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!

Why I Primarily Trade SPX

Those out there who follow my trades, especially my weekly series This Week @MidwayTrades will notice that I primarily trade one underlying vehicle: options on SPX, the S&P 500 Index. I occasionally do small spec trades in other underlyings but anything I do regularly and of significant size is always in SPX. This is not the way a lot of retail options traders operate so I thought it would be worth a blog post to explain why I spend so much time trading options of one underlying. Let me say up front, none of this is to say that there is anything wrong with playing lots of different options. I always say if you can consistently make money trading a different way, that’s the right way for you to trade. But in this post, I will spell out why I prefer to trade SPX whenever market conditions allow it (which is most of the time).

1. Liquidity

To me, liquidity is essential. Without liquidity, do you really know the worth of your position? I would argue no. Market prices are set when buyers and sellers agree on a price and if no one else is participating in a market, it’s tough to tell the actual price of something in that market. The CBOE (Chicago Board Options Exchange) tracks activity of nearly 3000 underlyings that trade options. I personally would only be interested in trading options in the top 100 in terms of volume. You can find this list here for your own inspection. This is for equities. I found stats on indices here. You will find that SPX is not only well in the top 100, but top 10-15 depending on the time frame. With all the available options out there to trade, why spend time and money fighting to get a fill on a low volume/open interest contract? Price slippage is very real and I rarely, if ever, have to give in more than $.10 of a reasonable mid-price for SPX, usually less.

Outside of good fills, good liquidity also gives far more options to trade (i.e. more strikes, and more expirations). SPX not only has Friday weekly expiration but Monday and Wednesday as well. I used to avoid the non-Friday expirations, but recently I’ve found that I get good fills on Wednesday as well. This makes it easier to put on multiple positions in a single account without stepping on other trades in the same expiration which can lead to confusion when closing or adjusting trades.

2. High Prices

I see lots of traders who head to the bargain basement because the option prices are cheap. It’s certainly tempting just as it is trading stocks. But there’s a downside to this. In stocks, it’s usually that the stock has a low price for a reason (low quality). But for options it means there isn’t much in the way of premium. As a trader who likes to sell premium, this means I have to trade a lot more contracts to generate enough premium to make it worth the risk. And while commission costs have come down significantly even this very year, they still add up vs the amount I want to make selling premium. A quick side note: when I say I sell premium that doesn’t mean just selling options or even that I open a trade for a net credit. In my non-spec trades, I am always selling more time premium than I am buying (thus being positive theta) and in many cases I am also selling more volatility than I am buying (unless volatility is extremely low as it is right now in which case I set up my trades to be positive vega and I’m a volatility buyer). But the price of the option starts with the price of the underlying. At the time of this post, SPX is a $3100 index. That means that even trading a one lot can involve over $1000 in margin. As I’m trying to make 7-10% of that as a successful trade, this means I can trade fewer contracts to make a decent amount of money on a trade. This is one of the reasons I prefer SPX to the ETF for the S&P 500 SPY which is priced at about 10% of SPX. Yes, the prices are lower, but I would need to trade 10 contracts for every 1 of SPX and that is 10X the commission to my broker. There are other reasons I prefer SPX to SPY that will come later. But the bottom line is, outside of unusual small spec plays, I prefer to trade underlyings above $80/share. Below that it’s tough to get enough premium to sell to make a decent profit.

3. Diversification

A nice feature of a large index like SPX is that it represents many different companies across different sectors by design. The S&P 500 consists of (to no one’s surprise) 500 stocks. That means that by trading this underlying I get a certain amount of sector diversification built-in. Is it perfect? Of course not. The index can get out of balance at times. But it’s rarely so out of whack that one stock or one sector will destroy it. I still have to be aware of what’s going on and be ready to take action if something does happen to move the index but it’s less impactful than say, earnings or news on one stock which can move it several standard deviations in a day.

And that’s another advantage: SPX doesn’t have earnings events in the same way that individual stocks do. Individual components have them all the time but they are spread out over many days so the effect is muted. That isn’t to say that there are no events that cause a move. The biggest one these days is Fed announcements. I do keep track of Fed meetings and am a bit cautious adding new positions right on top of them. There’s a nice site that keeps track of economic news on a daily and weekly basis called Econoday and it’s not a bad idea to keep a browser tab open to it on your trading station. Other news can move the index as well, the recent trade war has certainly moved the market and has been unpredictable at times, but I have found the risk to be more manageable than individual stocks.

4. Cash Settlemement

Equity options are generally settled in shares of the stock. Options that expire in the money are usually automatically assigned and shares of stocks change hands as a result. But indicies like SPX do not have actual shares so their options are cash settled. This is another difference between options directly on the index and ETFs (like SPY) based on an index. SPY options are settled in shares of SPY.

Now, it’s reasonable to think that as long as I close my position before expiration, this isn’t really an issue. Except that with share settled options, there is always a risk of early exercise. The buyer of the option, most of the time has the right to exercise their right at any time during the life of the contract (this is known as American style). But since there are no actual shares to exercise, options on indicies do not have early assignment (this is known as European style). I will use SPY as an example since it is an ETF based on the S&P 500. SPY has a dividend based on the dividends of the stocks in the index. One of the reasons that options get exercised early is to capture a dividend. Another can be a buyout. This happened to me once in my early trading days. I was writing covered calls against a position and the company got bought out for a higher price than the strike price on the calls I was writing. The next day, my shares were called away. The SPX doesn’t have real shares and, therefore, has no dividend and, while buyouts can happen to companies in the index, the index itself can’t be bought out so there’s no real advantage to early exercise which is why it’s European style.

5. Tax Treatment

This is US specific so if you are not in the US it may not apply to you. But in the US we have capital gains taxes as part of our income tax system. The basic idea is that selling something for a profit generates income that falls under our income tax. But the US tax code distinguishes long-term capital gains (meaning you held something for at least a year) and short-term capital gains. Most options are held for under a year unless you are dealing exclusively in LEAPs so any profits made by them would be taxed at the short term rate (which is my regular income tax rate vs the long term rate of 15%). But options on “broad-based indicies” (which includes SPX) are treated differently. Any profit I make on SPX options where I held it for less than a year (which is all of them in my case) is taxed 60% at the long term rate and 40% at the short term rate. While this is not a huge advantage for me, it’s a nice bonus. This tax treatment does not apply, however, to ETFs like SPY. Of the 5 points made here, this is the least important, but I thought it is still worth mentioning as a reason to trade options in big idicies.

Conclusion

There are multiple ways to make money in options. My style is mostly around non-directional plays on big indicies. SPX isn’t the only big index out there with options. I have traded options in the Russell 2000 (RUT) which is based on smaller companies than SPX. It tends to be a bit more volatile, but it is quite trade-able and all of these points would apply. As is the NASDAQ index which is priced even higher than SPX. But at the end of the day, each trader needs to find out what works for that particular person. There’s no one right way to trade. But I thought this discussion of SPX may, in addition to helping some folks learn more about options, could lead to other discussions of trading ideas. Feel free to comment below or reach out to me privately at midway@midwaytrades.com.

Good Trading!