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When a trader begins option trading they are bugged by payoff charts and diagrams. They try to know everything possible under the sun and try to make money. This is mainly with highly educated option traders.
By educated I mean traders just passed out from colleges who have access to smart phones etc. No there is nothing wrong in reading about options or futures or payoff graphs, Greeks etc., but having a wrong assumption about it is wrong.
What is a Payoff Diagram?
A Payoff diagram is a graphical representation of the potential outcomes of a option strategy. What can be the profit or loss and sometimes the success percentage of the strategy. It gives a visual representation of the possible outcome of a strategy if played at that time on a stock or indices.
A lot of Option traders rely on these payoff diagrams to plan their trades. It also helps them to evaluate how a strategy may perform over a range of prices, thereby gaining an understanding of potential outcomes.
But is a payoff diagram really helpful? I will discuss in this article.
Here is an email I got from one of site visitors:
I want to deploy more capital and earn consistent income from trading option strategies. And I am under the impression even after a trade is placed, you need constant adjustments to minimize your loss or maximize your profits. And for that you need knowledge of Greeks etc. Otherwise adjustments will be difficult to do.
Am I correct ?
Read this article to see how by just investing Rs.10,000 could have made any of your senior relative, one of the richest man in India. I am sure at that time the payoff graphs for investing in ITC and WIPRO might be same as investing in any other company – one straight line – which is same as buying any stock. But payoff worked wonders for these two stocks only – for the rest payoff charts and diagrams failed.
I know you must be thinking that payoff does not work for investing – it’s for options trading only. You are right but I am trying to give you some logic.
Here is the payoff diagram of the most dangerous trades done intraday/positional everyday by day & positional traders – the ATM Call or Put option buy according to their views:
The Long Option Payoff Diagram/Chart:
The chart says: Limited Loss Unlimited Profit
But what is the FACT? This happens rarely – 80% options expire worthless.
But still a lot people rely on payoff graphs and take a trade. The result is known to them only after the trade is over.
Please remember – once the trade is over the stock takes over. Its now in the hands of the trader to take a profit or loss anywhere he likes. Now a payoff diagram is a trash/worthless.
Let me take another example. Make a payoff diagram or chart for Nifty Future buy and sell.
Both will be same but one payoff diagram will fail.
Don’t go for things that will confuse you. Blindly following anything is a mistake in stock trading.
Does Adjustments Work?
Fact is traders who keep adjusting their trades according to payoff charts or diagrams or any of the Greeks are bound to fail and make their brokers rich.
When automated trading has failed badly in the US how on Earth adjustments manually will work?
Read these articles to see how Automated adjustment trading has destroyed wealth:
The 7 worst automation failures
High-frequency trading and the $440 m mistake
That’s $440 million gone.
I have never seen a payoff diagram ever in my life. I have never adjusted a trade. Its either profit or loss for me – but I never panic and do any adjustments to a trade as I know all my trades are properly hedged – so why bother?
Adjustments Will Cost You Brokerage
Option Greeks will change for every 50 points move in Nifty. So for every 50 points move the trade will exit one position and get into another one. This is not free. He has to pay a brokerage for that and is it really an adjustment?
By shifting the trade he either took a profit or loss in the earlier trade. In most cases its a loss.
Basically he took a loss in one trade and entered into another trade. Where is adjustment?
Adjustments Will Give You Stress
As soon as the stock moves away – the trader will check option Greeks ans the stress follows. What to do now? Adjust? Ok done. Stock moves again. Stress for the trader. What to do now? Adjust. 🙁
While the broker will bless him a lot. 🙂
Adjustment is a psychological myth for a trader. Its the most foolish trade in the world.
Adjustments Will Cost You Brokerage
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