It's a good thing that I've been trading for many years. Why is that? I suffered a disastrous loss last spring, one that I mentioned at the time. I let myself down, accumulating losses large enough to wipe out a year's worth of profits. I didn't wipe out the trading accounts, of course, but I did do damage to my long-term trading results and to my confidence.
I reassessed. I talked to others. Since I discussed what had happened at the time, I don't want to rehash the whole thing now, but some explanation might be necessary for some subscribers. I had been rolling my credit spreads each time they were threatened. I judged them to be threatened when the delta on the sold strike neared 20-25, depending on whether the put or the call side was threatened. I would resell however many contracts I needed to make up for the debit that I spent buying back the in-trouble spread, up to double the number of the original contracts. I left at least a third and usually half of the trading accounts in cash so that I could execute this rolling strategy. That seemed a lavish amount, a conservative amount. I didn't worry about the unrealized losses that were accumulating, because I never intended to realize those unrealized losses. I intended to roll. That's what I had been doing for years.
Then came this spring's runaway rally that also dropped volatilities. I had placed many contracts of various iron condors in two expiration months, and one of them, the front-month RUT iron condor was being threatened. It was time to roll. Only, my look at the charts showed that it was likely that every single one of my iron condors in two separate expiration periods were likely to be challenged. Low volatilities meant that I wouldn't get much for selling new spreads and so I was going to have to roll into at least double the number of original spreads to make up the debit to close the in-trouble ones. That was going to mean rolling into something in excess of $200,000 worth of risk on iron condors.
I wasn't going to do that. Many reasons existed, including some things happening with the health of a grandchild. Trading reasons deserved attention, too. I do try to evaluate each trade each day and say, is this wise? At that time, I had to ask myself, was it wise to roll into double the amount of all my original iron condors and take on double the amount of upside risk in what had proven to be a runaway market? I didn't think so. In fact, given the way that the markets were behaving and what was going on outside trading, splitting my attention away from the markets, I didn't think it was wise for me to take on any additional risk. Due to the difficulty managing all the separate draws for my attention, I had probably already mishandled the situation.
Suddenly, that unrealized loss became a realized one, a bigger one that I'd imagined I would ever take. Since I'm as human as anyone else, I bungled some of the exits. In addition, the runaway nature of the markets meant it wasn't always easy closing those spreads for a decent price. It's a good thing that I did close them, however. In many cases the indices just kept blazing upward. I knew where those rolls would have been, and some iron condors would soon have been in trouble again, requiring another roll. If anything made that period and my bungling of the trades easier to accept, it's the knowledge that the losses could have been so much worse if I had completely frozen or convinced myself that "it's going to turn around."
I revamped my trading plan, one that I'd thought had been tested and retested so thoroughly that it was both workable and trustworthy. Now you'll hear me talk a lot about unrealized losses. I watch them all the time. I don't count on a roll to get a trade out of trouble if my maximum present loss is being approached. I personally set my maximum loss level at 1.6 times my planned profit target. With iron condors and their 80-90 percent probability of profit, back testing has shown me that in the long run, I'll be okay if I keep losses to that level.
Maybe it won't feel okay in the short run, however. Just a month after that spring debacle, I put on an SPX 60-contract iron condor trade the day before the flash crash. I always add put insurance when I sell iron condors, and that put insurance saved me that flash crash day. I closed some spreads for a debit, lowering risk since none of us knew what was happening, and I also took profit in the insurance put position to lower the overall debit I'd suffered. The efforts I made to lower loss that flash crash day were to hamstring the trade so severely that I eventually had to close it out for that pre-planned maximum loss. That wasn't fun, but it was a heck of a lot more fun than letting myself down as I had earlier in the spring. I can't predict nor prevent a flash crash. I can protect my positions with put insurance if I feel it necessary and I can act to keep losses as small as possible, and I did take both those actions.
Because of what had happened earlier in the year, it hasn't been a good trading year. I'm still licking my wounds, and I'll be in for a fresh round of grieving when I have to face those numbers again when I prepare my taxes. I am reiterating all this for several reasons. Almost a decade ago, I was hired to represent the self-taught trader, and I'm still inviting you along on my experience. I want you to understand the importance of keeping an eye on that unrealized loss, even if you plan to adjust your trades and don't think you'll actually ever have to realize that loss and lock it in. I want you to reevaluate your plans or maybe ask for a pair of fresh eyes on the plan in case you've been blind to a big hole in the center of your plan, the way I was. Also, I suspect from the way the markets have gapped here and there, some of you may have experienced a similar year.
Will I continue trading? You betcha. This isn't my first go-around with the markets. I have done everything I know to do to protect myself from that error, ever again. Experience had told me that leaving that much money in cash and making those kinds of adjustments worked for me but despite my years of trading, I just hadn't had that particular experience I had this spring. You can bet that I've patched up that big hole in the center of my plan.
I understand about probabilities. We may say that iron condors have a 80-90 percent probability of profit, as I construct them, at least, and we may translate that into an expectation that in any given 10-month period, we expect 8 or 9 trades to be profitable and 1 or 2 to be losers, but that's not the way probabilities work. That's not a big enough data set to see the probabilities fulfilled in that way. It takes at least 30 data points to even begin to have an expectation the probabilities will shake out in the expected way. I fully expect to encounter periods when two trading years in a row might be profitable 11 out of 12 months and some, maybe only 7 out 12.
I also realize that those probabilities work out that way only if I'm not touching those trades. The moment I start making adjustments, I'm changing either the probabilities or the relationship of the size of gains I might make to the size of losses I'll take. With the iron condor, at least, adjustments typically cost money and take away from the profit, so that the profit against which losses are subtracted is smaller. As a trader, then, I have to decide whether I'm also going to lower the maximum loss I'll accept.
My job as a trader is to keep the number of contracts I trade manageable when compared to the cash I have available, and to keep my losses in proportion to the profit targets that I set. I'm constantly reassessing. In the long run, however, we have to have faith in the process and faith in ourselves as traders. The reason that the spring was so tough was that I felt that I'd betrayed my trust in myself, my belief that I wasn't the kind of trader who would let losses mount.
Don't do that to yourself. Make a New Year's resolution. At the end of what might have been a great year or a rough year, reexamine your trading plan. Are you ignoring holes in that plan? Did something about the way you trade contribute to losses or sleepless nights that told you that you were in over your head or putting way too much money at risk? Guilt won't do you any good at this juncture. An honest assessment will.
I hope those in the U.S. enjoyed a Happy Thanksgiving. I'm sending this out early because I'm about to take off to enjoy the second part of my Thanksgiving week with a daughter and her family. Wherever you're living and trading, I hope you have much to feel thankful about this year.