I have a problem that many option traders share with me. I sometimes want to take profits too early.
That problem presented itself again as late as the October option-expiration cycle. Along with my typical 75 contracts of iron condors, I was also trading a single-contract RUT calendar and a single-contract XEO iron butterfly as well as watching and learning from five paper trades.
Did I take profit in all those condors too soon? No. I'm used to trading those in size. However, late in September, the markets began chopping around a bit more violently as they were testing new recent highs. The way they were moving around was suggestive of the way that markets often chop around before giving way to the downside. The all-important jobs number was looming the next week. The VIX was probing levels that had represented a VIX low in late July and was showing signs of bouncing.
I--rightly, as it turned out--feared at least a temporary pullback in the making. I wanted to be able to concentrate on my iron condors which would require some close watching and maybe some adjustments if a pullback went too deep. I promptly shut down the RUT calendar and XEO iron butterflies at breakeven levels, taking in a laughable $56 and $15 profit for my efforts in establishing those trades. I set contingent or conditional orders to manage the paper trades. Then I dusted my hands and leaned over the keyboard, feeling settled. I had freed my attention to deal with my bigger trades.
No harm, no foul, you say? Not true.
Risk-of-ruin studies suggest there's strong potential harm in shutting down profitable trades too soon. The problem is that traders who cut off their profits too short don't build up enough cash to cushion their losses.
Let's look at the XEO iron butterfly I closed too early. The original position was as follows:
Long XEO OCT 520 Call
Short XEO OCT 485 Call
Short XEO OCT 485 Put
Long XEO 450 Put
XEO OCT Iron Butterfly Risk Chart:
I've positioned the red circle at the downside expiration breakeven, at 467.65.
My original plan for the trade, as written in my trading plan was to take a profit of 20 percent of the margin withheld ($1704.84), which would be $341. My maximum allowable loss was set. When 15 percent of the profit I wanted was available, I would then place a stop so that I wouldn't allow that profit to sink any lower than 10 percent. I also had a plan to exit, no matter what, the Friday before option expiration, and I had plans for how I would adjust the trade if it started going wrong, not allowing for that maximum loss to be hit before I adjusted.
Nowhere in that plan did I write down that I would get scared and exit at breakeven. Worse, the day I exited, the XEO/OEX ranged from a low of 482.79 to a high of 488.23. It was right in the center of that graph. I'm shaking my head at myself as I type these words.
But a rather deep pullback did occur, didn't it? Yes, it did. It wasn't "the" pullback that I had feared, but the OEX did drop 5.26 percent from its September 23 high into its October 2 low.
What would have happened to that XEO iron butterfly if I hadn't exited? By October 2, the XEO/OEX had dropped to a low of 472.75. That was not yet below my downside breakeven and wouldn't have likely required any adjustment, either. That drop likely wouldn't have produced a maximum loss, so, if I'd followed my plan, I would have remained in the trade through that drop. By October 9, the Friday before option expiration for that cycle, the OEX was hitting a range of 491.56 to 495.20, with neither the upside nor downside expiration breakevens having yet been breached. Earlier in the week before option-expiration week, the XEO/OEX had spent some time near that 485 level at which the sold strikes had been placed, the point at which the most profit was available at any one time. Although I wasn't tracking the trade those days, a theoretical pricer suggests to me that I would likely have been able to collect my full planned 20 percent profit, or more, sometime that week before option-expiration week.
In a January 13, 2007 article, I wrote about risk of ruin. As I mentioned again recently in another article, this is the risk of blowing through a trading account, and it's a name we traders can borrow from gamblers. That risk of ruin rises when profitable trades are cut short and rises rather more quickly when traders let losing trades run too long.
What's the solution? Try not to second guess the trading plan you developed in calmer times. That plan should include the maximum allowable loss as well as the anticipated gain. It should include an amount you'll devote to the original trade and, just as importantly, to adjustments you might need to make. It should include where you'll start locking in profits.
There's a caveat, of course. There always is. If your profits get to be generous but haven't quite approached your profit target, don't let them go to zero again.
No harm, no foul in this case, but if I make a habit of cutting profits short, my occasional loss isn't going to be cushioned as it should be. I thought I had a reason for doing what I did--I didn't want my attention scattered if I needed to manage those bigger iron condor trades--but that reason worked against my achievement of my ultimate trading goals in more ways than one. Not only did I lose the opportunity to familiarize myself with adjustments before I scaled up into larger size trades, but also I lost the opportunity to meet my original profit goal.