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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