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I once worked with an individual that had no trading experience, but had a C-Suite position in the industry. After attending a conference, I asked what they felt the big takeaway was and they responded, “I think traders are looking for an edge.” Go ahead and roll your eyes, yes they actually said that. Needless to say, they are in a different industry now.
On the other end of the spectrum, I once got to interview Ed Thorp, and when you have a chance with a legend like that you try to sneak in an off the record question after the camera is off. Mine was, “Where are you looking for alpha in the markets these days?” His response was, “I always try to look where most people are not looking or where my opinion differs than market consensus.”
In the option space, option pricing is a good indication of the market’s consensus. In fact you may have heard an options educator say something to the effect of, “This option has a delta of 60 so there is a 60% chance it will be in the money at expiration.” In reality, that 60 delta is the market’s prediction regarding the option, but it may differ from the odds of market action based on history. One way to make profits in the option market is to find these differences. Over the weekend, while looking over the trading tape, I came across an NDX trade that appears to have an edge relative to 2022 trading activity.
Short-term trades using options are all the rage these days as daily option expirations have opened up the opportunity to benefit from an outlook for a single day or less. For example, late Friday December 9, an NDX trade was execute using options that expire Monday December 12. Shortly before the market close and with NDX at 11563 a trader bought the NDX Dec 12 11320 Put for 5.30 and sold the NDX Dec 12 11310 Put for 4.60 and a net cost of 0.70. The result if held to expiration appears below.
This trade works best if NDX drops 2.19% or more which would result in a maximum profit of 9.30 on the close. Now that sounds like a bit of a stretch, but we like to run numbers, and for 2022 a 2.19% drop is nowhere out of the question. As of Friday there have been 237 trading days in 2022 and 37 of those days witnessed a drop greater than 2.19%. This is 15.6% of trading days. Based on that admittedly basic analysis, this trade looks pretty smart.
Here is why we like the trade, even if the result is a loss of the 0.70 cost of the spread. First, the dollar risk versus reward is attractive at a gain of 9.30 based on a risk of 0.70. Also, consider if this trader repeated this trade every day this year. This would be 37 winning trades making 9.30 and 200 losing trade losing 0.70 each. This means losses of 140.00 for the 200 losing trades, but a gain of 344.10 for the 37 winning trades or a net gain of 244.10, of course adjusted for commissions. That’s a trade with an edge and daily options are opening up multiple opportunities to find small edges and take advantage of them.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Image and article originally from www.nasdaq.com. Read the original article here.