Maybe after last week's article, you were prompted to update your trading plan and goals for 2010 or write them for the first time.
However, best-laid plans don't always work out, so it's best to factor in some market realities that may waylay you along the path to meeting trading goals. Those market realities include market conditions, slippage and emotional factors. I've addressed these factors periodically in other articles, but they bear repeating, particularly after market action that doesn't necessarily hone a trader's skills. From March until October, we had market conditions somewhat akin to those in late 1999 and early 2000. Buy a call with enough time left until expiration and you could likely profit, whether your entry was a good one or not. Under those conditions, just as was true in late 1999 and early 2000, an inexperienced trader was rewarded for not following a plan and just hanging on. Traders were set up to take bigger losses when different market conditions hit.
Gapping and fast-moving markets are two market conditions that often prevent traders from exactly following a specific trade's plan. If these conditions persist throughout a prolonged market period, they can undermine larger goals for raw or return-on-investment gains for the year. Lately, we've had a lot of mornings when markets gapped up or down at the open, sometimes playing havoc with a well thought-out trading plan. It was just such a situation that taught me long ago that I wasn't always 100 percent in control of whether my plan could be followed to the nth degree.
Annotated Daily Chart of CME in Summer, 2005:
I've mentioned this loss previously as one of the reasons that I went searching for a better way to adjust iron condors. In truth a better plan for adjusting still would have resulted in a bigger loss than when I adjust in calmer market conditions.
I didn't adjust by deltas back then, so I don't have a record of what the deltas would have been when trading closed the day before that big gap. If the absolute value of the delta on the sold call had been anywhere near the adjustment level at the close the previous day, the gap that morning likely would have pushed the delta beyond the adjustment level, especially since volatility was likely to have risen. At the open, my loss would have already been larger than I would have anticipated, if I'd been adjusting by deltas back then.
Although volatility often drops in a rising market, making options cheaper, the opposite can happen when a rise is sudden and sharp. Bid/ask spreads can widen. Options, including calls, can become more expensive than they would be in other market conditions. Credit spreads may widen, meaning that someone exiting a bear call credit spread that morning would have paid more to exit it than they would ordinarily have spent with the underlying at that price and with that same amount of time to expiration.
In addition, with price zooming higher, no one was willing to bargain with me on the debit I was willing to pay, either. My attempts to bargain resulted in my chasing the markets. By that time, the cost to close the trade was far above the ask from that morning. My attempt to save a little cost a lot.
In some extreme market conditions, it's hard to exit a spread or complex trade at all. It might become necessary to buy-to-close the sold strike and only then sell-to-close the long option. That's risky and not something I would recommend on a routine basis, but there have been cases when such action was necessary. However, CME's gap and extreme climb that day wasn't one of those times. Instead, my inexperience with trading this particular vehicle and the long years since I'd traded an individual equity were the reasons that I couldn't get my spread closed early that morning at the lowest price available that day.
That inability to close at the expected price leads me straight into the next two reasons that plans sometimes go awry. Those two reasons are slippage and the likelihood that, sometime or another, even the most disciplined of traders will perform his or her best interpretation of the deer-in-the-headlights syndrome. Investopedia defines slippage as the "difference between the expected price of a trade, and the price the trade actually executes at." In its strictest terms, the term references market orders that execute at prices different than what is expected. However, I would also apply the term to those times when a limit order that you expect to fill won't fill and you have to replace it with a less-advantageous order. A loss may widen or a profit narrow as a result of slippage.
An experienced trader who likes to back test strategies recently wrote me complaining about another site where none of the back-tested results included slippage. Perhaps, as you're setting up your own back tests, you haven't been including slippage, either, because you trade a highly liquid market with tight spreads and don't feel that slippage impacts your trades. However, a penny here and a nickel there does impact trading results for a frequently traded strategy, especially over a year's time.
In the case of iron condors, especially in the big indices, that slippage might not be pennies, but rather dimes and dollars. The trader who wrote me routinely includes a five-percent slippage when he's back testing a certain strategy. You might not think that such slippage would effect the overall profitability of a certain strategy, but it can in fact do so.
Traders rarely have control over disadvantageous market conditions or slippage. They do have control over their own actions. It's my belief and experience that it's actually a relief to take a loss when necessary and just move onto the next trade. Hanging onto a losing trade prevents one from utilizing the money in a trade more likely to be profitable. In addition, hanging onto a losing trade is not only deleterious to one's account, but also to one's confidence in one's trading skills. When you haven't followed your plan and experience a bigger-than-anticipated loss, the next similar market action can prompt real gut-clenching fear.
Fear results in all kinds of emotional and neurological responses that get in the way of a trading plan. Changes in the brain and thought processes literally keep the fearful trader from seeing logical strategies to adjust a losing trade. Fear prompts a narrowing focus on the losing trade, so that traders trying to "hope" prices back where they need them will let many profitable trades go by while their focus is tightly honed on that losing trade.
We'd all like to think that we're beyond that kind of reaction. I'm fairly good at taking losses when I need to take losses. That process has become easier as the years go by. I've finally hammered it into my brain that a trade that goes bad isn't a sign that I was a failure as a technician. Rather, a losing trade is a sign that something unexpected is happening in the market. If I were making sales calls, I wouldn't expect each one to be successful. Neither should I expect each trade to be successful. Occasional losses are part of the trading life.
Removing the guilt and shame from a failed trade helps traders to take the loss when the trade can't be repaired. For example, I took a loss in a RUT calendar just last week when volatility collapsed as RUT prices moved sharply higher. The collapsing volatility delivered my maximum loss with no realistic way to adjust. Each adjustment just created a larger loss. All I had left was the "hopium" trade, the hope that price would retreat and volatilities expand, rescuing my trade.
Instead, I took the loss. Slippage meant it was actually about $50.00 more than my maximum loss. Do I feel bad or guilty about that? No, my portfolio is structured now so that I have varied my risks. So far, all other JAN trades have been profitable, with one still open. I've got other trades to think about, including the FEB iron condors that I have since opened. I've moved on.
However, while I can usually control my emotions and take losses when I need to do so, I'm not any more in control of the challenges that life delivers to me than I am of the challenges that the markets deliver to me. Neither are other traders. When life events threaten our concentration, it's best to cut down the size of trades or stop trading. A trader under duress can manage 20 contracts easier than 100, so any trading plan should include provisions for how a trading plan would be altered during such times or even while vacations or work-related travel will impede the ability to focus on trades.
With a fifth grandchild due imminently--actually past due--I sized down my DEC and JAN trades, for example. I didn't want to be juggling my typical 75-90 contracts of iron condors, my typical size the last few trading cycles, when the call came that I was needed.
Cutting down the size of trades or not trading at all is fine and good when a trader knows ahead of time the life events that might interfere with concentration. However, last spring a series of health-related challenges hit family members all at once after I was already in MAY and some JUN trades. I had already scaled into the bear-call portion of my MAY XEO iron condors, for example, with the markets then taking off to the upside before I could get on the bull-put portions. Back then, it had been my standard practice to scale into iron condors over a period of days or up to two weeks. I would use a several-day rally period to scale into the bear-call portion and a several-day decline to scale into the bull-put portion. This method had worked well over the previous year or so, but I'd been caught in MAY by the strength of the rally with no pullback.
As I mentioned, I was in other trades, too, and all the bear-call portions of my trades needed close watching. This was happening at a time when I was dealing the emotional import of what was happening and was also dealing with the time away from markets needed to make various arrangements. To say my concentration was impaired would be to minimize the situation. My concentration was wrecked.
My iron-condor plan call for me to adjust when the absolute values of deltas reach 0.22-0.24 or 0.25 on the upside (22 to 25 on some charting services), with my maximum loss to be 1.5 times the original credit I took in. The original credit I took in for the bear-call portion of that MAY XEO trade was only $1,875.00, and I had no bull-put portion to add to that credit and cushion any loss, as I typically would. As the trade started going wrong, I closed the bad trade fairly well according to my delta-based plan, with slippage factored in, but I made other mistakes that that made my losses mount.
The worry and lack of control I was experiencing about family health issues transferred straight to my reaction to the unexpectedly strong rally. Fearful of a market rollover after such a strong move and equally fearful of the unrelenting nature of the rally, I had stalled every time I thought about putting on the bull-put portion of that iron condor while the XEO still climbed. If stress hadn't impacted my logical thought process, I would have had more faith in my ability to add put insurance to any bull-put credit spread and just get it put on during the normal time lag I had allowed between putting on one side and then the other.
But that didn't happen. After I had closed the bear-call portion mostly according to my plan, given the slippage, I was also too fearful to roll up into a new bear-call credit spread, which was also typically part of my plan. I knew that I was facing time away from the markets to sit in doctor's offices and hospital waiting rooms and I of course knew that my concentration was wrecked. Without the bull put portion's credit to cushion the blow and without my usual tactic of rolling up into a higher bear-call credit spread, my loss was $4,845.73, far more than 1.5 times the original credit I took in.
I'm glad that I could at least trust myself to exit the spreads when my plan said they should be exited. I would likely have severely curtailed my trading for a while if I hadn't been able to trust myself that far, no matter what the stresses in my personal life that gave me an excuse for trading so ineptly. However, my failure to complete the iron condor and also to roll up after exiting my bear-call spread turned what would likely have been a much smaller loss or even a small gain into a much bigger loss.
Let's look at some "might have been" numbers. Remember that these are just estimates based on my typical experiences and not a definitive statement of what might have been possible. For example, if I'd put on the whole iron condor at the same time, I'd likely have taken in about $3,750 in credit, and I'd probably have spent about $400 in put insurance, so would have had $3,350 in credit remaining once the iron condor and put insurance were all in place. These are typical amounts for me to take in on a RUT credit spread of that size and a typical amount for me to spend on put insurance these days.
Once the strong rally narrowed the price of the bull-put spread to $0.20, I would have spent about $637, including commissions, of that closing out the profitable bull-put side, reducing my left-over credit to $2713. When a spread gets into trouble, I usually roll into 1.5 times the original number of spreads if it gets into trouble on the upside, but I'll be more conservative in this estimate. If, when I'd closed the losing bear-call spread, I'd rolled up into only half the original contract size at a 0.10 delta, I'd likely have taken in about $900. If I'd rolled up the profitable bull-put side into half its size, too, I'd probably have taken in another $900. By the time I paid $0.20 a contract to close those new rolled-out positions before expiration and paid commissions, my typical practice, I'd likely be left with about $1163 in credit for that new rolled-up half-size iron condor.
Adding it all up, I'd have had about $3876.00 in credit to buffer the loss rather than the $1875.00 I had. That would have reduced my loss from $4845.73 to $2844.73. That's less than 1.0 times the theoretical original credit I would have taken in. The loss would have been well within my planned maximum loss. If, as is my usual tactic, I'd rolled into 1.5 times the original number of bear-call contracts rather than half, at the higher delta levels I allow myself when adjusting after a strong run-up, the loss likely would have been a small gain instead. [Note: I never roll up into more than half the size on the bull-put side when there's been a strong rally.]
That loss didn't decimate my account, of course. However, the calculations show I didn't have to have taken a loss so much above my maximum planned loss. A similar and maybe even worse scenario than the May one presented itself in the November cycle, and my loss for a 25-contract position was $5.00, while gains were eked out in iron condors put on in the SPX and RUT during that cycle. That's $5.00 total, after commissions, not $5.00 per contract. Life challenges hadn't impaired my thinking so strongly. I'd been more nimble.
I froze during that May cycle. I was paralyzed. I shouldn't have been trading but I was already in trades when I learned of all the looming family health challenges. My worry was transferred into my worry about the markets. I'm human.
So are you.
Is this article intended to prove that, no matter what your trading plan, you're going to suffer losses? Well, yes, you are. The market will sometimes work against you, the realities of placing a trade will sometimes work against you, and, at times, you will work against you. Does that mean that you shouldn't make a plan and that you're doomed to fail in your trading life, that this whole process will never be consistently profitable?
No. It means that you need to have some way to make sure you adhere to your plan. Set alerts. I do that, of course. Set "if the wildly unexpected happens and you can't place the order fast enough orders" to close your trades and take a loss. Don't plan on letting those trades be triggered, but many trading coaches suggest you always have them there, just in case. If the wildly unexpected does happen, it's likely going to impact all your trades at once, and you sometimes can't physically get all the orders set up, even if you're sitting there watching everything that happens. Before you set those kinds of orders, however, talk to the trading desk at the brokerage where you trade, to make sure that errant and odd values in the underlying won't be likely to trigger the trades, especially during amateur hour, the first hour of trading.
Setting that kind of order wouldn't have helped my particular situation last spring, of course, because exiting when I needed to exit wasn't my real problem. What I couldn't trust myself to do is trade the rest of my plan, the part that called for me to place the opposite side of an iron condor, no matter what I thought would happen in the markets, within two weeks of placing the first side. I also couldn't trust myself to follow through with the roll-into-a-new-spread part of the trade when I was fearful, when other forces were working against a calm assessment.
What can you do about that sort of reaction? Is there a solution? You betcha there is. One solution is just to close down all trades, no matter their levels, when you're confronted with a situation like that. I would have been better served to have done that last spring.
Other solutions are available, too. Back last spring, I already had a long-time group of trusted iron condor traders whom I tell about each trade I place and confess my slip-ups and crow about my successes. I think that's necessary to keep me accountable. You'd be surprised how unlikely it is for you to let a trade go too far when you know you have to confess that you've done so to a group of trading friends who know the score with iron condors. However, we're all experienced traders and we very rarely call each other to task. We might tell each other that we don't feel personally comfortable with a certain trade, but we're not going to tell each other we're being stupid. We're supportive of each other.
I need that support, and I value it greatly. But, after the spring fiasco, I realized that I also needed someone to tell me I was being stupid when I was being stupid. I needed to be accountable to someone who would call me to task for not following every iota of my trading plan even when I was struggling with other matters unrelated to trading. So, I have since set up that kind of support system, too. Now, other experienced traders and mentors see the results of each and every trade, calling me to task when I don't follow my plan exactly. Counselors themselves have counselors, and experienced options traders also need someone to call them on stupid stuff.
So, that's the last part of a trading plan. Make sure you have someone to whom you're accountable, someone who will say, "Why did you take profit early again?" or "Why didn't you roll up after you closed out that trade?" That someone can be a spouse who understands your plan, a trading friend who trades the same sort of trades you do, or the members of a trading club who trade similarly.
This year, life intruded into my trading. My yearly profits will suffer as a result. I did at least prove that even under duress, I can stop a loss from growing bigger. I didn't decimate my trading accounts by putting that whole almost $30,000 of withheld buying-power for just that one MAY XEO position, only one of many positions I had on at the time, at risk by just closing my eyes and letting what happened, happen. The loss I suffered for that XEO position seems small in comparison to what it might have been. However, I needed that last step in my trading plan.
I was originally hired back in 2002 to represent the self-taught trader. I don't know if I qualify as a self-taught trader any longer because I always avail myself of any learning opportunities that seem valid. However, I've always invited readers along with me in my growth as a trader, and I continue to do so.
I urge you to put these kinds of safeguards into your trading plans, too. Good luck to me this next year and to you, too!