Adjustments and trading costs

A recent comment from Fran (from Spain), who writes an options blog in Spanish, raises an important point.  The obvious goal for traders is to make money and one sure-fire method for increasing profits is to reduce expenses. [This assumes that using a less expensive broker does not result in losing money via poor trade execution].

Some time ago I penned an article (free registration required) supporting the idea of reducing trading costs as a 'sure-thing investment.'

Fran's comments:

1) What about transaction costs with all these adjustments? The best adjustment strategy (in my opinion :-)) is to  reduce position size, because in the long run, transaction costs are another risk to manage and make a big difference in your trading performance.

2) if you have a verified trading edge, how does your adjustment bias affect this advantage? Have you tested it?

Hard questions to answer for a lot of options traders, but that trader must be sure that when cutting costs, edge is not being eroded. You must manage risk with low cost trades. Here, less is more

 ***

Fran,

I never object to size reduction as an adjustment. In fact, it is a method that should be used more frequently.  I believe there exists a trader mindset that equates exiting a trade, or even reducing position size, with doing something unacceptable: giving up and accepting a loss.  This is a loser's mindset because every successful trader understands the importance of limiting losses and exercising sound money management.

I know that winning traders recognize that it's impossible for each trade to be profitable. But more than that, they understand the importance of not fighting when the odds are not on their side.  Taking losses when necessary is an important aspect of the trading game.

On the other hand, I don't believe that size reduction should be an automatic decision.  It is often advisable (i.e., profitable) to adjust a position, rather than cut its size. 

Most traders consider 'being forced' to make an adjustment to be an unfortunate situation.  They miss the fact that adjustments can increase both the likelihood of earning a profit and the size of that profit. That is not something to be ignored.

Yes, transaction costs are important – and that's especially true for those who trade one and two-lots with a broker who tacks a 'per trade' fee onto the regular commissions. I have no idea how costly commissions are in Spain, but US traders can find good brokers with very low commissions.  Low enough to make them a very small consideration when making trade decisions.

 

Edge

I don't worry about 'edge' when making an adjustment.   I have only two concerns:

  • Does this adjusted trade give me a position I want to own? [I'm not likely to want to own it if I had to give up much edge to create it.]  Do I like the profit potential? 
  • Does this adjusted trade truly make the position less risky? Have I reduced the probability of losing money (from today into the future)? Is the amount at risk (both short-term and worst case scenario) acceptable?

If both sets of conditions are met, I pay the commissions and make the trade.

As to 'edge': I do not make a trade that I believe adds negative edge. I will not accept a position that is worse that it is right now (when an adjustment is needed). I prefer to take the loss and find a new, better position to own than to add negative edge to my current position.  However, 'edge' is not easy to measure because it depends on making an accurate forecast for future volatility of the underlying. In other words, our volatility forecast must be accurate before we can determine the value of the options, and the edge, we own in our posiitons.

Fran, Much of this is art vs. science. It's also a matter of personal comfort. Not every trader has yet learned the importance of being willing to accept a loss on a given trade.

Avoiding that loss can result in poor adjustment decisions.  Why?  The mindset that requires the trader to hold a position, also forces the trader into making almost any adjustment.  This is especially true when  rolling the position to a later expiration date,  with the hope of eventually earning a profit.  I have a friend who makes 'ugly' adjustments in preference to exiting the trade. 

Traders with that "I must do something to my position – but will not lock in a loss" mindset are not on the success path.  These traders would do much better to consider reducing or exiting a trade that has run into trouble

Thanks for the discussion

828

 

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