Philosophy of Options Trading. Part II

Welcome to visitors from the 209th Carnival of Personal Finance.

Part I

Part II. It’s Your Money. Protect It

This topic is one I take very seriously and I admit that I have difficulty convincing people of the truth of the following statement:

When you own a position, unless there is something very unusual about the current option prices (that will be resolved shortly), the current value of the position represents your current stake. In other words, the price at which you can exit the trade right now (even when you don’t want to exit), represents your money.

If you have a profit, that profit is yours. It does not belong to the house. If the investment turns against you, and your $1,000 profit becomes a $600 profit, you lost $400.

I can hear the disbelief now. “How can I have lost $400 when I earned a $600 profit?” Here’s how I look at this situation, and hope to convince you to do the same: You have a position, or a bunch of positions. Every time you sit in front of your computer (or telephone or blackberry etc.) and look at the position, if the market is open, you have the choice: you can hold the position; you can add to the trade; or you can exit and accept the current price – regardless of whether it represents a profit or loss. If the market is closed, you can submit an order (when the market next opens), in an attempt to take any of those actions (holding requires no such order).

Holding is a decision. It’s a decision not to act. Because you can exit the trade at the current price, that price represents the value of your trade. This is marking to the market. No other accounting method makes sense [and that’s why I believe so many banks are insolvent – a few accountants excused them from being forced to mark to the market]. That’s the way your broker values your account when it provides the current net liquidation value. It’s also the value they use when determining whether to issue a margin call. Telling the broker that the position is worth more and asking that a margin call be postponed is a plea that is ignored.

When you make the investment decision not to close the trade – as will happen almost every time you look at your portfolio – that’s equivalent to closing the old position and re-opening it at the same prices – commission free. It’s a decision to own the position at the current price. Thus, if your position declines in value from this point, you lose money. Your money.

If you earn profits from this point, you make money. And that is true even when a larger loss becomes a smaller loss.

Why is this important? Why should you care?

It’s important for traders to have the correct mindset. Too many feel they can afford to hold a profitable position that’s become risky, just because they have a profit and feel they are playing with someone else’s money. If the position is too risky for the potential reward, why own it? When you respect money and protect it, it will remain yours.

Many investors refuse to take a loss. That makes no sense. If the current mark to the market tells you that the position is worth less than it was when you initiated the trade, you have lost (past tense) money. Don’t pretend that holding and giving yourself a chance to get even is always the right choice. Sure you can hold, but only when you want to own the position at its current price. You may even want to add to the trade, but in general, it’s a poor idea to add to a losing trade.

If the trade is unsatisfying from either an intellectual or comfort zone point of view, why own it? Close and open a better position. Open a position you believe has a better chance to earn money going forward. You are trading to make money, and to do that you want to invest in positions you believe have profit potential. If you recover $500 by holding a losing position, it may give you a feeling of satisfaction, but if you could have invested those same dollars in a new position and earned $1,000 over the same time, how can recovering $500 be considered a good result?

Unless you have a good reason to believe that an open position is more likely to make money than a fresh position, there is no reason not to move your trading dollars into the better trade. And that’s true whether the position is a winner or loser. It’s either good to own or it isn’t. Investors everywhere cling to those losing trades – hoping to avoid a loss, or they gamble with winners, believing it’s not their own money.

If you have a bad position, don't hold it.  Ignore whether it's a profit or loss – and open that better position. 

No specific trade owes you a profit.  When you earn your target profit each month, it doesn't matter which positions provided that profit.  Unload bad positions and manage risk carefully.   That's the path to winning.

to be continued

Two years ago I wrote a magazine article on this topic.

354

6 Responses to Philosophy of Options Trading. Part II