One of the toughest things traders can do is admit defeat and just exit a losing trade, especially when they or their families are depending on trading income to live. From the perspective of market pundits or advisers, it can be even worse. Not only does their livelihood depend on trading success, but others are looking for guidance as well. One’s trading track record then becomes an even bigger matter of ego and credibility. Trust me … I have been there.
Another problem many of us face is not listening to what our gut is telling us. From the time I started trading, I have tried my hardest to stay in tune with my emotions, my money management, and my risk. I’ve also always tried to stick to the guidelines I set for myself at the onset of the trade. From time to time, however, I certainly break the “rules”… it’s inevitable.
I have never been a big risk taker (in the markets, anyway). Part of the reasoning behind this is that I recognize my faults and realize I am human. I certainly allow greed to sometimes control me but ultimately I need to be able to control myself. In situations where my back has been against the wall because I had no other choice, I couldn’t let my account fall apart. I needed to be able to just stop the bleeding, take the loss, and move on.
With large positions and big risk, you may have so much on the line, you bet big with the intentions of winning big. When the trade goes against you, the loss may be too big to stomach, forcing you to hold on. Then the spiral gets worse and worse until you either finally exit (in order salvage what is left of your account) or worse, the position expires worthless, leaving you with a fraction of what you started with, only with shattered confidence and reluctant to follow your plan in fear of reoccurrence.
Having a manageable* position comes in handy when you need to hold onto a position that may be oversold and likely to recover. *”Manageable” means that normal variations in the position on a daily basis are not driving you (or your significant other) crazy or compromising your financial health.
Very seldom do we walk into a trade thinking how much we will lose. Why would anyone do that? Seems like that is like setting oneself up for failure right from the start. On the contrary, it may be the thing that saves your trading life or at least your dollars and sense. The market has dropped about 5% over the past couple of weeks and I know many of you may be frustrated. Perhaps you have been on the right side this time and for that, kudos to you!
But regardless, with the slew of economic data due out and the not-so-clear future of the American consumer and global economy, I thought it was a good time to dust off some old analogies that I frequently teach.
Buying an option can be like buying a condo.
When I am looking at an investment property, I look at worst-case scenarios like major plumbing or electrical damage, structural damage, the life expectancy and age of the systems in the building, the condo board’s management style and history, budget, taxes, the possibility of going months without rent, etc. All these possible occurrences and data get entered into my own little regression model of sorts and from that I come up with an acceptable price to bid for the home given my findings. This sounds rather complicated and in reality, placing an options trade in comparison may be much, much simpler because there are not as many variables.
That is not to say that investing in options is not without risks, but these risks can be clearly defined to an extent.
The regression model you use in an options trade could be something like the profit/loss and probability calculators in the OptionsHouse tools suite or some other tool or group of tools that allows you to model possible situations and outcomes. Once you have narrowed down your strategy, you must decide on how much risk you want to take.
This decision could depend on other positions in your account, macro market sentiment, fundamental stock data, earnings etc. From these steps, you should decide the strategy and risk you want to employ.
Before you place a trade, depending on how much risk you want to take, you can simply adjust the number of contracts you trade or modify the width of a vertical spread, which could increase or decrease your total risk in the trade. These are both simple risk-adjustment measures you can use.
Once you are in the trade, have a stop-loss in place (or in mind) and stay on top of your positions. Options positions do not have to be held until they are worthless and losing positions that should be abandoned are sometimes held by traders, perhaps because of the fear of being wrong and giving up some potential profit down the road (which may never come).
Another problem I see frequently is the abuse of leverage, where a trader buys as many options as they would stock, hoping to amplify return. This can be overly risky; look at your deltas to gauge the sensitivity your total position has to changes in the stock price. Remember that leverage works both ways; you can lose money just as fast as you can make it.
If you feel that a stock is running out of steam or you are satisfied with your profits, don’t be afraid to exit the trade and lock in profit before it potentially deteriorates. I am sure all of us have stayed in trades and watched a once-profitable trade turn negative (or at least lose some of its earlier profits).
Remember that the market does not know who you are, it does not care whether you make or lose money, and it certainly does not owe you anything. Take your bits and pieces while you can and keep you risk minimal. If something seems too good to be true or you think the market needs a break, chances are that many people are thinking the same thing…perception often becomes reality in the marketplace as all market participants are human like you and me.
Photo Credit: foundphotoslj
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Tags: option buying, Option Trading, option trading pointers
nice post Jared!