Why not, you might ask, since you've been trading options for two years with great success?
Five-Year Weekly Graph of the SPX, TD Ameritrade:
Notice anything about this graph? Of course, you do. Barring some initial volatility in 2010 and 2011, this chart shows a straight-up climb. Options traders in this kind of market learn one type of trade management. Or worse, they get away without a sound program of trade management at all. For an example, a trader who specializes in buying LEAP calls could certainly have made money since October 2011, with or without sound trade management.
Now let's look at a graph of the five-year period preceding the most recent five years.
The Five Years Prior to the Previous Graph:
Options traders working through this five-year period needed completely different skillsets. This period included sharp rises, a period of extreme volatility, a straight-down tumble, more volatility, and then a straight-up climb. Different trading skills and trade setups will be required for these differing market conditions. Are trading skills honed during the post-2009 period sufficiently versatile to change gears quickly during the more difficult trading and changeable environments such as those leading into March 2009? Are loss-management practices utilized in the last five years sufficiently honed to clip losses and keep them at manageable levels when compared to gains?
Let's take a look at my currently preferred trade, for example. It's a below-the-money put butterfly trade hedged to the upside with a DITM call and some call debit spreads. Because I am as conservative as I am, I also buy an extra out-of-the-money Armageddon put, but most people trading this trade do not do so. (Note: my articles are roughed out prior to publication and so charts are not current, and neither are the prices that will be discussed below. This is a comparison as of June 17 only. The trade seen below, for example, has since been adjusted, flies moved higher to swing the upside breakeven higher, too.)
My Live Trade as of June 17, 2014, about 1:20 pm ET:
I originally paid $105.40 for my DITM long 1060 call. I originally paid $12.85 for the first three of my 1140/1160 debit call spreads, and $13.20 and $13.02 for the last two. That's a lot of money spent on hedging against an upside move. However, at the time this graph was snapped on June 17, the mark on the DITM 1060 call was $118.05 and the mark on the 1140/1160 call debit spreads was $14.65. Obviously, these upside hedges were working to protect the trade against a too-large loss as the RUT's price rose ever closer to the expiration breakeven. At the time this chart was snapped on June 17, the trade looked likely to require an adjustment by my typical end-of-day adjustment period that day, and it did require that adjustment.
John Locke developed this trade during those years when the RUT and other indices were climbing nearly relentlessly. It's obvious why I would be willing to pay for those upside hedges, but the below-the-money butterflies also performed well when the RUT price dropped back. The trade of course requires adjustments along the way, as many butterfly trades do, but the PnL stays relatively flat.
If we returned to conditions such as those seen in the five years leading up to March 2009, would I want to pay dearly for those upside hedges month after month? Locke backtested his trades during that period, and so did I before I switched to this type of trade. It's possible that I would continue to trade this way, but it's also possible I would revert to my prior way to trading butterflies. I was an iron condor trader and not a butterfly trader during much of that five-year period leading into 2009. When I did trade butterflies, I tended to trade iron butterflies placed at the money. Depending on market conditions, I sometimes entered only about a third my eventual number of contracts and added the other two thirds as the days progressed and as the expiration breakevens were approached. That was the way I controlled price and time risk then.
The point? Do not quit your day job to trade options and never-ever trade anyone else's money if you have not traded through several different market environments. If you've traded for two years, you have not traded through all market environments. Back-testing trades is vital and can show you much about how markets behave. Back testing shows you little about how you will behave in different market environments, however.
I would argue that the market environment over the last couple of years may not have done the best job of preparing traders for other market environments. That doesn't mean it's been easy. A relentless climb with dropping implied volatilities can be murder on some trades. I'm not dismissing the trauma of trying to manage a delta-neutral kind of trade in this kind of environment, but rather saying that the skills learned here do not necessarily prepare you for the other types.
In my opinion, right now is a good time to learn about how options can be used to protect your long-term portfolios--collars anyone?--or think about the strategies you would employ if market conditions changed. It's the time to think about how you would manage your trades if you find that extreme or extremely different market conditions undermine your confidence. Are you proficient with setting conditional or contingent orders and letting them work to take you out of the trade when you don't trust yourself to pull the plug? Have you noticed a tendency to try to jump back into the market and wrangle with it just after a big loss, and have you developed strategies from stopping yourself from reacting with such emotion? This is the time for working on those types of issues. It may not be the time to quit the day job and begin trading options for a living for the first time.
For those of you who might be retiring for other reasons and planning to increase your options trading, start small at first. If you've been trading for a while but just not full-time, don't ramp up your size immediately. Read everything you can about controlling risk. Ask yourself some hard questions.