Chicken? When it’s smart to exit a trade early


The Risk Based Stop Loss Order

Common Sense From Dr. Brett Steenbarger

Today I found another interesting point being made by Dr. Brett.  He's a trader, trading coach, psychologist and outstanding blogger.

"While it's important to have stops, it's not necessarily the case that
all stops need to be price-based. You should stop a trade when you see
that the underlying idea is wrong, not simply when you've lost a
certain amount of money."


His advice is directed to short-term traders, nevertheless the advice can work for us as well. 

One of the constant problems facing iron condor traders is the fact that a sustained market move hurts those iron condor positions.  To manage risk, we each have our own mental 'stop-loss points.' 

Those are the prices at which we make an adjustment to our positions – often locking in a loss and reducing or eliminating risk.  We all know what it feels like to see the market edge nearer and nearer to a point at which we plan to adjust or abandon our positions. 

We don't like to see the market moving towards that point.  Yet, we sit, seldom considering doing something just for the safety factor.  That would go against the original plan. 

So what?  I always felt that this frequently offered advice: 'make a plan and stick with it' to be foolish.  It allows no consideration for new information or a change in market conditions.

If you are holding because your ego is involved and you would feel afraid or 'too chicken,' that's a poor excuse for holding onto a position when you feel strongly that trouble is imminent.  Yet, we frequently wait.  And sure enough, some time in the not too distant future we abandon the trade.

Why do we do that?  Why do we ignore early warnings? Why can't we recognize that the 'underlying idea is wrong' and that the market is not likely to trade in the required range?  Why don't we see that we are too short or too long and that it's unlikely this trade is going to be a winner?

My answer is that I have no idea where the market is heading next and that making a premature adjustment or closing the trade out of anticipation of coming events is just as wrong as doubling the size of the trade.  I don't know what's coming next. So I hold.  That's not as risky as it sounds because I also own insurance in the form of kite spreads. 

But insurance or no insurance, it's not necessary to stubbornly hold onto a trade, hoping the clock will tick away the days faster than the market moves against a position.

Brett's idea is sound.  If you see a twister down the road, there is no point waiting until your home is blown away before seeking shelter.  That's doing too little too late.

In Dr. Brett's world, technical analysis is a mandatory tool – and when that tool provides a hint that's what's coming next is not good for your current positions, it's okay to act.  In fact, it's smart to act.

I'm not going to start using technical analysis tools – but the point is that if you feel uncomfortable when holding a position, it doesn't really matter whether your predetermined 'adjust point' has been reached.  It's okay to stop yourself out of the trade before things get out of hand.

***

Follow the Trade

I've discussed the idea of following a specific trade – from entry to exit – via this blog.

That idea is being used in the new digital magazine, Expiring Monthly.  It's 100% devoted to options and options traders.  In the inaugural issue, two trades are followed in detail.

One trade is an iron condor, using RUT options and the other is a double diagonal spread, using NDX options.

The magazine premieres March 22 – Monday following March expiration.

Through the end of February, there's
a special pre-launch discount ($79/year, or $20 off the regular
subscription price).  Click the image below for details.


EMSubscribe2

616

2 Responses to Chicken? When it’s smart to exit a trade early

  1. Andy 02/17/2010 at 11:56 PM #

    Mark,
    Early last week, I sold an OTM, march put spread for about 50 cents when volatility was high. Currently, I have a chance to close that spread for ~10 cents, which seems good considering how difficult it is to close spreads for less than a dime with so much time decay left.
    I was wondering, though, how you felt about letting these options simply expire. Even though there’s more than a month to go, this option is way out of the money and with a low premium collected, it would be nice to save that extra dime and commission fees by simply letting it expire.

  2. Mark Wolfinger 02/18/2010 at 8:29 AM #

    1) I would close almost anything for a dime.
    2) But I don’t sell @50 cents. Thus ‘a dime’ is very cheap from my perspective.
    3) From your perspective that dime represents 20% of the premium collected. It also requires payment of commissions, and even if that’s only another 2 cents, it raises the cost to 12 cents.
    4) If you are almost ‘all in’ – and by that I mean if you are using almost all of your available margin, then the question becomes: Is there a better way to use that margin than to earn ‘a dime’ over the next 4 weeks? The answer should be yes, and I’d try to cover at some low price.
    5) If margin is not an issue, then the only way to decide is your comfort zone. Are you willing to take the risk involved to earn $10 per spread? If the answer is yes, then hold – or enter a bid of $0.05.
    Andy there is seldom a one size fits all solution when trading options.