Here are nine important concepts you must take into account when practicing options trading in a virtual account
by Giorgos E. Siligardos, Ph.D.
Virtual Trading (VT) is a general term referring to hypothetical trades made by a trader for either practicing or for evaluation of his/her methodology. You may have also heard the term “Paper Trading” which is usually used interchangeably with VT. In fact, the days prior the rush of personal computers in all aspects of life (trading included) virtual trades were done on paper instead of being done in a real account hence the term ‘paper trading’. Nowadays the astounding massive use of personal computers and the extensive use of internet have made virtual trading possible in an amazingly convenient way. The virtual trader does not have to adjust his notes for corporate actions, dividends and other labor intensive stuff. All these can be done in a simulated computer environment and plenty of information including price quotes is readily available from the internet. There are many sites who offer free virtual trading either for either educational or promotional purposes and this is an excellent chance for all types of traders to grasp this pennyworth opportunity for practicing their skills in a risk free environment. VT via a simulator in simple tradables such as stocks is done decently in most available simulators today especially for long term or position traders. However, VT on complex tradables such as options is a more complicated matter. In the present article I will try to describe in detail a few concepts (usually half-mentioned by other articles in the same subject) you must take into account when trading option strategies in a simulated environment.
1st concept: equity-settled options
Generally, options are either physical-settled or cash-settled. Physical-settled means that in the case of option exercise the writer of the option must sell the underlying entity (shares, bonds etc) to the option buyer. In effect, the exercise of a naked option renders the buyer and writer having long and short positions respectively in the underlying. Cash-settled means that if the option is in the money the writer simply pays (and the buyer receives) the difference between the settlement price of the underlying and the strike price of the option. The latter method is usually performed in the case of index options where it is practically impossible for the option writer to deliver a precisely weighted portfolio of 100 or more stocks to the buyer. A virtue of cash-settled options is that you don’t end up with any positions that would generate margin calls. Therefore, what you must demand from your trading simulator provider is that in the case of exercise or assignment of physical-settled options you must end up with a long or short position in the underlying. This is absolutely critical for a decent simulation of options trading.
2nd concept: Corporate actions
You trading simulator must call all possible corporate actions and modify your account accordingly. Stock options must be modified when mergers or acquisitions take place and a modification is due in reality. Also, when you have stocks in your virtual account that pay dividend you must collect that dividend and when you are short these stocks you must pay the dividend.
3rd concept: NBBO and complex option trades
The National Best Bid and Offer (abbreviated: “NBBO”) is a term applying to the SEC requirement that brokers must guarantee customers the best available ask price when they buy securities and the best available bid price when they sell securities (www.investopedia.com). Simply put, the NBBO is the highest bid and lowest offer for a security in all exchanges and market makers. Since there are NBBOs for simple option positions (long call, short call, long put and short put) there are also ‘implied’ NBBOs for more complex option positions such as spreads, butterflies, condors etc and here is where things get more complicated (note the word ‘implied’ above). Consider for example the following hypothetical case: The NBBO for the 80 put is 1.2/1.4 (1.2 bid and 1.4 offer) and the NBBO for the 90 put is 1.5/1.6 (1.5 bid and 1.6 offer). The implied NBBO for the spread is therefore 0.1/0.4. This is because if you want to buy the spread you must buy the 90 put and sell the 80 put thus paying $0.4 ($1.6-$1.2) and if you want to sell the spread you must sell the 90 put and buy the 80 put thus getting $0.1 ($1.5-$1.4). Now, many brokerages allow you to put a vertical put spread as one order with two legs (a long leg and a short leg). You are charged commissions as if the spread legs are done separately but your order is transmitted as one order. This is a great advantage from a risk management point of view because you save time and you may define exactly the debit/credit you want for the spread. The one leg is executed only when the other leg can also be executed. There is a significant drawback however: In real trading both legs of the spread must be executed on the same exchange and by the same market maker. In other words, spreads (being not standardized contracts such as puts and calls) are executed at the discretion (and by the manual action) of a market maker. Since the NBBO you get for the spread can be constructed by bid/asks from different exchanges and different market makers your order to buy or sell the spread in its NBBO may not be executed. Caution!. This is not taken into account by virtual trading simulators and you may get unrealistic fills using spread NBBOs. When you want to virtual trade complex option positions always leg in the position (that is, trade each leg separately).
4th concept: “Shaving” the bid/ask spread
Normally, when you see for example a Bid/Ask of 1.6/1.8 for an option this means that the theoretical fair value for the option is somewhere in the middle (that is, approximately 1.7). Market makers buy below the fair value (at 1.6) and sell above the fair value (1.8) thus making a risk free income. This does not mean that a market maker is absolutely not willing to sell you the option for say 1.75 but he/she has no benefit of posting the 1.75 ask price since he/she may find a buyer for the contract at 1.8. An important thing to bear in mind is that the in-between orders are processed individually by market makers and this cannot be incorporated in a trading simulator. In effect you have to buy on the ask price and sell on the bid price when trading virtually and you are not let getting filled in between the bid and ask (aka “shaving” the spread). This is not so important factor when you simulate few trades in tight bid/ask spreads but it seriously skews the simulation results when dealing with many trades.
5th concept: American-style options and the ‘threat’ of early assignment
The buyer of an American-style option has the right to exercise the option any time until the option expires. When the buyer exercises such an option, the other parity (the writer of the option) is said to be “assigned”. Option writers are usually afraid of assignments for equity-settled options even though theoretically it is to their merit. When an option is exercised, the buyer purchases the tradable at the strike price thus getting only the intrinsic value of the option. The extrinsic value (aka time value) of the option is left to the writer of the option. Why do the writers then afraid of assignments?. The answer is simple: an early assignment will leave them with a long or short position in the underlying which may distort their risk profile and money management rules. This is even more present when one leg of a multi-leg option position is assigned. Consider the case of a trader who has sold a 80/90 vertical credit bear call spread (short the 80-call and long the 90-call) in SPY (S&P Dep Receipts) and he is assigned in the 80-call. He looses his 80-call and gets a short position in the SPY. The short position in SPY combined with the long 90-call equals a synthetic long put which is something different than the credit bear call spread he started initially.
Early exercises/assignments occur in real trading and do not occur at all in virtual trading. In fact early exercises/assignments cannot be simulated due to the random selection method used for assignments. More precisely, assignments are being sent to the broker from its clearing firm, who gets them from the Options Clearing Corp. The bottom line is that if you want to simulate options trading in the best possible fashion you must avoid American-style options. If however you badly want to simulate options trading in American style options you can do it in a decent way by avoiding cases where there is a great possibility of early assignment. To isolate these cases you must take the side of the option buyer for a while and think about what would make you exercise an option prematurely. You will find that it all depends on interest rates, dividends and synthetic positions. Suppose that you own a deep in-the-money call with very little time until expiration. The underlying of the call is the stock XYZ which is about to pay a respectable dividend before the expiration date. Since the risk/reward profile of a long call can be replicated with a synthetic position (Long Call with strike x = Long stock + Short put with strike x) you can either stay with your long call position and loose the dividend or exercise the call and simultaneously buy a put with the same strike price. The latter method does not alter your risk/reward profile and it may be better than just staying with the long call for the following reasons: First, since the call is deep in-the-money, the put will be far out-of-the-money. Both options should have very small time value so exercising the call and buying the put will not incur much pecuniary damage. Second, by exercising the call you must buy the stock thus spending a lot of money from your account and loose the interest rate you would enjoy on this money (cost of carry) but you get the dividend. If the dividend is greater than the interest you loose and the cost of constructing the synthetic position (time premiums plus commissions) then you are better off moving to the synthetic. Similar hold for early exercise of puts but this time the situation is reversed. The dividend lost plus the cost of construction of the synthetic (long call + Short Stock) must be less than the interest earned from the cash you get by exercising the put. Put assignments are generally less common than call assignments due to fact that the interest earned for a short period of time is generally low but the assignment threat is nevertheless present. Concluding, you generally eliminate the assignment threat when you write out-of-the-money options (calls or puts) with plenty of time until expiration. Especially for short call positions make sure to close them well before the ex-dividend date (ex-dividend date is the first date that the buyer of the stock will not have the right to receive the dividend). Bear in mind that there is also a more subtle issue with assignments. The likelihood of early assignment is reflected in the real price of options and it might seem that there is an arbitrage opportunity for complex trades (Boxes for example) when in reality there is not.
6th concept: The settlement price
Not all options settlement prices are determined the same way. Many index options (DJX, NDX and SPX for example) stop trading on the third Thursday of the month but expire the next morning and the settlement price is determined by the opening prices of all stocks that comprise them. This is important since not all stocks that comprise an index make their first trade exactly the same time. As a result, the Friday opening price of the SPX index for example is not always the actual settlement price for the expiring options since their settlement price does not depend upon the SPX. The SPX itself has a Friday opening price calculated upon Friday opening prices or Thursday’s closing prices for its components. Even though this is a technical and sophisticated matter, it can make a difference in VT when your simulator provider uses the opening price of an index as the settlement price instead of the opening prices of its components. If it does then it may be better closing your positions before expiration or migrate to another simulator.
7th concept: Initial size of the VT account
In order to evaluate a trading tactic using virtual trading you must execute a number of trades for a significant period of time. You will often here that it is recommended to use a large virtual account (many times the size of the real account your intend to use) so that you can perform many trades many times. I disagree with this recommendation, for the size of the account can play an important role in trading decisions especially in derivatives. Options trading has a lot to do with margins and in addition, many trading brokerages charge a base commission and/or a minimum commission for every order and this can significantly variegate the profit/loss percentages between accounts of different sizes. There is also the diversification issue. Small accounts cannot achieve the same level of diversification as large accounts. As a result, if you have to choose between 10 trading candidates and your small account cannot afford all the trades you must choose among them. This is the issues you face in reality and in effect this is how you must virtual trade. My advice therefore is to virtually trade the size of the account you can afford to trade for real. To accomplish a reasonable evaluation of your trading style use many different accounts at the same time each one of the same size and treat them independently. If your trading style is robust you should be able to achieve more or less the same performance figures in every account.
8th concept: The number of contracts per order
A Bid/Ask of say 1.5/1.8 for an option does not mean that you can sell/buy unlimited number of contracts in these prices. Make sure that your simulator provider takes into account the guaranteed minimum size for each quote and does not let you buy/sell arbitrary large numbers of contracts.
9th concept: Choosing the right simulator provider
The selection of the right trading simulator is very important. Use a simulator provided by an exchange or brokerage firm which will be as close as it gets to its actual web based or software based platform. Make sure that your simulator takes into account real commissions, fees and other expenses. As an example, the Chicago Board of Options Exchange provides a free trading simulator based on OptionsXpress virtual trading tool.
I use to encourage my students to VT in derivatives for I believe it is an excellent way of getting a sense of the trading actuality and note the difference between academics and the real world. It is also a way for me to monitor first-hand how the market newcomers think and act. There are many trading professionals who do not advocate VT arguing that it is not meaningful and that you should use real accounts and real money if you want to learn how to trade. This is half true. Yes real trading cannot be duplicated in its entirety in a risk free environment and this is why virtual trading is often called ‘simulated trading’ (simulation is an imitation of a real process) not ‘emulated trading’ (an emulator duplicates the functions of one system using a different system). Aside of the technical issues of trading the psychological factors of dealing with real risk indeed cannot be emulated in any way with virtual money. The point is that just as you wouldn’t recommend a busy road for a first time driver you shouldn’t trade a strategy unless you have previously traded it virtually. At least you are not going to loose money from the aspects of trading that can be simulated. As for the psychological factors, you will be surprised to see that the greed-fear emotions are present to VT even though on a slightly different degree. Since virtual accounts usually overestimate trading performance (due to the lack of actual risk) you must bear in mind that though having success in VT does not imply success in real trading in the long run, not having success in VT almost guarantees a failure in real trading in the long run. My final advice is to make a mandatory rule that you will not engage in real trading unless you show decent and stable profits in the majority (if not all) of your virtual accounts.
SHORT AUTHOR BIO:
Giorgos E. Siligardos holds a PhD in Mathematics from the University of Crete and a Market Maker/Trader certificate from the Athens Derivatives Exchange. He has given lectures on Technical Analysis in the University of Crete and he has published several articles in the Technical Analysis of Stocks & Commodities magazine. He is currently a scientific fellow of the Department of Finance & Insurance at the Technological Educational Institute of Crete teaching Investment Analysis and Derivative courses. His academic website is: http://www.tem.uoc.gr/~siligard and he may be reached at: firstname.lastname@example.org.
Giorgos has also developed a technical analysis add-on software which is available from his commercial website: http://www.daedalussoft.com