Option Investor
Trader's Corner

Experimenting

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As many of you know, I'm all about setting trading goals. My trading goal for this year is to experiment with trades that will vary my income-producing trades. Since I was originally hired to represent the self-taught trader, I thought some might want to follow along with some of my attempts to meet my goals.

This year, I want to experiment with varying my delta, theta and vega risks (price, time and volatility risks). I've decided to focus on four types of trades in addition to the condors or credit spreads that make up the bulk of my trading: ATM condors rather than the high-probability ones I've been trading; butterflies, both ATM and even more speculative OTM ones; calendars; and double diagonals.

So, that's the first step in my trading plan: deciding what needs to be changed and how to go about changing it. Almost all investors understand the need to diversify their portfolios. Traders need to diversify their repertoires, too, as well as the securities they trade. Market conditions change. The trades that worked great for trending markets aren't necessarily so great for channeling ones and vice versa. The trades that worked great for bullish environments--environments in which volatility tends to be decreasing--can be disastrous in environments in which prices are dropping and volatility is expanding.

However, experimenting with new trades can incur unexpected risks. I thought I'd devote this Trader's Corner to some ideas about how I approach new types of trades or familiar trades on new securities. I'm not approaching this article as an expert telling you what to do: I'm a self-taught options trader who is still learning. I'll even let you in on some of the mistakes I've made, too, in hopes that you won't repeat them.

First, set a goal for how much money you'll risk each option expiration cycle on experimentation. Most people pay a tuition fee as they're learning new trades. The market collects that tuition in losses when some unexpected wrinkle occurs or just when you're doing your best deer-in-the-headlights impression.

Experimenting collects a fee in another way, too: when you're experimenting, trade size is smaller and commission costs eat up an exorbitant proportion of the potential profits. Sometimes a trade that would be profitable if one were trading 20-25 contracts and taking home $0.25 profit per contract, for example, is only break-even or results in a small loss when trading only 1-2 contracts and paying commissions out of that smaller profit.

I've set a specific goal of risking no more than $500 per option expiration cycle on new trades. That will go up as I experiment. That's a very small portion of the two accounts in which I trade, far less than 1 percent. While I'm experimenting, I consider all such trades speculative trades and appropriate only for the speculative portion of my trading accounts. That's true even though most of the trades with which I'm experimenting will eventually move into the income-producing part of my trading account when I feel comfortable with them again and bulk up the number of contracts I trade.

For those of you experimenting with new types of trades or familiar trades on unfamiliar vehicles, move such trades to the speculative part of your trading account where they properly belong. To summarize where we are so far, then, set a trading goal, decide what needs to be done to accomplish that goal, and determine a maximum amount that will be risked in meeting that goal.

Then it's time to educate yourself. Read as much as you can about the new tactics you intend to employ. Talk to other traders who have traded that type of trade or that vehicle. Listen to webinars presented by CBOE or your brokerage.

Paper trade an opex cycle or two before you attempt a trade with real money, but there's really nothing that approximates the real give-and-take of trading except real trading. Only testing your skills with real money will elicit the kinds of emotions that sometimes cause problems in trades. Just make sure you do it with small numbers of contracts and that you're vigilant about your stops.

Before escalating higher in size, traders need to know that they can handle the emotions wrought by a particular kind of trade. Although I love condors, I've heard traders confess that they can't sleep at night with condors in their portfolios. Me? I don't do long straddles. Something about this rather sedate trade doesn't fit my personality or, apparently, my trading skills. Give me a condor, and I can let it play out; give me a straddle, and I'll keep trying to leg in and out and end up with a mess. An unprofitable mess. My normally patient personality turns into something else irked by that straddle sitting there in my account.

I would even go so far as to warn that you shouldn't escalate the size of trades too much until you've had a bad month and handled it well, both in terms of the losses you incurred and the emotions engendered. It's only then that you know that you can trust yourself to honor stops, to act when appropriate and stay steady when appropriate. Woe to the trader who collects profits for the first month of trading a new strategy and immediately ramps up the size of the trade. A number of would-be condor traders, not having faced a losing month, don't understand what it feels like to have a condor that goes bad when prices start zooming toward a sold strike.

Those of you trading with a $2,000-25,000 account, particularly those under $10,000, might have more difficulty experimenting in live trades. They may represent too high a percentage of your trading account. That's okay. Although not a perfect solution, there's a way around that difficulty: continue paper trading.

Paper trading is more sophisticated these days than in the early days of online trading, when most traders were restricted to a spreadsheet in which they noted the parameters of a paper trade. If life got busy, it was all too easy just let it go without updating or "forget" to tend to a paper trade gone sour. Most trading platforms enable paper trading these days that mimics the actual trading platform so closely that it can even engender some of those emotions that trading does. I remember testing a simulator for trading currencies, grumbling under my breath about how they kept coming up and deliberately hitting my stop during thin trading . . . until I realized that no one was seeing my stop. It wasn't a real stop on a real trade.

If your online brokerage doesn't provide for paper trading or a simulator, the CBOE does. Let's look at an example of a trade on a CBOE simulator. I gave myself a $5,000 account and a high level trading clearance so I could sell options and enter combination trades. Then I looked for an example trade.

Lately, I've been researching calendar spreads. I haven't been a fan of calendar spreads in past times, but I'm forcing myself to try a few now and then. I have been studying a recommended practice of trading calendars on the MNX each month, placing them a couple of percentage points above the ATM level about 30-40 days before option expiration. So, on May 14, with the JUN options within that 30-40 day window, I set up an example order. The page is difficult to read due publication parameters, but it involves the sale of a JUN 205 call and the purchase of a JUL 205 call. My main goal here is to show you how closely the CBOE's virtual trading platform mimics an actual trading platform.

CBOE Virtual Trade Spread Order Preview:

The difficulty reading that chart might also make it impossible to read the cost for the order. It's $254.90, so it fits my parameters of risking $500 or less a month. I'm sticking to that even though this is a paper trade. Since it fits that parameter as well as my goal of varying risks, it's time to punch the "Place Order" tab, right?

Not so fast! What are the risks of calendars? We're told that the only risk in this type is the original debit that's paid, but is that true in all cases? (Hint: no, it isn't.) What do we know about the MNX or its options? Are they American or European settled? How is profit taken and when are losses taken? I would never enter a real trade without knowing those things, so shouldn't I know them before initiating a paper trade, too? What do I expect to happen if the MNX moves up or down?

The MNX is the Mini-NDX index, "based on 1/10th the value of the Nasdaq-100 Index (R)," another portion of the CBOE site tells me. It is a European-style index, meaning that it's cash-settled, and it normally stops trading the Thursday before option expiration. For June, that option expiration would be Saturday, June 21, so the MNX would stop trading Thursday, June 19. The settlement value would be shown as XMS and would be 1/10th of the NDX's settlement value. The fact that it is cash settled would be reassuring to some traders since some freak unnecessarily about a sold strike (the June call in this case) being exercised.

Get in the habit of checking such essentials, even before placing a paper trade and especially if trading live, even if the number of contracts is small. We all are going to make dumb mistakes in our trading, as I did recently when I thought I was entering a June bear call spread and instead found myself the proud owner of a July one, 65 days before July's expiration. We're human and we're going to occasionally make those mistakes, but that doesn't mean we should be deliberately cavalier about placing any trade, even a paper one.

It's still not time to click on that "Place Order" tab. Before you place a trade that involves a sold option, investigate whether the underlying delivers dividends. If so, when does it go ex-dividend? You don't want to discover when in the midst of a trade that your underlying pays a dividend, and that your sold call has been exercised, but only after you've collected the obligation to pay the holder of that sold call a dividend.

Does that have the ring of something that may have happened to me? It did, with SPY options. Fortunately, the cost wasn't a large one, but it was an unexpected one, and it taught me a lesson. Subscribers have had harsher ones. Through the years, I've heard from some who wrote a few minutes before Thursday afternoon's close on opex week, asking if I knew when their SPX options expired. By the time their emails arrived in my mail and I could answer, they might have had little or no time to make decisions as to whether they would close out their positions or risk the sometimes crazy settlement action on Friday morning. Verify whether the options in your vehicle stop trading when the cash market stops trading or if, as happens with most indices, it continues trading fifteen minutes after the close. That difference can sometimes mean the difference between a profit and a loss.

I've heard from subscribers who turned on CBNC, noticed that gold or some other commodity was up "too much" and jumped into a bearish trade on some security related to the commodity or into a futures trade. One futures trader didn't know how much was being lost or gained in that trader's trading account with each jit or jot of the gold futures; another didn't know the differences in the ways that some of the crude-related indices behaved in relationship to the movement of crude. Crude rising doesn't always mean that the refiners will rise, for example. I've heard from a trader who wasn't aware whether an expiring crude-related security was cash settled or settled by delivery of crude.

In summary, after deciding on a trading goal, the method for meeting that goal and the amount to be risked on testing, traders must meet other parameters, too, when experimenting. Even when paper trading options, traders should check on the type of expiration of the options (European or American), type of settlement (Friday morning or Friday afternoon), and whether the underlying pays dividends as well as the date it goes ex-dividend. If your underlying is an equity, traders should determine whether the company has earnings or any other price-moving event scheduled during the period the trade will be in effect.

What about profit or losses? How does a trade work? Where, in practice, would traders cut losses or take profit? An example might be shown using the MNX calendar trade profiled earlier. Although the CBOE site doesn't offer a profit/loss chart for the MNX trade shown above, my brokerage, BrokersXpress, does and so would most others.

Profit/Loss Chart at Expiration:

The chart and figures indicate that the calendar trade's breakeven points are $197.95 on the bottom side and $212.89 on the top, with the greatest profit accrued if the MNX ended the JUN expiration at the 205 strike. Of course, this chart ignores the commissions. In practice, traders can't do that, of course, but traders who are experimenting with small trades have a bit of a quandary. As mentioned earlier, with some brokerages, commissions exhort a greater proportionate toll on trades of one or two contracts than on a greater number of contracts. Depending on the trade I'm experimenting with, I may consider the commission cost a donation for educational purposes. While experimenting, I may prefer setting my stops and profit targets without reference to the commission costs so I can better watch how the trade unfolds. Again, this might not be possible with a smaller account.

The P/L chart and figures display information about what happens with changes in price, but experimenting traders also need to ask themselves what happens if volatility changes or if time goes by. Without going into too much detail because explanations would require at least several other articles, this calendar trade is positive vega and slightly positive theta, so that it would benefit both from a passage of time and a rise in volatility. That part about benefiting from a rise in volatility prompted my reluctant exploration of calendars again. The condors I prefer are hurt when volatility expands.

What does all that mean? If price movement isn't too large, so that prices either stabilize or move slightly higher, both the passage of time and the likely decrease in volatility that comes along with such price action would benefit the calendar trade. The spread would hopefully widen and the trader would be able to collect more credit when the trade was exited than the debit paid to open the trade.

That's how it worked when I tried an actual AMX May/June calendar in real trading. The weekend of April 26-27, I'd done some work with various screens, looking at securities with unusual volume the Friday that had ended the previous week. I'd discovered that after announcing earnings on 4/25, AMX had dropped precipitously. My study with volume/price-spread analysis had convinced me that AMX was likely to steady or maybe climb.

Note: this chart does not feature current prices, but AMX has continued to trend sideways.

Annotated Daily Chart of AMX:

Although the timing wasn't quite right, I could initiate (and did initiate on April 28) the trade for $1.10 per calendar contract. I sold two May 55 calls and bought two June 55 calls for a debit of $2.20 plus commissions. The $220 cost and total risk fit my parameters for how much I would risk testing the trade. Because it was closer than I'd like to expiration and not as much extrinsic value in that sold $55 call as was optimum for a new calendar spread, I knew I'd have to watch it carefully. If the calls got too close to par as they went into the money and closer to expiration, they could be exercised.

I would remove the trade if the spread narrowed so that I was losing 25 percent of my initial debit, I decided. That would mean that since I'd paid $1.10 per calendar contract, I would exit if the spread narrowed so that I could get only $0.825 credit when I sold it. I was looking for 20 percent profit, so I wanted to exit for $1.32 or more. In actuality, if commissions were factored in, I would have needed to collect about $1.70 credit to collect that 20 percent profit, but since commissions exact a higher toll on small one- or two-contract trades than they do on larger ones, as discussed earlier, I set my profit stop at $1.45, which would be a little above breakeven once commissions were paid. It was a compromise between totally ignoring commission costs and requiring 20 percent profit with them.

AMX cooperated with my original viewpoint of what it would do. After the trade was initiated April 28, AMX traded sideways to sideways/higher, moving up toward the level that I thought would be resistance on daily closes. It bounced back down from it.

I exited on 5/12 for $1.45 credit. I reaped just a little over a whopping $10.00 profit after commissions for my efforts, but I did begin the process of reacquainting myself with how a calendar unfolds. I gained confidence about trying it again, even in this market climate, and moved a step closer toward my goal of participating in a trade that's on my list of repertoire-expanding trades but is the only one that's completely new to me: those double-diagonals. Because a double diagonal is a sort of a combination of a short strangle and double calendars, easing back into the more familiar calendars seemed a good start for me.

This week, I initiated my first double diagonal, and I lost $169.64. Before I initiated it, I went through all those steps listed above. I identified the amount I would put at risk, the vehicle I would use, the expiration type of that vehicle, the way it's settled, whether or not it awards dividends or has earnings. I'll knew as much as I could about how the trade unfolds. I've already studied P/L charts for double diagonals, but I did it again for the specific trade I entered. I knew, before I initiated the trade, where I would put my stop and where I would place my limit order for my intended profit. I expected to pay a tuition for the learning experience, hoping I wouldn't, hoping I would instead be able to pull off one of those like-magic adjustments with double diagonals. In fact, I had the first one saved and ready to go, turning the put side of the diagonal into a double calendar when markets headed down, but the trade forced me to kick in another rule I'd set. If the sold strike was too closely approached within a week of entering the trade, just take your losses and go because it's just a bad trade.

What did I learn? I learned that it made me jittery and I had to think many times, checking options chains over and over to make sure that I was saving the right order to convert a put diagonal into double calendars. I also learned that I still can take a loss when needed and not do the deer-in-the-headlights thing. I learned I have the go-ahead to keep trying.

It sounds daunting, doesn't it? It should. It's your money that's eventually going to be put at risk, your real money. More than that, it's your confidence in yourself as a trader and that can be more vulnerable than your trading account.

Oh, and that MNX calendar I set up as a paper trade? MNX on Friday, May 23 had dropped below the breakeven point, so that it would have been time to adjust or roll down the calendar. With MNX at 195.90 that afternoon, the bid/ask was still 2.07 x 2.27, so a trader who elected to exit and not adjust wouldn't have lost much. Time to go back to the drawing board and think about that one before the close!
 

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