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Doesn’t making money mean it was a good trade?

Some days it's difficult to find a blog topic.  When that happens I spend some time reading other blogs, looking for ideas.  One, by the Stock Bandit, Jeff White, drew my immediate attention.  I've been saying the same thing for a long time, and it's always reassuring to see someone else with the same opinion.

In a post titled: Succeed by Not Failing, Jeff offers his opinion on a topic that many consider to be controversial:

"Too many traders think a winning trade is a good trade, and a losing trade is a bad trade…a failure.  I disagree."

The result of a trade is either a profit or a loss, but not a success or a failure.  Good trades can end up being losses, and poor trades can sometimes result in a profit. 

John gives an example and provides three common ways that traders fail.  It's worth reading.

***

If this is a topic that has not bothered you, consider the situation of someone learning to trade.  He/she dutifully opens a paper-trading account, chooses a strategy, but is not confident when choosing which options to trade. 

  • The covered call writer may be torn between selling ITM, ATM, or OTM options.  Then there's the problem of which expiration month to choose
  • The  butterfly trader may not know how far from the center strike to place the wings
  • The iron condor trader is told to find a comfort zone and begin from there

Comfort zone.  That sounds good.  We can tell when a position makes us nervous or whether we are entering into a trade with more confidence than usual.  But how do we do that?  It's based on experience.  We know what works and what doesn't work for us.  It's far better to have written trade records than to rely on what may be a faulty (biased) memory, but we have a feel for what to trade.

What is our beginner to do?  When initiating an iron condor position, the beginner has no idea what makes him/her comfortable.  With no experience, how far OTM is 'safe'?  Or how much premium does he/she have to collect?  Certainly there's no clue about an appropriate position size, and trading 1-lots is often the default choice.  But there's no 'comfort' there.  It's all uncertain territory.

The Winning Trade

 If this new trader is going to learn from making practice trades, There must be an understanding of how the trade was handled. 

Let's say our trader opens an iron condor position and the market moves.  The short put option goes well into the money and even the long put is ITM.  Doing nothing – out of fear and inexperience, our trader sees the market reverse, the iron condor expires worthless and here is a winning trade.  Not only a winner, but a maximum winner.

If the conclusion is drawn that this trade 'fits' into the trader's comfort zone and that the best way to handle iron condor trades is to wait for expiry, then this trader is already in trouble. 

This is a simple example of why it takes many trades before viable conclusions can be reached and why the result does not describe whether the trade was 'good.'

On the other hand, if the trader had felt queasy when the underlying declined and covered the entire position when the puts were 2% OTM (later than many would cover), he/she would have a losing trade and may conclude that this was a bad trade and that it was handled poorly.  Especially if the trader pays attention to what would have happened (I suggest not doing that).

In reality, it was the same trade and cannot be good part of the time and a poor choice at others.  Either it was suitable for this trader, done in the right size, had a reasonable risk/reward ratio – or it wasn't.  In this extreme example, it's risk management that made all the difference.  And to make matters worse as a learning example, it was poor risk management that led to the profitable trade.

Thus, profit or loss is not the deciding factor.  It's not to be ignored, but there are other things to consider.

Please use judgment when evaluating your initial positions.  Do not allow the final monetary result to enter into the decision-making process. Take your time.  Collect data and learn to read your own body.  Discover trades that make you comfortable and those which don't. Most traders sense when there is too much risk.  That could mean 'too likely to lose money' or 'too much money can be lost.'

That trader must also try to judge how well risk was managed because that's going to be an important factor in the trader's future profitability.  When first beginning to use options in a virtual account, it pays to take notes and try to gain something from every experience.  In reality, it's not easy to understand just what was done correctly (with the odds of success on your side) and where luck (good or bad) played a role.  However, the trader does accumulate knowledge as time passes. As he/she understand the trades better, the opportunity to ask questions accelerates the learning process.

Bottom line:  There's data to collect, experience to gain, and time before a new trader can know him/herself well enough to place money at risk.

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What is a good trade?

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Mark,

What do you consider to be a good trade? It seems a lot of this post
is about making good trades regardless of money gained/lost. But how
does one define a good trade? Adhering precisely to your plan? Honoring
risk management accurately? It seems quite possible to present
exceptions that would make a "good" trade seem like a bad trade.

How do you characterize a trade as good?

Thanks,
Burt

***

Burt,

Ultimately, trading is all about making money.  To do that, you must make trades that are statistically valid.  That means taking risk, reward, and probabilities into consideration, the trade is worth making.

First, when talking about a trade, we are talking about the action of entering an order and getting filled.  That is making a trade.  It's a good trade if it meets certain conditions and is a poor trade if it fails to meet those conditions.

If you decide to make an adjustment, that adjustment trade can be ranked as 'good' or 'bad.'

However, the whole process of making the trade, i.e.,opening, holding and then exiting can also be considered to be 'a trade.'  That is not what I am discussing here. That is one reason why profit and loss are not considered.  Thus, if we want to discuss whether it's a good trade by the second standard, much more must be discussed.  For example, you asked about sticking with the plan and exercising good risk management.  Those are very important to long-term trading success, but have nothing to do with making a trade by the first definition. Yet each is very important to 'making a good trade' by the second, more inclusive, definition.



1) A good trade is one that you want in your portfolio.  It is not a random trade idea recommended by someone else, nor is a borderline trade that you wanted to try – just for the fun of it.

2) A good trade is always sized properly.  That means a worst case scenario doesn't result in a loss that is greater than you are willing or able to handle

3) A good trade has enough of a reward that it is worth seeking.  In other words, it cannot be too small to be worth the effort.  Selling OTM options for 5 cents, paying a commission, tying up margin, and waiting one month to collect what remains of that nickel is not a sufficient reward

4) That reward must be worth seeking when considering a) the probability of earning the reward and b) probability and size of the potential loss. 

If you make a trade with a 70% chance of earning $100, a 20% chance of losing $900 and a 10% chance of losing $300, this is not a good trade. Why?  On average, every time you make this trade, your expected loss is $140.

If you have a 70% chance to earn $300, a 20% chance to lose $700 and a 10% chance to lose $200, it is a good trade because your average expectation is to earn $50. 

To me, a 'good trade' is one that fits within your comfort zone, has a profit worth earning, has an acceptable level of risk, and the numbers (statistics and probability) justify the trade.

A good position (and that means the trade at a later point in time) must meet all the criteria of a good trade.  There is no point holding a position that you hate or one that you would never considering opening as a new trade. [I concede that there can be a middle ground where you neither love it nor hate it and don't know whether to hold or exit.]  A good position must be managed well, and as you mentioned, adhere to the trade plan.

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