How Trading Options is Like Playing Chess

Many novice traders think that making money with options is simple.  One merely needs to guess the direction a stock will move correctly.  Get that right, and you’re a winner.  If you think the stock will rise, buy a call.  If you think the price will fall, buy a put.  Do that and you’ll make money every time.

Ah, if only it were that simple.

That kind of naïve view of options trading is akin to thinking that chess is a simple game because it’s played on a checkerboard.

The truth is that trading options is very much like playing chess.  Neither endeavor is simple nor straightforward.  Without a keen understanding of fundamentals, both pursuits can be frustrating.  In the case of options trading, that frustration is typically accompanied by losses of real money.

Why Chess Is So Complicated

A chess board is an alphanumerically labeled grid with the numbers along the vertical axis and letters along the horizontal axis.  The board doesn’t display these numbers or letters, but experienced players know they exist.  It’s how tournament champions diagnose other players’ moves and their own mistakes after matches.  Importantly, the grid structure and virtual labeling make it possible for computer software to emulate the board and come up with playing algorithms.  And, indeed, people do play a lot of chess on computers. 

A chess match places two players, and their pieces face to face horizontally.  The object of the game is to move pieces so that an opponent’s King is compromised in an indefensible position.  The simplest way to make that happen is to control the center of the board from beginning to end, defending a position, and killing the opposing player’s high-value pieces.

Easy, right?  One player marches a miniature army across the board, killing the opponent’s pieces until that player’s King is backed into a corner.  And checkmate!  The game is over.  The problem is there is no way of knowing what the other player is thinking and how he or she might react to any of his or her opponent’s moves.  Both of them seek to control the center of the board.  Each player has the same objective, and only one of them can win.  Both players can sacrifice pieces on the board to gain a strategic advantage.  And each of them has their eye trained on their opponent’s King.  But with every move, the dynamics change.

Why Options Trading Is So Complicated

In a roundabout way, options trading is also performed on something of a grid, laid out not alphanumerically, but still with important information displayed along vertical and horizontal axes.  The images below display an options matrix for a given stock’s calls and puts.  I’ve broken the matrix into two pieces to make it easier to view.  Importantly (and intentionally), this matrix doesn’t show option premiums.  It displays what experienced options traders will recognize as the “Greeks” for each options series running up and down the vertical axis.

As you can see, each Greek of each strike for each expiration has a different value.  And each one of these Greeks affects all of the others.  That’s the case for both types of options, calls (above) and puts (below).  With every tick of a stock’s price, up or down, the dynamics change — every one of the Greeks changes.

In fairness, I could have shown an options matrix that displays premium, the price an options buyer will pay, or a writer will receive.  But the point here is to explain why options trading is so complicated.  The Greeks are the reason that an options trader who correctly picks the direction of a stock’s price can still lose money.

Common Elements of Success

The skills necessary to be successful at playing chess are the same ones an investor needs to be successful trading options.  There are certain constants in both endeavors.  These are discipline, preparation, analysis, purpose, versatility, risk management, and composure.  Let’s look at how each one of them relates to both playing chess and trading options.

Discipline

Successful chess players have a predictable pattern of how they move pieces around the board.  Their opening moves are generally the same.  They are consistent.  They are disciplined.  Their manner of play is focused, strategic, and deliberate.  This is the same for successful options traders.  To be successful, they must also be consistent.  They must do the same things every time, without exception.  For chess players as well as options traders, the worst trait to have is a lack of discipline.

Preparation

Being disciplined also means that the steps one takes before execution are also consistent.  This is the case in chess and options trading.  Chess Grandmasters don’t go into matches haphazardly.  They prepare.  Likewise, successful options traders don’t enter trades without proper preparation.  The chess player must understand and prepare for an opponent.  He or she must know what the opponent’s strengths and weaknesses are.  The same is true of any options setup.  The trader must understand how a given trade structure will perform under different circumstances.  A long call spread will behave differently than a long calendar call spread, and the trader needs to know which one is most likely to achieve its intended outcome.  Proper preparation moves both the chess player and the options trader closer to their intended result.

Analysis

Part of preparation means analyzing the environment.  The chess player needs to consider the other players in a tournament to determine how to play each possible matchup in the various brackets leading up to the finals.  Likewise, the options trader needs to consider the many variables that could impact the success or failure of a particular trade setup.  As the chess player needs to evaluate the competition, the options trader needs to consider the variables that affect a trade.  The options trader needs to know where support and resistance are, how implied volatility compares to historic volatility, and what the potential is that some event could cause a sudden price change in the underlying stock, such as a dividend payment or earnings announcement.

Purpose

All of the above analysis needs to be considered in the context of both the chess player’s and options trader’s specific goal.  Both want to win.  For the chess player, this might mean moving up through each bracket and playing in the tournament’s final round.  Maybe it means achieving a personal best.  Maybe it means something else.  For the options trader, it must mean closing out the trade profitably.  Yet what is appropriate for one trader may not be acceptable for another.  For one achieving a 10% return might be a reasonable goal.  For another, it might be something higher than that.  For both the chess player and the options trader to be “successful,” they must have a stated goal or purpose for what they are about to do.

Versatility

Setting goals helps frame the focus for both the chess player and the options trader.  Having an intended purpose helps each to visualize and work toward an intended singular outcome.  But things don’t always go as planned.  So, both the chess player and the options trader need to be versatile.  They need to be able to think on their feet and change course when necessary.  For the chess player, maybe this means looking ahead and altering planned moves to counter an unanticipated attack by an opponent.  For the options player, maybe it means closing one leg of an iron condor as a stock breaks out of an originally anticipated range.  In either case, being flexible to respond to unexpected changes can help both the chess player and the options trader make the best of a bad situation.  This is what separates the champions from the amateurs.

Risk Management

Being versatile, however, doesn’t mean stubbornly committing to an alternative strategy that fails to achieve its intended purpose.  Even the best chess players can embark on a game plan that doesn’t work out.  At a certain point, understanding that a draw is a preferable to a loss sets the new best-case scenario.  The same happens in options trading.  Now and then, a trade does not work out.  For the chess player altering moves to force a draw limits the players risk.  For the options trader closing a setup at a small loss also helps to mitigate risk.  Risk management means reserving capital for the next trade instead of risking a total loss hoping a trade will turn around and work out.

Composure

Reserving capital for the next trade isn’t just an economically sound move; it is also psychologically sound.  Successful options traders know they can’t win on every trade.  So do successful chess players.  Losing is part of playing the game.  The successful players and traders take that in stride.  They remain focused and devoid of any negative emotion that can get in the way of performing at the top of their game.

The Difference Between Chess and Options Trading

The alphanumerical grid of a chess board has led to algorithms that make it possible for people to play the game on computers.  Software programs even help teach kids to play chess.  Maybe someday chess tournaments will pit top-ranked humans against machines.  Who knows?

One thing is for sure, while chess players don’t currently have to compete with computer algorithms to be successful, human options traders do.  The reality exists that some day in the future algorithmic trading and artificial intelligence will dominate the options market.  Even when it happens, I’m convinced that a trader behaving like a chess player and following the seven rules above will have ample opportunity for success.

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