Option Investor
Educational Article

Escape To Tehran

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By David Popper

There is an ancient Middle East parable about a rich merchant. Somehow he learned that Death was looking for him. The merchant decided to jump on his horse and escape to Tehran in order to outwit Death. Upon his arrival in Tehran, he ran right into Death. His appointment with Death was scheduled to take place in Tehran. In his panic, the merchant left safety and hurried into the clutches of Death.

Just like that merchant, sometimes when the short-term action moves against my trade, I prematurely escape my position for a perceived safer position. Only then, I discover that I would have been better off if I had just held firm. A good example of this took place in January of this year when I decided to make longer term "safer" plays in one account.

I bought 1000 QQQ (AMEX:QQQ) at $60 per share and wrote the January 2002 $60 call at $15. This provided a 25% return over the course of the year with the chance to do better if I could repurchase the calls cheaper during a downturn and eventually rewrite the calls. Well, everything went according to plan as the value of those calls eventually shrunk to $2 before eventually recovering. Had I simply held my ground, I would have been able to write the calls twice and achieved another $7,000 in premium. The problem was not the plan, rather it was my nerve. I read too much Barron's and watched too much CNBC, and eventually closed my position at a poor level. Instead of being underwater, I could have been profitable.

How hard it is, however, when it seems the whole world is in panic, to remain resolute. How difficult it is to trust your plan when everything seems to be blowing up. Trading is so emotional. It shouldn't be. But eventually, the market will uncover any emotional weakness. This begs the question of whether it is possible to remain resolute in the face of adversity so that a good plan can be executed, even in the face of volatility.

The first thing necessary is to understand how you personally handle short-term losses. If losses throw you, it is better to understand the possible downside to a position prior to entering the position. With tech stocks, it is possible that you will have to endure being stopped out or alternatively suffer a large "paper loss" while the play develops. In short, it is critical to understand the downside risk as well as the upside reward.

A second idea, which may be helpful, is to consider short-term trades over multiple sectors so that a hit in one sector does not rock your boat. For example, I currently hold positions in Johnson & Johnson (NYSE:JNJ), and Washington Mutual (NYSE:MU) simply because they have announced splits. This factor ought to provide some momentum for the stock through the split date. Additionally, these two securities are in different sectors and provide balance. Of course, these companies are leaders in their field and have charts that indicate that a breakout is due.

A third idea is to only trade issues that you wouldn't mind owning in the event that the market went south. If you only trade stocks of companies that have real businesses and real earnings, then an enormous amount of pressure is relieved. It is far easier to hold Cisco (NASDAQ:CSCO) for a loss than it is holding Amazon (NASDAQ:AMZN). Alternatively, trading a basket of stocks such as QQQ provides the same sense of security.

Fourth, determine a realistic time frame in which to make the trade. It is not realistic to enter short-term trades using short-term signals if you can't watch the market during the day.

Fifth, when you enter a play, use basic technical analysis to make a decent entry. If you are entering a long-term play, use long-term indicators such as the 50- and 200-day moving averages, volume indicators and relative strength tools.

Once you have selected a trading strategy over a reasonable time period, select a security that represents a solid business and enter that security at a technically good point. Even then, it is still a good idea to maintain a percentage of cash in order to allow flexibility to take advantage of market downturns.

When all of these factors are utilized, you have taken every reasonable precaution that is possible. Knowing that you have thought through a sound plan will give you the fortitude to confront the feeling of panic which happens to most traders at some point. Further if you write down the reasons for the trade and the precautions taken, in times of market downturns, you will be able to revisit your original ideas to determine if they are still valid. In my case, I needed a downturn in order to repurchase the calls for a pittance. When the storm comes, if your ideas are still valid, maybe you can hold the line and prevent an escape to Tehran.


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