Lessons from the Pros

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A Lesson from a Losing Trade

This article shall look at the perfect trade; at least it was perfect until the very last day.  We will analyze what could have been done differently versus what actually was done.

Trading credit spreads on the weekly options has greater advantage over trading the monthly options in terms of forecast, which needs to be accurate for a shorter time. The disadvantage of trading weekly credit spreads is that if the price action goes against you, there can be a significant loss. This is not surprising because risk and reward always go hand in hand. Back in February, I had a small position on that worked extremely well until the very last day when the market gapped up.

The position was actually an Iron Condor that was position-sized based on the Max Loss. The trade produced a credit of only 0.85 cents while the risk was so much greater: $4.15 to be exact. The wings were equal distance, meaning both strike price spreads were the same, five points wide. Once the trade was entered, the underlying was forecast to most likely remain trading within the sold strike prices. Those strikes were the 605 call on the upside and the 580 put on the downside. The protective legs are worth only a brief mention because they both would have gone out worthless had the trade worked out as anticipated. The sold 605 call was covered by the higher strike price, or 610 call; whereas the sold 580 put had put insurance at 575, which was the lower strike price. The bottom line for trading iron condors is that the underlying should stay within the range, in this particular case in between the 605 call and the 580 put. There are different ways of managing an iron condor trade.  Conventional teaching includes buying back the entire four-legged creature for half the Max Profit. For instance, if the sold iron condor brings in from both the Bear Call side and Bull Put side, a whole dollar then the Buy to Close (BTC) would be placed for the entire Iron Condor at 0.50 cents. In my case the credit was 0.85 due to low implied volatility and a sideways moving market.  The premiums were not rich enough, hence the skinny premium of only 0.85. Had I applied the conventional “wisdom” of closing with a BTC order of half the profit it would have been closed by buying it back at 0.40 because the underlying does NOT trade in penny increments but nickel increments.

Chronologically, let me go over the closing prices. The position was entered on Friday 01-27-2012 while the underlying was at $592.84.

Closing Prices Sold 605call Actual Price Sold 580 put
Monday 1-30-2011 Safe 594.51 Safe
Tuesday 1-31-2011 Safe 593.83 Safe
Wednesday 2-1-2012 Safe 598.02 Safe
Thursday 2-2-2012 Safe 598.54 BTC for a nickel
Friday 2-3-2012 ITM by 1.89 606.89 Closed

Figure 1

For the entire week, until the very last day everything looked good. The two closing orders were entered after the trade was opened as BTC orders for 0.05 on both the obligations. Notice in Figure 1 that the 580 put was purchased back for a nickel while the other sold leg, the 605 call was not filled. Besides placing the BTC order as GTC (Good ‘til Cancelled), I also placed an ALERT at those same levels. I had two alerts on, one if the price was trading at or below 580, and another one if the price was trading at or above 605. None of those were triggered until the very last day. On Friday, February 3, 2012, the ALERT for trading at or above 605, went off. Figure 2 shows the price action of Thursday and Friday with three minute candles. The 605 level, marked with a red horizontal line, was punctured on Friday morning.

Figure 2

At the time of the ALERT on Friday morning, the premium of the 605 call was trading at a much higher value than what the total credit of my Iron Condor obtained. In fact, the next figure shows the Time and Sales (T & S) for that particular contract. The lowest traded premium for the 605 call was a dollar, while the total credit, for the entire Iron Condor was only 85 cents.

Figure 3: Time and Sales of the 605 call on Friday 2-3-2012

By looking at the bottom T & S’s fourth (the Date) column we could see that the very first trade (1.00) was traded with 5 contracts at 7:07 PST and then the premium went higher. Had I placed a BTC for the 605 call at the market price when the underlying reached the 605 level or higher, then I would have paid more than just the intrinsic value of my contract. However, I have seen this situation so many times where the price reaches a certain level, such as 605, flirt with it for awhile (triggering the stop loss orders), and then suddenly turn around and head lower. By having the ALERT on, we as traders need to choose to manually manage the trade. The last figure shows, the order history of my 605 call trade management.

Insert Figure 4: Order History for the 605 call

Figure 4

Prior to placing another order to buy to close, we should cancel the existing BTC order. This explains the first line, the second line shows my failed attempt to buy back my obligation for 0.60 when the underlying was trading around $605.50. My order was in existence, visible to the CBOE exchange, but the reason why it did NOT get filled was that the Bid & Ask spread was too wide and there was still seventeen minutes of time remaining in the option. Rather than chasing it, which is a sign of getting emotional, I settled for the fact that my trade risk was position-sized based on the Maximum Loss so I consciously selected to BTC at the very end of the day, when there was no more time premium left. I took the full consequences for my actions and feel completely accountable for my decision. My thinking was based on the assumption that there might be some profit taking at the end of the week after such a strong “gap & go” move. I was wrong.

This realization was staring me in the eyes even in the last minutes of the trade. Hence, I entered a BTC my 605 call at the current underlying price ($606.80) just before the bell, which was 1.80 in premium value. (The trade is highlighted in Figure 3 in red.) I used a limit order and was able to get filled at 1.80 although the trade right after me, most likely a market order, got a much higher fill, or 2.00 to be exact, assuming that the trader was also BTC his 605 call contract.

In conclusion, it is a great feeling to make hundreds of dollars or thousands, yet ask yourself how you would feel if the opposite was the case. A trader should never be judged by the size of his/her position or solely by his/her gains. The professionals know that what really matters is how much money could have been lost on the trade, or how much money was at risk at any given time during the open trade. The question that a novice trader needs to focus on is: Are you going to be able to withstand the loss and still be back to trade the next trading session? Even if you do lose money on a trade, do not lose the valuable lesson that a losing trade can hold. Trading is all in the mind set and the risk management.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.