Surviving Wild Market Drops

If you’ve followed my style of trading you know I like non-directional income style trades where I try to make money on time decay (positive theta). Most of the time, this works out well. I do lose on occasion as everyone does but I go into each trade with a plan to handle various market conditions. Most of my trades have enough time that I can adjust them if the market moves too far against my position. This, essentially, allows me to buy more time to allow the trade to work. If you’ve watched my This Week @MidwayTrades series, you’ve seen me execute this plan over and over again. Most of the time on these income trades my adjustment plan involves adding structures such as butterflies or calendars making a double or removing a structure from a double and returning to a single.

But there is one kind of move where this does not always work: A big market drop. I work hard to keep my trades in a good enough position to handle at least a 1 standard deviation move in either direction. Statistically, a stock should move less than that about 67% of the time so this keeps my trade in a relative safe position. On the bigger moves, I can make adjustments as described above. But what about a 2 SD move? Or even more? These moves tend to be on the downside so that’s where I’m going to focus this post. We do get occasional big crash moves and just adding or removing spreads isn’t going to work well because pricing is all over the place. Finding a steady price for 2 or 3 legs in a spread just is not practical, and legging out one at a time can be just as dangerous. You may be able to get out for some price, but that price could be really bad and make a big loss. As traders, we like to avoid big losses so what can we do to try and ride out the crazy storm?

Back To Basics

As one learns more about trading and gets more sophisticated with multi-legged trades, it’s easy to forget why options were created in the first place. In short, they act as insurance to protect a position. Traditionally that position was a long or short position in a stock, but it works just as well to protect a position made entirely of options. And for a big drop, that answer is simple: long puts. A properly purchased single long put can save your position and, in some cases, your account (if it got that bad, I would strongly suggest you are trading too large, but it still works). The simple act of adding a long put to a position at the right time can make the difference between a big loss and a small loss, or even a win. They come with a consequences, of course, so I do not like to use them all the time but, at the right time, a long put is a simple fix to a bad problem.

So this post will look at when I buy them, what I buy, and when I sell them. You may tweak these to suit your style, of course, but don’t think a trading plan is complete without having this as a possible response to a big down move.

When to Buy Puts

Buying puts is not a free pass. First, they cost money. You are sinking money into a trade that has gone badly. If done at the wrong time, you can easily dig a bigger hole for your position and take a bigger loss than needed. In addition to costing money, long puts reduce theta. All long options have negative theta so adding a long put to a position will hurt the theta of the position (maybe even taking it from positive to negative). As one who likes positive theta trades, this isn’t my goal. But when things get really bad, sometimes theta has to take a step back to the threats of delta and gamma (i.e. price movement risk). When delta and gamma get out of control quickly, a long put can stop the bleeding and give you time to catch your breath when things are going wild. This has an added benefit of allowing you to think clearer about your next move. If done properly, the stock can continue to tank and you’ll be just fine. Very few good things come from a state of panic so fixing the big problem in front of you helps with the next decision.

With all that being said, my guidelines for buying a put are the following conditions:

  1. The stock has moved at least 1.6 standard deviations down. Less than that and my regular adjustments should work just fine. This is a guideline so don’t take it too literally but I think it’s a good rule of thumb. It’s beyond this point where prices tend to get weird and buying or selling a spread gets really difficult. But in a big down move, buying a put is easy as there are plenty of folks willing to sell them.
  2. My position is at an adjustment point. There’s no sense buying long puts if the trade is still working even with the big move down. Sometimes, my trade can withstand a 2 SD move down. If that’s the case, there’s no need to add long puts.

What To Buy

So that’s when I buy puts, but now what puts do I buy? The critical idea here is to not buy too much or too little. As I stated before, options aren’t free in terms of cost or in terms of the Greeks so my goal is to buy just enough but not much more.

My guideline here is based on the delta of the position at the time I am buying the put. I want to buy enough to nearly flatten my position deltas such that further big movements won’t harm me. This means I’m looking to cut them around 80%. Yes, that’s a big delta cut but this is in response to a big move. That being said, this usually means I am buying far out of the money. This has the advantage of being less expensive while still getting the job done. If, for some reason, I need a lot of deltas, there’s nothing wrong with still buying far out of the money but buying multiples to get to the target. Which to do would be based on the price of the options you are considering. For example if I needed 40 deltas. I could but a .40 delta put or I could consider buying 2 .20 delta puts. Both will do the job so I would choose which ever is cheaper. Most of the time I don’t need anywhere near that many deltas so a single put will suffice.

But there is still the question of expiration. This depends on the spread I am trying to protect. If it is a vertical style spread where all the options are in the same expiration (this includes butterflies, condors, etc.), then I tend to buy in the same expiration as the spread. The only exception to that would be if there were very little time left in which case I would go further out in time. I’ll explain how far when I talk about when to sell, but as I tend to not be in trades during expiration week, this rarely comes into play. If the trade involves spreads in different expirations (e.g. calendars or diagonals), then I will use the later expiration.

When To Close the Put

The final piece of my hedge plan is when to close it. The temptation here is to look at the price paid for the put and base when to close it on the profit or loss of that put, essentially looking at it as a trade within a trade. I don’t do that. This long put hedge is part of my trade and so I try to look at it in terms of the what it’s doing for my trade. The goal isn’t to make money on the put (although that can happen), but to make money on the entire trade which now has this put as a part of it. So there are 4 times I look to close the long put hedge.

  1. When I’m ready to simply close the entire trade. If I have hit my profit target or my max loss on the entire trade and it’s time to close the trade, then it’s time to close the put along with it. Again, the put is not separate from the trade.
  2. When the market calms down and I can do a proper adjustment. So let’s say we had a big drop and I added a put, but the next day things are calm and a normal adjustment to the trade is now possible. The storm is over, I can buy that new spread or close the upper part of the double. Once I do that, my Greeks will be out of whack due to the long put. If I can do the regular adjustment, I will close the put after I get the adjustment done. Do not do it before because until that adjustment is on, the trade is still at risk.
  3. The trade recovers. Sometimes a big drop if followed by a recovery. Maybe it’s the next day, maybe two, maybe even the same day in a really crazy market. If the market recovers such that my trade doesn’t need the help anymore, I will close the put for a loss. That leads to the question “what is a sufficient recovery?”. For me, a sufficient recovery is if the underlying comes back far enough to cross the center to the structure (or, in the case of a double, the center of the lower structure). There’s a big temptation here to take it off earlier to take a smaller loss on the put. The danger here is that if the stock drops back down again, you bought high, sold low, and potentially bought high again. That’s not a formula for profit. So the key here is to be patient and keep the insurance until the chances of needed it are lower.
  4. Time. Long options have time decay. As they decay, the help they provide your trade diminishes. My rule of thumb is I will keep a long put on for up to 20% of the time remaining when I bought it. So if when I bought the put it had 20 days to expiration, I will keep it for up to 4 days. This would be the exception to the rule above on what expiration to buy. If there isn’t much time left in the spread, then buying the put in that expiration may not make sense based on the 20% guideline. In that case, I would consider buying something further out to avoid having to close it too quickly. If time runs out on the put and I still need the protection, I simply roll it out to a later time with the needed delta help.

Real World Examples

I’ve thrown a lot of information in this post so I think it’s valuable to show some examples of trades I’ve done where I’ve deployed this strategy. This year has certain had some volatility, so it wasn’t too difficult to find examples that demonstrate my methodology.

Back on January 29 I put on a simple butterfly:

This is a common setup for a butterfly for me. It’s an unbalanced butterfly 44 days out, 40 points up, 50 points down which makes a nice flat delta trade with .80 deltas on a 2-lot. However, 2 days later the trade looked like this:

SPX moved 51 points down in a day which constituted a 2 SD move. My trade is at an adjustment point so instead of trying to buy a lower fly, I add a put:

I bought a 2550 put (way out of the money). This is because to cut my deltas by about 80% I needed around 1.75 deltas. But now I’m not worried about the trade getting into trouble on the downside and I can wait it out and see what happens given that I’m really flat so that price movement doesn’t scare me. In return for that, my position is negative theta at the moment. While I don’t like that, I’ll take it for now to help stop the delta/gamma bleeding. When I bought the put it had 42 days left in it. That means I’m willing to keep it on for about 8 days before I need to sell it outright or roll it out. This happens to be a Friday so I kept this put on over the weekend and even into the early part of the week. It wasn’t until Tuesday Feb 4 that the trade looked like this:

Note that we had a big up day that put the stock above the middle of the fly structure. At this point it’s time to sell it off at a loss. I lost a bit over 50% of the value of the put but it was just insurance that wasn’t needed. On the plus side, I didn’t pay much for it and this trade eventually closed for a small win. In perfect hindsight, I could have done nothing and done better but there was no way to know that at the time and it was better from a risk management perspective to buy the put and protect the position so that it did not get out of control and become a big loss.

Another interesting example was on June 10 when I put on a narrow calendar.

This is a very typical trade that I put on for much of this year. In the crazy market we’ve had this year, I really like the initial room this trade has and the relatively low vega exposure for a calendar. However, the very next morning I woke up to this:

So in the first hour of trading SPX is down 2 SD and my trade is at an adjustment point. This was a rare exception where I was able to put on lower calendars as an adjustment. Had I not been able to get a good price on it, I would have gone right to the put, but since I was able to do so it looked like this:

So I got my double calendar on and I have a lot more room now, right? Not so fast, later that same day….

Just 2 hours later, SPX is now 133 points down or 3.3 SD down. At this point there is no way I’m going to try and take off the upper calendars (I was lucky enough to get the lower calendars on when I did), so I go ahead an buy a put:

By buying a 2400 put in the back side of the calendar I was able to cut my position deltas to 1.8 from 5.4 and stop any more bleeding. The next day, the market calmed down and I was able to properly take off the upper calendars. At that point I was able to sell off the put since, with my proper adjustment, it was no longer needed.

Now the trade is back to normal and, in this case, I was able to sell the put off at a profit. While that was never the goal, it was a nice bonus. This trade ended up doing very well (over 30% profit) and it was made possible by being able to weather the quick storm that came through the market.

In these examples I used long puts to save trades that got hit by a big market drop. Long puts are not a cure for every trade. I have used these and still lost money, although not as much as I would had I not bought the put. But long puts can be the right fix for a crazy down move.

Hopefully you found this helpful. I’d love to hear what you think or other ideas you may have to handle these kinds of big moves. Feel free to comment here or reach out me directly at midway@midwaytrades.com.

Trade Idea: A Narrow Calendar in a High Volatility Market

This market has been crazy for a couple of months now and this means that traders need to adapt to the conditions. I believe good traders can trade in almost any environment. A big part of my options journey is to learn how to trade in as many different market environments as possible. Only then can I consistently make money no matter what the market does.

As one who has only been trading consistently for about 5 years now this is, by far, the longest stretch I’ve ever seen with high market volatility. As many of you know I primarily trade SPX and my trading plans were built around normal volatility ranges with the VIX in the range of about 10-25. This market hasn’t been in this range since the start of the virus crash which is now been about 3 months. When it started, I did some of my usual alternative trades: trades on non-correlated things like metals, even doing some directional plays like synthetic covered call like I discussed in my last blog post. But this market is now in very new territory for me. VIX has settled down in the mid to upper 20s which is pretty low for the last 3 months but is still historically high. So what’s an SPX trader like myself to do? I usually don’t start going negative Vega trades like Butterflies until VIX is in the low 20s and forget calendars with their high positive Vega, right? Well…maybe not.

At least for now, a relatively low VIX is in the 20s. But that’s still pretty high. Calendars are tempting because volatility is relatively low compared to the last couple of months but it’s still high enough that calendars give you lots of room. But nothing is free in this market. The reason the market gives me a ton of room on calendars is because while a 25 VIX may feel low right now, it’s still quite high and so the risk of a big move is still around. Add in the fact that volatility is mean reverting and we could have the risk of dropping volatility while we’re very long Vega. That wide tent could contract and put the trade into trouble quicker. As I’ve stated in a previous blog post, when I set up my usual calendar in a low volatility market, I like to put my longs 2 weeks away from my shorts. This give me a nice mix of price and Vega exposure. The further out in time, the more expensive the calendar and the more Vega you get. This is because the longs will have more extrinsic value than the shorts so they will cost more and that extrinsic value will decay faster as the distance between them increases so you get more of a time difference and positive volatility exposure.

So how could a calendar be adapted to fit the market today? Here’s a modified setup that has been working well for more recently. I’ve named it a “narrow calendar” and it has the following differences from my standard calendar:

  • It is shorter in duration
  • The longs are very close to the shorts

To show some examples I need to set some guidelines. I could simply compare two calendars: one with 14 days between the shorts and the longs and one with three days. You will see a huge difference in the Greeks but I’m not this is a fair comparison because the risk is so much smaller. As you can see below:

An 11-day calendar with the longs 2 weeks out

This is an 11-day calendar with the longs 2 weeks from the shorts. The cost is $2291.30, I get very flat delta since it’s at the money and my Theta is 65 and my Vega is 106. Compare that with a one lot where I put the longs 3 days away and I get this:

An 11-day Calendar with the longs 3 days out

So you can see here, I have drastically less Theta and Vega but the cost is about 20% lower since the long is so much cheaper. This can be a benefit if you want to keep you risk down, but it’s not really a fair comparison with respect to the Greeks since they are proportional to size. So I think a fairer comparison is to make the narrow calendar a 5-lot to get similar risk size:

An 11-day Calendar with longs 3-days out (5-lot)

Now with a 5-lot the cost is $2306.50 which isn’t exactly the same but close enough that I think it’s a fairer comparison. The Vega is higher, but if you look at the ratio of Theta to Vega: it’s much better, almost 1:1. Yes, I have a bit more overall Vega risk but the Theta benefit more than makes up for it so my risk/reward ratio is better. And because this is a 5-lot, I’m able to scale this down to lower my risk while the first example is a 1-lot which can’t be scaled down.

So why wouldn’t I always do this style of calendar? The reason there is the volatility level of the market. I usually do calendars when VIX is under 13.5. In that environment, I don’t mind taking on more Vega risk relative to Theta because VIX is low and will most likely pop. But with VIX in the 25-30 range, I like to lower that ratio to help cushion the blow of a volatility drop. Also, when VIX is very low, I expect the size of the tent will be much narrower which will make this structure less appealing than it is now. So I would prefer to get more room by going back to a two week time spread.

Another thing to consider: with most underlyings you may only have Friday expirations so the shortest time you would have is one week. This is why I like doing this in SPX (or if you want to scale it down even more, you can use SPY), because it has Monday and Wednesday expirations so it’s possible to get very short distances between the shorts and the long.

Of course, I cannot say if this trade is right for you or not. Everyone’s experience level is different. If you aren’t familiar with spreads or calendars, you may want to paper trade a few to get the idea. Also feel free to check out my Options Fundamentals series where I try to explain these concepts in more detail for beginners. But it’s a good lesson in the Greeks and hopefully can spark some thinking about how to adapt a trade to different market conditions. If you would like to see how these trades have worked out, check out my This Week @MidwayTrades series around the end of May into early June. You can see my put these on and how I manage them.

As usual, I’d love to hear any feedback or questions on this or about options trading in general. Feel free to reach out here on the site or you can email me at midway@midwaytrades.com.

Stocks vs Options in a Volatile Market

At the time of this post, the market has incredibly volatile. Not only has volatility been extremely high, but it has stayed very high for weeks. In a normal market VIX in the 20’s would be considered high. Breaking 30 or 40 happens but it is usually quick and returns to normal. These are not normal times as VIX has been above 30 for about a month and over 60 for about 20 days. If you’ve followed the kind of trades I like to so via my video series “This Week @MidwayTrades”, you will understand that I’ve had to stop trading that way until things return to normal. I’ve been looking for different trades that I can try at a smaller scale while things are crazy. I think this is a good opportunity to show the power of options and how you can do very conservative trades while reducing your risk over stocks.

As with everything I do online, this is for educational purposes only, not trading or financial advice.

Thinking about Risk

Risk is on everyone’s mind right now but, in reality, it should always be on our minds. Managing risk is not just a trading skill but a life skill. But here on MidwayTrades I focus on trading skills. Every trade has risk whether with stocks or with options. With stocks, the primary risk is price, whether you are long or short, you have price risk in the opposite direction. In the world of options, we have more risk factors. Of course we have price risk, but we also have volatility risk, as well as time risk. (I’ll leave aside opportunity cost at this point, but that exists too). In the options world we use the “Greeks” to help describe the various risks to a position. My “Options Fundamentals” series covers these at a high level if you want to better understand them. But there’s a risk that’s ever more basic than the Greeks: How much can I lose in a trade? The most fundamental way to control risk is by knowing and limiting the total risk of a trade. This is done by the strategy deployed as well as the size of the position.

When I tell people I trade options, the first thing many say is “that’s too risky for me, I’ll stick with stocks”. While it is true that trading options can be quite risky, it’s all on how you set them up. I can create a position with options that is nearly identical to the risk of a stock trade for a fraction of the capital risk.

Long Options vs Stock

The simplest option position out there is simply being long a call or a put. This is the equivalent to being long or short a stock for a given amount of time. How equivalent? This is mostly dependent on which option you buy and it’s Delta. Very quickly Delta measures the price risk of an option if the underlying stock moves up 1 point. When you own a stock, your delta is 1. While this is technically impossible to match with an option we can get really close. The more in the money an option is, the more is will act like the stock. So a perfect at the money option will have a delta of .50 which means it will move up $.50 for every $1 the stock moves. As you go further in the money, the delta will increase until you get get 99%+ of the stock’s movement. Of course, the deeper you go in the money, the higher the cost of the contract. Also, the further you go out in time, the more expensive the contract. But this cost is generally still less than the cost of 100 shares of the stock, mostly due to the fact that it is time limited.

For example, let’s take a reasonably high priced stock like AAPL. Apple currently trades at about $284/share. So if I look out to June (65 days), I can get a .80 delta call for about $4,155. That’s a lot of money until you realize that a call represents 100 shares of stock and to own 100 shares of AAPL today would cost about $28,400. So the call is about 15% of the cost of the shares and it should move at about 80% of the stock. That’s not too bad. It also has similar risk on the downside where it will lose .80 for every dollar Apple stock loses. So the risk/reward ratio is much better and, I would argue, makes this a safer trade. If Apple goes to $0, the worst I can lose with my option is $4155, while with the stock I can lose $28,400. That’s a big difference!

Now, nothing is perfect, so if I’m going to pay 85% more for the shares, what am I getting for my money? Two things:

  • Time. This option expires in 65 days. At that point, it’s only value is the difference between Apple stock and $250 (the strike price of the call). If Apple doesn’t go up in those 65 days, I can lose money.
  • Dividends. Dividends go to owners of stock, not owners of calls. If you like a stock for the dividend, options are not your play.

So while you do give up some advantages of stock ownership, if you look at it from a risk/reward perspective, it may be worth it.

On the bearish side, the risk is not even close. To short a stock like Apple, a broker may require a good deal of margin in the account since the upside risk is unlimited. But if you a bearish on Apple, you can simply buy a put at any strike you wish. Because you long the put, there’s no extra margin worries but you are synthetically short Apple. Just like in the call scenario above, you can pick the strike (delta) and the amount of time, but it is far safer than shorting a high priced stock like AAPL.

Long Diagonals vs Covered Calls

One of the safest options strategies out there is the covered call. If you own 100 shares of a stock, you can sell a call against it to lower you cost basis. If the stock stays under the strike of your short call, you can keep the premium, and can sell another one later if you choose. If the price goes above your strike, you risk having your shares called away at the strike price. This usually only happens at expiration, but there are conditions where it can happen earlier (usually around a large dividend). This is a great strategy and many people use this as their first foray into the world of options (along with just buying a call or put). If done correctly, you can create a small income stream off of stocks you own even if the stock doesn’t pay a dividend. And each time you do this successfully you, essentially, lower the cost basis for your stock.

But as I showed above, owning 100 shares of stock can be expensive vs owning a deep in the money call far out in time. Buying such a call can act as a stock surrogate against which I can sell a call. This strategy is called a long diagonal but doing it in this manner is also sometimes called a “synthetic covered call” or a “poor man’s covered call” because it acts very similarly to a covered call without actually owning the stock. You may see other names for this strategy. Brian Overby of Ally Invest calls this a “Fig Leaf” because you are kind of covered.

So let’s compare these two strategies and compare the risk vs reward. Let’s use AAPL again as I think it shows well as an expensive underlying but this will work with any underlying. So in this example I have a standard covered call in AAPL. I bought 100 shares, and I’m selling a 300 May call against it (a .33 delta).

AAPL Covered Call. Risk: $13,575

This is a typical risk graph for a covered call. The total risk is the price of the 100 shares minus the premium received for the call. In this case that comes to $13,575. Pretty expensive, but AAPL is an expensive stock.

Now let’s compare that to buying a far out deep in the money call and selling the same call against it.

AAPL Diagonal. Risk: $5,980 (.80 delta)

The blue line is the original covered call. The green line is a long diagonal using a January 2021 $230 strike call (.80 delta). As you can see the risk graph is very similar but the total risk is significantly less at just under $6000. Now, the profit potential isn’t quite as good as the covered call, but this is primarily because the stock surrogate is an .80 delta while the stock has a delta of 1. While I think this is a good risk/reward, it’s possible to make the diagonal even closer to the covered call with respect to reward.

AAPL diagonal. Risk $10,190.50 (.93 delta)

In this case I bought a deeper in the money call: $180 strike with a delta of .93. This almost matches the reward of the covered call exactly. However, the risk of this trade is $10,190 which is much closer to the cost of the covered call than the .80 delta. This is why I prefer the risk/reward of the .80 delta, but the risk/reward ratio is really up to each trader.

Back to Risk

So, back to the risk of stocks vs options. In these example I have shown that in terms of real risk (the total amount that can be lost) options, using a conservative strategy and good risk management can be less risky than stock. Of course, there are valid reasons to own stock but I think it’s important, regardless of the vehicle, to understand the risk vs the reward of any trade or investment. Especially in times of market volatility, it’s good to have ways to reduce risk while still getting a good reward and options can be a way to do this.

As usual, I love to hear feedback on all of the content I create. Feel free to reach out here on the site or directly in email at midway@midwaytrades.com. How do you mange risk? Is this a strategy that makes sense? If you have questions, I’ll be glad to address them. I do this so that we can learn from each other.

Until next time …. Good Trading!

Pets vs Cattle: My Biggest Trading Lesson

In the years I’ve been trading, I’ve learned many things. Of course, I started out with the mechanics of options, the Greeks, the strategies, etc. If you are interested in these fundamentals, check out my video series Options Fundamentals here on the the site or on my BitChute channel. I go over many of those early lessons about options trading.

But the craft of trading is more than just understanding the mechanics. Trading is also psychology. Paper trading is a useful tool, but you will never get the full experience until you are trading live money, your hard earned money. The ups and downs of the market become much more meaningful. It’s easy to get obsessed or stressed about your trades. The financial investment can lead to an even bigger emotional investment. Your idea is sound. Your plan will work. You have the skills to fix things when the market moves against you. You will make that profit. While confidence is certainly needed when one is in the risk management business (and that’s how I see options trading), you must be able to look at your trades as assets in your business. After all, what are options? They are simply contracts, a set of obligations that we exchange with others. They are derivatives of pieces of paper that represent ownership rights. Or in my case, as one who trades mainly the SPX, I trade a derivative of a derivative of pieces of paper which represent ownership rights

Why do I say all of this? Because recognizing this has helped lead me to the biggest lesson I’ve learned in trading so far. And the analogy I use is “Pets vs Cattle”. Bear with me for a bit and (I hope) it will all make sense.

If you have pets, as I do, you understand that they are more than just animal companions. To many of us, our pets are part of our family. We do our best to take care of them, feed them, get their shots, make sure they have the best life we can give them. When they get sick, we collectively spend billions of dollars a year getting them the best medical care we can. When they die, we mourn them. And, outside of truly obsessive behavior, all of that is perfectly fine and normal. We take in these animals, keep them in our homes and our lives and treat them and protect them as our own.

However…..

A farmer or rancher also has animals. He takes them in, feeds them, and protects them. But it’s very different. Those animals are not part of his family. His goal is to eventually sell these animals to make his living. If one of his animals gets sick, he is far less patient with medical care. Time and costs matter and he can’t let one sick cow infect the entire herd. While he may try some limited things to make that cow better, if that fails the cow must be put down and he moves on and focuses on the rest of the herd. To the rancher, the animals are a business asset. They exist to make him money to feed and protect his family (and his family’s pets). But he doesn’t have the emotional attachment to his cattle like he has with his pets.

So, let’s bring this back to trading. After learning the basics of trading, I struggled mightily with consistency. I knew how to win. But for ever few wins I’d get, one loss would wipe most, if not all, of those wins out. I just couldn’t get ahead and actually make any money that way. Losses happen in any business. You can’t avoid them. If you never lose, you never really took any risk and, as I said earlier, risk is how the options market pays traders.

So, I started critically reviewing my trades, especially the big losses. I needed to find what was common in my losses as well as what was common in my wins. And what I found was that when I would lose too much, most of the time I was holding onto a position too long trying to fix it and try make it profitable. I was adjusting my positions every time they went against me and was sticking with them stubbornly to try to make a bad trade work. In short, I was treating my trades like pets. I became emotionally attached to them. I knew if I just did more more adjustment, it would come back. This would go on until finally I was down so far that I finally gave up. A trade that I was trying to make a 10% profit was now down 35-40%. And when I tallied up my trades at the end of the month, it was those one or two bad losses that was the difference between a good month and a bad month.

I needed to change my attitude. I needed to see these trades for what they really were. My trades are my cattle. And like any herd of cattle, some won’t make it to market and that’s ultimately ok. But I can’t let one sick trade infect my account. Every trade takes up capital in my account. There are times when the best thing I can do is close the trade and re-deploy that capital into a new one that could be a winner.

So how am I applying this to the real world? First, before I put on a trade I always have a plan. That plan starts with the setup of the trade, the profit target, and the max loss. But the plan goes further. It also states what I will do when a trade moves against me. I have a plan for the upside as well as the downside. My plan then has the details for subsequent adjustments if needed. That’s all well and good, but I needed something more because just doing that wasn’t helping me avoid these bad losses. So I added some guidelines to my plan which I call my “Pets vs Cattle” rules to remind me of why I made them.

Guideline #1: I don’t adjust in the first 3-4 days. What I found was that when my trade went against me early and I started adjusting, I rarely made it back and it would have been better had I just closed the trade instead of adjusting at all. My trading style relies on Theta (time decay). Because I sell more extrinsic value than I buy, time works for me. But adjustments cost money, either by putting more cash or margin into the trade or taking a loss on part of the structure. So I’m sinking more capital into the trade to, essentially, buy more time for it to work. But if I do that very early in the trade, I haven’t really accumulated much time decay from which to draw. So I was digging myself into a deeper hole before realizing much Theta in the trade. And when I looked at the position at the first adjustment, it was usually a small loss or sometimes even a small gain or near break even. Here’s an example:

An example of a good loss.

So here I had my standard SPX 45-day butterfly. This shot was taken 3 days into the trade and I was already just outside of my butterfly tent. This is normally an adjustment point for me. But, instead I took the trade off for a loss of about $13 after expenses. On a $1300 trade, that’s about a 0.7% loss. Could I have adjusted here and saved it? Maybe. But if the trade goes against me this quickly, I’d rather just take it off and re-deploy the capital. Making up $13 on another trade is much easier than making up a max loss. This trade is cattle and I’d rather not sink more money into it if it’s not working early. Had this been day 5, I’d certainly consider adjusting, but not on day 3. (At 4 days, it’s a judgement call, thus the guidelines says 3-4 days).

Guideline #2: I consider taking off a trade that is at an adjustment point and up money. So assuming I’m past at or past the 4 day mark, if I’m at an adjustment point and up money, I could adjust it and try for more. But, more often than not, I’ll just take it off and re-deploy the capital. If the market gives you a profit, there’s nothing wrong with taking it. Generally if I’m up at least 4%, it’s a no-brainer to take it off. Less than that is when I’d consider adjusting since I’m getting close to break even.

Guideline #3. I limit the number of adjustments to around 4-5. Another observation I noticed in my bad losses was I was over-adjusting. This is somewhat related to the guideline #1 as adjusting too early can lead to over-adjusting. But as each adjustment costs money at some point I have to stop digging and move on. If I hit this limit, I take off the trade even if I’m not yet at my max loss. If I’ve adjusted 4-5 times in a trade, that’s a sign that the market conditions aren’t good for that particular trade and it’s best to take it off and either wait for things to calm down or put on a trade that is more conducive to the current market.

Ok, this blog would not be complete without an example of not following these rules so here it goes. On this trade back in 2018 (before I established my guidelines), I was doing an Iron Butterfly. My first adjustment came in day 2. I then went on to make 8 adjustments before taking a bad loss. Here is what the trade looked like on day 2 when I made my first adjustment

Bad Loss – Day 2

So, at this point, this trade isn’t in good shape. I’ve been in it for 2 days and I’m at an adjustment point and I’m $324 down or 11.5% on the trade. But I can fix it, right? I have an adjustment plan that will make this all better. Well, here’s what it looked like when I finally took it off after 7 more adjustments on day 15.

Bad loss after 8 adjustments in 15 days!

Ugh! I finally closed it for a loss of $1,145 or about 40%! So as bad as it may have felt to have lost $324 after 2 days. I’d take that over losing $820 more. But I was treating this trade like a pet, not cattle. Had I just cut my losses on day 2, I would have lost $324 but I could have re-deployed that capital and perhaps even made some or all of it back in the next 2 weeks. And it’s certainly easier to make up $325 than $1150.

So, hopefully, I’ve shown why a silly mantra of “Pets vs. Cattle” helped make me a better trader. I still say this to myself today whenever I’m tempted to break one of my guidelines. I put it in my trade notes when I close a trade early. This little phrase helps keep me from getting too attached to my trades. It reminds me to not get emotionally invested in my trades. Losses will happen and are ok as long as they are small losses. Maybe this can help you too.

As always, feel free to leave me feedback here on the site or reach out via email at midway@midwaytrades.com.

Good Trading!