When The Market Goes Awry, Get Back To Basics

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When The Market Goes Awry, Get Back To Basics

Getting Back To The Basics Of Trading

The key to successful trading is consistency. You have to consistently execute your trading plan, taking care to follow strict entry rules, in order to gain an edge over the market. This edge should, hopefully, allow you to profit more often then you lose and to win bigger than you lose. Sometimes, times like these, even the most well-though plans can go awry and that is just a fact of trading.

When the market resets like this, when volatility is high and no asset is left unscathed, it pays to get back to the basics of trading. At the core of sound trading is money management and risk control, a factor I think contributed to the scale of the current market sell-off.

What is risk management, money management, and risk control? They are all roses of a different name, frameworks for how to treat a trading account, and the foundation of any successful trader’s arsenal of tools. To start, managing your trading account means preserving your capital. You can’t trade if you don’t have any money. The catch-22 is you can’t make any money if you don’t trade so you have to find a balance.

Most traders like to keep their trades small relative to the size of the account. A trade equal to 5% of the total account value may not sound like a lot but that size trade can whittle an account away quickly with only a few losses. For best results, trades equal to 1% to 3% of the account are best to ensure a long account life. Using a percent versus a set figure is useful for two reasons. The first is that your trade size will grow when your account grows so you make more profit with each win. The second is that the trade size shrinks with each loss so you lose less with each progressive loss.

Successful trader may choose to increase their trade size after a string of wins and that’s ok. A very successful trader may be comfortable with higher percentages like 5% for regular trading and that’s ok too. Successful traders also know that when volatility is up, and the markets are whipsawing like they are, it’s ok to reduce your trade size to reduce your risks.

Another tool for traders is the leverage. You may think of leverage as a gift from the brokers but it’s not. Leverage is a two-edged sword you can use to cut your own head off if you aren’t careful. Just like trade size, it’s ok to reduce leverage when volatility is up. If you win, you are likely to win big and/or quickly and if you lose, well you won’t lose as much as you would have.

Get Some Perspective

What I want to leave you all with is the knowledge that losses happen and that’s ok, it’s a part of trading. What’s not ok is letting those losses wipe you out or getting discouraged. If you are having a hard time with the market, maybe it’s time to take a step back and get a new perspective. I know it’s easy to get caught up in the day to day grind. Taking a step back to see the bigger picture, take look at a different chart, or reassess the fundamental situation is often the best remedy. Winning is hard enough without throwing money away on bad trades or damaging losses.

What constitutes a market? Back to basics for CCI as its orders go awry

This year, the CCI has passed a string of orders ranging from suspected cartels formed by aviation companies to corner fuel to anti-competitive behaviour by a chess federation

Subhomoy Bhattacharjee | New Delhi Last Updated at October 15, 2020 05:30 IST

In a first of sorts for India’s regulators, the Competition Commission of India (CCI) has begun to reopen some of its past orders and has hired 24 reputed institutions to conduct surveys to help it understand what constitutes a market. The introspection has been spurred by more than one embarrassing court verdict staying its orders.

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The latest order is from the Delhi Bench of the National Company Law Appellate Tribunal (NCLAT). The NCLAT told the CCI it had made a mistake in penalising Hyundai Motor India a sum of Rs 870 million for alleged “anti-competitive .

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What To Do When Your Options Trade Goes Awry

Successful options trading is not about being correct most the time, but about being a good repair mechanic. When things go wrong, as they often do, you need the proper tools and techniques to get your strategy back on the profit track. Here we demonstrate some basic repair strategies aimed at increasing profit potential on a long call position that has experienced a quick unrealized loss.

Defense Is Just as Important as Offense
Repair strategies are an integral part of any trading plan. I always review a well thought-out set of “what-if” scenarios before putting any money at risk. Too often, though, beginner options traders give little thought to potential follow-up adjustments or possible repair strategies before establishing positions. Having a great strategy is important, but making a profit is highly correlated with how well losing trades are managed. “Play good defense” is my options-trading mantra.

Fixing a Long Call
Many traders will buy a simple call or put only to find that they were wrong about the expected movement of the underlying stock. An out-of-the-money long call position, for example, would experience immediate unrealized losses should the stock drop. What should the trader do in this situation?

Let’s examine a simple long call example, which demonstrates a concept that you can apply also to a long put. Suppose it is currently the middle of February and we believe that IBM, which at 93.30, is poised to make a move above resistance (the upper green line in Figure 1) at about 95. We have good reason to jump in early with the purchase of a July 95 near-the-money call. With about 150 calendar days left until expiration, there is plenty of time for the move to occur.

Figure 1 – IBM daily price chart showing medium support/resistance levels.

But suppose, not long after we enter the position, IBM gets a downgrade and drops suddenly, perhaps even below medium-term support at 91.60 (the lower green line in Figure 1) to about 89.34. The price of the July 95 call would now be worth about $1.25 (assuming some time-value decay), down from $3, rendering an unrealized loss of $175 per option. Figure 2 presents the profit/loss profile of this trade.

Figure 2 – IBM July 95 long call profit/loss.

With so much time remaining until expiration, however, it’s still possible that IBM may reach and surpass the strike price of 95 by Jul 16, but waiting could add additional losses and present additional opportunity costs, which result from our forgoing any other trade with profit potential during the same period.

Initial IBM Price July 95 Call Purchase Price Lower IBM Price Lower July 95 Call Price July 90 Call Price
93.30 $3.00 89.30 $1.25 $2.75

Table 1 – Options prices before and after IBM price change.

One way to address unrealized loss is to average down by purchasing more options, but this only increases risk should IBM keep falling or never return to the price of 95. Actually, the breakeven on the original July 95 call, which was purchased for $3, is 98. This means that the stock would have to rise by nearly 10% to get to the breakeven point. Averaging down by purchasing a second option with a lower strike price, such as the July 90 call, lowers the breakeven point, but adds considerable additional risk, especially since the price has broken below a key support level of 91.60 (indicated in Figure 1).

One simple method to lower the breakeven point and increase the probability of making a profit without increasing risk too much is to roll the position down into a bull call spread. This is a strategy presented by options educator, Larry McMillan, in his book, “Options as a Strategic Investment”, a must-have standard reference on options trading.

To implement this method we would place an order to sell two of the July 95 calls at the new price of $1.25, which amounts to going short the July 95 call option since we are long one option already (selling two when we are long one, leaves us short one). At the same time, we would buy a July 90 call, selling for about 2.90. Table 2 presents the price details:

Transactions Debits/Credits Cumulative Net Debits/Credits
Buy July 95 call -$300 -$300
Sell 2 July 95 calls +$250 -$50
Buy 1 July 90 call -$275 -$325

Table 2 – Transaction details of rolling down into a bull call spread

The net result of this adjustment into a bull call spread is that our total risk has increased only slightly, from $300 to $325 (not counting commissions). But our breakeven point has been lowered considerably from 98 to 93.25, a drop of 4.75%.

Suppose now that IBM manages to trade higher, back to the starting point of 93.30. Our bull call spread would now be just above breakeven, with a potential profit as high as 95, although limited to just $175 per option. We have, therefore, lowered our breakeven point without adding much additional risk, which makes good sense.

Alternative Repair Approach
Another repair attempt (which can perhaps be combined with the one above) is to roll down into a butterfly spread when IBM falls to 90. With this strategy we sell two July 90 calls, which would be going for about $4 each, and keep the July 95 long call, and then buy a July 85 call for about $7.30 (assuming a little bit of time-value decay in these numbers).

Transactions Debits/Credits Cumulative Net Debits/Credits
Buy July 95 Call -$300 -$300
Sell 2 July 90 Calls +$800 +$500
Buy 1 July 85 Call -$730 -$230

Table 3 – Transaction details for roll to a butterfly spread.

The total risk actually decreases on the downside since the total debits fall to $230, but there is some limited upside risk should IBM move back above 92.65 (breakeven). If IBM goes nowhere, however, the trade actually produces a nice profit, occurring between 87.30 and 92.65. The profit/loss table below presents our different scenarios for this repair strategy:

IBM Price At Expiration Profit/Loss
85.00 -$225
87.30 Breakeven
90.00 +$264
92.65 Breakeven
95.00 -$235
100.0 -$235

Table 3 – Profit/loss details for butterfly spread repair strategy.

Meanwhile, maximum potential losses are $235 (upside) and $225 (downside). Maximum potential profit is at 90 with $264, and profit decreases marginally as you move toward the upper and lower breakeven points, as seen in Figure 3.

Figure 3 – Butterfly Profit/Loss Profile

Combining the Repair Strategies
Since this is a butterfly spread, maximum profit by definition is at the strike of the two short calls (July 90 calls), but movement away from this point eventually leads to losses. Therefore, the best overall approach might be to mix our two repair strategies in a multi-lot repair approach. This combination can preserve the best odds of producing a profit from a potential loser: the bull call-spread repair has a profit from 93.25 up to 95. And, there are ways to adjust a butterfly spread given moves of the underlying (a topic that would require a separate article).

The Bottom Line
We’ve looked at two ways (which might best be combined) to adjust a long call position gone awry. The first involves rolling down into a bull call spread, which significantly lowers overhead breakeven while preserving reasonable profit potential (albeit this potential is limited, not unlimited as in the original position). The cost poses only a tiny increase in risk. The second approach is to roll into a butterfly spread by keeping our original July call, selling two at-the-money call options and buying an in-the-money call option. Whether used alone or in tandem, these repair strategies offer some flexibility in your trading plans.

There will always be losses in options trading, so each trade must be evaluated in light of changing market conditions, risk tolerance and desired objectives. That said, by properly managing the potential losers with smart repair strategies, you stand a better chance of winning at the options game in the long run.

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