Contingency Plans

June 3, 2007

204

OptionSage submits:

Most traders I encounter are what I call ‘binary’ traders. They have a win-loss attitude. Either a trade goes as expected and they make money or a trade moves against expectations and they suffer losses. This approach to trading requires good timing on the part of the trader to stay in the game and indeed good discipline. Investor’s Business Daily, for example, imparts an approach of letting winners ride and cutting losers short. While this approach has its benefits, I tend not to be a huge fan of it because, by definition, it implies you must accept losses and (if your timing is wrong sufficiently often) those losers, though small in percentage terms, on an individual basis can add up to some hefty losses!

I prefer trading with what I call contingency plans. Contingency plans take your trading to the next dimension. It’s like only being aware of 3 dimensions and the finding out there are 10 – like in this video. Suddenly you realize a world of possibilities exist that had not been countenanced before! Contingency plans are strict rules that I follow in the event that a trade moves opposite to that which I expected. You will find Phil has contingency plans in place too for the same reason I do – neither of us are arrogant enough to believe that the market will do exactly what we want it to do 100% of the time and so we have to account for the times when we are wrong! For Phil, this might include following basic rules for position sizing. For example on the $25,000 account he discussed in this week’s wrap-up that means no more than 10% in a position, 5% for contracts under $1. You will see his rules for doubling down in his Strategy section too. We are both aligned in remaining flexible in the market and accounting for surprises and new trends should they occur unexpectedly.

An example of where contingency plans offer you the opportunity to mitigate loss or indeed maintain profitability is an iron condor. In this week’s wrap-up Phil commented on the BIDU iron condor from a few weeks back “I vetoed Options Sage’s iron condor example that weekend but the lesson on condors is great to reread at this point, following through on the trade (which still might work out but I’m sure glad I skipped it!" Of course Phil vetoed the iron condor that had short options at strikes 120 and 140 which in fact, the article itself vetoes! For greater symmetry, in fact, short strikes at 120 and 145 were considered a preferable trade based on a probability argument but I stated that we still had reasons to be concerned about that trade.

Does that make it a bad trade?

Answer: Yes if you have no contingency plan & No if you do have a contingency plan!

Recall an iron condor makes money if the stock remains between the short option strikes – in this example between 120 and 145. With the stock currently at $140 a binary trader would be getting concerned at this point. The stock only needs to run another $5 before the short call starts to move in-the-money and potentially move the trade into real trouble. BUT, if you really believe the stock is going to run above the short call strike price, why would you ever leave the iron condor in place to run into trouble? This is the deer in headlights approach to trading that involves taking no action even though danger is apparent and potentially imminent!

In speaking to Phil this weak he explained to me that his primary concern was that many people reading that trade as a recommendation would be those proverbial deer as we have a hard enough time getting the members used to the idea that their positions are not fixed in stone and can be adjusted on the fly. Just because most of us have been conditioned to take losses when positions go against us doesn’t mean we have to!

In fact, options are so dynamic that all we need to do in the above example is consider the addition of a long call option to the existing position. That turns the bear call part of the iron condor into a ratio call backspread. This simply means we have more long options than short options in play. In fact, when I enter iron condors, I like nothing more than for the stock to blow through the short option strikes because I know I can often make more money adding long options to the original position than if I were to simply profit from the short options expiring worthless.

The question might then arise “Well what if you add the long call and then the stock reverses back down on some surprisingly bearish news?” Again at that point there is no reason again to sit on a losing trade. In fact, at that point a short call could simply be added at a lower strike to the new long call and another bear call formed. You can simply iterate through this process until at some point the bear calls expire worthless or the bullish stock movement has made you oodles of money on the long calls and turned the entire trade profitable. Either way, the knowledge and enforcement of a contingency plan means that you can significantly reduce your stress levels in holding a position because you will know exactly what to do to mitigate risk. This is a key component to successful trading and diminishes the possibility of greed and fear dominating your trading decisions.

Key Learning: Manage fear and greed by defining your target profits and clearly define what action you will take if a position does not move as you expect.

During the week, we will feature discussions about trades we are "saving" on the member site as we position ourselves for the new options period, both Phil and I feel we need to be prepared for a market downturn (just in case!) and we want to make sure everyone is thinking in terms of contingencies for their virtual portfolios.