Q & A. Taking The Loss

Hi Mark, I want to trade Iron Condors. I have your Rookies book and found it very useful.

I'm stuck on figuring out when to close a losing position. It seems that closing too early is not good and neither is closing too late. Is that something that needs to be determined by back testing? Thanks,
Jim


[This post was updated 10/04/2010]

Hi Jim,

You are correct.  It's difficult to make the decision.  But, it's a necessary part of your overall trading strategy.   In the spirit of full disclosure, there are people who claim that no risk management is necessary because when you buy an iron condor you already own options that limit your losses.  But, IMHO, that's insane.  It's just wrong to allow losses to get so large that they overwhelm profits. It's far better to take smaller losses, even when it means taking fewer profits.  A combination of good profits, small profits and small losses is my objective. 

Let me begin by telling you what I do in this situation.  This may not work for you, but it's something to consider before making your own decisions.

Accepting the fact that I cannot predict the future, and believing that buying iron condors is a long-term winning strategy, I am willing to take necessary losses along the way.  I make the best decision I can at the time the decision must be made.  Thus, when I find the immediate risk involved with holding a position violates my comfort zone and makes me queasy, I take my loss.

 Sometimes I act before that point is reached, but I almost never (I wish it were never) hold out just a bit longer hoping things will change.  It's very temping to gamble by holding longer.  It's very tempting to attempt to recover losses because no one likes to lock in a loss.  But because I am able to make money buying iron condors, it's not that difficult for me to take those losses.  For someone new to trading iron condors, you don't have a profitable history to give you confidence – and taking a loss hurts.  I fully understand. 

As you state, when you do cover, part of the time turns out to be the 'winning' decision – in that it saves you from further losses.  Part of the time it turns out to be the 'losing' decision because the market either stalls or changes direction.  Nothing can change that.  Thus, I make the best decision I can, and move on.  I put on my risk manager's hat and ignore the plea from my trader to wait just a bit longer.

Once we decide, our emotional side wants to know whether we would have come out better had we acted differently.  Success in the option game is measured by the growth of our accounts – over the longer term.  Some attention must be paid to doing what is right – and by that I mean doing what the odds tell us to do.  If I've lost $2 on a position, that's in the past, and there's nothing I can do.  Holding may give me a chance to recover that $2 plus make an extra $2. But if there's an equal chance of losing another $5 or $6, I take the loss and move on.  My goal is to give myself the best chance to earn the most money – with the least risk – going forward.  And holding is a high-risk play.

If I make the decision that the risk manager part of my personality tells me is the prudent thing to do, I am comfortable with it.  It truly no longer matters whether I would have done better by making a different decision. I make the 'correct' (correct for me) decision and live with the results.  I KNOW that this works for me.  I KNOW from experience that taking (for example) a $2 loss on a trade is better than risking a loss that may reach $6 or $7.

And, here's one more reason why taking the loss is not quite as bad as it seems.  The current position is not a good one.  It's  not market neutral and is threatening to lose more money.  If you take your loss NOW, you can open a new position that suits you.  It can be market neutral, it starts at a point that does not (immediately) threaten you with further losses.  It gives you the best chance to make money in the future.  Don't think of getting even, think of growing the value of your account – starting right now.

If you play poker – do you take a look at the card you would have drawn had you not folded?  I don't.  Once I fold, it no longer matters.  That's the same situation here.

Regarding back-testing.  That's completely inappropriate.  Technical analysts may find back-testing specific chart patterns is worthwhile, but you have nothing so specific to back test.

First, you would never be able to find an enough analogous situations to test. Why?  Because you would not only have to find a case in which the options you sold are x points or x% in or out of the money, but you would have to find the identical implied volatility.  We all know that IB fluctuates over time, so sometimes a 25 IV is relatively high (for recent history) and sometimes it's pretty low.  It's next to impossible to find similar situations to compare.   Not only that, but there's a difference in how option prices react in rising and falling markets.  There are so many variables that you could  never find a meaningful number of situations to test.

But, even if you could, I ask, so what? Would you be willing to take a big risk now, just because it would have been the winning decision 60% of the time in similar situations in the past?  Your primary goal should be to avoid going broke.  Making money comes second.  To me that means moving away from risky situations.

Consider this: if you had chosen different strikes prices for the troubled iron condor, the situation would look different to you now.  Suppose you had decided (this time) to sell options with strike prices that were 20 points further out of the money, then you would not be in immediate trouble now.  There is just no way to take that into consideration when back-testing.

I know it's not easy to take losses, but successful traders will tell you it's necessary.   Again, all the above is how I feel and why.  It's truly up to you to decide if this makes sense or if you would rather proceed differently.  NOTE:  I am not suggesting you take a loss every time the underlying move 2%.  I am telling you to understand the boundaries of your own comfort zone.

I wish you the best.
Mark

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4 Responses to Q & A. Taking The Loss

  1. Jim 09/28/2008 at 7:55 PM #

    Mark,
    Thank you for the detailed response. I read it over twice.
    I appreciate the need to take losses. My concern is that my comfort zone is not a reliable indicator of when to take losses. My comfort zone will fluctuate based on whether I made or lost money on my last trade and who knows what else.

  2. Mark 09/28/2008 at 10:49 PM #

    Jim,
    Obviously everything I say here is my opinion. I cannot know what’s best for you. I’m sharing what works for me.
    I think of my comfort zone as being an UNEMOTIONAL, independent place – a place well understood by the risk manager portion of my trading personna. I should be more aware that it’s not as easy as it sounds for everyone.
    But I understand. I was very stubborn. It took me a long time finally to become a disciplined trader.
    When I first started as a market maker, I had people (especially risk managers) tell me I was being very foolish to take as much risk as I did. I pooh poohed the advice, and fought with them frequently) because I knew what I was doing – or at least I was convinced that I knew. Today I recognize how wrong I was.
    Well, you can only buck the odds so often. Eventually I lost it all, made a comeback – and quickly forget how quickly one can lose money.
    So, it happened again. I made another comeback. But it was not easy to drum it into my head that I could make plenty of money and there was no need to take such risk.
    Today I am very disciplined. Better late than never, but I would have been well served to know in 1984 what I know now.
    The point is: If you BELIEVE that controlling risk is the key to success, you will be able to exercise unemotional risk control. If somebody else (me in this case) tells you, it’s far more difficult to believe. But, I’m telling the truth. I lost too much too many times. I was fortunate in being a good enough trader to be able to make comebacks. Not everyone gets a second or third chance.
    I’m not talking to you about losing it all or going broke. Just trying to tell you that if you have any ability as a trader, you will win the game (making consistent money over the long term) by allowing profits to take care of themselves and being certain losses are not hurtful. I don’t mean you must adjust every time a position loses $100. That’s foolish. But there must be a point at which you are either ‘afraid’ of additional losses; or perhaps aware that further losses will put your account in jeopardy; or that there’s no reason for the market to change direction immediately and that it’s simply too risky to hold etc. I don’t know what it takes for YOU to take action. I just know if I have an even chance to make back a small loss or triple that loss, I’m not going to take that chance.
    And there is always the compromise. You can close a portion of the position. It does not have to be an all-or-nothing proposition. For example, if you own a position, you can close 20% when the slightest bit uncomfortable; 30% when the trend continues; and the final 50% when it suits your trading style. I just suggest taking losses (especially if you open a new position quickly) is just part of the game.
    The truth is I don’t want to win every month (at any given time, I hate to lose) – but being aware that this game is not a gimmie and that it requires effort and the ability to understand just what you are doing – is important. It prevents me from becoming lazy. Thus, I take my losses and move on.
    Not everyone can do that. Especially when it may mean that the ‘whole month’ is lost. It may help to have more than one position open at any one time.
    Take a look at this entry: https://blog.mdwoptions.com/options_for_rookies/premature-celebration/
    It’s not helpful to get overconfident with a string of wins. I believe there are no ‘hot streaks’ and that each trade should be managed on its own. For example, as an iron condor buyer, you will do well when the markets are not very volatile. That has noting to do with you. Thus, a year of non-volatile markets and a 12-month winning streak may be due to market conditions and have nothing to do with your skills. If you believe that’s true, then your comfort zone should be unchanged – not expanded because you are on a hot streak. That means the ‘numbers’ dictate my comfort, not my confidence in coming out a winner on the trade.
    Mark

  3. Jim 09/29/2008 at 12:31 PM #

    Mark,
    Here is an example of how I look at this. Lets say I’m considering an IC trade with $2 reward and $7 risk.
    I imagine putting on a long string of trades with the same risk/reward. Then I try to figure out the net consequence of closing out every trade if it reaches certain loss points.
    With a $.50 loss I figure there would be many losing trades with small losses and a few winning trades. This would probably not be profitable.
    With a $4 loss I would have many winning trades. But overall profitability would not be good due to the size of the losing trades.
    When I consider loss points of $1, $2 and $3 I’m not sure what to expect in the long run.

  4. Mark 09/29/2008 at 1:43 PM #

    Now I understand why you were talking about back-testing. This is back-testable (in theory), but I doubt you can find the necessary option data. In other words, I don’t believe you can find the daily value of a specific iron condor – especially those important intra-day values. Such data is VERY expensive.
    Except for one experimental iron condor idea, I never consider how much has been made or lost when deciding whether a position should be adjusted (and I adjusted one today – as posted)
    This is a continuation of our discussion on the emotions of trading.
    I believe (very strongly) that a trader must ignore the price paid (or received) when initiating a position. It requires putting your emotions aside, but I believe a trader does best when he/she looks at the position as it is right now – and makes a decision:
    a) Good position, I’ll add to it
    b) Decent position. Risk/reward ok. I’ll hold
    c) Too risky. R/R not good. I’ll close.
    And those choices must (again, that’s how I think and manage the trades) be made independent of whether the trade is profitable; whether you are having a good or bad month; whether you MUST make a profit this month to pay bills etc.
    The position is good or it’s not. It’s worth holding or it’s not.
    BTW – no trader should ever be thinking that a profit MUST be made to pay the bills. The money must be available for trading – because trading is a business, not a hobby – and not needed elsewhere.