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.
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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.