At Bigger Capital we run many trading experiments at any point in time. As part of this process we back up with our capital fledgling traders that have unique strategies. We run one or two of these at any point in time. If the traders demonstrate to us they have something unique and profitable then we are happy to invest in a more formal way.
One of the experiments we are running right now is a strategy involving short term options. As they approach maturity these options display increasing convexity or price sensitivity to a change in price of the underlying.
The interesting thing is that the trader psyche is also affected by a change in price of the underlying. It gets worst as we approach the last few hours before the options expire. I call this state of mind; Mental Convexity.
Here is a discussion I had with a trader (Mr. A) who runs an experiment for our group.
Mr. A Please buy to close XX contracts of 167 SPY calls expiring today. Holding till close is not worth the risk. Friday closes often have a strong move in the last few minutes.
Me: One thing I am curious about is that your model exploit inefficiencies in the distribution of returns (if I get this correctly). This is the part that deals with options pricing and all that. What I am curious about is how you adjust your model for the mental convexity approaching maturity/short strike. On Friday, you made a call, saying the market was going strong in the close and we unwound the position. Is your model accounting for that?
Mr. A I made a wrong call to unwind the position. The model statistics were correct. I will adjust to trading ..........., but with the win/(max loss) size much less scary.
Mr. A A down day would be helpful today.
Me: "A down day would be helpful today." I call this mental convexity. It is totally irrelevant to the process. It either works or it does not.
There you go, Mental Convexity at work. We all should realize that Mental Convexity steals return from us. Listen to the noise on the stream when stock prices bounce around. You hear it...right?
Isn't about time we use Mental Convexity to our own advantage? How exactly should we do that?
Mental Convexity is My Opportunity
P.S. If you have an interest in participating in our trading experiments just visit our Analyzer and use the contact button on the top right hand corner to reach out to us.
Written by Michael Bigger. Follow me on Twitter and StockTwits.