Option Investor
Trader's Corner

Maintaining Control

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A subscriber recently submitted two suggestions for separate Traders Corner articles. A central theme connected the two: maintaining control. The subscriber commented on a situation with limit buys and sells that he had noticed more often with options than with stocks. "It seems that the market makers bounce their price temporarily in order to hit these limits and make a few extra dollars. Then they allow the price to return back to normal. How do we get around this?"

Is there a way to wrest that control away from market makers? One method employed by some traders is to set up a conditional order. Interactive Brokers, one of the online brokers offering this type of order, explains that such conditional orders are "submitted automatically ONLY IF specified criteria for one or more defined contracts are met." This means that your limit order will not be a sitting duck for market makers to target, but instead will be submitted by IB only if the conditions you've set up are met. IB allows setting up to three conditions. A logical one might be setting an options order based on movement in the underlying security. However, if traders wanted to submit a limit buy order on an OEX call option only if the OEX and BIX reached certain levels, they should be able to do that.

Employing conditional trades allows traders to maintain some control, but no method proves fail safe. All traders get caught in stop-running moves, even experienced traders. This subscriber's question displayed his experience, and that experience has perhaps taught him how to handle trades once they go bad. No one likes exiting a trade right after entry, but sometimes that's exactly what's needed. Maintaining control also extends to deciding how to handle a trade when prices reverse immediately after the entry. At what point does the original entry no longer make sense? If traders make exit plans before entering any order, even a conditional one, that plan helps manage the fear or worry that arises when prices immediately reverse after getting into a trade.

Fear was the subject of the subscriber's second question. "I purchase an option at the recommended level," the subscriber writes. "Then, the option drops 15 cents. I go into panic mode, and it's all I can do to keep myself from not going and selling it before it goes down further."

All traders experience fear. The March 2005 issue of ACTIVE TRADER featured an interview with Daniel Gramza, president of trading, consulting and education firms Gramza Capital Management Inc. and DMG Advisors LLC. In addition to discussing the technical trading tools he uses, Gramza discussed emotional reactions to trades, extending the dialogue to those traders who have difficulty placing trades, letting profits run and reacting to losses. He believes that such emotional reactions can get in the way of traders' success. Traders need to create effortless action, he believes.

How do traders create such effortless action, so that they click the trading button when it should be clicked? Gramza believes that traders should employ two tactics. One involves methodical testing of the methods traders tend to employ. Whether trading range-bound markets with stochastics signals, trending markets with CCI zero-line rejections, or candlestick patterns, set up parameters for entries and exits. Either back-test them or test them real-time using a simulator package, Gramza suggests.

If an online broker does not offer backtesting, traders using that service can still paper trade, keeping rigorous records. Calculations of the maximum number of losing trades in a row encountered during the test period and the total drawdown during that stretch of losing trades should be included. This fine-tunes the decision, allowing traders to reject those types of plays that do not fit their trading styles. For example, trading breakout plays tend to produce gains over the long run, but often produce a large number of failed plays in a row. Some traders could not handle a large number of failed plays in a row. The fear and worry would overwhelm such traders, and they might take profits too soon on a winning play because of the fear engendered by the previous run of losing ones. Conversely, antsy traders might not be able to manage the boredom that arises during slowly unfolding plays such as credit or debit spreads. Maintaining control includes fitting trade types to trading style.

Once a trading plan has been tested and its parameters established, traders feel more confidence. Losing remains a necessary part of trading, however, and Gramza offers advice for the self-castigation that sometimes comes along with those losing trades. He counsels that traders should be aware of negative thoughts. He advises using a stop-sign method, replacing those negative thoughts with reassurances that the loss was an expected consequence of trading. He does advise taking responsibility for trades, with that responsibility encompassing any needed fine tuning of trading plans.

Gramza mentions a problem that some traders experience with winning trades, already noted above. Just as fear can cause traders to bail out ahead of their stops, it can also cause them to bail out ahead of the planned profit target. The same tactics to control fear of losses can help manage this fear.

Education, testing, planning, and actively stopping negative and unproductive thoughts help traders maintain control. The subscriber's two questions turned out to be related to control issues, issues we all ought to consider in our own trading plans.

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