By: Steve Smith
Unfortunately, losses are an unavoidable part of options trading. However, our discipline and risk management will hopefully minimize our losses. A disciplined approach to risk management is the most important (and perhaps difficult) things you can learn.
Taking and dealing with losses is not the fun or glamorous part of the job, but learning proper risk management is crucial for long-term success. A big part of this is removing ego, admitting we were wrong, and cutting losers early.
So, while I don’t want to be a Negative Nancy, especially as Options360 experiences to a 21% year-to-date gain while SPY is down 15% YTD, I think it’s important to show the process of how, why, and when I take a loss.
And since every trade is independent of the one (winner or loser) that came before it, I take note of what I did wrong to learn from my mistake, and I never look back.
The best way to show you what I’m talking about, and give a peek at what you receive as a member of Options360, is to show an example of a trade alert.
Here is an alert I sent last week on September 7: (Don’t put this trade on now…)
Deere (DE) makes farm equipment.
Not sure what the state of that industry is – relatively strong commodity prices accompanied by higher costs and uncertainty over supply/demand dynamic.
Also, a strong dollar makes DE, which makes 35% of sales overseas, susceptible to currency impact.
But this bear trade mainly rest on the chart.
I’m not a big ‘head & shoulders’ guy, but if the formation is gonna work, this is a good set up.
The key to believing in the H&S is having the right shoulder break the left shoulder… which should lead to lower prices.
DE carries a high ticket price making any trade at the threshold of my comfort level in terms of asset allocation.
But, we will manage this tightly; initial stop loss is a move above $388.
The trade recommendation is a form of risk/reversal, buy a diagonal put spread and a credit Sep. call spread.
Note the different expiration dates being used.
- Buy to open 1 contract Nov (11/18) 360 Put
- Sell to open 1 contract Sep (9/16) 355 Put
- Sell to open 1 contract Sep (9/23) 395 Call
- Buy to open 1 contract Sep (9/23) 405 Call
For a Net Debit of $14 (+/-0.20)
Seemed like a great setup, and as you can see, I took an aggressive approach, using a combo of bearish put spread with a bearish call a spread.
In fact, the $1,400 net debit understates the risk; the credit call call spread makes the max risk close to $2,200. That is four times the typical $300–$600 I allocate to most Options360 trades.
I loved the setup and put my money where my mouth was.
However, I’m not going to be stupidly stubborn.
Two days later, DE gapped up, signaling it was time to pull the plug.
As I wrote to members in the follow up alert:
DE has gapped above the 20 EMA and the head & shoulders formation has now been invalidated.
I don’t want to go down the path of chasing this for a month of adjustments.
I was wrong. Time to move along.
We ended up taking a 10% loss. Not fun, but a necessary part of the long term process of producing consistent gains.
It is best to cut your losses early and prepare for the next opportunity rather than watch your losses run away on you. Cut and run, even if it wasn’t the right move, we live to trade another day.
When I see the stock down over 3% today, I could go back and question my judgment, however, I quickly remind myself the first directive of money management is do no harm.
The second is, as Bob Dylan sang, don’t look back.
That trade is no longer ours, and the market is never short on opportunity. Focus on getting our minds right, so we can take on the next day with no emotion or bias. We take what the market gives us.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.