Tuesday, September 29, 2015

Diagonal/Vertical Spreads + Portfolio Risk (Part 3 of 4)


From Our August 2015 E-mail Archives: One of our traders sent a multi-question email about his recent trading. Our Head Trader, Robb, answered with a 1,500-word reply. No one can ever say that Robb is a man of few words! So, we are breaking up the original email into four parts. Today, we present the reply to Question #3 of 4.*


-----Original Message-----

From: Thomas G.
Subject: Trades

Robb,

Hope all finds you well. I have a few questions from my recent trading.
  1. Diagonals – In my Trading Plan, it says that if I'm down on the diagonal option spread at expiration, then I either take the trade off the table or use lower lows to exit the trade. If I bought September and sold August and I'm down, then is there a way to sell against it again since I'm down overall in the trade?

  2. Verticals – In my Trading Plan, it says keep vertical option spreads until expiration to increase my R/R (Reward/Risk). So, when do you scalp these or take them early, if ever? I placed a trade on CAT this week: a 77.50 / 75 vertical. I'm up a little on the trade and I do believe it will get to 75. However, I'm not as confident in CAT staying below 75 until August expiration with it being this extended to the downside. Maybe I just picked the wrong strategy or time frame; however, if it were to bounce, then I can't just see holding it to a max loss...but I also don't want to cut my winners.

  3. On lower lows, is it a closing low or just a lower low during the day? Editor's Note: We will show the answer to this question this week and the answer to the remaining question next week.

  4. When I trade my account, I often have over 20% of my portfolio at risk. If I had less than 20% and I was trading at 2% per position, then I would have 6-8 trades on at a time. Are 6-8 trades of $3k-$4K invested at a time enough trades at a time? I'm over trading currently (I'm trying to work on that!), but I don't want to under trade either.
Sincerely,

Tom


-----Reply Message-----

Hi Tom,

Thanks for your questions. I’ll try to answer them as best as possible:
Editor's Note: Answer to Question #3 below. We will show the answer to the remaining question next week.

What makes a lower low – intraday or end of day? It actually doesn’t matter as long as you treat them both the same.

Let’s say that Trader #1 defines a "lower low" as intraday and Trader #2 defines it as end of day. Let’s also assume that there is price support of ABC stock at $50/share and that both traders have the plan to exit if/when ABC stock goes below $50 based on their criteria.

  • Trade Scenario #1: In this trade, the stock breaks below $50 intraday, but then recovers back above $50 by the end of the day. On the next day, the stock takes off to the upside. Trader #1 exited on the first day since his criteria was intraday while Trader #2 was still in the trade because her criteria was end of day. Trader #2 stayed in the trade and made a profit as the stock moved upward, while Trader #1 took a loss.

  • Trade Scenario #2: In this trade, the stock also breaks below $50 intraday and then recovers back above $50 by the end of the day. However, on the next day, the stock gaps down to $47 at the open. Trader #1 exited on the first day since his criteria was intraday, while Trader #2 was still in the trade because her criteria was end of day. Trader #2 stayed in the trade and exited on the second day at a significantly larger loss this time.

As you can see, there is no right answer since both of the above scenarios can occur. However, over 1,000 trades, both Trader #1 and Trader #2 will likely have very similar performance results if they stick with their criteria and are consistent. It’s why we stress at Maverick Trading that consistency is the most important thing in trading once you have developed your trading plan.

I personally use end of day since I have found there are a whole lot of emotions on days where the moves are big and pierce through support/resistance areas. I’ve found I make less mistakes when I use end of day.

Hope this helps.

Robb

* NOTE: Some original wording has been modified for legibility.