Taking Losses. It’s a big part of the learning process

hi mark,
 

a co-worker just told me that he was selling front
month credit spreads on index options all of last year and did "okay,"
but then got creamed in sept and oct and then again in jan of this
year. he said others that he knows of also suffered the same fate,
and as a result, he is no longer trading options of any kind.

this
hasn't discouraged me but i know there are important lessons to be
learned.

i am curious about how you (a pro and not a rookie
like my co-worker) did last fall of 2008. were there any special
precautions that you took and what signals were you watching that
warned of trouble?

 

as always, thank you mark for taking the time to answer my many questions 🙂

***

Debra,

Your co-worker has had the misfortune to begin making profits with his newly discovered strategy.  Sometimes getting off to a good start turns out to be the worst possible result.  Tadas, at abnormalreturns.com made the same point recently and his discussion is worth reading.

Too many quick profits can lead to overconfidence.  I've written about that problem once before.


Selling credit spreads is a high probability strategy.  That means the number of winning trades exceeds the number of losing trades by enough of a margin to instill confidence in the trader.  The problem occurs when the underdog wins, as it periodically must.  The good trader manages risk, never allows the losing position to get into enough trouble to result in the loss of a good-sized chunk of cash, and takes losses as necessary.

Taking losses is not always easy and no one likes to do that.  Especially when thinking: 'if the market only turns around, I'll not only recoup my losses, but earn a profit,as well.'  It's that wishful thinking, that out-of-place optimism that the good guys will win in the end that prevents the average trader from becoming successful.

It's also true that after you exit a trade and accept a loss,  many times the market reverses.  The way to keep score is not how often the decision to exit or adjust a position works vs. the number of times it proved to be unnecessary, but whether the decision to exit was a good one. 

To me, it's 'good' when it gets you out of a position that violates your comfort zone. When risk is too high, when your position is too large, when the cash at risk is too great, when your position makes you nervous – these are all signs that the current position is no longer suitable and it should be reduced or eliminated.  In fact, if any of those items is true, it's probably past time. 

Your rookie trader was too overconfident and chose to ignore risk.  He probably held his positions all the way through expiration and took the maximum possible loss for each trade.  One cannot survive very long doing that.  The sad part is that he may never return to trading options.  If he is incapable of learning to manage risk, then it's probably for the good.  But he never understood risk and was never given the opportunity to see what he could do.  He chose to trade first, and perhaps learn later. 

The good news for you is that you have seen a perfect example of what can happen.  We usually learn the best lessons when we take the loss ourselves.  You may be lucky here.  If you learn the hard lesson by seeing someone else bite the dust as a trader, you may be able to avoid that trap.

It's easy to make money when selling credit spreads.  The problem is that it's much easier to lose far more than you earn, using the same strategy.

***

I did reasonably well through most of 2008, but ended the year a small loser.  I owned insurance – enough to  generate profits, but somewhere it got away from me.  A market like that was perfect for my methods – when I'm using insurance.  But less than perfect position management, negated the profits.

For me, it's more proof that managing risk successfully is the name of the game.  Taking small losses and avoiding the big losses is all you really need to survive and prosper.  Of course, this assumes that when you are not taking losses, you are making good decisions and can generate profits consistently.

The precautions I took was in owning insurance. My current favorite method was described earlier

I had no inkling that the market debacle was coming.

507

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