Somewhere around mid July, I found myself with a position with an ugly looking expiration profit-loss chart. It was a negative-delta position in a rapidly climbing environment. Adjustments had turned the trade into a directional one, and the direction was the wrong direction, for the time being! Further adjustments could be made, but the adjustments I'd already made had sapped the position of much of its profit potential. It was underwater.
What did I do? I just took it off. A day later, I started easing into a new position, one that was not directional. I'd had the opportunity to reposition the graph over the current price of the underlying.
Why close the position and start again? Why not just fight the original position? I could make adjustments that would flatten the risk even if they also flattened the profit potential, with the hope that the position could be brought back to the flat-line by expiration. After all, I set my maximum allowable loss in line with the typical profits available on a strategy, so even if the new position was profitable, the total was going to be a washout anyway. Maybe it was just better to stay in the original position and fight it out.
Sometimes, it is.
Lots of times, it isn't.
Unfortunately, my position was graphed on a proprietary profit/loss graphing system that I don't have permission to use in my articles. I can't show it to you, but let's just say that if the underlying had reversed at that moment, the position could have been minimally profitable, essentially a washout. I could have inflated the profit potential by deciding that the underlying was ready to reverse and adding more negative-delta adjustments, such as selling more credit spreads or buying put debit spreads or just long puts. Whatever strategy I chose, however, I would have had to have been right about timing as well as right about the direction, and that's the antithesis of what we do as income traders. If I wanted to do that, I could do it with a lot less angst by daytrading long options or ATM or ITM debit spreads, closing them at the end of each day and not carrying any risk overnight.
That's what I did for a while early in my trading career, but it's not what works for me now. I hadn't intended my trade to be a directional trade and I didn't want it to be one. When I asked myself at the end of the day if I would have entered a trade that looked like that on that day, the answer was a resounding "Certainly not!"
The real kicker for me was my reaction to the trade. The chart was ugly, and it required me to make moment-by-moment decisions about what adjustments needed to be made, paying particular attention to end-of-day decisions that would flatten out risks from a gap the next morning in either direction. The adjustment that I made for one direction would make the reaction worse if the underlying gapped the other direction.
I was, again, riveted to the computer monitor, as I used to be in my early trading days. I don't trade like that any longer if I can help it. That kind of obsession, as I said last month, can lead to wrong-headed decisions. We're obsessively focused on wrangling with the markets and emerging with a successful trade, in cowboy or cowgirl mode. We miss other trade setups that might be superior to the trade we're trying to rescue. Worse, studies have shown that when caught up in such situations, we're making decisions with a more primal than cerebral part of our brains. We may miss logical and workable adjustments to the trade on which we're focused.
The markets have been good at depositing us in such situations over the last couple of years. Yes, sometimes, it's okay to wrangle the markets, and we certainly shouldn't abandon every trade that's giving us trouble. However, I have a personal checklist that you might consider, too.
1. Has the trade become an unintendedly directional one?
2. Does it require me to closely time my adjustments?
3. Does it require me to watch the screen all day?
4. Do I think about the trade after the market closes?
5. Does it cause me to lose sleep?
6. Am I foregoing other trades to focus on this one?
7. Would I enter that trade that day?
8. Can I safely lower the risk?
And, finally, for the same or a smaller margin requirement, could I set up a better trade that doesn't require that close attention and focus?
The answer was easy for me in July. Some trades just stink. If the trade had been entered just a day or two either side of the original entry, it might have been workable. It's sometimes just the luck of the draw that you entered a trade before a major unanticipated development. Staring at an ugly chart that requires spotless timing leads to more emotional and less sound decisions. I'd rather set up a new trade with a clean-slate chart, one that allows me to re-examine the conditions.
I try to give myself at least a day to rethink the trade before I enter a new one. That breaks that "I'll wrangle that market to the ground" mentality. It allows me to decide with a cool head whether that particular strategy on that particular underlying is even a good idea at the time, and whether another strategy or another underlying might be a better idea. That practice of waiting a day also gives me an evening when I can make intelligent conversation and get a good night's sleep.
In normal market conditions, don't abandon each trade the moment it gets into trouble. There is a time and a place for adjusting a trade. However, do give consideration to writing your own personal checklist. That checklist should help you determine when you should close a trade, taking the loss before obsessive decisions lead to a bigger loss, and walk away from the computer. You'll find that sometimes, it's just best to take it off.
This article was roughed out several weeks ago, superseded by other articles that I thought more urgent, relating to dangerous market conditions. The ideas here relate to normal market conditions. We do not have those normal market conditions yet. The TED spread, a marker of default risk, is on the rise again, and equities don't tend to perform well if it continues rising. I don't know what's going to happen next, but I do know that I'm going to continue to use extreme caution entering new trades. As I've been suggesting to you for the last few weeks, I'll be entering smaller trades and make sure I'm in flexible vehicles.