I received two questions from a reader. I believe the discussion will be of interest to other rookies and am converting that reply into today's blog.
1) I am interested in
getting an idea of how much diversification is possible when doing
market neutral trading.
What about opening another position in Oct if there
is still enough time left?
currently have a RUT Sept IC [iron condor] paper trade that I placed on Aug 27 for a
credit of $3.60. This morning the position had a profit of $1.20 and
now it is $0.70.
If you can watch a position during the day would you advise locking in
a profit at a certain point in a situation like this?
1a) You can diversify by trading as many different issues as are comfortable for you. I have no idea how many that is. But you can easily over-diversify. When buying stocks, no one thinks it's necessary to own 30 different stocks to have a diversified portfolio. The same applies with option positions.
I prefer to diversify by eliminating the risk associated with trading individual
stocks – where news events can have a significant impact on stock price.
Thus, I trade an index. Should you continue to trade indexes? I have no idea.
1b) Of course you can open another spread that expires in October – whenever you are ready. How much time remaining before the options expire is one of those 'comfort zone' decisions. How many positions you want open at the same time is another a comfort zone decision.
Less time before expiration translates into more rapid time decay. That's good. But it also translates into more negative gamma and larger losses when things go badly. That's not so good. You will learn which combination of risk factors is acceptable to you. If you follow my preferences that's not good for you in the long run. Trading involves many decisions and you must learn to make them for yourself. It's okay to get advice.
Regarding your 2nd question:
I cover early. That's my comfort zone. You must find your own.
How much you collected originally is immaterial.
How much profit you have is immaterial.
All that matters is this:
You can cover this position by paying $0.70. Do you want to take the
risk of holding this position when your potential is all, or part, of $0.70? Are the options far enough OTM that you are happy to hold? Or would you be holding just because you cannot bear the thought of paying 'so much' to close?
Ask yourself if you would open this iron condor as a new position for
$0.70. If 'yes' then don't close. If 'no' then you have a decision to
too risky for you to hold? I cannot possibly know the answer. It's a personal decision.
I offer this advice: Don't allow the actual result to sway you. If you
decide to hold, and this time that turns out to be a losing decision, don't
conclude that you should close early next time.
If you close early and the position goes out worthless, that does not mean you should hold next time.
Trading is about RISK and REWARD. Not how much you coulda, woulda, shoulda earned.
By the way, if you opened @ $3.60 and your profit is $1.20, and the current price is $0.70, the numbers are inconsistent. Also, your decision on holding/closing should not be dependent on how closely you can monitor the position.
Why did I turn these questions into a separate post?
You and I have exchanged a bunch of questions and answers, and although each is interesting in its own right, I don't think you are focusing on the important issues.
You are in the learning
of your options trading career. You are gaining experience. Education
is an ongoing process, and requires time. Before you risk real money,
you must (IMHO) understand the strategy you are using and have some
basis for believing you are capable of managing the risk of your
investment, should the market move against you.
You are still paper
trading. So trade; manage risk; keep a daily diary of how you 'feel' about
your positions: Are you comfortable? Are you concerned about volatile markets or pending losses? Are
you confident (overconfidence is a killer)? Are you anxious to lock in profits or do you prefer to try to collect the last penny from a trade? Put your thoughts into writing.
Answering these questions – in your diary – is important. Your own commentary will lead you down a path that is good for you. And you can modify your comfort zone as the years go by.
It takes time to find a strategy that works for you in today's market. But, no strategy is always 'right.' Times change and markets change. You must also determine position size: how much
cash to place at risk.
Take your time. If you develop good habits now, those habits will last a lifetime. If you go broke now, you may give up trading options. I cannot
tell you what will work for you – but you will figure it out as you go along.
As I mentioned in a previous post, this is an important sequence in anyone's trading education:
The primary goal is to survive. That means protecting your assets.
The secondary goal is to make money.
The tertiary goal is to build wealth.
Concentrate on getting experience with iron condors, finding your
comfort zone, and protecting your assets. That's important now.