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Apr 13, 2021

Trading Mechanics 101: Four Options Trading Tips to Know | tradeTALK Series

By:Mike "Beef" Hart

Research has established that consistent trade mechanics improve profits and the probability of success. Consistency keeps us on track and in the game, ultimately limiting guesswork in our trade decision making.

Trade mechanics is a term often used but rarely explained in trading. Having a well established set will assist in all areas of trading, of course with the goal being an improved bottom-line. tastytrade’s Mike Hart covers four types of trading mechanics that traders should spend extra time on this year.

Principals should not be confused with steps. I listed these as 1,2,3,4 but no principal is more important than the other. Ideally we internalize these as they will ultimately assist us in the following three areas:

  • Maintain Consistent Risk

  • Find Quality Opportunity

  • Control Probability

Principal #1: Pick the Right Times to Adjust

The market is captivating in its power to express millions of traders' emotions and decisions in establishing equity prices from moment to moment. In a real way, equities' trading reflects the human psyche defined by sophisticated metrics and mechanics that help us decipher the code. A well-defined set of mechanics can help us mitigate the guesswork out of trade decisions to allow us to choose when is an appropriate time to adjust. The goal here is to avoid over trading while at the same time being consistent in the way you look to adjust probability.

Adjusting credit has to do with our mechanics. To do this correctly and timely, we need to rely on our predetermined rule which states, “we will adjust when breached on the short strike.” Mechanically we will then adjust the untested side and collect additional premium. Or have a predetermined range that portfolio delta can move before making adjustments.

There are three main ways we will adjust:

  • Adjust Credit Received 

  • Adjust Duration

  • Adjust Probability

Principal #2 Simplify Decision Making

Strong mechanics help in the ability to make quick decisions on trades. Making quick decisions rooted in this principle gives us the confidence that the correct path was followed. 

It’s important to always remember that we are working with imperfect information when investing. You can have an assumption on where you think something might go in the short term or long term, but there are no guarantees, and we are not in control of the markets. 

One thing we can control though is our mechanical approach to this concept, and acceptance that we know nothing in terms of where a market will be tomorrow, so we focus on the here and now and are comfortable with our risk and assumption at trade entry

Mechanical trading speaks to sticking to the mathematical approach to investing, and believing that in the long run, the math will play out, even if we experience short-term variance. Some decisions that are rooted in mechanics include: 

Principal #3: Be consistent:

Work orders. Avoid selling bids and buying offers when entering and exiting.

Trading a liquid market (narrow bid-ask spread) is imperative, so that we can get in and out of the market at a fair price. 

If we’re giving up 10 cents to get filled on the bid, selling an option, and giving up another 10 cents to get filled on the ask to exit the trade, that’s $0.20 off the top of our premium collected. 

If we only collected $1.00 up front, that is massive “slippage” that we are realizing and making it hard to be sustainably successful over time. Pennies here and there add up!

Size control. Always trade small and make incremental adjustments if needed.

Trading small can truly be the difference between having an account in 20 years and blowing out after a few bad trading months. Consider the coin flip, where we expect a 50/50 result over time. If I bet $100 on heads over the course of 500 flips to make $100, and I have $10,000 in my account, It would be difficult for me to really make a mess of the account, considering I would need to realize 350/500 tails flips against me to get to $0 if I make no bet size adjustments. 

If I am betting $1000 on each flip though, I only need to have 10 flips go against me before I blow out the account. Trade small to sustain the variance of imperfect information that we will come across at some point in time.

Stay active. Follow mechanics and keep a consistent amount of portfolio allocation in the market.

Trading often goes hand in hand with trading small and the example above - the more occurrences we put on the board over time, the closer our realized win-rate will be to our expected win rate. 

Our research shows that if we don’t have at least 200 occurrences or near that number, our realized win-rate can be very different than our expected win-rate. This makes sense when we revisit the coin flip example above. Trade small to withstand variance, and trade often to push our realized win-rate closer to our expected win-rate.

Principal #4 Market Awareness.

Market awareness is a term not commonly used in finance; however, it is essential in the trading world. It’s an encompassing term but not specific. It is not a one size fits all.  Market awareness is the sum of a trader’s trading exposure and knowledge of current market conditions that set the stage for assumptions. It also magnifies what we value as essential and non-essential for any given trade.

Ultimately market awareness is different for every trader. However, there are methods used that can enhance one’s market awareness.

It begins by reflecting on the big picture: Where does the market currently stand from a macro-economic perspective and what drives it right now.  What is the current state of interest rates or where the futures market is trading? Are binary events on the radar, or are there other uncertainties playing a role?  The market and its focus always change, and each day presents a different picture.

Next, we refine this to what the market volatility tells us using the VIX index. Where do we sit today?  Is it high or low relative to its historic 30-year mean of 15.5%? Check the IV Rank level to build your plan of attack.

Knowledge of equity indices is the next step. For this, we will first compare the recent price movement for, say, the S&P 500 or the NASDAQ. This step will include interpreting the level of IV Rank for each.

Finally, we get specific, gauging what stocks are in play and choosing our best opportunity based on our current market awareness assumptions.

An example of this is following futures markets. It is one of the best ways to improve market awareness.

One Simple Takeaway: Options Trading Tips

Strong mechanics are essential building blocks in a well planned trading strategy.  By following these four principles, we are best able to maintain consistent risk, find quality opportunities, and maintain a healthy balance between delta and probability.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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