The Importance of Being Flexible

"One of the least recognized trading strengths is mental flexibility: the ability to keep an open mind to the evidence of the evolving marketplace and revise views and strategies accordingly."

The quote above is by Dr. Brett from his excellent TraderFeed blog.

We all have our favorite methods for using options.  If you have been earning good profits year after year, it's difficult to accept the fact that times may have changed.  For example, most individual investors only understand bullish strategies, such as owning stocks and mutual funds, or writing covered calls (or writing naked puts, an equivalent strategy). 

When neutral to bullish markets are absent – such as when the technology bubble burst early in this century, or during 2008 – those who insisted on continuing to trade using bullish strategies performed poorly.  Those who adopted an investment strategy that provided a partial hedge, e.g., the slightly risk-reducing strategy of writing covered calls, fared better than those who owned a diversified stock portfolio (compare BXM and SPTR for 2008*).  But those who recognized that times had changed soon enough to do something about it fared far better.

    *The buy-write index (BXM) declined by almost 29% in 2008

SPTR (S & P total return index declined by >36%

During the market declines, the bears were successful.  But even bullish traders who owned insurance (by adopting the collar strategy, for example) performed far better than their bullish peers.

The point is that it's not so easy to abandon successful methods.  But it's also important not to fight the trend and to recognize that your favorite methods will not always be appropriate. 

If you consider yourself to be a better than average market prognosticator, then there must be times when you don't want to be either bullish or bearish.  That's the time to adopt a  market neutral strategy (iron condors, for example).  Such flexibility allows you to survive in any market – but only when you are diligent in managing risk.

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4 Responses to The Importance of Being Flexible

  1. duane slyder 02/19/2009 at 12:25 PM #

    Trader expectations are that the RUT will be moving away from its current position down or up in the next month. So as a countertrend trade, I bought a put butterfly on RUT with 120 point wings and a 420 strike body. I will hold till the 13 – 16 of March and set a stop at a 10% loss of $768. I am paper trading this, and might work on adjustments in the paper trade if necessary. What are your thoughts on a wide butterfly like this and it’s pros and cons versus RUT Iron Condors?

  2. Mark Wolfinger 02/19/2009 at 12:52 PM #

    You bot the 300/420/540 butterfly, paying approximately 77 points. (I deduce that from your number that constitutes a 10% loss.) Max gain 43 points.
    You are betting that the expectations of a significant price change will not be met – as you stated, a counter-trend trade.
    I don’t like this. Sure, you can earn over 50% if you dare to hold through expiration and see a miracle finish of RUT = 420. But, you have established a stop loss and that may get in the way. [BTW, I do not like the idea of a stop-loss on option trades. Here’s a question for you: How does your broker calculate the value of the spread so that it knows when to get you out? Does it use bid/ask midpoints? And if it ‘decides’ to close, does it pay offers and sell bids – guaranteeing you a horrible fill. You must know this stuff before entering a stop loss with options.]
    If you want to bet against a big move, the iron condor is easier to trade. For the same margin requirement (for butterfly, it just the cash you paid) you can buy 8 -10 iron 10-point iron condors [margin = 1,000 per, less cash collected].
    The IC gives you the same maximum loss (when you buy the appropriate number of ICs] and you can choose the same strikes if you so desire: 410/420P; 540/550C.
    IC gives you much less chance of being stopped out so soon – and at horrible prices. You may earn a bit less – depending on premiums collected – but in reality the chances of earning the max from a butterfly are very small.
    Keep in mind that a wide butterfly is equivalent to a bunch of overlapping butterflies. Thus, you can consider than you own 22 different 10-point flies instead of one monster.

  3. Ron S. 02/19/2009 at 5:45 PM #

    Hi Mark: One question I have deals with the basics…… The presentation of the option chain.
    Is the option chain a listing of those willing to sell a call….. or a listing of those who are willing to pay that price to buy a call?
    It seems that the options chain is presented well – but a little more definition and possibly how the numbers are created within the chain would help me out.
    Thanks for clarifying this.
    Ronny

  4. Mark Wolfinger 02/19/2009 at 7:11 PM #

    Hello Ronny,
    The option chain has nothing to do with ‘who.’
    The chain is merely a LIST of all options available for trading for a given underlying security. The option chain lists the various strike prices, expiration dates, and option type (call or put).
    Not everyone displays the chain in the identical manner. If you see a premium for each option, it’s most likely the last price at which the option traded. If the chain has more detail, it shows the current bid and price. But the list never contains information on who is bidding or offering to sell.
    How are the numbers created? It’s merely a list of all available options. The is no ‘creation’ of numbers.
    For example, the CBOE chains contain the following information (your broker may offer slightly different information):
    Symbol. Option ticker symbol. There are two columns, one for calls and one for puts.
    Price of last trade.
    Change in price, from the previous day’s closing price.
    Bid. Highest published price anyone is willing to pay.
    Ask. Lowest published price at which anyone is willing to sell.
    Interest. This is the ‘open interest’ and represents the total number of this specific option which has been written (sold), but not yet covered.