Monday, September 22, 2008

Money Management

Money Management
After graduating from college, Rohit Shah was eager to make big cash by day trading. He heard many stories about market operators making thousands of rupees a day flipping in and out of stocks. Rohit believed that all he needed to do was catch a couple of waves a day trading software stocks. If he did this, he would make anywhere from five to ten points, or ten to twenty thousand rupees, per day using 1,000-share lots.
Rohit went to a broking office in his local area and plunked down his money, Rs.25,000, plus another Rs.25,000 he borrowed from his father. With the Rs.50,000 he would qualify for 8 to 10 times intraday positions, providing him with Rs500,000 of buying power. He estimated this would be enough to allow him to trade high-flier Tech stocks such as Satyam, Zee, or Himachal.
On his first day of trading, Rohit was briefly up Rs.4,000 on a 1,000-share position in Satyam. Then the stock turned against him and he was quickly down Rs.8,000 - a Rs.12,000 reversal. Instead of cutting his losses, Avi bought another 1,000 shares, in order to "average down." Satyam sold off another 7 points and suddenly Rohit was down Rs.15,000, or 30 percent of his Rs.50,000, in less than two hours. Unable to take the pain anymore, Rohit sold his 2,000 shares - at the bottom of the move. Within three weeks Rohit had lost all of his Rs,50,000 Rupees, and on top of that he owed the firm Rs.3,000. If he had understood the principles of risk control, his chances for success would have increased dramatically.
Risk control is the foundation of survival for all traders. It is one of the few aspects of the marketplace that a trader has control over. The most common error made by beginning traders is a disregard for risk control by taking overly large positions. Unreasonable expectations can cause beginners to gamble 50 to 100 percent of their portfolios on a single trade. Taking wild shots with huge positions is not trading - it's gambling. Successful trading is developed over time, by winning consistently and conserving capital.
Trading positions that are too large often results in huge losses; it is the most common reason beginning traders go broke quickly. Large positions go hand in hand with large emotions: The bigger the position, the more intense the feeling of either greed or fear. The large profit and loss swings associated with big positions usually cause traders who are just beginning to abandon discipline and to trade subjectively and emotionally. On one hand, it is harder for them to take profits run on a position that's too big. Traders end up cutting their profits short and letting their losses run - the opposite of what they should be doing in order to be successful.
Trade only with money you can afford to lose
Sun Tzu said that "Every battle is decided before it is ever fought." He meant that through meticulous planning and preparation before a conflict, a person should be able to get into a position such that victory is assured. When the battle occurs, it will take place against an opponent that is already defeated - a result of the prior planning. The same methodology should be applied to trading. Before trading, traders should put themselves into a position such that the victory can be assured by substantially reducing the meaning of their losses.
The emotional pitfalls of trading are magnified exponentially when you have to trade successfully in order to survive. The most successful traders have an almost complete disregard for money. The need to make money forces a person to be attached to the outcome. This attachment normally influences the decision-making process for the worse, because fear is magnified, distorting reality.
Traders must be comfortable with the worst-case scenario before they even consider the best. The most successful traders have become comfortable with the idea that they can lose it all; paradoxically, that idea provides them with a sense of security. Only you can determine how much money you can afford to lose. The money you trade with should be money that you are comfortable with never seeing again. If you decide to invest in a career as a day trader, ponder this question carefully.
Smaller is larger
The importance of financial management when applied to position size cannot be overemphasized. Dalal Street is filled with stories about experienced traders who went broke after long and successful careers because they ignored the oldest and most important rule of money management: Don't take positions that are too big for your financial comfort level.
The urge to make money quickly will always tug at you when you're trading. Fight this urge so you don't have to learn a painful lesson the hard way. Successful trading is first and foremost about survival through financial preservation and consistency, not about hitting home-run trades with huge positions. It takes strict discipline and careful preparation to match your positions to your risk profile. The smaller your positions, the easier it will be to maneuver in and out of trades, whether you are adding to a winner, cutting a loss, or taking a profit.
There is a direct correlation between correct position size and higher profitability. Losses are inevitable; but smaller positions produce smaller losses, allowing quicker recovery and less emotional attachment. The key here is emotional attachment. Traders tend to develop a comfort zone for position size, given their financial capacity to take risk. If you trade a position that is too big, then your sense of detachment can be thrown out of whack, adversely effecting your ability to maintain objective discipline.
What causes a trader whose comfort zone is 2,500 shares to buy 10,000 shares? Traders take positions that are too large for a variety of reasons: greed, lack of understanding of money management techniques, faulty trading tactics, the ever-present ego, and unrealistic expectations.
Larger losses are the product of bigger positions. A big loss requires higher gain in the future to offset it, because of slippage, time, and commissions. It is much harder for a trader to trade out of a large hole than out of a smaller one. If a trader is down around 6 percent on the month, chances are that the trader's confidence and buying power will remain intact. Successful traders are not afraid of reasonable losses, because they have confidence that they will persevere to make back what they lost and more. However, if a trader is down 50 percent on the month, it will be a lot harder to regain confidence and stability. Large losses sting, and can cause a trader to be gun-shy in the future.
It becomes increasingly difficult to recapture an unusually large loss when you trade position sizes that are not evenly distributed. In addition to making back the equivalent percentage lost on the bigger position, you'll have to make back the spread and commissions. Many traders who experience a skewed loss resulting from a position that was too big believe that the only way they can make it back is to take a large position again. When this occurs, a trader is operating at a disadvantage arising out of desperation. The result is that the risk profile is endangered, and the trader loses the best source of protection.
Trade with balanced position size
Position size in trading should be adjusted for broadly uneven stock price levels. Uneven stock price levels result in uneven probabilities that a large percentage move will occur. If you hold both a Rs.100 stock and a Rs.1000, a ten-point price change in each one will have an equal impact on the profit or loss of your portfolio if the position sizes are equal. However, a ten-point move in each stock would represent very different percentage changes. A ten-point move in the Rs.100 stock represents a 10 percent price move; a ten-point move in the Rs.1000 stock represents a 1 percent price move. The 1 percent price move in a stock is statistically less significant, and thus more likely to occur, than a 10 percent move. Therefore, it does not make sense for traders to take equal position sizes in stocks in terms of value that have price discrepancies, although they do it all the time.
A Rs.1000 stock would have to move 100 points in order to yield an equivalent percentage change to a 1-point move in a Rs.100 stock. The 10-point move would have 10 times the Rupee impact on a portfolio if the position sizes were the same, an unbalanced risk allocation. Position sizes should be adjusted according to the price and number of stocks you are trading, such that an equal percentage price change will have an equal profit or loss impact on the portfolio.
THE 2 PERCENT RULE
One of the principles of risk management is the 2 percent rule. The rule states that no more than 2 percent of a total portfolio should be lost on any individual trade. Ideally this figure should include the costs of commissions and slippage. This means that the largest loss you should tolerate on any single trade is 2 percent of your portfolio. Some people misinterpret this rule to mean that only 2 percent of your trading equity should be allocated to each trade, but that's not the case. The 2 percent rule is designed to limit a trader's losses while preserving capital. It is powerful insurance because it provides a trader with a number; you know before you enter a trade how much you can afford to lose. Applying this principle, a trader can afford to be wrong numerous times and still live to see the next trading day.
Keeping your losses to 2 percent per trade often means that you will have to trade smaller positions. Many traders who are just starting scoff at the idea, thinking that bigger positions will allow them to strike it big and make a large monthly income through big profits. Nothing could be further from the truth. When beginning traders take on bigger positions, it often causes them to lose money faster because they have not built up the tolerance for accepting larger losses or bigger profits. They tend to take profits off the table faster when they are winning, because of the immediate gratification associated with being right. They also tend to let their losers run longer, because they are not willing to accept the pain associated with being wrong.
It is not uncommon for traders to enter into positions not knowing beforehand how much they are willing to lose, because they think they are going to win. When expectations for a trade are not met and no exit strategy exists, a trader is often forced to cut a position based on either emotion or financial pain. The goal of a trader should be to accept losses without letting them affect his confidence. This is accomplished through preparation before the trade, budgeting for losses just as you budget for an insurance bill.
The 2 percent rule is pivotal because the success of an individual is not necessarily correlated to the number of winning trades: Some of the most successful traders in the stock markets earn up to 80 percent of their profits from just 20 percent of their trades. This means that the majority of their trades may not earn them the big money. The reason they are profitable as a trader is that they have learned to quickly accept and manage loss, not disregard or try to eliminate it. Successful traders aim to keep loss controlled. When losses are controlled a trader is free to focus on and add to winning trades.
By limiting individual losses to 2 percent or less of your portfolio, you increase the odds that you will experience more break-even and winning trades. Over time, these trades tip the scales toward profitability, as long as are managed. The 2 percent rule is particularly beneficial for beginning traders. Your probabilities of success increase with the number of times you play. A 2 percent maximum loss guideline increases the life span of beginning traders, providing them with the opportunity to learn from their mistakes.
A loss of 6 percent to 8 percent is the maximum a trader should accept for the entire month. A trader who has four consecutive 2 percent losses should stop trading for the month and evaluate what's going wrong. You can always begin anew the following month. Taking time off after a string of losses is beneficial, because it provides you with an opportunity to regain your confidence. A trading time-out is similar to a basketball time-out after the opposing team has scored a number of unanswered points. The time-out slows the winning team's momentum and helps the losing team regain confidence with a pep talk and a breather. If you enter a trading day lacking confidence, close the shop and begin again tomorrow. Confidence in yourself and what you are doing is your strongest ally.
Margin madness
Using margin to increase buying power is an accepted and common practice among most day traders today. It is important for day traders to be aware of the risks of margin, and to learn how to handle the augmented buying power effectively if they choose to use it. Using excessive leverage through margin is a dangerous game. The sell-off in Internet stocks in the spring and summer of 1999 resulted in a huge number of margin calls for day traders and investors. The risks associated with margin require careful planning and tighter stop-loss criteria. Many investors are not aware of the risk inherent in using leverage, and should stay away from it. When the market turns against a highly leveraged position, a trader is often forced to liquidate it at the worst possible moment.
Even the brightest and most highly regarded traders on Wall Street are not immune to the danger of trading with excessive margin. During the predicament in the global financial markets in September 1997, the Long Term Capital Management (LTCM) hedge fund reported that it had lost $2.3 billion in high-risk trades and was on the verge of bankruptcy. Fund founder John Meriwether and his partners, Nobel laureates Myron Scholes and Robert Merton, traded with ridiculously high levels of margin. (Myron Scholes is a Nobel Prize winner for his famous Black-Scholes Options Pricing Model) At times they took huge positions, putting only 5 percent down. Although they attempted to diversify the risk with long and short spreads in their bond funds, the bloated margin ultimately proved fatal. The amount of margin power that LTCM used is the equivalent of a stock trader buying $100,000 worth of stock with only $5,000 cash down. A small hiccup in price could easily wipe a trader out with such high degrees of leverage.
In our independent research and observation that it is not uncommon for some day trading firms to encourage day traders to borrow money from other traders in order to meet margin calls. This practice files in the face of the most basic risk management practices and should be avoided at all costs. It is a clear sign that the trader is acting out of financial desperation and that the end is near.
When you choose to trade on margin, enforce strict risk-control standards geared to the amount of underlying cash you have to trade with. If you have Rs.100,000 to trade with and you are using leverage through margin, your risk standards should be focused around the Rs.50,000 in underlying cash, not the amount of buying power you are using. Applying the 2 percent rule, your maximum permissible loss will be Rs.2,000 per position.
Success in day trading is first defined as survival. Your ability to survive as a day trader depends on your money management techniques. When you manage your money properly, you provide yourself with valuable risk insurance, which any business should have. The best way to control risk when trading is to manage your losses. Determine the most that you are willing to lose on any one position, which should not exceed 2 percent of your underlying equity.
Keeping your individual losses to 2 percent of less often requires that you trade smaller positions to start. Smaller positions can be empowering because they allow you to trade with less attachment, permitting you to cut your losses sooner and easier. The key to success in trading is to have the least possible emotional attachment to your positions. If you are trading because you have to win, chances are that your attachment to the outcome will be high, adversely affecting your decision-making process. When you trade only with money that you can afford to lose, your attachment will be minimal and your results will be better.
Risk control is a crucial component to successful trading. Improper risk standards result in trades that can easily wipe out even the most experienced traders. Traders last in the business because they have learned to manage their expectations and control their exposure. When addressing the risk factor, remember the importance of position size. Never allow yourself to trade a bigger position than you can afford. The temptation will always be there, but managing this urge through discipline is the mark of a successful trader. It is always better to start out small and add to your position, rather than starting out large and regretting it afterward. Remember the old saying: "Discipline weighs ounces while regret weighs tons"
FIVE STEPS TO DETERMINE THE PROPER POSITION SIZE
Endurance in trading is the first step toward success. Especially when a trader is beginning, surviving means you can learn and become better. Living to see the next day in trading is the most basic and important goal of any trader. This sound simple, but its importance cannot be overemphasized. The outcome of any trade is not within a trader's control; how much money you lose is. Controlling loss is the only security a trader has; without that security, catastrophe can strike.
The way to maintain a 2 percent maximum loss risk profile is to determine beforehand the proper position size. Determining the proper position size involves five simple steps. These steps should be taken methodically, every day, before trading.
STEP 1. ALLOCATE CAPITAL PER POSITION
The first step is to determine the maximum capital per position, or the most money that should be invested in a single trade. This figure is calculated by dividing the total capital in your account by the number of positions you wish to take. If you have Rs.100,000 of risk capital to trade with and you want to take four positions, allocate an equal Rupee amount to each position: Capital per Position = (Risk Capital) / (Number of Positions)
Risk Capital = Rs.100,000Number of Positions = 4Capital per Positions = Rs.100,000 / 4 = Rs.25,000
The maximum capital per position you should being willing to invest is Rs.25,000.
STEP 2. CALCULATE MAXIMUM SHARES PER POSITION
Once your capital per position is allocated, the next step is to calculate how many shares of each position to trade. Divide the risk capital per position, or Rs.25,000 in this example, by the share price. Assuming there are four stocks you want to trade with prices of Rs.1000, Rs.500, Rs.250 and Rs.100, the calculation is: Maximum Shares per Position = (Capital per Position) / (Stock Price)
Capita per Position = Rs.25,000Stock Price = Rs.100, Rs.50, Rs.25, and Rs.10Maximum Shares per Position = Rs.25,000 / Rs.1000 = 25 sharesRs.25,000 / Rs.500 = 50 sharesRs.25,000 / Rs.250 = 100 sharesRs.25,000 / Rs.100 = 250 shares
These figures are maximums that take into account your buying power per position.
STEP 3. DETERMINE 2 PERCENT RUPEE RISK PER
To determine the maximum amount of money you can withstand to lose per trade, multiply 2 percent times your capital per position. In the example, using Rs.25,000 per position:
Maximum Rupee Risk = 2% X Capital per Position Capital per Position = Rs.25,000 Maximum Rupee Risk = 2% X Rs.25,000 = Rs.500
In this example, Rs.500 is the most you are willing to lose on a trade, given your capital allocation per position. Taking another example, if you have Rs.100,000 to trade with and decide that you want to take two positions, then your rupee risk per trade is Rs.1,000: Risk Capital Capital per Position = Number of Positions
Risk Capital = Rs.100,000 Number of Positions = 2 Capital per Positions = Rs.100,000 / 2 = Rs.50,000 Maximum Rupee Risk = .02 Capital per Position Capital per Position = Rs.50,000 Maximum Rupee Risk = .02 Rs.50,000 = Rs.1,000
STEP 4. DETERMINE THE STOP-LOSS POINT
Various stop-loss strategies will covered later in detail. For now we'll determine our stop-loss point from initial entry. Stop-loss exit points vary greatly given the different price of stocks. In our example, a ten-point move in the Rs.1000 stock (1%) would represent a small percentage change compared to a ten-point move in the Rs.100 stock (10%). It is prudent to use wider stops for higher-priced stocks and tighter stops for lower-priced stocks. Assume that, based on your calculations, you have identified a lower-priced stock with one point of risk. Using Rs.250 stock as an example, if the current market is quoted Rs.250 - Rs.251, then Rs.245 is the stop-loss exit point if you are trading from the long side with one point of risk.
Adjusting for slippage on entry and exit can be difficult because many different elements determine what sort of executions you may receive, including liquidity, volatility, technology, the market environment, and the execution medium. Always provide enough room for a poor execution on exit. When adjusting for slippage, it is always better to prepare for the worst and be glad if you receive the best. For this example, we have factor in an extra 50 paise of a point on each side of the trade for slippage.
STEP 5. CALCULATE MAXIMUM POSITION SIZE
After determining the 2 percent maximum Rupee risk and the stop-loss, you can calculate the maximum position size: (2% Maximum Rupee Risk per Trade)/ Maximum Position Size = (Stop-Loss Point per Trade )
2% Maximum Rupee Risk per Trade = Rs.500 Stop-Loss Point = 5 points Maximum Position Size = 100 shares X Rs.250
If you have Rs.25,000 allocated for a trade and you have picked a stock that you believe has 3 points of risk, then the maximum position size is 165 shares. If the price of the stock is Rs.250, you will use only Rs.25,000 of buying power (Rs.250 X 100 shares = Rs.25,000), which is appropriate given your Rs.5 stop-loss point and your Rs.500 maximum tolerance for loss. In our example, because you're using only Rs.25,000 of buying power for the Rs.250 stock, you free up Rs.75,000 in capital to allocate toward another position.
Even though the maximum position size for a Rs.250 stock is 100 shares given your capital allocation, you would trade with that size because the loss you might sustain with a 5 point stop-loss would be larger than your Rs.500 maximum loss risk tolerance. On the other hand, if you selected a Rs.100 stock with the same 5 point stop-loss risk profile, then your maximum position size should be limited to 250 shares, because that would be the maximum you could buy given your Rs.25,000 capital allocation.
Higher-priced stocks also normally require wider stops. Chances are that the Rs.1000 stock would have a wider stop-loss point because of higher slippage and volatility. With the 25 share position in the Rs.1000 stock, the maximum stop-loss point would be Rs.20.
When you carefully prepare to manage risk before trading, the outcome will always be manageable. Trading with appropriate position sizes is extremely important for beginning and professional traders alike. Appropriate position size is determined by knowing beforehand how much you can afford to lose on any one position. When you know that figure, you can determine how large your position should be given your initial stop-loss point and the price of the stock.
HOW TO WIN WITH THE STOP-LOSS
Being wrong about a trade is okay. In fact, the only way for a trader to become comfortable with the notion of loss in trading is to experience it regularly, while developing the discipline to cut it out quickly without even thinking about it. Some of the most profitable traders are right marginally more than they are wrong. The most successful traders have developed the ability to accept loss as part of the game, and to cut it out before it cuts them out. This allows them to spend their time focusing on the winners rather than the losers.
"Substance is the inner quiet of mind, free of individual failings." ZEN SAYING
Profit by managing lossEnter into trades only when you have established a sensible game plan, with a stop-loss exit strategy mapped out in case the trade is a loser. A stop-loss is your insurance if the stock does not perform the way you hoped. If and when that initial stop-loss point is reached, it is crucial to get out of the position without thinking about it. A protective stop can be entered on the actual terminals of the BSE and NSE. There will be times when a stock will turn around moments after you were stopped out, but keep in mind that in the long run, this makes absolutely no difference.
Managing loss is what risk control is all about. Losing correctly requires inner strength, discipline, and resolution. It takes strict control to set a stop before you enter a trade. Setting a stop before trading means that you are considering the risk before going after the reward. The only way to last in trading is by preserving capital; adhering to predetermined stops will allow you to do this.
After you enter a stop, do not adjust it to give yourself more leeway if the trade is not working out. Why a trade is not working doesn't matter; you can always find rationalizations and excuses for loss. Price action, however, does not warp reality. The sooner your stop announces to you that your position is faulty, the better off you second-guess yourself by going back and changing your answer, you will probably be incorrect. Moving stops or ignoring them is similar to second-guessing yourself on a test - your first choice for a stop-loss is probably the best, and you should adhere to it.
There are different strategies for placing stops. With practice, most traders develop their own stop-loss strategies based on individual preferences.
Initial stop-lossInitial stop-losses can be placed in many different areas. Depending on why you entered a position, the initial stop-loss will ensure that your original thought process remains intact. When a trade is initiated, a stop-loss should be placed immediately. There are various technical levels to place a stop, but a general guideline for long positions is that the initial stop-loss should be placed 50 paise point beneath the previous day's low. For short positions, the initial stop-loss should be placed 50 paise point above the previous day's high. Only after you choose an initial stop-loss can you take the steps to determine your proper position size.
The previous day's low and high prices represent the first technical price levels of daily support and resistance. Yesterday's low or high point was the furthest that the bears or bulls could push the stock before it changed direction. Stops tend to accumulate just below or above these price ranges. A move through the lows or highs of the previous day may trigger stops and tend to clear the path for further momentum.
Break-even stop-lossAfter the initial stop-loss is set, the next stop-loss to use is a break-even stop-loss. After you have entered into a position and have your initial stop-loss protection in place, your objective would naturally turn toward implementing a superior exit strategy to use when the trade is earning you money. The first step toward exiting a winning trade is to protect your profits by moving the stop-loss order to your entry point.
With a break-even stop, you are in a sense catching a free ride on the tail of the market, and the worst-case scenario is nothing lost, except for commissions. A tightened stop-loss does increase the possibility of being prematurely stopped out while the trade still has a shot to meet your original objectives, but you can always get back into the position. The break-even stop-loss provides peace of mind along with a sense of detachment. When the trade is working and the break-even stop-loss is in place, you have successfully created an opportunity with little or no cost to you.
The best time to raise your stop-loss to the break-even level is subject to individual trading styles. A guideline that seems to work well when adjusting stops to the break-even point is the 2 percent move. The 2 percent move suggests that you should adjust your stop-loss to break-even after your position has moved at least 2 percent above your entry point. For example, assume you bought Satyam at 200 and your original stop-loss was 196. When Satyam moves 2 percent above 200 upto 204 points raise your stop to 200, you should slide your stop-loss up to your entry point of 20. The 2 percent adjustment yardstick is useful because it can be applied across the board to broadly ranging prices.
The 2 percent break-even parameter is meant to be flexible according to each trader's individual style and comfort level. Some traders raise their break-even stops immediately after the stock has moved 5 points in their favor. Others wait for a move of at least 10 or more. Experiment with this parameter and utilize its psychological advantage.
Trailing stop-lossIf stocks have lingered in no-man's-land for the day - that is, they have not moved above the 2 percent break-even stop-loss barrier or have fallen beneath the initial stop-loss point - they require a trailing stop. A trailing stop is an adjustment of the initial stop taking into account the price action of the current day when the market has closed. Remember that you can always reenter a position after getting stopped out if you believe the trade still has potential. It's always better to reexamine the position with a clear mind and nothing at stake. If you still like the position after stopped out, then your strategy was probably sound, based on objective reasons.
Profit-taking stopAnother type of stop-loss is one used to protect your profits. This is used when your position is working well and has moved at least 5 point above the 2 percent break-even stop-loss zone. At this point your break-even stop-loss is in place and it's time to preserve some of your gains. Your objective is to move your break-even stop to 1 point below the 2 percent profit-taking barrier. In our example, if after you go long Satyam at 200, it moves to 205, your break-even stop would be moved upward from 200 to 201. The 201 price represents a 1 point move above the break-even stop-loss entry zone.
Locking in some profits using a stop-loss strategy is an effective way to trade without worrying about losing your gains. It helps a trader to let profits run longer while not missing out on a solid gain. Depending on the trader's style and the type of stock traded, the stop-loss level used to lock in some gains could be adjusted. More aggressive traders may use wider stops to protect profits, while less aggressive traders would use narrower ones.
Developing a comfort level when using stops takes practice and discipline. Each stock has it own personality and reacts differently throughout the day. Some stocks advance and pull back quickly, while others may creep along steadily. After becoming familiar with the stock you're trading, you will be able to place stops more effectively.
Stop-loss orders are protective measures and are not perfect. Market forces can swing prices through stop points, resulting in larger-than-anticipated losses. Stops are still the most effective form of insurance a trader has. Successful traders have learned to exit their positions quickly when their stops are hit, without thinking about it. They understand that tomorrow is another day and they will have another chance. Stops give traders breathing room, discouraging them from being "psyched" out of a position due to choppiness or indecision. Stops provide peace of mind because they represent a decision that was made before the trade. Placing a stop-loss order means there is one less decision traders have to make because of a prearranged stop, you are reinforcing discipline and confidence in your game plan. Remember to always stick to prearranged stops.
Trade liquid namesProperly evaluating the liquidity and the volatility of a stock may mean the difference between a successful or a hapless outcome for market makers and day traders alike. One of the toughest jobs a market maker has is to properly size a market. This means correctly assessing the proper risk, given the current liquidity and volatility of a stock. Market makers are constantly putting up risk for accounts to capture larger order flow. This involves either buying or selling a block of stock at or very close to the inside market. For example, if Zee's current inside market is 105 - 105.5, with 7500,000 shares traded on the day, what is the proper amount of stock the trader should be willing to buy or sell on the inside bid or offer? What is the most the trader should be willing to sell u or down 50 paise from the inside market? What kind of slippage, or movement, if any, would be involved before buying back or selling the size bought or sold?
A market that is oversized can easily lead to a large loss. If a market maker were putting up risk for a large order, the object of the next part of the trade would be to trade the order for a small profit, for a small loss, or flat. This would eliminate the up-front risk, allowing the market maker to trade the rest of the order for a profit, generally without risk. Day traders who are about to enter a trade should also be careful to judge how much slippage may be involved before they will be able to exit or enter the position.
Diversity your positionsTraders cab spread out their positions in order to minimize market risk while optimizing their chances for success. Many professional Dalal Street traders look for ways to increase their probabilities for success in a trade by diversifying the number of positions they take within a given sector. Diversification tends to increase the odds that if the sector does move in the anticipated direction, other stocks that the traders have selected will move that way too.
Diversification among individual stocks within one sector spreads out the alpha, or individual, risk inherent in each stock. Every stock in the marketplace is subject to both market risk (beta) and stock-specific risk (alpha). The market risk (beta) of a stock refers to how it moves in conjunction with the motions of the broader market. The beta risk of a position is the risk that the broader market will turn against you, pulling the stock you are long with it. Some stocks have higher betas than others, which means more exposure to the fluctuations of the market. Stocks that have a beta of 1 should move in step with the market. If the market is up 2 percent, a stock with a beta of 2, then it moves at twice the rate of the broader market. If the market were up 2 percent, a stock with a beta of 2 would be up 4 percent.
The alpha risk of a stock is the individual risk inherent in every issue. This includes risks that cannot be foreseen, such as fundamental news specific only to that stock. By selecting several issues within a given sector, traders protect their portfolios from the chance of having individual positions turn against them or alpha risk.
Suppose a sector trader is bullish on the software sector, for example. Instead of putting all your money into one stock, you can go long in several stocks by allocating less money to each one. Instead of buying Rs.500,000 worth of Satyam, you would buy Rs.100,000 worth of five different stocks, such as Satyam, Wipro, Infosys, Digital, and SSI. The number of shares you purchased of each would depend on their prices. All five of the issues are correlated. This is called basket trading, and it reduces the alpha of a portfolio but not the beta risk. Basket trading involves added expense in terms of commissions and spreads, but it provides insurance against individual stock risk.
Some traders look to reduce the beta risk as well. There are various ways to reduce the broader market risk, including hedging with futures and options, pair trading, diversifying among sectors, and using different long to short ratios.
One way to reduce broader market exposure is to hold both long and short positions of correlated stocks. The ratio of your long to short exposure should be in accordance with the current underlying trend of the market, combined with individual stock selection. If the trend as you perceive it is up, and you want to reduce broader market risk, then your long to short exposure ratio should be long by 2 to 1, but a minimum of 2 to 2. This means that for every two long positions you hold, you hold at least one short position.
The long to short exposure ratio could be spread out among sectors so it would not adversely impact the conviction you have on a specific industry. Reducing the beta risk by taking concurrent long and short positions only works when the different sectors you have selected have similar betas. For example, if you like the software sector but don't especially like the software stocks, and you think the broader market will rally as a whole, your strategy might be to go long two hardware stocks and short one software stock. If you are more neutral on the market, then you might hold two longs in the hardware sectors and two shorts in the software stocks. Because the hardware and software sectors have similar betas, this strategy should reduce your beta risk.
Stick to your game planSticking to your plan is the hardest thing to do as a trader. The reason it's so hard is that it takes strict discipline and an emotional detachment from the outcome. Knowing what to do and doing it are two separate issues. Trading involves so many unforeseen elements and market forces that mishaps and fuzzy thinking materialize even through this sea of uncontrollable elements is to have the discipline to stick to your game plan. Your plan is the shield that no market force can penetrate, unless you let it.
The main reason experienced traders lose is that they fail to follow their own rules. There are hundreds of reasons and excuses for deviating from a trading plan - for breaking your rules. In the long run, the reasons make zero difference. In the end, people are judged by their results, not the quality of their excuses. In an unstructured environment with multiple sources of reason pulling you in different directions, rules become the cornerstone for success.
A trading plan is predictable. It provides sources of reason given any number of existing circumstances. It filters out noise and encourages discipline. Remember that having a trading plan and sticking to it is invaluable. The simple recognition of this fact can provide the stimulus to adhere to your own plan.
The association a person attaches to losing can be deep-seated. Feelings of unworthiness or shame usually have their roots in childhood and can cause people to act in unpredictable ways. Loss in trading is unavoidable. The best traders do not get upset when they lose; they maintain equilibrium. Seasoned traders do not perceive loss as a personal or professional setback. Instead they acknowledge loss as a necessary and important step on the path toward success. Do not be afraid to lose. Act quickly to cut your losses without thinking about it.
MIND GAMES THAT CREATE MILLIONS FOR MASTER TRADERS
It is easy for trader to get hooked into subjective interpretations of what the market is doing, because their minds are playing tricks on them. Different people react in different ways to stress. Day trading takes an enormous amount of mental exertion, which requires physical energy. Successful trading is the by-product of a ruthless mentality that allows you to make quick decisions when there is a lot at stake. The best traders can make decisions objectively under stressful circumstances, without looking back.
Many traders fall into a middle ground wavering between subjective and objective interpretations. This happens because they are more attached to the outcome and what it represents than they should be. A trader who falls into a losing rut, for example, is more likely to perform poorly because of a negative state of mind. You tend to attract what you focus on. If you are in a losing streak, chances are that you are focusing on loss, thus attracting more loss. Detrimental mind games start to kick in when you refuse to accept the fact that you were not able to achieve your desired outcome. When you accept loss gracefully and refrain from beating yourself up, your mind-set will improve and you will be able to focus on where you want to go. This will improve your chances for success.
What not to do"When you learn what not to do in order not to lose, only then can you begin to learn what to do in order to win." EDWIN LEFEVRE, REMINISCENCES OF A STOCK OPERATOR
Successful trading involves two spheres of choice: action and inaction. The proactive course of offensive action is a step taken in order to win. It means that you have made a decision and are acting on it by putting yourself on the line. It should stem from a plan that provides contingencies for entering and exiting positions. It's an approach that requires doing something in order to benefit from it. It requires taking action now.
Playing offense by taking action, however, is only half of the equation. The other half of the equation that leads to successful trading involves inaction, or negative selection. Inaction involves refraining from trading in order not to lose; it is a preventive posture used for insurance. Not taking action under certain circumstances can be harder than taking action. It is very hard to be patient when you are bored, looking for excitement, and eager to make some money.
Many traders wrongly believe that they need to have a position in the market at all times. They ask themselves, "Should I be long or short here?" They rationalize that if they don't want to be long a stock anymore, then they have to be short it, or vice versa. Choosing not to trade, however, is also a decision. It's hard for some traders to admit that they may have no conviction on the current stock or market trend. There are times that having no position will statistically improve your chances of winning in the long run. If you consider being flat, along with being long or short, then you will begin to look at opportunities with more patience and less effort.
An example of defensive inaction in day trading is refraining from chasing a stock too far past your ideal entry point. Not chasing a stock is, in many cases, a way to avoid unnecessary loss. In day trading, entry is a crucial part of the equation and should not be done impatiently. If an entry point is missed, so be it. Take non-action. Choose not to chase. Wait for the next opportunity.
Traders should consider themselves to be on sentry duty throughout the trading day. Sentry duty is one of the hardest military assignments because most of the time nothing happens: It gets very boring. Even so, it requires careful attention to detail and concentration at all times, even though you may be bored. One little slip-up during a cigarette or coffee break could mean the difference between life and death, for the individual as well as the whole squad. The human mind will go to great lengths to avoid boredom. Yet in trading the natural human tendency to avoid boredom is a negative quality that must be recognized and controlled.
Avoiding certain actions preserves a trader's life and provides a shield from unforeseen difficulties. Defensive trading means not taking a course of action that might cause you harm or lost money. Inaction in trading is like defensive driving: It's a technique that involves knowing what not to do in order to get into an accident, such as not changing lanes before you look, or not gunning the gas when a light is about to turn.
In order to win, a successful trader must first learn that how not to lose. Knowing what action not to take is just as important as knowing what action to take.
Bottom fishing
No stock is ever cheap or expensive; it just is. A common rationalization is that because a stock was trading at 400 last week and now it's at 300, it's cheap! Stock price reflect the current supply and demand for an issue, regardless of past or future. A day trader's goal is to make money today, not to analyze long-term value. Each trading day must be approached with complete disregard for the past and future. Here and now is all there is. Today is when the money will be made, not yesterday and not tomorrow.
As a day trader, do not believe for a minute that the way to make money trading is to buy low and sell high. This is false in day trading. Attempting to buy low or to short high is the way to lose money, not to make it. Buying low and selling high is a description of bottom and top fishing, which are the enemy of all traders. Bottom fishing is the by-product of a faulty ego-based approach to trading. It involves a guessing game in which you are pitting yourself against the broader consensus. Let go of your desire to bottom fish.
"In a bull market one should trade only from the long side. In a bear market one should trade only from the short side."WALL STREET PROVERB
Although the above proverb sounds deceptively simple, experienced traders who attempt to pick bottoms and tops of trends lose fortunes. Bottoms and top fishing seem like the comfortable, rational thing to do. However, in the less than zero-sum game of trading, comfort and rationalization are costly goals that should be avoided whenever possible.
The most successful traders make their profits from buying high and selling higher or from selling low and buying lower. The market does not take your opinion into consideration when it decides where it wants to go. When you buy high and sell higher, you eliminate a large part of the guessing game that so many traders get entangled in. Always allow the market to show you where it plans to go. Do not try to guess when it is going to stop. Allow yourself to do the uncomfortable thing, which is to buy strength and sell weakness.
The myth of averaging down
A trader should never average down under any circumstances. Averaging down is buying more stock above the price where you originally shorted it. Averaging down means adding to a loser and hoping it will turn around. Whenever you hear the phase "average down," run for the hills. "I'll average down" is really a coined excuse that means, "I'll refuse to admit that I'm wrong."
Remember that you want to buy stocks that are moving in your direction, not against you. Your objective is to trade with the momentum. If you throw money into a losing position, you are fighting the momentum. Losses can easily become compounded in a snowfall effect when you average down. Adding to a loser is similar to rolling the dice out of frustration or desperation. If you maintain discipline in the first place, you will not be caught in the painful position of watching the size of your loss grow exponentially because you have thrown more money into a losing pit.
When you add to a loss, you are throwing good money after bad. That money could much better serve you if it were put to work in a winning position. When you average down, a small manageable loss can easily be transformed into a large unmanageable one. As a simple rule, ever add to a losing position, under any circumstances.
Rolling the dice
Great traders have proven time and again that they can consistently win by speculating when the odds are in their favor. They have the ability to correctly assess and integrate a risk-reward ratio that statistically favors a profitable outcome. The outcome is based on a statistical distribution, whereby the probabilities are measurable when the same strategy is employed consistently. Both novices and professional traders often confuse speculation with gambling.
Speculation is derived from probabilities; pure gambling, on the other hand, is based on hope. Gambling is a less than zero-sum game in which the outcome is not based on any measurable probability. Traders sometimes gamble with positions, and gamblers sometimes count cards and play when the odds are stacked in their favor. When you become aware of the difference between speculation and gambling in trading, you'll be able to repeat profitable trading scenarios while cutting out blind gambling shots.
In gambling, the house is the one that stands to collect, because the odds are in its favor. A gambler who wins will never really be able to explain why, except to say that "luck" was favorable. If you are trading for excitement, you are probably gambling. Gambling will force a trader's hand when no plan or discipline exists.
Gambling is a sickness and an addiction in many people. Gambling is believed to increase dramatically during times of stress and pressure; many gamblers are unaware of or just don't care about their real probabilities of success. They rely on some untouchable or unexplainable gut feeling. There are between 2 million and 5 million compulsive gamblers in the India who bet on anything from cricket matches, election results, Miss World winners, horse races and even on Film success and a number of day traders may fall into this category. Gamblers in trading fall into the low end of the performance spectrum, if they last. They are usually influenced by some hyped-up sector that is receiving all the attention in the media. The impulsive gambling instinct causes them to trade from the hip, sometimes with an all-or-nothing destructive urge. It is hard for some gamblers not to trade if they fear they will miss the current craze.
Successful traders are diametrically opposed to the gambling types. They do not look for excitement in the marketplace; they come thoroughly prepared with a clear plan and a search routine that is methodical. Rational traders maintain superior discipline, which shields them from the human emotional biases, such as hope and boredom, that are prevalent in gamblers.
Swinging for the fences
The desire to hit a home run in trading is the earmark of a beginner. The key to earning profits in day trading is consistency. Steadily hitting singles and doubles is how the pros fill the coffers with profits and produce dynamic results over the long run. Statistically speaking, a large swing occurring in a given stock at the precise time an order is entered is an anomaly. The stocks that make large and fast moves regularly are the ones that require a more diligent risk profile, translating into a smaller position with a wider stop-loss point.
Focusing on hitting singles and doubles does not mean that you cannot maximize your gains. It simply means that you are focusing on technique. When a batter hits a home run in baseball, it happens naturally, usually without any effort. The same holds true with a home run trade. The home-run trade should not be the focal point. Successful traders pile on the profits take care of themselves. Successful traders tend to view trading as a business, like any other, in which wishful thinking is kept to a minimum.
A Cricket batter who is attached to the idea of hitting a four is distracted by the thought and usually performs worse for it. Successful batters first visualize correct technique before getting up to the plate. They stay focused on the motions and technique that lead to consistency and greatness, such as stance, eye contact, grip, swinging motion, and other details. Proper technique leads to fours and sixers; boundaries do not lead to proper technique. Correct routine in trading revolves around visualizing and implementing proper methods, not around the big swing.
Swinging for the fences in trading is destructive on several counts. The first reason it's destructive is that it's the product of unrealistic expectations. Having unrealistic expectations may set you up for a letdown in the future, because the odds can be slim that the hoped-for event will occur. When high expectations are not met, traders generally experience a sense of disappointment and frustration; emotions that interfere with optimal trading performance and could result in a downward confidence spiral.
Another reason swinging for the fences is destructive is that it often fosters an-all-or nothing mentality, and traders risk far more than they should on a single position. The extra large position makes it harder for the trader to cut losses if the position turns the wrong way. A trader who is not willing to cut losses quickly will not last long. When traders focus on hitting home runs, their attention is diverted from other, profitable possibilities.
Position size envy
Traders often take larger positions than they should because they are experiencing size envy. Position size envy occurs when your ego whispers to you, "The sky's the limit." You may be in an environment in which other traders are taking positions larger than yours. You decide that if they can do it, so can you: You jump in without sticking your toe in the water first. If the water is ice cold, you could be in for the shock of your life. A trader's risk tolerance develops over time, given experience, confidence, and the emotional and financial ability to withstand losses.
Someone who can trade large positions had arrived at that point through a long and painful learning process. Most people cannot walk into a gym and bench-press 100 kilos if they are used to putting up only 20. The only way to get to the 100 kilos mark is to slowly build up your strength and tolerance over time through a gradual increase in the weight lifted. The same holds true for increasing your position size. It should be a slow process based on your financial capacity and psychological and emotional development, discipline, and strength. Traders should judge themselves by their own goals and nothing else.
One reason traders take positions that are too big is the almighty greed instinct. Greedy traders have an insatiable attachment to money. Remember, the most successful traders on Wall Street have a disregard for money. When you are glued to your Profit and Loss as a trader, your ability to act objectively is limited. Everyone experiences greed to some extent, but traders have to keep this human trait under control. Attachment in trading is detrimental because it represents emotionally charged subjectivity. The fewer associations and attachments a trader has, the better.
Emotional attachment to money and what it represents is the main reason traders freeze and have a difficult time taking losses, especially large ones. They find themselves in situations they're unprepared for financially or mentally. One of the hardest things for a trader to do is to stick to a game plan when emotions blow things out of proportion. A trader who freezes is unable to act or think quickly. This hesitation usually makes the difference between a profit, a loss, or a huge loss.
Another reason why a trader might have a position that is too large is because he adds to a loser, or averages down. Adding to a loser is probably the most deadly sin in trading, but the vast majority of traders do it at one time or another. Many do it out of sheer hope or desperation, refusing to acknowledge that they were wrong. Adding to a loser is the worst excuse for a trader to have a position that is too big. Wishful thinking and hoping to make back what was lost often result in huge losses. A snowfall effect is created, gaining size and momentum in the wrong direction.
One way to avoid adding to a loser is to realize that you can always cut your losses now and get back in later. Successful day traders are constantly selling stocks for small losses and reentering the position when they think the momentum has begun to move in their favor. Successful traders add to winning positions, not losing ones.
If losses set in that are above your risk tolerance, it becomes much harder to act quickly and to face the truth that you are wrong. As your account accumulates money, your position sizes should increase gradually. This will allow you to slowly build up your risk tolerance based on financial soundness. Position size in trading should be dictated by risk control, not high hopes. The anguish of being wrong in a trade grows exponentially when your positions get out of control. If the mind and wallet are not accustomed to taking large hits, it becomes very difficult to act swiftly and to cut your losses.
Vengeance trading
Vengeance trading occurs after a trader takes a hit on a trade and wants to get even with the stock. The reason the trade went sour doesn't usually matter; the trader is angry, but not wanting to accept blame, will quickly place it elsewhere. This misdirected emotional firestorm usually translates into pure revenge. The only solution in this cloudy state of mind is for the trader to avenge honor and money lost by getting them back from the stock that took it. The stubbornness festers, and pretty soon it's an all-out battle.
"The telecom stocks seemed likely to sell off hard this morning," thought Amar Damani, a market maker for a large firm. "They had a nice run yesterday, and with negative news out in Himachal and Global Tele, they should be down further." The Tech index was weak when Dhiren decided to short 5,000 shares of Himahcl, which at the time was down 3 points. For some reason, Sterlite Optic started to bounce off its lows and Himachal and Global followed along with it. "I can't believe this stock! This thing should be down ten points and for some stupid reason it's now up five rupees! I'll prove that I'm right and that the market is wrong and I'll get my money back by shorting another two thousand shares here." Amar added to his losing position and shorted 2,000 more shares. Soon after, Himachal ran another three points. By this time, Amar was red in the face and could not think of anything else but getting back at Himachal. He was cursing at Himachal, at the market in general, and at the computer screen.
Throughout the day, Himachal continued to rally along with all the other Tech stocks. Amar refused to cut his losses. As the day progressed, he became completely irrational and frozen with fear. His eyes were glued to the computer screen and he even punched the computer and the desk. He kept blaming Himachal and continued to short more stock so he could get even, until he was short 7,000 shares with Himachal up ten points. By the end of the day, Himachal was up 12 points touching the upper 8% filter and Amar was down Rs.100,000, and almost out of a job."
The problem with vengeance trading is that the initial loss probably occurred because the original direction of the trade was incorrect. Vengeance trades rarely take place in the opposite direction of the original losing trade. It takes a seasoned pro to change directions on a position after initially being wrong. The vengeance trade goes in the same direction because vengeance traders need to prove that they were right in the first place, that it wasn't their fault they lost money. They need to get even so their egos can be restored to their original perches.
The common misperception is that when you are trading, you are fighting the market, which is the enemy that must be defeated. Ameritrade recently ran an advertisement pitching on-line day traders and asking them if they were ready to take on the market with the following quote: "I don't want to just beat the market. I want to wrestle its scrawny little body to the ground and make it beg for mercy." This is faulty ego-based, unrealistic thinking that will lead toward losses, not profits. The market is never wrong and it cannot be defeated. It is selfless. It does not experience feelings of victory or defeat. The market is a cold battlefield and its participants are engaged in a life-or-death battle against themselves.
"Every battle that takes place, whether within the body and mind or outside of it, is always a battle against oneself."ZEN SAYING
Vengeance trading can quickly turn into disaster, because revenge is one of the strongest and most stubborn of emotions. Vengeance trading is a futile exertion of time, energy, and money. Its grip only tightens, clogging clear thinking and profit; it drains the resources of a trader, sucking time away from other profitable opportunities by encouraging the trader to focus on where the losing trade did not go, rather than where another trade could go. Instead of fretting over lost money and trying to get even with a market that does not care, use your time and energy to focus on other situations that will be more profitable.
You will immediately begin to improve as a trader when you stop wanting to control the outcome. The desire to control that which cannot be controlled creates a distorted reality, leading to stress and mind games that will thwart your success. It will be easier for you to acknowledge objective circumstance when you treat yourself kindly, and when you realize that each trade is just one step in the sphere of things to come. Acknowledging that you are not your results will help you to step outside of yourself and to trade with increased detachment and objectivity.
The trading mind
All the great traders attest to the impact psychology has on trading. Many believe that psychology has the greatest impact on trading decisions. Crucial psychological elements, both conscious and unconscious, affect the decision-making process for traders. Many of these mental elements and psychological profiles are ingrained from childhood, and traders are unaware of them. Prices move with emotional extremes, triggered by psychological associations with gain and loss. The first step toward successful trading is developing an awareness of the influence of psychological and emotional factors on your actions.
No fear
"There is only one thing that makes a dream impossible to achieve - the fear of failure."THE ALCHEMIST
Fear is perhaps the most debilitating emotion a trader can experience. Painful memories produce fear, which warps a trader's focus. When you are afraid to lose for one reason or another, you will end up focusing on loss and, by doing so, will attract precisely the opposite of what you hope to avoid.
When you operate out of the fear of being wrong, you are focusing your energies in a losing direction. Fear is the main reason traders cut their profits short and let their losses run. With winning positions, traders fear that they will lose what they have grained. Because of the fear of loss, they look for signs that indicate that the trade will reverse course, instead of looking for reason why it should work out. They eventually find a reason that confirms their fears, so they cut profits short instead of letting them run.
The fear of loss is a double-edged sword that will convince a trader to do the wrong thing not only when you have a losing position. If you have a position that is going against you and is losing money, your fear of loss will cause you to look for signals that the trade will work, because you do not want to accept the fact that you are experiencing loss. Because of this fear, you will let the loss run instead of accepting it and quickly cutting it short.
According to scientific research, the Reticular Activating System (RAS) is a mechanism in your brain that determines what you observe and how you pay attention to it. The RAS attracts information to support what you are focusing on and alters your conscious experience. An example of the RAS in action is when you suddenly notice an item that you just purchased everywhere.
If you believe that you will win at trading and you focus on where you want to go, then the RAS will attract information that supports your focus and belief. On the other hand, if you continually harbor fear in your heart about losing money on a position, your RAS will draw pieces of information that support your fear. If you enter into a trade that is working but you are afraid to lose what you have gained, the RAS will feed off the emotional intensity of fear, and will attract you to information on why the trade might not work, encouraging you to cut your profits short.
Because your brain can only focus on a limited number of items at once, the RAS blocks out whatever it does not hold important. It filters out the noise it believes to be unimportant to your priorities. When you are trading stocks, innumerable tidbits of information about the market come streaming in, all of which require your interpretation. Because it is impossible for your brain to absorb all of the information coming at you at once, your RAS will determine what you will notice. When you focus on where you want to go, the RAS will block out information that is nonessential for you to achieve your objective.
Doctors describes fear is "...the anticipation that something that's going to happen soon needs to be prepared for." Regardless of whether the event ever takes place, fearful anticipation is a reality. Preparing for the anticipated event beforehand is a crucial step toward managing fear. The worst thing a trader can do is deny that fear exists. Fear delivers a message that will not disappear until it is acted on. Action cures all fear.
If you relinquish control to fear, then you allow it to increase its grip over your actions. If you ignore fear completely, then you are not respecting the potential value behind its message. The first step toward managing fear is to acknowledge that is exists. Be aware of its presence and determine what steps you need to take in order to diminish its power.
Fearful emotions in trading range from small quantities of worry, unease, and apprehension to extreme levels of anxiety, panic, and horror. The associations a trader has developed about what a loss means to you on a personal, professional, or financial level will dictate your various levels of fear. The very best traders are comfortable with the notion that they can be lost it all. This acceptance of and detachment from loss eliminates a large part of their fear. Because their fear is managed, they have the mental freedom to focus their energies on winning.
One of the best recipes for conquering the fear of loss is to prepare for the loss beforehand with proper risk control. Detachment from loss comes with the knowledge that you can financially withstand to lose everything you have riding on your current positions. If your liquid net worth is Rs.500,000, and you have a large percentage of that riding on a few positions without an adequate stop-loss risk profile, the fear of loss will be magnified dramatically. This holds true especially if you are trading stocks that are volatile and less liquid, with a large slippage factor.
When a day trader is trading with high levels of margin in volatile stocks, and the lion's share of his portfolio is riding on a few positions, his levels of fear will be magnified because a loss under these circumstances will mean a lot. If he loses under these circumstances, it will be easy for him to get caught up in a losing cycle. Desperation may set in and he will trade emotionally and subjectively to win back what he lost. The emotions he will experience at this point are not just fear of financial ruin, but also feelings of guilt, shame, and unworthiness. Under these circumstances, his confidence and conviction will be close to zero, which just happens to be the very worst time to be trading.
When you invoke the financial discipline to trade with only a portion of your liquid net worth, and use a stop-loss risk profile of about 2 percent of your portfolio, then your fear of loss will be substantially reduced because you can afford to lose. This requires keeping expectations realistic about the amount you can expect to earn from trading, especially when you are just beginning.
If you have Rs.500,000 in liquid assets and you earmark 20 percent or Rs.100,000 to trading, using a Rs.2,000 maximum stop-loss level per day, you have made a realistic pre-emptive strike against fear of loss. As you trade this money and if you are successful, you can reinvest your gains and use the profits to expand your base for larger trades.
Managing and reducing the fear of loss also requires a willingness to understand and accept the fact that the money you have invested in day trading is money that you may never see again. When you come to this understanding beforehand and you are willing to lose the money, then you will not be attached to or afraid of loss. When you trade in this state of mind, your chances for success increase because you are free to act objectively, without hesitation or inhibition. When you reach this state, you are levels ahead of most of the other traders. Don't be afraid of the worst-case scenario when you are trading. If you understand that failure is a natural and necessary part of the trading process, you will have increased confidence to take risk and to cut losses quickly.
Listen to the market
The current price of the market represents the belief and perception of all the traders who are participating in the market at the current time. The last price represents the emotional unanimity of the masses that are currently acting on their perceptions. The reason a stock or the market has reached a certain price level is irrelevant. Price action represents the interpretations of all the players, whether they are valid or not. If someone has inside information about a stock and acts on this information, the price action will be portrayed for all to see. Information that is acted upon cannot be hidden, because price and volume will always uncover it.
Being right and making money when you are trading can be two separate issues. Your goal as a day trader is to make money, not to be right. Prices move in the direction of the strongest energy behind them. When you listen to the force behind the prices and jump on board for the ride, your actions will not conflict with the market's opinion. For example, suppose you have done research on a company and you know that it is undervalued relative to its peers. Because of your conclusion, you buy 5,000 or 10,000 shares, only to watch it drop two points. Who was right - you or the market?
Waiting for the market to confirm your initial opinion is crucial. The market provides clear signals for the best course of action, regardless of your opinion. You must be go of any preconception about what the market is going to do, and instead remain focused on what the market is doing here and now. The clues and signals about what is happening are readily available to all who are willing to put aside their opinions and listen to the market instead.
To increase your ability to listen to the signals of the market objectively, you should develop a mental state of mind that Deepak Chopra calls detached awareness. Detached awareness occurs when you observe what's going on with little at stake to your ego. Detached awareness occurs when you step outside of yourself and calmly observe your actions. For the trader, this detachment means abandoning your associations about what a stock's move will mean for you emotionally, financially, and personally.
Accept responsibility
Taking responsibility for all your actions and all your trades at all times, regardless of the rhyme or reason, takes a great deal of maturity and can be a hard thing to do. Even if something happened that was outside your control, act as though you alone were responsible for the outcome.
You alone are in control of your mind, and therefore your actions and your results. When you accept responsibility for all your actions, you will be empowered with the ability to choose how you want thing to be. You alone will be the cause and effect for your outcomes.
Time and again, traders rationalize their actions by passing the buck for something that went awry onto someone or something outside of themselves. Rationalization has a corrupting influence on a trader, because it encourages you to dodge responsibility. There will always be excuses and reasons why a trade or anything in your life did not work out the way you planned or hoped for. The strongest traders are the ones who recognize that excuses and rationalizations are folly.
As soon as you relinquish responsibility by rationalizing your actions, you lose the power to learn from your mistakes, which is the best way to learn. You can always think up reasons for holding on to a loser or adding to a losing position. Even when your reason for doing the wrong thing is sensible and learned, if you do not accept responsibility for the loss, you will not learn from it.
Rationalization forms a barrier between what you know is the right thing to do and what you hope will ultimately happen. It indicates that you are having trouble admitting that you are wrong. When you catch yourself making excuses for things that went wrong, it is a sure sign that your ego is swelling up and getting in the way of your improved future performance.
You immediately empower yourself as a trader when you accept the consequences of all your actions, regardless of how painful it might be to do so. Trade with the belief that you are the cause in your universe of trading results. Do not believe for a second that there is such a thing as an accident in trading. When you accept principle of cause and effect, you will be empowered to take responsibility for everything that happens on your trading pad and in your life.
There will be many times when you are faced with a situation you do not want to take responsibility for, one that may not be your fault. Some common excuses in trading include faulty trading systems, slow executions, backing away, an assistant who made a mistake, misinformation, false rumors, listening to others' opinions, and fuzzy thinking. Many of these could be valid, but resist the urge to fall back on them.
When you do not accept responsibility, you relinquish the power to make things different in the future. This is a short-term fix used to alleviate discomfort, but a long-term blunder. When you accept responsibility for everything that happens in your life, you empower yourself to create the trading world you would like. By accepting responsibility for your trades, you empower yourself to consistently improve your performance in the future.
Greed is an obstacle
Webster's dictionary defines greed as excessive or reprehensible acquisitiveness. The problem with greed is that it feed on itself and fosters a state of lack: the opposite of what you are trying to achieve by being greedy. When you are driven by greed, as you attain more you want more, so you have less instead.
Wanting can actually be defined as a state of lacking. When you want something badly, your brain is sending you signals of destitution. If you live in a state of wanting something, then you will attract scarcity. Whatever you focus on and attach emotional significance to expands in your life. If you are driven by greed, then you are trading in a state in which you are constantly aware of what you do not have. This is called poverty consciousness, and it will work against your goals of creating abundance in your life.
Greed indicates that your attachment to money is ironclad. It arises from the belief that you lack something because there is not enough to go around. This belief is destructive and false. The universe's natural state is one of abundance and wealth. Deep down, if you did not belief this was true, then you would not be trading with the objective of fulfilling your potential. Greed is unfulfilling because there will never be enough to satisfy what you believe you lack, so the more you get, the more you believe you need.
Greedy traders are attached to what money represents to them on a personal level. Most people go through life with the belief that money and material objects that it secures represent the acknowledgement, approval, and validation of others. The thirst for approval is one of the strongest emotions human beings experience. These feelings are ingrained from early childhood and are dominant in the subconscious.
The quest for approval causes traders to act in all sorts of weird ways, disregarding their trading plans in the search for the stronger desire to attain approval in all forms - from their peers, their parents, their childhood teachers, themselves; the list goes on. Acknowledging the fact that you are seeking approval and recognition in a given situation is the first step toward releasing that emotion, which will provide you with freedom to trade objectively and without greed.
Conquer frustration
Traders make some of the worst decisions when they are frustrated. Frustration clouds thought and destroys objectivity. Frustration is a state of insecurity or discontent stemming from unconcluded problems or needs that have not been fulfilled. This dissatisfaction can be commonplace among traders who are experiencing losses. It is very easy to become frustrated when you are trading. Hundreds of factors in trading can leave a door wide open to feelings of frustration.
Trading is one of the most intense and physically demanding occupations. With so much dependent upon technology, and with so much at stake, little mishaps can pile up to create a state of agitation and frustration. Frustration is a common emotion in trading because so much effort is put into preparing for the moment when it's time to trade. Because loss in trading is natural and common, a trader can get frustrated quickly if you experience a string of losses without experiencing any reward.
The perpetual motion of markets and prices causes discrepancies in price that will often test a trader's mettle and conviction. If you let yourself become frustrated due to a lack of immediate results, you are setting yourself up for a blurred subjective vision. When you experience frustration, realize that it is a sign for you to complement your approach to trading with increased flexibility and patience.
Your success as a trader at times hinges on your ability to conquer frustration. Frustration will always appear on your path toward greatness. Some will triumph over it, while others succumb to its pettiness. When you encounter obstacles on your trail toward achievement, remind yourself that they were placed there in order for you to overcome them, so you can learn from them and become better than you were before. Remember, little things affect little mind.
Don't look back
Regret is a poisonous emotion that traders experience all too often. It can be very painful to watch a stock move forcefully in your direction after you missed the chance to get on board for one reason or another. Because of the vast number of trading opportunities in the market, it is impossible not to miss many of them. Let go of regret and instead treat yourself kindly when trading. Do not beat yourself up for having missed an opportunity. Remember that there will be many, many more chances for winning trades. Regret is toxic because it encourages you to look back and to focus your energies on the past, when you should be using your valuable time and energy to focus on the here and now in order to uncover trading opportunities.
When you acknowledge that you are feeling regret, then you have taken the first step toward diminishing its power over you. Regret can serve a purpose when you admit that it exists, learn quickly from its message by accepting responsibility, and then pardon yourself and move on.
Rather than living in the past by regretting what could have been, resolve to live here and now, in the present. Remind yourself that if you could have taken action, you would have. Excuses have no place in trading, because in the end they never make a difference anyway. Admit to yourself that for some reason, something within you prevented you from action. Only you know what it was, and only you can fix it. By accepting responsibility without blaming yourself, you will learn from the experience and develop into a stronger trader, without regret. Growth in trading is a continuous process. There is always room to become better, so give yourself the space to breathe and to learn unencumbered by feelings of regret.
Exude confidence
The best traders are successful because they are able to maintain unshakable confidence in themselves and in their decisions. This serene self-confidence creates a positive state of mind and the will to act.
There is an old saying: "If you would be powerful, pretend to be powerful." One technique for developing confidence when you are trading is to role-play. Think of a confident role model, preferably a successful trader whom you look up to, and pretend to be that trader. Imagine that you have the power to act decisively when trading, without hesitation, letting your winners run and cutting your losses short. This will transform the way you perceive yourself and how you make your decisions.
We communicate more with our body language and tone of voice than with our words. When your body language and voice portray a confident person, then people will respond to you as if you were a confident person. Practice sitting, talking, and acting confidently in everyday life and watch your conviction and decision-making process on the trading desk improve.
Exercise also substantially boosts your confidence. When you feel positive about yourself and how you look, you are more inclined to act confidently. Exercise also has a number of other positive side effects for traders, including alleviating stress and reducing anxiety. Because trading is such a physically demanding occupation, you owe it to yourself to exercise as often as possible. Consider exercise an investment in your trading career.
Dress well when trading, because looking good will increase your self-esteem. High self-esteem will positively affect your everyday decisions and help you feel more optimistic in general. Developing confidence in yourself and in your actions is a continuous, lifelong process. This is an area that you should devote time to every single day. As your confidence increases, you will feel better about yourself and the world around you. As you practice using a confident tone of voice and body language on a regular basis, that confidence will be readily accessible when you need to use it in your decision-making process. When you look, sound, and act confident, you yourself will believe that you are. Others also react to you as a confident person, which in turn will empower you.
Maintain prosperity consciousness
World renowned Spiritual guru Deepak Chopra says that "all relationship is a reflection of your relationship with yourself." If you feel guilty or insecure about having wealth or good things in your life, those feelings are a part of your character that you have to address. Profitable trades will not solve these issues. As a trader, an important question to ask yourself is whether you feel that you truly deserve to be wealthy. This question must be answered honestly. If you do not believe you deserve to be wealthy, sooner or later you will sabotage your chances for success.
Many people carry around feelings of unworthiness ingrained from childhood. These feelings often stem from the association parents or a religion attaches to money. The first step toward changing these destructive and unrealistic feelings is awareness. Only when you allow these feelings to surface consciously can you address them, release them, and let them go.
You are your own harshest critic. The feelings of guilt and shame that people carry around have no bearing on reality. People may have distorted memories of how they injured or hurt someone else, when in fact that was not the case. To achieve success in life, you have to learn to have compassion for yourself. Feelings of self-worth translate into positive outer manifestations in all areas of your life. Those who feel that they deserve only the best in life attract other people and circumstances to themselves that will confirm those beliefs. When you understand that abundance and wealth are the natural states of the universe, and you recognize that you deserve to be wealthy, your actions will begin to model your inner beliefs.
Security is an illusion
Are you trading for security? If you are, you may be in the wrong business. If a trader is trading with the objective of being secure, you are juggling two opposing forces. You are attempting to derive stability and safety from market forces that are inherently unstable and insecure.
Is there such a thing as security? Deepak Chopra said, "Life is either a daring adventure or nothing at all." If you are attached to the concept of security, it will have the effect of making you feel insecure. An attachment to something outside of yourself is unfulfilling, because you feel empty without it. There is no security in the markets. Time and again, some of the so-called smartest names in trading have gone bust practically overnight.
When you are trading for security, you are attempting to keep what you have because you are afraid to lose. This fear will inhibit your actions and will make you a less effective trader. When you fear losing, you will actually create losses. You will be unable to cut your losses when they are small, and you will miss great trading opportunities because you are afraid to lose. The same fear of loss infects the actions of people in everyday life, holding them back from living the lives that they always dreamed of. Security is a very fleeting thing and can never come from money itself. Attachment to money or profits creates anxiety and a feeling of lack. This attachment means that your sense of well-being is dependent upon something outside of yourself, which there could never be enough of. If a person cannot afford to lose, fear and attachment will always reign.
A good question to ask yourself is what is the worst that could possibly happen to you, the worst outcome that you can imagine? You've managed to live up until now. You've always been provided for and cared for, or else you would not be reading this book. There has always been enough food on the table. Life will go on. You will be okay.
The acceptance of loss puts into perspective the fact that each trade is only a single trade in the design of things to come. Ten years from now, when you look back at the loss, it will seem like an insignificant speck, a learning experience that happened for the best. The only thing that is sure in trading is that you'll win some and you'll lose some. The markets will always change. Nothing is permanent.
Deepak Chopra said that "...to die having failed is not a shameful thing. It means that if you keep your spirit correct from morning to evening, accustomed to the idea of death, and resolved on death, and consider yourself as a dead body, thus becoming one with the Way of the Warrior, you can pass through life with no possibility of failure and perform your office properly." When the possibility of death or failure is accepted, which everyone will face eventually, then what is the worst that could happen to you? If you are trading with money that you can afford to lose, then you have accepted the worst-case possibility up front. Anticipation of failure or loss is worse than loss itself. Not being afraid to fail or to lose is true freedom.
"To foster life all fear must be killed. Once all fear is killed you can dwell at ease. If you understand this meaning, an iron boat can float across water." ZEN SAYING

Write down what you want
"You have to be specific with your goals because the universe will deliver what you want. The universe will give you what you dwell upon. If you Dwell upon ambiguity it will give thou just that."NOSTRADAMUS
Write down your trading goals, and be as specific as possible. The goals need to be measurable, so when you achieve them you will know it. Remember to be very specific. Once your brain has the target, it can begin to figure out ways to best achieve it. Your profit and loss objectives should be broken down into yearly, monthly, weekly, and daily goals.
Develop goals for all areas of your trading development. Focusing on the reward aspect of trading alone is a faulty approach. Certain areas of your trading approach will require more development than others. Only you know what you need to work on the most. This requires honest introspection and diligent analysis.
You may be an expert at letting your profits run, but you may have trouble cutting your losses or taking profits. Perhaps you chase stocks past your ideal entry point too often, or it could be that you are not aggressive enough at executing trades. At the end of the day, record in a journal the correct and incorrect trades you made throughout the day, so you can learn from them. Keeping a daily journal is a potent way to zoom in on your strong and weak points as a trader. Once you are aware of shortcomings as a trader, you can convert them into positive written goals.
All your goals should be written down in the present, as if you have already achieved them. When working with goals, act and feel as if you already have that which you are seeking. When you act and feel and believe that you have achieved your goal, your confident state of mind will reject the obstacles that stand in your way. If your objective is to earn Rs.100,000 a month, write down the goal as follows: "I now earn Rs.100,000 a month trading." If your objective is to stick to your stop-loss criteria, then your written goal could be: "I always stick to my prearranged stop-loss points." Read these goals out loud in the evening before you go to sleep and in the morning when you wake up. When reading them, use as much emotion as possible so you can work yourself into a state of experiencing the outcome.
Your trading goals should be as realistic as possible. If you do not believe inside that you can accomplish the result, then it will be hard for you to internalize it. A goal that is unrealistic is discouraging. The way to make your goals realistic is to start where you are today. Decide what specific action you can take and what sort of results you can expect to receive from that action. Begin with a more conservative goal for the near term. Use your past achievements as the immediate benchmark for what you can expect in the future.
Your goals need to be timed toward your objectives. Setting specific dates is very important. Once you write down and commit to a deadline, your brain takes over, sometimes in mysterious ways. We use only a very small part of our brains consciously. Having a written goal accomplishes amazing things. Write out your goals as far as possible into the future, with as much detail as possible.
Remember that you should always judge yourself by your goals only, not by anyone else's. What others are doing or have done should be of no concern to you. Financial goals in day trading can range from as little as Rs.500 a day to over Rs.5,00,000 for big time market makers. Just remember that it is important to maintain realistic expectations about your abilities and your resources.
Psychology has a powerful impact on trading results. It is impossible to separate your psychological makeup from your results. Being aware of the way your mind works is the first step. You must know your own strengths and weaknesses before you can hope to grow stronger and to overcome the obstacles that will inevitably appear in your path toward trading greatness.

TIME TESTED TRADING RULES TO BE A MASTER TRADER
This is a list of classic trading rules that was given to me while on the trading floor (called the trading ring of BSE then) in 1994 when I just begun a career in stock markets having passed out of HSC then. A senior trader collected these rules from classic trading literature throughout the twentieth century. They obviously withstand the age-old test of time. I'm sure most everybody knows these truisms in their hearts, but this list is nicely edited and makes a good read.
  • Plan your trades. Trade your plan.
  • Keep records of your trading results.
  • Keep a positive attitude, no matter how much you lose.
  • Don't take the market home.
  • Continually set higher trading goals.
  • Successful traders buy into bad news and sell into good news.
  • Successful traders are not afraid to buy high and sell low.
  • Successful traders have a well-scheduled planned time for studying the markets.
  • Successful traders isolate themselves from the opinions of others.
  • Continually strive for patience, perseverance, determination, and rational action.
  • Limit your losses - use stops!
  • Never cancel a stop loss order after you have placed it!
  • Place the stop at the time you make your trade.
  • Never get into the market because you are anxious because of waiting.
  • Avoid getting in or out of the market too often.
  • Losses make the trader studious - not profits. Take advantage of every loss to improve your knowledge of market action.
  • The most difficult task in speculation is not prediction but self-control. Successful trading is difficult and frustrating.
  • You are the most important element in the equation for success.
  • Always discipline yourself by following a pre-determined set of rules.
  • Remember that a bear market will give back in one month what a bull market has taken three months to build.
    Don't ever allow a big winning trade to turn into a loser. Stop yourself out if the market moves against you 20% from your peak profit point.
    You must have a program, you must know your program, and you must follow your program.
    Expect and accept losses gracefully. Those who brood over losses always miss the next opportunity, which more than likely will be profitable.
    Split your profits right down the middle and never risk more than 50% of them again in the market.
    The key to successful trading is knowing yourself and your stress point.
    The difference between winners and losers isn't so much native ability as it is discipline exercised in avoiding mistakes.
    In trading as in fencing there are the quick and the dead.
    Speech may be silver but silence is golden. Traders with the golden touch do not talk about their success.
    Dream big dreams and think tall. Very few people set goals too high.
    A man becomes what he thinks about all day long.
    Accept failure as a step towards victory.
    Have you taken a loss? Forget it quickly. Have you taken a profit? Forget it even quicker! Don't let ego and greed inhibit clear thinking and hard work.
    One cannot do anything about yesterday. When one door closes, another door opens. The greater opportunity always lies through the open door.
    The deepest secret for the trader is to subordinate his will to the will of the market. The market is truth as it reflects all forces that bear upon it. As long as he recognizes this he is safe. When he ignores this, he is lost and doomed.
    It's much easier to put on a trade than to take it off.
    If a market doesn't do what you think it should do, get out.
    Beware of large positions that can control your emotions. Don't be overly aggressive with the market. Treat it gently by allowing your equity to grow steadily rather than in bursts.
    Never add to a losing position.
    Beware of trying to pick tops or bottoms.
    You must believe in yourself and your judgement if you expect to make a living at this game.
    In a narrow market there is no sense in trying to anticipate what the next big movement is going to be - up or down.
    A loss never bothers me after I take it. I forget it overnight. But being wrong and not taking the loss - that is what does the damage to the pocket book and to the soul.
    Never volunteer advice and never brag of your winnings.
    Of all speculative blunders, there are few greater than selling what shows a profit and keeping what shows a loss.
    Standing aside is a position.
    It is better to be more interested in the market's reaction to new information than in the piece of news itself.
    If you don't know who you are, the markets are an expensive place to find out.
    In the world of money, which is a world shaped by human behavior, nobody has the foggiest notion of what will happen in the future. Mark that word - Nobody! Thus the successful trader does not base moves on what supposedly will happen but reacts instead to what does happen.
    Except in unusual circumstances, get in the habit of taking your profit too soon. Don't torment yourself if a trade continues winning without you. Chances are it won't continue long. If it does, console yourself by thinking of all the times when liquidating early reserved gains that you would have otherwise lost.
    When the ship starts to sink, don't pray - jump!
    Lose your opinion - not your money.

Sunday, September 21, 2008

Time Decay with Option

Example of Time Decay

You pay me $1.00 for an OTM option with 10 days until expiration.
With each day that passes, let’s say the option loses $0.10 of time value (please note this is just an illustration. In practice time decay is not linear).
So, assuming there is no movement in the underlying stock price, the option value will behave as follows:

Day Option Value Buyer Profit Seller Profit

Day 0 $1.00
Day 1 $0.90
(0.10) + 0.10
Day 2 $0.80
(0.20) + 0.20
Day 3 $0.70
(0.30) + 0.30
Day 4 $0.60
(0.40) + 0.40
Day 5 $0.70
(0.50) + 0.50
Day 10 $0.00
(1.00) +1.00

Do you see how time decay has helped me (the seller) and hurt you (the buyer)?

Lesson: Never buy OTM options with less than 1 month to expiration unless it forms part of a multi-legged spread trade.

The negative value of theta indicates to us that as time gets closer to expiration, time decay increases. With options, time decay increases exponentially during the last month before expiration. Put another way,

time value decreases exponentially

during the last month before expiration.

The big question is how can we mitigate time decay?
  • Sell off any owned ATM or OTM options with 30 days left to expiration. Time decay accelerates at its fastest during the last 30 days to expiration. Remember that OTM and ATM options have no Intrinsic Value, so they must be made up purely of Time Value. Since we know that time value decreases exponentially during the final month before expiration, it makes sense not to hold onto these options.
  • Sell options you don’t already own as an adjustment to existing trades – we’re not talking about creating naked positions here, the sold option would be complementary to your existing play (for example, Bull and Bear spreads).
  • Buy short-term deep ITM options, e.g. a deep ITM put or deep ITM call will have lots of Intrinsic Value and virtually no Time Value. If there is no Time Value, then it can't decay any further, can it? Remember about Time Value and Intrinsic Value. Well, here we’re talking about there being so little Time Value as a proportion of the option premium because the option is so deep ITM.
Let’s take at look at each one of these points in turn:
Sell off OTM or ATM options with less than 30 days to expiration
The diagram below gives us a perfect illustration of how theta decay works with options. Notice how the slope falls off at its steepest during the last 30 days.

Diagram: Time Decay
Time Decay.jpg



Sell options you don’t own as an adjustment to existing trades …

Note that here we’re not advocating selling options naked and exposing yourself to an unlimited risk profile. Many people successfully sell OTM options every month and collect a decent premium. However, if the market suddenly jolts against them and they get exercised, then an entire year or more can be wiped out (or more) in literally one day. The fact remains that selling options naked is not a businessperson’s way to trade. Although there are some high-probability mathematical techniques of naked options selling, if your capital can be wiped out that fast when you’re not looking, then that’s simply not a sensible way to go about your business. It’s far better to be able to sleep at night, that way you’ll pass the test of longevity and be able to consistently trade and invest for many years even well into your retirement.

Buy short-term Deep ITM options
You can mitigate the effects of time decay by buying Deep in the Money (DITM) options, the reason being because Intrinsic Value is vastly outweighing Time Value. If there is little to no Time Value in the option (as compared with Intrinsic Value) then your risk exposure to time decay is, by definition, little to none!


Diagram: Time value for deep ITM options
Time Value for DITM.jpg



Example:

Let's say a stock is priced at $42.10. There are only 18 days left to the May expiration and just over six weeks left till the June expiration.

Question:

How much Time Value and Intrinsic Value is there for the following options?

Remember:
  • Call option Intrinsic Value = stock price – strike price

  • Call option Time Value = call option price – Intrinsic Value

  • Intrinsic Value minimum = Zero

See if you can fill in the table below:



Call option Last ($) Intrinsic Value Time Value
May 12.5 30.20 42.10 – 12.50 = 29.60 30.20 – 29.60 = 0.60
May 15 27.
May 17.5 25.30
May 20 22.80
May 22.5 20.30
May 25 18.00
May 40 5.50
June 20 23.20
June 22.5 20.90
June 25 18.70
June 40 8.20

Answers: (take note of the percentage of the entire option premium which is taken up by Intrinsic or Time Value as the option gets Nearer the Money)


Call option Last ($) Intrinsic Value Time Value
May 12. 30.20 29.60 98% 0.60 2%
May 15 27.80 27.10 97.5% 0.70 2.5%
May 17.5 25.30 24.60 97% 0.70 3%
May 20 22.80 22.10 97% 0.70 3%
May 22.5 20.30 19.60 96.5% 0.70 3.5%
May 25 18.00 17.10 95% 0.90 5%
May 40 5.50 2.10 38% 3.40 62%
June 20 23.20 22.10 95% 1.10 5%
June 22.5 20.90 19.60 93.8% 1.30 6.2%
June 25 18.70 17.10 91.5% 1.60 8.5%
June 40 8.20 2.10 25.6% 6.10 74.4%

Do you see how DITM options premiums are heavily weighted by Intrinsic Value and minimally weighted by Time Value, thus reducing the exposure to time decay? And how Time Value tends to dominate the short-term ATM options?
Say we have a simple call option, the stock price is $69 and the 70 strike January call option is priced at $9.80. Let’s look at the theta as at 20 April and compare it with the position of theta with only one month left to expiration:
Notice how both theta lines are negative but especially notice how much more theta decay is harming our long call position when there is only one month left to expiration. Also notice how theta is at its lowest at the $70 level, i.e. At the Money (ATM).
Chart: Long Call theta profile
Long Call Theta.jpg


The same applies to puts. Let’s look at the equivalent example with puts:

Chart: Long Put theta profile

Long Put Theta.jpg

Now have a look at theta decay for the Short call and Short put positions. Can you guess what will happen and how they will look?

Chart: Short call theta profile
Short Call Theta.jpg
Chart: Short put theta profile

Short Put Theta.jpg

Generally, when theta is positive, time decay is helping the position. When theta is negative, time decay is hurting the position. When we buy options, we have a negative theta, indicating that time decay hurts our long option position. This makes sense as an option is a wasting asset. When we write options, we would expect the opposite to be the case, which of course it is. When we write an option, its value will decline as we approach expiration. If we write a $1.00 OTM option with 10 days left to expiration, assuming that time decay reduces the option by $0.10 per day, then by day 5, we’d only have to pay $0.50 to buy it back, thereby making a $0.50 profit assuming the stock has not moved. In this scenario time decay has helped us, the writer of the option. On the other hand, the person who (stupidly!) bought the OTM option from us with only 10 days to expiration has lost 50% within the first 5 days assuming there is no movement in the stock price.

If time decay is unhelpful to your long option positions, then it stands to reason that it will be helpful to your short option positions. You can see this by way of simple graphical representation in that now the theta lines are positive, showing that theta decay is helpful to a short option position.
Diagram: Theta Summary

Theta Summary.jpg