The Importance of Having a Trading Plan

Mark,

In my last post I explained how I am in my second month of trading
spreads. I also explained that for this month I entered the call side
first and entered the put side last Friday. As you continue to point out,
the key to being successful in these spreads is how you adjust (or NOT
adjust) not just whether you make or lose money.

At this point, I could
exit my call side (these are May index options) for about a 60% of
max profit. If I exited my put side I would probably lose most of that
profit, and have a slight gain from the whole transaction. the delta on
my puts are about .06 so I am not at risk at this point.

How would
you normally handle this situation? There are many "options" I see, but
most likely are:

1. Close all positions, take a small gain

2. Close the Calls for a 60% of maximum profit and either

a) sell a new call
spread to try and bring in more premium; or

b) do not sell a new call
spread and wait and watch the put spread

3. Do Nothing

Scott

***

I've previously explained my personal methods.  They suit me but may not suit you.

1) The point of adjusting is to prevent loss and to give yourself an increased chance to earn profits going forward


2) When you opened this trade, did you have a plan?  Did you have some idea of WHEN you hoped to exit or HOW MUCH you hoped to earn?

Having such a plan makes these decisions so much easier.  The fact that you lack a plan is why you are asking questions now.

The plan is not the absolute final word.  You can be flexible.

Would your plan call for exiting now at a small profit?  If not, why are you considering doing that?  Are you afraid?  Are you outside your comfort zone?  Do you fear a rally – is that why you want to repurchase the calls?  You cannot expect to be able to continue trading when you don't know he answers to these questions.


3) I always exit my 'winning side' regardless of whether the 'losing side' is in serious trouble.  The problem is when to exit and how much to pay.  I trade my iron condors, collecting about $3 credit.  I close almost any spread at $0.15, and will bid as much as $0.25, depending on circumstances.  That's my plan.  Decide what your plan is.

I don't care about 60%. That's not enough information.  For example, if you sold @ 10 cents, would you pay 4 cents to cover?  You'd lose money after commissions. 

How much would it cost to cover?  That's the key issue.  Are you willing to take the risk of remaining short this call spread at its current price?  If yes, then do nothing.  If you are a bit concerned, then consider covering a few of your short call spreads.  Enough to move you back withing your comfort zone.

If you are covering because you are bullish – that's okay, if you want to trade with a market bias.  There is nothing wrong with doing that.  It's your money.  But be certain that's what you want to do.  There is no shame is risk avoidance.

Selling another call spread is a legitimate way to play this.  But I dislike that idea.  I prefer to establish a plan and not increase risk at any time.  Selling a new call spread brings the position back near delta neutral and that is desirable for many traders. 

I prefer to be satisfied with my target profit – if I can get it – and not be greedy.  To me, selling new call spreads just sets up the possibility of a huge whipsaw.  You are too new to do this.   One major decision you must make:  how much extra cash must you take in to make this trade worth the added risk?  You are too inexperienced to have a good idea.  I recommend saving this idea until you have proven that you can manage risk well enough to take the chance of increasing it.  That does not mean six months.  Take your time.

Keep in mind:  Some extra cash from call spreads provides very little protection if those put spreads get into trouble.  That's why I don't like selling replacement spreads.  Too little to gain, too much chance of losing.

When I cover a call spread, I almost never sell other call spreads as a replacement.

4) If you have no plan write one right now.  Look at your position as it exists right now and make some decisions:

  • When do you hope to be able to exit?
  • How much would you like to pay when that time comes?
  • How flexible do you want to be in the above goals?
  • How much are you willing to pay to exit the call (put) spread?  How much is cheap enough?
  • Does time remaining prior to expiration affect that low price you are willing to pay?
  • When do you plan to take a good look at risk?
  • How high must the delta of your short option be before you plan to adjust; or
  • How much money must you be losing before planning to adjust; or
  • How much time must pass before you would consider exiting the whole thing at a small profit?
  • Anything else that occurs to you

The trading plan offers guidance in making a difficult decision under stress.  If you already have a plan in place, you can execute that plan. 

As a beginner, the more guidance you can provide for yourself – in advance – the easier it becomes.  A good exercise is to look at that plan daily and decide if it's still good, or whether you should revise it.  The point is for you to THINK about your positions frequently and make a plan often.  It is NOT to change the plan.

The plan gives you more confidence because you have already thought about what's important.

It truly helps manage risk.  It makes decision-making easier.

668


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4 Responses to The Importance of Having a Trading Plan

  1. Scott 04/19/2010 at 2:01 PM #

    Mark,
    Thank you very much for this very detailed response. A lot to absorb and very insighful. I am purposely trading money that is Well within my comfort zone, but is still real money, so I am trying to build a better understanding for the day where I put more money at risk (of course still in my comfort zone. Thanks again!!

  2. scott 04/19/2010 at 9:47 PM #

    Mark,
    I have read your post about 20 times trying to absorb each of your points. Of course the key aspect is the “trading plan”. Part of why I am trading relatively small money right now is so I can start formulating my trading plan for future trades. Many would say I should paper trade, however, I believe that paper trading is no substitute for how you behave when real money is being traded. The reason I did not have as in depth a trading plan as I should is in part because with each of these trades I am seeing all that needs to go into the plan. This in by no means an excuse for not having a plan, just trying to explain that for traders new to this strategy its not easy to fully appreciate what will go into that plan (if that makes sense). One thing about your post, you mention that you don’t like the idea of covering the spread and adding a new call spread because of the increased risk. I saw this a bit differently. By covering the spread and making a nice profit, when selling the next spread I felt as though it would be decreasing the risk. The original put premium plus the new call premium plus the profit in pocket could reduce the overall risk of the position by a fairly significant amount. Am I seeing this incorrectly?

  3. Mark Wolfinger 04/20/2010 at 8:27 AM #

    Scott,
    Hre is one point I never mention: As a rookie, you have lots to learn. It cannot all be distilled into a short post or response. Take it one step at a time. I;ve tried to provide a lot of information below. Bu this should take several full posts.
    Trading with real money – when it represents a SMALL portion of your account value is fine.
    If you want to experiment, you can use a paper account – just to see how something would have worked or perhaps ‘I’d like to try this variation’ etc.
    Trade Plan:
    Start simple. Make a couple of guidelines for yourself regarding profit. Or risk. Or anything else that occurs to you. Do not try to make it all-inclusive. Each month you may find something new to add to the plan.
    Decide if you are someone who wants to hold as long as possible – perhaps through expiration. Or decide to exit when risk/reward is not favorable.
    Plan a target profit.
    Decide if you will grab that profit as soon as it’s available, or if you will try to milk it for another couple of days.
    Decide how much to pay to exit a winning side.
    That’s stuff is easy. Especially when rules are not written in stone. But don’t get too flexible or else there is no plan.
    You are not seeing anything incorrectly. But please, do not think in terms of profits. Think in terms of current risk and current reward. You will not survive if you think of ‘profits.’
    You do not own two different spreads. You own an iron condor. A big ‘profit’ on one side is often accompanied by a big loss on the other.
    You exit one side as a ‘winner’ with big profits. I prefer to look at it as exiting one side just because there is so little to be gained from holding, that I exit the trade. I don’t expect this to lead to additional profits, but just in case the market reverses, I don’t want to face the risk. For me it’s ‘facing that risk that’s important. Thus, selling a new call spread to replace the old one does add that new risk.
    Yes, selling a spread and collecting $100 or some other number does add to profit potential. But it also introduces new risk when the market moves higher. I will no longer do that. Why? Two reasons: 1) profit: Too little to gain, too much to lose; 2) psychology: It hurts me to get whipsawed. I don’t mind losses, those are part of trading. But a whipsaw hurts me deep inside. Thus, I avoid it. You don’t have to avoid it, but I do.
    Forget ‘old put premium plus new put premium.’ Forget that. Here’s a valuable lesson (lesson of a lifetime) for free: Look at the position this way:
    When you sell the new call spread, you have a new trade. It’s the CURRENT price of the put spread plus the CURRENT price of the call spread. Do you love that position? Do you want it in your portfolio? Unless the answer is ‘YES,” don’t do it.
    Regards

  4. scott 04/20/2010 at 8:37 AM #

    Mark, thanks again