T2W Trading Community

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.

Epilogue
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.