How to Trade with an Edge?
What Exactly is a Profitable Edge?
Traders are constantly looking for a trading system that hits 100% winners or a system that never makes a losing trade. This for many reasons is impossible and further below in this article it is explained in more detail why achieving an 100% win rate is simply impossible.
So firstly what is an edge? A profitable edge is nothing more than an Indication of a higher probability of one thing happening over another. In other words, a trading edge is a higher probability of one thing happening over another. The key words are “Higher Probability”. Sell Options to receive option premium and create high probability trades.
To be a successful trader you need a profitable trading edge. You need to have something that will give you an edge on the market. Your trading edge needs to give you an “an Indication of a higher probability of one thing happening over another”. That does not mean that every single trade will work out because we know that is simply impossible, but what it does mean is that when you have your edge it can give you a higher probability of putting you into winning positions to make money and that is the key.
The next key is to learn, practice and master your trading edge so the “probability” grows higher and higher and with it the profits as well!
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How to create an traders edge
A trader creates a trading edge when they sell options they are at a price extreme. It could mean that the underlying is moving much. But it also could mean too sell options that hits a top or a bottom. These options are rich on premium. So that you can benefit from theta decay. Sell them in such a way that it is most likely that they expire worthless.
Theta measures how much value an option will lose each day due to the passage of time as the option gets closer to expiration. This is known as theta decay or time decay. Each day that passes a small amount of time value ticks away. And you can literally see how much it’ll lose each day even if the underlying stock is unchanged. These options has a high possibility of profit.
Being long options, whether that’s buying a call or a put, means the Theta is working against you. However, there are many different strategies where theta can work for you. Those strategies entail selling options aka writing options, i.e., being short options, either calls or puts, in combination with your longs.
The mostly used strategy is to Sell out of the money options so that you receive option premium. Out of the money options will expire worthless if the underlying does not reach the strike price. When this happens you can keep the premium.
High Probability Trades
You can create an edge by setting up high probability trades. An investor enters High probability trades when they sell options which are much likely to expire worthless. This kind of trader uses option Greeks to sell options. The choose options with high delta. They most of the time sell 1 standard deviation options with a delta of 68. When a trader sell these options they have sold an options which has 68% change to expire worthless. The trade always choose liquid options which have a high Implied Volatility. Options will get a high Implied Volatility when there is uncertainty in the market. This happens when the price of the stock drops or fluctuates more.
Entering options when they are at an price extreme is another way to create an traders edge. When the prices of stocks are dropping it causes extra fear with investors. Therefore the price of the option prices are most of the times overstated. Mean reversion is simply the fact that investments can trade far above or far below their long-term average returns for periods of time, but in the end they eventually tend to move back towards their average. The phrase reversion to the mean refers to a statistical concept that high and low prices are temporary and a price will tend to go back to its average over time. We seek out options that are at an price extreme. We are selling options who moved much or at an all time high or low. Most of the time these options has a high Implied Volatility.
Traders want to have an edge in trading. We discussed how you can create an edge in three ways. You Sell options to receive Option Premium. Making use of theta decay. Of course you choose options with enough premium. When sold at a price extreme you know that they will revert to the mean. And you seek out options that far enough out of the money so that they expire worthless.