Option Investor
Trader's Corner

Surviving as a Trader

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What's your first goal as a trader?

Surprise! It's not to make money: it's to preserve your trading capital.

While it's been nice to have some quiet days at the end of this week, some experts surmise that we've moved into a high volatility environment, one that might quiet down temporarily but then continue well into September and October.

Last fall's market action was relatively tame by comparison to that seen many Septembers and Octobers. Look back at a VIX chart over a several-year period, and you'll notice many summertime peaks are followed by new peaks in September or October. Although in recent years, those VIX peaks have tended to be lower highs than the summertime highs, switch to a longer-term chart using the VXO (the old VIX) and you'll see a different pattern emerging in some years.

Annotated Weekly Chart of the VXO:

As I edit this article, written earlier in the week, I can hear CNBC in the background. Commentators are discussing whether the Fed should ease as it did in 1998, again comparing this year to that year.

Those seasonal spikes in the VXO seen on the chart were accompanied by steep declines in equities, of course. In each case, the summertime lows were pierced.

While I'm not predicting that we'll see a repeat of the 1998 and 2001 declines this September or October, we can't assume that the pattern can't repeat just because it hasn't for several years. It can. Some year, it will. This could be that year.

How does one protect one's trading account? I've culled some ideas from various trading coaches and have added some of my own, including some of my thoughts about the types of options plays in which some of our some of our subscribers engage.

Make a plan.
Always set hard stops.
Consider trading smaller.
Consider not trading at all.

If ever traders needed a roadmap to help them negotiate difficult conditions, this may be the time. The global jitters are almost palpable. When some fifty-something somewhere in Asia panics about the money she has tied up in an Asian tech stock and begs her broker to just get her out at any cost, don't you almost feel the quaver in her voice in your own throat, too? (By the way, I'm a fifty-something, a late fifty-something, so I'm not picking on fifty-something female traders.)

In a calm time when the markets are closed, make a plan for how you'll approach the season, the week, the day, and the trade. Think about setups. Check economic calendars.

Include at least a brief glance at foreign markets, too. You can find one on www.forexnews.com. Last week and again early this week, I warned traders via my Wraps and Market Monitor comments that the Bank of Japan's rate decision Wednesday night would likely impact our equity markets, although the direction that decision would send our equities depended on the decision made, of course. I had an email from at least one subscriber who rued not taking the advice to carefully consider whether one wanted to hold positions overnight. That subscriber was stopped out of a short futures position during the overnight session.

Knowing what might impact your trade helps you determine whether the climate is good for trading at all. If you determine that the climate or your own life situation supports trading, determine what a good setup would be.

During periods of high volatility, options prices are inflated. That means that in addition to the normal premium decay that works against the options buyer, an additional element of risk has been added. To benefit from a long put or long call purchase, you'll need the markets to move in your favor, and perhaps move big in your favor, to overcome that possible premium decay. You need optimal setups.

You don't want to jump on a seemingly great long SPX play, only to find out a moment later that the TRAN and the USD/yen are headed south and the VIX and TRIN are headed north. Think twice before initiating any options play near the close if the ECB or Japan is due to receive an important economic release that might impact future rate-hike decisions for those central banks.

Pass up any trade that doesn't meet your desired setup parameters. We can all tell tales of the one that got away without us, but another big trade will always come along.

Part of that plan should include determining where a "this is a catastrophe, have to get out" type of stop will be. Almost every trading guru, coach or mentor I've heard advises setting such a hard stop.

Why set such a stop if you're sitting in front of the computer monitoring the trades moment by moment? I remember during early 2000 when I headed to the bathroom nearest my office to brush my teeth after a lunch eaten at my computer desk, returning to find that I had $9,000 less profit than when I'd left my seat a few moments earlier. I remember times when the market was moving so fast that it was tough to actually punch the order in and get it submitted before conditions had changed again, rendering that order unacceptable to market makers. Meanwhile, my profit had turned into a loss. For me, most of those times last occurred in late 1999 and early 2000, but they're happening again now to some traders.

If you were trading last Thursday morning, you experienced such a time. While these were unlikely occurrences only months ago, I can't tell you how many emails I've received lately with someone telling me about the disasters that occurred when a phone call was accepted or when someone stopped by to chat for a moment at an office door. Trades were ruined in the few minutes that attention was diverted.

The most important reason for setting such hard stops, however, is to help you control the emotions of trading. When you know you have that safety net below you, exit decisions are made with more equanimity. The goal is that you won't let the "this is a catastrophe, have to get out" stop ever be hit. You'll make a more reasonable exit at a more favorable price. It's easier to avoid the deer-in-the-headlights reaction when you know you have that safety net below you. Panic is more easily avoided.

Another tactic for those who buy calls and puts is sometimes employed by Jeff Bailey. He sometimes advises that you use your trading plan to determine what risk you're willing to take in an options trade. Once the purchase is made at that maximum risk amount, no stop is set and the trade is allowed to work. Or not work.

Not all OIN subscribers buy calls and puts, however. Many buy leaps or stock. Maybe their trading plans, taking into account their ages and goals, include attempting to weather market downturns. You still need that "this is a catastrophe, have to get out" hard stop. For those of you following Jim Brown's leaps suggestions, he's provided you with more favorable exits than those, and I'd advise that this is not a period of time that you want to ignore such stops.

Other protection is available for those who want to hold leaps or stock during times of market instability. A put can be purchased, although puts are expensive insurance these days. A previous Trader's Corner article addressed collars, a method that can provide some limited downside protection for little cost. That article can be found at this link.

Many subscribers trade condors or other spreads. Rising volatility widens those spreads, and that's not a good thing. In fact, rising volatility murders condors, as many who were trading condors during August's option expiration period can attest.

Frankly, condors aren't the best of vehicles to trade when you expect volatility to expand, but if you're considering trading them anyway, consider some methods for controlling risk. Dan Sheridan, a former floor trader and frequent www.cboe.com webinar presenter, offers a couple of suggestions. One is that you know when to adjust those condors. On one webinar devoted to adjusting condors, he suggests that when the delta of a sold call reaches 25-28, traders close out the condor and roll the whole thing upward. When the delta of a sold put reaches 20-22, he suggests it's time to roll the condor down.

I employed that method through August's option expiration period, adjusting positions when prices were 21-50 points away from my sold strike, depending on what point in the option expiration period those delta values were hit. The benefit was that the spreads still hadn't widened inordinately when the trigger delta values were hit. I didn't feel rushed making the decisions until Wednesday afternoon of opex week, when the delta of my sold put, at SPX 1385, began moving above 20 near the close. I managed to close out 10 of my 25 contracts that afternoon.

I felt a little rueful and maybe even a little silly closing them out when only one trading day remained in the opex period and the SPX was still more than 21 points above the sold strike at the close. However, as Jane Fox on the Market Monitor portion of the site sometimes says, "Rules is rules." You can betcha I was glad I'd closed out at least 10 of them the next morning.

Dan Sheridan said once, in answer to a webinar attendee's question, that he doesn't fear a big move, even one that brings prices through several standard deviations, as long as it's not a gap-open move. Barring that, he believes he can adjust positions.

I would add some caveats to that, however. It's not going to be optimal to roll down or up on the last trading day before option expiration or adjust any time when the markets are cascading or soaring on volume so high that trading desks and brokerages' online pages are swamped. Sheridan advises that, if markets are cascading or soaring, you wait a day or two before rolling into a new position after closing out the first one.

Another suggestion that Sheridan offers for trading condors in a trending market is to buy extra long options in the direction of the trend. For example, if markets were trending down and you felt compelled to trade a 10-contract condor or perhaps had even entered the trade several weeks before the trend began, Sheridan might suggest that the bull put spread be altered to contain 10 contracts of the sold strike and 12 of the bought strike. The extra long strikes would ameliorate the loss, he says, and wouldn't cost too much when initiated.

If the trend begins after the condors have been established and within a couple of weeks of option expiration, Sheridan suggests that the extra long strikes be between the current price of the security on which you have the condor and the sold strike, not at your original long strike. For example, if I had a 10-contract MID 910/920 bear call spread and, two weeks before option expiration, the MID had begun trending upward toward my spread, it would be too late to buy a couple of extra 920's. They wouldn't appreciate quickly enough in price to do me much good as the MID trended up toward the spread. Instead, Sheridan might suggest that I buy a couple of MID 900 calls. Their price would appreciate faster as the MID trended higher and better help ameliorate any loss, should I forced to take one. I haven't tried this suggestion and so can't give you any information as to how well or how little it tempers any loss.

A better idea might be to diversify the portfolio so that it didn't include so many condors in the first place. Traders are accustomed to thinking of diversification when investing 401K or IRA funds, but diversification is needed when considering options strategies, too. Investigate strategies that benefit from expanding volatility to combine with those that suffer from that expansion. If your trades are mostly of the cowboy/cowgirl speculative type, blend in some less speculative plays. Investigate the different types of options plays offered on our website as well as clicking over to the CBOE and listening to every webinar offered.

But don't try new strategies in a tough market condition. Paper trade them. I know that some traders and even trading gurus discount the value of paper trading. I understand their comments. I've been as guilty as anyone else of setting up a paper trade and then just letting it go when life gets tough. Admit it: you've done it, too.

However, my reason for paper trading in the first place was usually because my knowledge of the strategy or the complications in my daily life didn't allow me to responsibly commit funds to the strategy or to any strategy at that time. Paper trading in a difficult market allows one to judge all the things that might go wrong with a strategy. If you're wrong about your ability to concentrate on a trade during such market turmoil, it's far better to let a paper trade go unwatched than it is to let an actual trade do so.

Maybe you're relatively new to options trading, but you've been doing well. I would suggest that you've been doing well in a different market environment than we might have now. For months on end, it didn't much matter how good your technical analysis skills or account management skills were. As long as you went long and bought enough time, you were almost guaranteed to profit eventually.

That's not true any longer. So, if you're relatively new, you might need to know about some of the things that have changed. Paper trading, even for a few days or weeks, can be eye opening. For example, option values already inflated by the volatility can be further inflated near the open during the amateur-hour period. They're expensive. They can be exorbitantly expensive.

What happens if you buy one of those exorbitantly expensive options during amateur hour? Even if the underlying moves in the direction of your trade, you may discover a phenomenon that you haven't experienced much in the last year, until recent weeks. If you paid too much for those options during amateur hour, their price can deflate while the market moves in your direction. This wasn't as noticeable or problematic a trait when volatility levels were already low and options were dirt cheap, but it's certainly one now. Just last week, I received an email from someone whose call never again reached its amateur-hour value even though the underlying climbed all day. It just climbed too slowly for the underlying's price increase to make up for the deflation in extrinsic premium.

That leads directly into the next two suggestions. Consider trading smaller or not trading at all until market conditions appear more settled. If you went long a bunch of August calls at the SPX close at the 200-sma on August 13, with the day having produced the second doji in a row, something you considered a clear sign of steadying conditions and a bounce to come, don't you wish you'd either foregone that play or else had traded much smaller than you did?

Even with the best of account-management tactics and the best of technical analysis skills, trading in a volatile market can decimate an account. Isn't it better to spend a month or two in intense study of various options trades than to decimate both your account and your confidence in your abilities? One trading guru says that if you start experiencing one losing trade after another, your trading skills haven't changed: market conditions have. It's hard not to blame yourself, however, for each of those losing trades and to lose confidence. Recognize ahead of time that market conditions are changing. Don't put yourself in a spot in which you're almost guaranteed to take a hit to your trading account and your confidence level.

If, in the coming weeks, you're paper trading new options combinations or trying them on new underlying vehicles, I will be, too. If you're signing in to the latest CBOE webinar, I'll likely be listening right along with you. I'm taking my own advice.

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