In 2009, John A. Sargent's "Sizing Up for Success" appeared in Stocks and Commodities
. Sargent featured options trader Tony Sizemore's story . At the time the article was written, Sizemore traded as many as 500-1,000 options per week during a week when his positions required adjustments.
The article spent more time talking about the specific trades Sizemore employed than it did another important point. "Gradually, Sizemore sized up," the second paragraph begins before quickly tackling the combination of trades and management style Sizemore employed. When I first read the article, I feared that the lure of all those contracts, "freestyle" adjustments, and 64.9, 119, and 41 percent total returns Sizemore reported for 2006, 2007, and 2008, respectively, might overshadow the importance of the way Sizemore sized up his trades.
Here are my precepts for sizing up: Start small. Always keep your eye on unrealized losses and gains. Become familiar with your vehicle and strategy. Learn adjustments that work for you and your trading style. Don't size up until you've made it through a bad month trading well. Trading well might not mean that you made a profit. In a bad month, trading well may mean that you kept losses a manageable percentage of your average gains. Do not size up just because you've had a number of profitable months in a row. Those who were employing bullish positions in a many-months rising trend don't know how they'll fare in a choppy or sharply declining market. That was the fate of many bullish traders in 2000. In late 1999 and 2000, you didn't need skills to trade options. You bought calls and, as long as you gave yourself enough time to expiration to weather a pullback here or there, you made money. Sometimes lots of money. Those traders had little or no experience in handling what was to come.
Here's the thing: if you're new to trading or new to a specific strategy or underlying, you don't know what you don't know. To take a simplistic example, back in early 2000, I often traded a specific underlying, Enron. I watched how the stock prices moved and noted a pattern during the day that helped me trade it profitably. But about one morning a week, I kept getting blindsided by a move that seemed to come out of nowhere. That move sometimes helped my position and sometimes hindered it, but it didn't fit the normal pattern of the way the stock tended to move during the day.
Of course, as we infamously know now, Enron's energy trading business was important. That move, I eventually realized, was occurring in conjunction with the weekly release of inventory numbers. As a newbie trader, I hadn't realized that I didn't know the importance of that weekly number to Enron stock's behavior.
What are some of the things you might not know you don't know? Perhaps you've been trading iron condors for years, but you decide you'd like to trade them on the Weeklys instead. Do your skills on trading the monthly options translate to trading the Weeklys? Some do, of course. Some don't. For example, I try to be out of my monthly iron condors the Friday before option expiration week. One Friday before an expiration week, a down day, a trader friend asked another to look at an adjustment being made on a position in Weekly options. I commented on the theta level, and was told that "in Weeklys, theta doesn't matter with that particular adjustment." Is that true? I don't know. I don't know what I might know or not know about Weeklys because I don't trade them.
We talk quite often about how implied volatility on equities expands in a sharply declining market. When you're looking at a theoretical profit-loss chart for your equity-related position, I've certainly written about the need to roll up the implied volatilities a little to give a truer picture of how the position will look if prices drop sharply. For example, in a sharply declining market with rising volatilities, the price of put spreads will widen. That means that if you have to buy back a sold credit spread that's threatened, you'll like be paying far more for that put spread than you would if prices had just gently drifted down to the same level. If you haven't ever been caught in a sharp market move that required you to adjust an iron condor or a butterfly, you might not understand that the loss could be much higher than it looked as if it might be when you looked at a theoretical profit-loss chart a few days earlier, before the expansion in volatility.
If you've never traded options on commodities, you might not understand that options volatilities tend to go up when prices rise, the converse of what happens with equity options. That means that if a call credit spread on a commodity-related underlying is threatened, the spread might have widened alarmingly. You might pay far more to buy back that spread than you would if prices had just gently risen to the same price over a few days or weeks.
Sizemore believes it's important to "master your own emotions." I would put a little twist on that. Despite the many times you'll hear that comment made, I don't honestly believe it's possible to be emotionless when trading. Nor do I believe it's desirable, a belief some will consider trading heresy. Our emotions serve to remind us that we're taking on risk and we'd better manage it. Our emotions warn us that, despite the statistics and the best intentions of even seasoned traders, trades can go wrong. They keep us on our toes. I think the key to "mastering your own emotions" isn't in trying to squash them completely. Rather it lies in starting small with your trades, then gradually increasing the size of those trades as you gain confidence in your abilities to trade profitably most times and to pull the plug on a trade when necessary, when it's just not working. It's important to gain confidence in the predictability of a trade because if you don't have that confidence, you can't let the trade work. Emotions will rule your decisions. I may not believe that it's possible or maybe even desirable to squash all emotion, but emotion certainly should not overwhelm one and rule trading decisions. Making sure you have confidence in your strategy and your abilities, including your ability to take an appropriate loss in time, goes far toward managing emotions.
More important than anything, it's important to find that level at which you can trade comfortably, feeling those twinges of evil emotion, if you would believe some pundits, but managing that emotion. I've said it previously and I'll say it again: if you can't sleep at night, can't think about anything but a trade, stare at charts trying to predict where prices are going to go next, you're in over your head, and it's time to ask for help. Then the trade should be scaled back the next month.
In my own experience trading iron condors, I started with three contracts, then five, then eight. I did not scale up until I'd weathered a bad month. Over a two-year period, I gradually scaled up until I was trading 100-120 contracts a month. When October, 2008 hit, I thought I managed the market action well. I lost money, but I lost about what I made in a typical month. Given the probabilities of profit in iron condors, keeping those losses in line with a typical month's gain would mean that I was leaving plenty of room for profit over a year's time. However, my personal circumstances had already begun changing, and the markets certainly had begun changing. I gradually found that although I'd once been comfortable with that many trades, I was no longer so comfortable. I should have paid attention to that feeling and not been so dutifully thinking, "this is my plan and this is a business and I must trade my plan." Sticking doggedly to the former number of trades when I was no longer comfortable with that number contributed to my oft-mentioned loss that I experienced in the spring of 2010.
I mention this again because the importance of changing market conditions and changing life circumstances also contribute to a condition when you don't know what you don't know. I didn't know, when my husband was retired and my trading income was the major income and not the "extra" income, how that would change the emotional import of those trades. I of course had experienced several sharp market moves by then, but some of you may not have traded through such moves. Sarkett notes that Sizemore's "adjustment methods have changed to apply to the changing environment" . Those changes included adjusting more quickly in a high-volatility environment, preparing "for the market to move further than you think, up or down" .
No matter what your experience level, current market conditions do not lend themselves to sizing up in trades. Now is not the time.
Therefore, instead of just "Sizing Up for Success," perhaps traders ought to consider "Sizing Appropriately for One's Experience Level and Market Conditions." I guess that wouldn't make for a snazzy title, though, would it?
Good luck to all in these market conditions.