"Trading Is A Zero Sum Game"

Or is It?

I was looking at my email inbox this morning and one of the subject lines was Trading Is A Zero Sum Game. The implication was, you need to buy the newsletter in question to succeed in today’s dog-eat-dog trading environment.

In options trading, this is almost never the case. Let’s look at an example:

• Trader One : Buy One Straddle at 1.00, assuming 20% volatility

• Trader Two : Delta Hedge the Same Straddle at 25% volatility using underlying only, no options

At the end of the trading period, Trader One sells his straddle for 1.25, for a 25% profit. Trader Two pockets 1.45 from hedging profits from buying and selling stock. So much for a zero sum game in this example. It looks like both traders were winners.

There is another way to look at it. The example above shows that both traders had profitable volatility estimates. But what if their estimate was too low? Instead of making 1.45, the Delta Hedger might (hypothetically) have made 1.75 if his estimate were better. And the Straddle Seller might have timed his sale to capture bigger profits. In this viewpoint, both traders are losers, when compared to the theoretical max profit.

In reality, we can never approach the best “what-if” scenario. However, there are things we can do to get better parameter estimates going forward. My favorite way to do this is to look at the realized result, compare it to the best case scenario, and adjust the parameters to capture 1/2 of the error the first estimate. This technique is used by signal processing techniques like the Kalman Filter, which you will encounter when you work on robot tracking projects, target acquisistion systems, self-driving cars, etc.

In our example, if the Delta Hedger had a volatility assumption of 10% and the actual volatility was 20%, he would adjust his next estimate to 15%, or one half of the error. When the next data point comes in, the estimate is updated to 1/2 of the new error. And so on.

If you don’t know about Delta Hedging, put “Delta Hedge” in the comments and I’ll follow up with a detailed, non-mathematical post in the next week or two so that you can understand it. Remember, if one person posts a question, at least 10x as many also have the same question so there is nothing to be bashful about.

AIR RAID SIGNAL UPDATE : Market is calm so no signals today.

COMMUNITY SPOTLIGHT:

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Money Machine Newsletter is a financial newsletter providing high quality, equity research. Their picks are on the aggressive side and a good starting point to use for vertical spreads and long options.

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DISCLAIMER: All content on he Nuclear Option Substack is for Education and Information Purposes Only. It is not a recommendation or solicitation to buy or sell any security. Before trading, consult your Professional Financial Advisor and read the booklet Characteristics and Risks of Standardized Options Contracts, published by the Options Clearing Corporation.