Position Management

Options Sage submits:

Over the past few weeks we have discussed virtual portfolio management with respect to different account sizes.   In this week's article, we'll concentrate on position management within a virtual portfolio.

Before we kick-off, take a moment to reflect on your accuracy timing the market.  Ask yourself "For every 10 trades I make, how many times do I get the direction right first time and hit my target?"

If your answer is 5 out of 10 or above then you are likely to be very profitable at the end of the year providing:

1. You cut your losing trades quickly.  For example, a 20% maximum loss on a full postion  (see Trade Entry below).
2. At least one of your five winning trades is big winner.   For example, a single 100% gain could offset the five losing trades.
3. You take remaining four winners off the table, banking at least 20% on each. 

Unless your answer was 10 out of 10, timing the market perfectly 100% of the time is the holy grail of trading which means, no matter what, you should NEVER EVER, EVER ENTER A FULL POSITION WHEN YOU START A TRADE!

By committing all the capital you have allocated to a position at the beginning of a trade, you are falling victim to the sin of arrogance.   It is equivalent to a declaration that the moment in time that you chose to enter your position is THE PERFECT TIME to enter the trade and that there is NO CHANCE that you could be wrong!  

Since we acknowledge how challenging it is to achieve a winning record of trades even with dedicated due diligence, we should make every effort to weigh the probabilities in our favor and one of the simplest ways of doing that is to keep in mind the old phrase:

"The Trend is Your Friend"

In fact, Phil and I are both generally averse to entering positions when the underlying security is moving in the wrong direction (or indeed when the market/sector is moving in the wrong direction).   There are exceptions, of course, when we will trade as contrarians (often at the ends of trends, sentiment extremes, divergences between fundamentals and market action and so forth).

In fact, Phil sometimes will pursue a position doggedly when he is convinced his due diligence is correct.   For example, TSO this week one of those trades that has been working against him for some months yet a small victory was claimed during the week when Phil opened "Thrilling Thursday Morning's" article with the eureka statement "I am in a GREAT mood today.  TSO missed!  I knew they would miss (see last 50 posts!) and I knew I would regret being forced out of my $120 puts yesterday but we redeployed the capital to great effect on longer puts and a spread"

Although these moments of vindication are worth all the effort and persistence, Phil and I are both much happier when we are right first time!   Although it may seem like an obvious statement, it's worth highlighting the reason behind the statement is the difference between returns and rates of return.

In my experience, most traders I come across ignore the subtle but huge difference between returns and rates of return.   For example, if you ever were on the message board and saw a comment that stated "I only made 30% in 4 days" you know that the person who wrote that has been invaded by greed demons and is forgetting that if they could make 30% every 4 days they would likely be in Tahiti by the end of the year sipping pina coladas and would never ever have to worry about money again!  

As much as we love being right even after we're initially wrong, we should always focus on doing as much due diligence as we can upfront to ensure we are right first time in order to improve our rates of return.

See-Saw Trading

Despite our best efforts at conducting smart due diligence, the market will often prove us wrong!   This is so hard for most of us to accept that it's worth repeating internally "I will be wrong, my account value will suffer and I accept that as a fact of trading!"  That doesn't mean it's okay and you will be happy, it just means it will happen and it's a big red flag to go take action!

If you are a relatively conservative trader, have weighted your virtual portfolio towards longer term plays and/or are relatively inactive (trade on a weekly/bi-weekly/monthly basis) then the 'See-Saw Trading' approach to position management is worth considering.

See-Saw Trading involves the following steps:

1. Analyze the market as a whole and determine a 1-2 year outlook .  More often than not this will be bullish (or potentially stagnant/bullish). 
2. At opportune moments (fundamental discrepancies, sentiment extremes, technical bullish reversals), commit to long-term trades that align with market expectations and those of the security in which you are taking a position.  These opportunities present themselves infrequently so it doesn't require very active trading.   It does require decisive action when the moments appear though!
3. Determine objectives (% gain, price level etc.)
4. Scale-in.   See Phil's strategy section.  Depending on capital traded, you could consider entering in tenths, fifths, quarters, thirds or even halves.  In general, the more capital you have the more you want to scale in.   With lower capital amounts, commissions could cannibalize gains if scaling in tenths was executed.
5. Ignore small fluctuations.   Stocks will go up and down and the fact that a stock is moving against your long-term play on any given day should not be a cause for concern unless it is accompanied by some significant news event that detrimentally affects the company or a news event that is likely to detrimentally affect the company is imminent ( e.g. earnings).
6. When uncertainty reaches a peak – earnings is a prime example as seen by peaks in options implied volatility – hedge aggressively.  This might mean maintaining the original bullish bias but minimizing the degree of bullishness through hedging.   For example, when earnings is imminent, long calls could be hedged with long puts, stocks hedged with long puts and/or short calls and so forth.
7. If a trend moves continues moving against the original position, continue adding further hedging until the position is effectively unbiased – neutral .  This means you cannot make or lose much money on the position no matter which way it moves in the short-term.  And it's much better to hedge heavily and not lose money and give up some potential gains if you're wrong then to remain stubborn and watch the position continually decrease in value as the position keeps going against you.
8. If the market proves you wrong, change direction!   By now you've already added so much hedging that a little more will tip the see-saw in the other direction and you will move from being biased bullish to biased bearish.  
9. Exit the trade when you have got your money back!

See-Saw Trading works well if you are not perfect at timing the market.   Not only are you committing capital in chunks and hence allocating capital to the position by scaling in but you are committing to hedging in chunks also and so you are unlikely to be faked out by short-term flushes and pullbacks.   In fact, it's really not until a change in direction has been established and confirmed by the market that you will be changing your bias. 

See-Saw trading is considered to be a reactive form of trading.  For those of you that like to be more active and can spot moves just before they occur or as they are occurring then the next section is for you!

Mattress Plays

As a more active trader (or a trader trying to take advantage of short-term or more aggressive plays) you can approach your positions in a more pro-active manner.   For example, if you are concerned about a market correction you could rapidly jump on board some mattress plays.  Mattress plays refers to the concept of protecting yourself as gravity pulls you from orbit towards the ground.   Just imagine that you are falling and falling and every 100 feet or so you know the impact upon hitting will be more and more severe so you will need more and more protection!  

One way to protect your virtual portfolio is through index put options.  These are often pre-emptive plays that can be initiated 'just in case'.   On Friday afternoons you will often see Phil take some mattress plays just in case some dramatic news hits the wires over the weekend or Asia sells off triggering US panic Monday morning or whatever…   

Mattress plays offer a means of mitigating risk and simply cushion against some of the loss in value from positions biased in the opposite direction.   In general, my rule is that if an account is overweight technology then the QQQQs offer most appropriate protection, if an account is overweight DOW stocks then the DIAs are most suitable and if the account is broadly diversified then the SPYs are worth considering.

Phil has a different take as he will attack what he considers the most vulnerable index on the off chance he can pick up a bonus on a pullback – currenltly he sees the Dow as ripe for the biggest fall but you'll note he did pull his QQQQ longs on Friday as well.

Although these mattress plays can be entered into through scaling, when the market aggressively sells off, my general rule is to purchase an equivalent number of index put options to shares in my account.   For example, if my account comprised 10,000 shares of technology companies I would purchase 100 puts on the QQQQs usually at-the-money or slightly out-of-the-money.   This is a nice way of protecting oneself heavily before purchasing puts against each stock position individually.

Trade Entry

Phil's comments on entering positions are as follows:

"I do not generally enter a position when it is moving the wrong direction or if the market/sector is moving the wrong direction . I rarely take a full position right away. Generally, out of the list I share with you, I look for ones that go the WRONG way and then (after I check news and other factors to make sure my assumptions weren't wrong) see if there is an opportunity to jump in as a contrarian, getting my options cheaper than I planned.

"When entering a position I generally have a goal, say 100 contracts that I want to buy for my watch price or less. I usually put in a bid a dime under the asking price and hope for a pullback on my first 10 contracts then wait to see which way they go. If it takes off the way I thought, I buy 10 to 30 more (depending on confidence, my target price, why it is moving (news)…) at which point I usually will wait a day to see where it shakes out.

"If a position goes my way quickly, this method means I only get 1/2 or less of what I intended but the profits usually make up for it . If it goes my way slowly, I build into a full position over the next few sessions.

"If a position goes against me quickly, I only lose say 20% of 10-30% of what I intended to bet so I'm not devastated. At this point it gets complicated because I re-chart, recheck and generally rethink but sometimes I will wait a bit (an hour, a day, a week) and add to my position at the lower price, reducing my base cost.

"As a rule of thumb, if I'm not willing to put in more money when I am 20% down then I kill the trade entirely . At that point, I either move on or target a new entry, perhaps at 50% down but with options I often need to move into the next bracket by then (like an LVS trade we made where I started with $50 puts, which got smoked, and ended up with 150% of my original target in $55 puts).

"Always be aware of the premium you are paying for an option and how the time value of the premium deteriorates every day . If, for example, you buy TXN calls 1 month out for a $1 premium, you are automatically losing .05 per session in time value. Unless you have a very good reason to think the stock will gain more than .05 every single day for the next month, you are just letting money drip away from you!

"My goal in buying an option is almost never to hold it to expiration. Generally, on short-time contracts, I am playing for a swing in the equity price (or just the implied volatility of the contract) that will net me 20%"

Law of Freight Train Trading

Well just as Phil believes his Microwave Oven Theory of Behavior was worthy of Nobel Prize consideration, so too did I expect my Freight Train Trading theory was going to be highlighted at a fancy ceremony in Oslo.  As it turns out we had both arrived at similar conclusions as to what makes a successful trader – just through different analogies!

The Law of Freight Train Trading states:   "If you commit to an action at some point in time (such as standing on railroad tracks for a 60 minute period) but discover new information subsequent to that point in time (such as an oncoming train) that necessitates reconsidering the original thesis, then it doesn't matter how close you are to hitting your goal (even if you only have 1 minute to go to reach your target), get the heck out of your current position as quickly as possible or at the very least take action to account for the new information (or else the train will roll right over you!).  

It's all well and good to set 30% as your target or some price level as your exit point but if the stock market disagrees with you then exercise discretion and get out of the position quickly or hedge aggressively.   When disaster is impending and you know it's impending, it's not going to serve your account whatsoever to remain with the position.  In fact, it simply acts to keep you in the trade longer and hence diminish your rate of return.

Indeed Phil comments "If you can do that, you can beat the market because 95% of the people you are trading against cannot let go of those arbitrary targets they set for themselves when circumstances were different." Also keep in mind Phil's statement: "No one ever went broke taking a profit or a small loss! Learning to lose is probably the most important part of trading. When I'm wrong, I'm wrong. I get out and move on, end of story."

Stay flexible and have a great week!

OptionSage