Spread Betting & Exotics

I commented on NADEX.com in one of my first posts. Despite the insane commissions  they charge it still represents the only opportunity for US investors to get into binary and exotic option trading short of having a Prime Brokerage account. Let’s examine why one would even be interested in some, well exotics, like a No Touch Barrier or a Range Expiry Bet? But first let me digress for a second.  Successful trading, IMO, boils down to two things:

  • 1) Finding an edge
  • 2) Managing Risk

Additionally any system, strategy, and even discretionary trader can be broken down into the following equation:

Probability of Win * $ Expectancy * Frequency of Trades

IMO most people focus on Probability of Win, that is trying to find that perfect pattern or setup that will guarantee profits eternal. Too bad that doesn’t exist; some of the best discretionary guys out there probably bat 60%-70% but look closer at their edge and it may be as simple as large buying power and semi-martingale approach. Nothing wrong with that style, its a high probability of profit. The problem occurs in the second portion of the equation and the differentiating factor between a good trader and a broke trader is $ Expectancy. In a nutshell this describes how much money you win/loss on average. If you were like me in a previous life, you would win a few, up your size, then allow one or two major losers to wipe you out by holding too long. Mean Reversion trading is especially susceptible to riding losers too long.  There is huge potential for  gurus to sell the Trading Psychology workshops and books to make themselves a quick and easy buck. The trader thinks there is something wrong with their brain and there is just one thing, a saying, perhaps a pithy phrase, or another indicator! and it can be learned for $999.95.

Well you can try to rewire your brain, perhaps run into a wall headfirst, maybe drink a lot of whiskey? Or you can try a different approach. To make matters simple, an exotic option can offer you an opportunity to make multiples on the money at risk. So if previously your $ expectancy was negative, you can quickly turn it into 2:1 or more through the use of a clever placed range option. This can be in the form of a bullish no touch, buy a No Touch barrier below your perceived low on a bullish signal; a bullish range expiry; a binary up/down; and probably many other methods.

Think back to probability theory and the fair coin example. If we have a 50/50 coin and we make or loss a $1 a flip. We are destined to break even, if we increase our probability to 51% or increase our win to even 1.01 then with enough flips we should make a fortune. Similarly our pattern or edge can (hopefully) be tested and examined in a rolling period. Mean Reversion strategies can run on the order of 60%-70% probability. But lets say we are a 50/50 trader, by purchasing a binary at 50 that pays 100 on a win, we are assured to become millionaires with enough frequency. Well not quite because just like trading, our probability and $ expectancy can change and we have that nasty problem of limited bankrolls.

But it does significantly alter our equation. Additionally we can add something like half Kelly betting to maximize our growth rate over time. Think like a casino because they make lots of money and the one thing we have the most control over in the market is how frequent we trade.

Below is a very simple range probability study, it displays the probability of price closing between the highest and lowest price over the previous 5 days for QCOM. The long term probability is about 53%, below that is some randomly generated equity curves based on the formula above.

Long Term Probability & Equity Curves

Long Term Probability & Equity Curves

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~ by largecaptrader on July 17, 2009.

One Response to “Spread Betting & Exotics”

  1. […] designed with FX in mind it probably serves as a decent proxy for pricing exotic bets. I blogged here about spread betting sites which in a nutshell give you the ability to control your risk to reward […]

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