"Fear" is a word that kept bombarding me this month.
Although my deaf grandchild has cochlear implants, those implants come off when she's bathing, swimming, participating in contact sports or running through the rain. I study sign language for those times, so that I can still communicate with her.
This week's lessons involved a review of signs related to emotions. The sign for fear gained special poignancy, given what was happening in the market. In addition, when reviewing archived Option 101 articles from 2000, I noticed one titled "The Fear of the Day." Last Saturday, I was listening to a Web-Ex presentation on how to back test options strategies, but the presenter spent the first twenty minutes talking about how fear might have prompted some options traders to over-adjust the previous week. The word "fear" seemed to jump out at me, no matter what I was doing.
How do we guard against fear that stays our hands from trading or from that kind of over-reaction mentioned in that presentation? Prevention starts before the trade is initiated.
Realize that all option strategies other than a straight directional bearish trade are likely to be adversely impacted by a straight-down move such as the one that occurred from January 19 to February 5, and that such moves are going to occasionally happen. While it might be possible to predict that such a move is overdue, even the best market technicians can be wrong in their prediction of the exact timing. The first step in prevention is to keep the size of your trades manageable. Nothing engenders fear faster than realizing, after it's too late and an adverse move is underway, that you've taken on too much risk.
What makes a trade's size too big? A trade's size is unmanageable if the maximum loss that you could experience would wipe out your trading account. As simplistic as it seems to say that, I know many who have traded up to the limit of what their account size allows them to trade, and I have seen the accounts of such traders wiped out in a single month's adverse action. I personally leave at least a third and often more than half of my trading accounts--Reg T accounts, as of this writing--in cash, just in case of a Black Swan type event. I would be devastated if I woke up one day and something had occurred that would mean that all my iron condor trades had suffered a maximum loss. That would mean that one- to two-thirds of my trading accounts were perhaps permanently wiped out, barring a quick move the other direction.
I would be devastated, yes, but I would still have money to trade. I don't expect any Black Swan event to occur. I'm not being doom and gloom here. However, knowing that I'd still have a trading account allows me to avoid at least some of those sit-up-gasping-in-the-middle-of-the-night moments.
Even if you've left plenty of money in the trading account, a trade's size is unmanageable by any definition if you're having those sit-up-gasping-in-the-middle-of-the-night moments. Those can occur when you're trading too many contracts of a new or unfamiliar strategy or a familiar strategy on a new underlying. Over the last three years, I've typically traded 70-120 iron condor contracts each month, but now that I'm working toward a diversification into other strategies, I trade those butterflies, calendars and other strategies in 1-3 contract sizes. I'm not yet convinced that I know how all these strategies on each of these underlyings works in every market condition. The small size of the trades keeps me out of terrible trouble, avoiding actions that would undermine my confidence. I can't get into too much trouble, so I sleep better at night.
If your account is too small to allow you to place your regular trades and also 1-3 lot try-out trades on new strategies or underlyings, consider paper or simulated trades. If, like me, you tend to ignore simulated trades while you handle your real ones, consider trades on ETF's such as the SPY, IWM or DIA rather than indices such as the RUT and SPX. (Be careful of sneaky ex-dividend days set in option-expiration week on some of these, though.)
Trading small-lot try-out trades can be tricky if your commissions are too large. If your brokerage charges a minimum ticket charge, as my primary one does, either paper trade those small-lot strategies or open a small account in a brokerage with no minimum ticket charge for the express purpose of trying out these small trades. It's impossible for me to trade a 1-3 lot SPY butterfly on my primary account, for example, and expect to make any profit at all because of the minimum ticket charge. Once I get over 10 contracts, my commissions are relatively low.
If you're up against the same difficulty and don't have the funds to open a second account, use your brokerage's or CBOE's trade simulator to try out these trades for several cycles. Learning something as simple as how close to the mid-price between the bid and ask to place your order can mean the difference between a profitable and losing strategy in some market conditions. You may have to position that order differently for a calendar than you would for a credit spread, for example. An ATM butterfly order might go closer to the mid than a far OTM credit spread, or vice versa, depending on your underlying. My brokerage's simulator was more realistic than the CBOE's, if I'm remembering correctly from the times I tried the CBOE's. I believe I mostly had to buy at the ask and sell at the bid to get simulated fills on the CBOE. Still, if your brokerage doesn't have a simulator or allow paper trades, the CBOE's is a good alternative, and those fills might have changed since I last tried it.
Pay attention to volatility when you're thinking about how many trades to place, hoping to avoid too much fear if things go wrong. As long ago as 2000, in another of those archived Options 101 articles, a former Options Investor writer was warning that volatility should be considered before trades were entered. Volatilities in the high range for the last six months to year mean that options are likely to be expensive. Volatilities in the low range for the last six months to a year mean that options are likely to be cheap, but they may mean more.
Volatilities tend to expand or rise when prices drop, especially if they drop sharply. When volatilities are extremely low, experienced iron condor traders start getting antsy. A sharp drop in prices and a concurrent rise in volatility will hurt our positions on two fronts, so that when our trades get into trouble, they get into bigger trouble, faster, than they do when markets are moving up.
When volatilities are particularly low and perhaps due to rise, some iron condor traders will cut back on the size of their positions or will use the fact that options are still cheap to buy extra long puts when they enter their iron condor positions. Those puts can be bought in front of the bull put credit spread, at the same strike as the long in the bull put credit spread or under the bull put credit spread, depending on how much the iron condor trader wants to spend on those extra puts and how much protection the iron condor trader wants. I learned this technique through former market maker Dan Sheridan's presentations for CBOE and have employed it throughout this year. It has allowed me to keep trading and manage the fear that comes about in trading in uncertain times. When SPX prices were recently approaching my adjustment levels for an iron condor position, the extra cheap put I'd bought when I initiated the position had gained $660 in profit. That helped offset some of the debit when I rolled out of the bull put credit spread, adjusting the position.
Another method of managing risk and the fear that too much risk engenders is to take off some of the risk if market prices start swinging wildly and market conditions prove too dicey for the trader's experience and comfort level. Someone who initiated an iron condor on January 19, as I did, might have soon realized that the market conditions they'd feared had indeed come to pass. Especially if inexperienced with the strategy, a trader would have been employing a perfectly reasonable tactic to just buy back some or all of those iron condors, probably not incurring much of a debit if it had been done relatively soon. Waiting to reposition them until market conditions had settled a bit would have been a viable tactic.
I didn't do that because I had the extra puts on all my positions. While I was worried about where prices might go, of course, the insurance allowed me to stay in the trades, knowing that any losses would be at least partially offset if I had to adjust the positions. However, in October, when another downdraft that looked severe hit, I quickly closed down profitable butterfly, calendar and double diagonal positions in an effort to manage risk, keeping open a number of other trades once I had trimmed the risk to a level that felt comfortable and not likely to engender crippling fear.
I've spoken for years about another method of controlling fear: having a trading plan. Know, before you enter the trade, where your profit limit and maximum loss will be. I used to trade an OEX directional strategy that produced many more profitable than losing trades, but one difficulty with the strategy was that it was based on the advance/decline line's behavior. There were no hard and fast profit limits or stops based on OEX price. I couldn't set the profit limit and stop appropriately, and that eventually led to my abandoning the trade. As I mentioned in a recent Trader's Corner article, having a written-down plan allows me to reference that plan and just act on what I typed in calmer times.
When fear overcomes traders, that fear isn't actually the fear of what the markets will do, in my opinion. It's fear of what the trader will do in the circumstances, fear that there's not enough knowledge, money in the account, or experience to handle the market action. Real fear arises when traders don't feel they can trust themselves to manage the risk that they've incurred. Prevent fear by allocating risk appropriately for the market conditions and by writing down a trade plan for each trade. Then manage that fear by acting on the plan so that you know you can trust yourself.