The FOMC decided this week not to taper quantitative easing policies, but we know the day is coming when the word "taper" will be included in an FOMC statement. After stronger data Thursday, many market watchers still anticipate that the FOMC will soon scale back quantitative easing. Others argue that such efforts will not be made until the economy has proven its resilience. What few dispute is that the tapering of the Fed's current QE program could result in market upheavals.
If we're about to go through a period of market upheaval, should you change your well-honed trading plan? Yes, maybe, and no.
March, 2000 marked a time of market upheaval. Many new traders had begun day trading over the preceding year, many buying calls or stock with abandon. Some had not developed good trade management skills. Trade management hardly seemed to be needed, since a bad entry could be overcome as long as one had enough time and funds to hold onto long positions until any temporary retracements finished and prices rebounded. Bad habits were reinforced, since traders were often rewarded for ignoring their original planned stop losses. Instead, they might close down their computers and walk away until the rebound, then collect their profits.
Yes, your trading plan should be changed if it does not include sound trade management strategies and you cannot trust yourself to take losses when they occur. Changes that should be considered include choosing trades where risk roughly equals losses, trades that lend themselves to setting OCO (One Cancels Other) profit and stop-loss orders and letting them work, or trades that have a smooth profit-loss line and are easily adjusted. Another alteration could include scaling way back on the size of the trades.
KO OCT Call Debit Spread, Simulated Open on September 5, OptionNet Explorer Chart:
This trade comprises a long, slightly in-the-money KO OCT 38 call and a short KO OCT 39 call. The cost for the trade, with commission both ways at $1.25/contract, is $47.50. Possible profit is ($1 difference in strike x 100 multiplier) - $47.50 = $52.50. This is one example of a trade with the risk ($47.50) and possible profit (maximum of $52.50) about equal.
Please note that this is not a trade suggestion. After a quick survey, I noted that KO was a relatively inexpensive stock and that price appeared to be approaching a long-term trendline. KO could either steady and then bounce from that trendline or break through it. I did not do any kind of in-depth analysis of the charts or check for upcoming events. Prices will be outdated by the time this article appears. I checked the PnL of this trade at 10:34 am CT on Friday, September 20, and the trade had a profit of $16.00 after round-trip commissions.
However, despite the caveats, this is one example among others of a trade that might be structured so that risk and potential reward are roughly equal. The close approach to the long-term trendline would provide the trader with a logical stop loss level at which to pull the plug on the trade, too, if KO broke through that trendline and headed south.
If traders who can't trust themselves or their trades do need to change their trading plans, what about other traders? Perhaps traders who have been trading ten-contract iron condors and feel slightly uncertain about the trade or their skillset with adjustments could scale back in size. Traders who have proven to themselves that they are particularly good at emulating the deer-in-the-headlights stance should definitely scale back the size of their trades. It's much easier to pull the plug on a two-contract trade showing a $300 loss than it is on the same trade in a twenty-contract size, showing a $3,000 loss, even though the percentage loss is the same.
Even if a trader has rigorously backtested a preferred strategy, sizing down might be an appropriate measure if live trades have not included at least one severe market jolt lower. When I'm backtesting new guidelines, I never look at the price charts and never scan the listing of upcoming economic releases. I just follow the trade guidelines I'm testing. The trade works or it doesn't: that's what I'm testing. It's much harder to just follow those trading guidelines when you're trading live and you know that the next day includes an FOMC meeting or a pivotal non-farms payroll announcement.
When I've traded the strategy through all kinds of market conditions, I feel confident enough in the trade to follow those tested guidelines, but it's harder when the live trading has just begun. New traders or those who have not adequately backtested their trades may find themselves pulling the plug at exactly the wrong time because they can't stand the pain or don't know how to adjust.
Even if a trader has rigorously backtested the trade and has not experienced markets that suddenly jolt lower while in live trades, trades should not be sized up if the trader believes that volatility may suddenly expand. That would also not be the time to begin trading your father-in-law's retirement fund for him, even if he asks after seeing your stellar returns the last year. I can't stress this enough because it's a situation that has occurred each time the market has a period of relatively low volatility as it climbs. Relatives and acquaintances see how well a trader is doing, and the trader wants to help . . . and they're courting disaster. I've talked to many traders through the years, and I know that it's particularly hard to pull the plug when needed and lock in a loss when that loss is someone else's.
Maybe, then, the trade size needs some tinkering if you haven't traded it live through all kinds of market conditions, especially including rapidly expanding volatility. And, if your broker's online platform can't handle big volume and tends to freeze, that's a problem that requires extra caution, no matter the trader's experience level.
What if a trader has rigorously backtested the trade and traded live through all types of market conditions, proving that he or she can trust herself? No, that trader's plan shouldn't necessarily be changed. Sometimes experienced traders do voluntarily scale back or change profit targets anyway during times of particular market upheaval. In the Couch Potato newsletter, Dot Hazlin often suggests lowering profit targets and closing trades early on her suggested weekly trades when she expects unusual market volatility. Sometimes she suggests not trading.
Many traders today may have been trading for more than a year without having experienced the kind of market upheaval that I'm referencing, just as many had not traded through such a period when March 2000 rolled around. Should you change your trading plan if you expect market upheaval? That depends, doesn't it? Honestly assess your confidence in your trade and your ability to lock in a sudden and bigger-than-anticipated loss.