are done manually and no algorithm exist for that 🙂

Figure out the market sentiment

This is the most important thing, being right or wrong here will dictate profit statement end of the day. Here you need to figure out the market phase, this can be done by by looking higher timeframe charts (like Daily charts), find out whether they are in down-trending, up-trending or consolidation phase, also you need to check for important levels. Based on these realization you are going to fix trade style and strategy.

Take for example, you have a daily chart of ABC stock, find out market is making consecutive higher or lower peaks/valley, you will need to add least add following indicators, Bollinger band (20) , MA10, MA20, MA50, MA200, now if stocks approaches any of these levels one has to be careful and change the signal type from trending to reversal. Let me explain a bit more that.

There can be infinite number of algorithms, but all of them fall in either of, trending or reversal category. A trend signal is one which gives trade alerts in the same direction of prevailing trend, it may give a signal on first impulsive move or upon pullbacks that’s the algo implementation thing, but both will be in the direction of major trend. A reversal signals on the other hand, works opposite of this, they typically give signal against the prevailing trend, it’s philosophy is, any trending move, however strong, sooner or later going to fade, so attempt is to time that perfectly.

When your market is up trending you should use trend signals and in only Long
mode, this will allow you to enter at every pull back. Whereas if the market
is ranging or reaching to a crucial support resistance you switch to
reversal signals.

Three breakthrough for a profitable trading

A lot has been said about, “what makes a winning traders traits”, in this post I am going reiterate what are those and try to make it more clear. Although the points remains abstract in nature.

A profitable trading career a rare thing to see,, as it demands combination of multiple skill-sets in a single person. A successful trader usually have to pass through three phases, and on mastering 1 or 2 of these itself is not enough to believe you are done! Some peoples may have built-in traits to handle situations better, hence little time is needed for them and they can move to next phase.

Three phases are, discipline, knowledge and intuition  and if they are learned the the same order, earlier you reach goal, if you ended up in jumbled order, you will need to again go back to earlier and learn missing ones. Needless to say these three fields are from three different worlds, and usually a person strong in one area is likely to struggle in other.

trading traits

Discipline comes the first, most trader in their start of trading career believe that knowing, how the markets work will put them profitable position and so first priority to learn that, this is not true! The fact is knowledge part requires some mentor-ship and with time only you will learn them, whereas a trading discipline is in your hands ( although most difficult )

Knowledge, is your IQ, it is made of the part of our physical world, an intelligent person may find it easy to grasp existing financial markets know-how. he/she maybe able to understand technicality and math side of market very well Technical analysis, and Fundamental analysis you learn in this stage.

Part of this knowledge is learned onset of this phase and then its a lifetime learning. Sadly knowledge alone is never been substantial for making a profitable trading, but it cannot be ignored also, as without basic knowledge a trader will fail badly no matter how lucky he/she is.

Finally,most important, intuition part, but no one talks about it, if you are doing everything right and still failing, this is where its lag is. ask yourself, world is full of intelligent analysts who share very good tips, but their own trading suffers, else why would they choose to be an analyst. intuition is your subconscious minds power. it guides you all the time without you knowing.

Lets go in this deeper, suppose your trading system has edge of 60% means 6 out of 10 trades are found to be winner in backtest. if you ended up trading only losers and missing winners, so despite a winning trading system, it fails you in trading, on the contrary an not so sophisticated trader whose, who relies on simple moving average cross but mostly ends up taking winning signals, now who tells you a certain trade to take ?its the subconscious mind.

Many successful traders may not realize about helps coming from subconscious mind, and not even bother. Some peoples call it luck, again persistent luck or bad-luck is something to look. Mediation is a proven technique to fix-up the vibrations in your subconscious mind and make it work in your favor.

Finally to conclude, all these phases unless you have not mastered don’t quite trading, as without that its not even imaginable.

 

 

Myth of options time decay

One of the much touted jargon of trading industry is, that option value decays over the time,  hence with selling options – easy and consistent premium can be earned on a regular basis, everyone wants to believe that, specially new option sellers fall into prey for that, In this post we will discuss risks involved in options selling.

First of all let say that, I am not debunking option selling or instead suggesting to buy options, For nimble traders in fact it does work with right risk management in place. But just ask yourself, if selling were so easy everyone would have done the same? and no one has to lose money in stock market!

options price change

Big money fund managers sell options but they do it for hedging purposes this is, so called option experts won’t tell you. And to profit in selling a naked option you must have a robust prediction mechanism in place, there is no excuse for that along with that you need a stop loss too.

We hear all the time, that options decays its value over the time, and there are popular pricing models (Black scholes) for that like, can it be simple as plain vanilla ? Well not denying that there is drops at discrete times, but its not like they lose value every hours or so, certainly in a longer expiry like months or more you will see options price losing its value on some days.

Wait, but peoples want to apply that on day trading or where holding period is few days. Let me tell you as long as there is a hope in traders who bought those options, it will not drop 1 penny, real options work like that, get this clear.

First thing to keep in mind is in options risk-reward don’t work in favor of a seller , an option seller may get 10-10 points in 3 trades and can lose 50 in 2 trades later. that’s how options price moves, to put it in simple words option price don’t change similar on either sides of falling and rising market.Without bringing in complexity of option pricing models, let us see little bit of math of this then it will be clear.

We can roughly say, at any point of time option moves by certain percentage of its own price, this is in either direction, in technical terms we call this delta, so a 100 rs option may be changing +/- 5% every 5min (5 rs either side), when the options are rising the further change also becomes large, for example that 100 rs option becomes 150, next change will be 7.5rs and thus options rise at exponential rate, on the opposite side if market is falling further drop is curtailed on every next drop. hope this is clear.

Reality of option selling trading do not rely on prediction or trend following rather a guess of market limits, so you may be having an opinion that market will remain range bound around +200 and -200 during this expiry so you can take a position

 

Debunking common misconception in algorithmic trading

Algorithmic trading is a fairly complex field and for most retail traders it gets painfully difficult to make algos that will work for them, but there are number algorithmic vendors who can provide signal generation software which a retail trader can subscribe and benefit from that, still I think there are critical questions that needs to be answered;

Algorithmic trading not equals to HFT !
Algorithmic trading has countless variants and HFT is one of them, algos can be used by all sorts of traders in all time-frames, unfortunately media coverage reports only HFT for their sensational values, this creates a wrong perception is built on retailer traders about algorithmic trading

Can algorithmic trading provide profits on its own with any human assistance ?
A: The answer to this question is not yes or no for most cases, it is true that there exists fully auto and intelligent which can operate on its own but they are hardly shared. there are “options” algorithmic which can provide some profits on their own, however they might not be enough.

If algorithmic trading does not produce profit on its own then are they are useless !
A: To summarize most algorithms work in conjugation with “news and manual analysis” and together they make up a profitable trading system. Primary goal of these signals are to avoid emotions, over-trading and strictly implement risk management which grapple in a manual trading.

Algorithmic signals allows you to enter a trade with a good risk-reward setup without adding too much delay in entries and timely notify you whenever a trade opportunity arises.

Then how do we actually use an algo system ?
A: As discussed earlier one should not run the algos on a random basis and expect profit, first you need to arrive at bullish or bearish sentiment for the day by doing manual analysis and then apply a signal in a suitable script and in a correct direction (buy or sell)

An automated algo trading deprives us of human involvement in trading !
That’s one big misconception, an algo trading is more about trade execution, but the planning and analysis still required and done by a human analyst, that way correct tools are utilized in proper areas. Human brain is very efficient for static analysis but delivers very poor in live markets, this way we split the work between two great masters, Brain and Machine.