By: Steve Smith
As promised, we’re introducing a new feature: A weekly video (watch it below) where I discuss the markets, look at current Options360 trading service portfolio positions and answer whatever questions you submit. Today’s inaugural episode includes a quick introduction of my background and the Options360 Concierge Trading Service’s “unconstrained” approach to trading.
Now, back to our regularly scheduled typing. I’ll keep it short today.
It’s been another week of heightened volatility. Hence, I’d like to cover a few basic rules for trading in this type of environment.
- Keep position size small. Proper position sizing is one of the easiest ways to control risk. If you usually allocate 3%-5% of your portfolio to each trade, reduce them to 1%-3% per trade.
- Reduce the number of positions. When the market gets volatile there is an increase in correlation among stocks and sectors. In other words, they tend to all move in a similar up and down direction. If you were leaning with the wrong bias, you want to avoid having too many positions suddenly go against you.
- Give more latitude for winners to run. This will allow for a smaller allocation to deliver profits comparable to your standard position size. Give stop-loss levels a larger cushion to avoid getting chopped up.
- Never, ever use a stop-loss order that triggers an options trade into a market order. You are basically opening your wallet for market makers to pick you clean.
For a good example, we can look at a Tuesday trade that Options360 made in Home Depot (HD).
The set-up was pretty straightforward; the chart showed important support at the $300 level; a good entry level for a bullish trade.
We used a basic vertical spread of buying 1 contract of the 300 call and sold the 310 call for a $4.10 net debit. Notice I only did 1 contract for a total cost and risk of $410; about 60% of Options360’s typical $550 allocation.
For risk management, I’d normally say any break of the $300 level triggers an exit. In this case, I gave a bit more room down to $298 for my “mental stop.”
HD shares gapped lower the next morning triggering an exit. I will typically wait five minutes before entering the closing order to see if the stock can quickly reclaim the stop level and also to let the bid/ask spread on the options tighten up.
This last item is important; an Options360 member entered a stop-loss order before the opening to sell to close the spread at the market price of shares dropped below $298. He was filled at $1.50 resulting in a 63%, or $260 loss. Meanwhile, members who waited for the Alert 5 minutes after the open, closed the position for $3.20 (22% or just a $90 loss) even though HD shares were actually lower than when his order was triggered.
He emailed me and I explained how the bid/ask during the opening minute or two of trading was a $1.50 bid at a $5.20 offer. You can tell by the $5.20 offer price, which was well above the $4.10 we paid despite HD shares being $6 lower than the bid/ask. His market offer went straight to the lowball bid and was filled. The spread never traded below $2.10 the rest of the day, even though the stock made new lows. It was a case of him simply not being familiar with the mechanics of the opening bid/ask prices. An error he won’t make again.
Of course, today HD shares are above $310, which means our spread would be fully in-the-money and worth about $7.00, or what would have been a nice 70% gain in three days.
This brings us to my last point; don’t ever look back in anger. Simply follow your rules, put past trades — both winners and losers — behind you, and look forward to the next opportunity.