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 #2 of 4.*
-----Original Message-----
From: Thomas G.
Subject: Trades
Robb,
Hope all finds you well. I have a few questions from my recent trading.
- 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?
- 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. Editor's Note: We will show the answer to this question this week and the answers to the remaining two questions over the coming weeks.
- On lower lows, is it a closing low or just a lower low during the day?
- 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.
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 #2 below. We will show the answers to the remaining two questions over the coming weeks.
Verticals – Vertical spreads are great for managing and sitting through volatility. If there is anything I have seen over the years, it is that volatility is the biggest contributing factor to why most traders end up losing money. For the most part, even an intermediate trader is quite good at identifying trends, reading charts and identifying entry points.
For example, let's say there is a stock trading at $50 and a trader buys 500 shares of that stock. He puts in a stop at $49 for a projected loss of $500. The very next day, the Fed President says something that the markets don't like and the stock plunges to $48 before recovering back to $50 later in the day. The trader's stop loss kicked him out of the position on the quick drop down, even though the stock quickly recovered back to the original $50 entry price.
As an alternative, the trader could have utilized a vertical spread position sized for $500 max loss. By doing so, the trader may now sit comfortably through the $50 to $48 to $50 volatility since there is no stop loss in place.
The downside to using a vertical spread is exactly what you pointed out: When the stock moves your way early in the trade, you don't get a lot of realized profit on your vertical spread and you typically need to hold the position into option expiration to get all the benefits of the remaining time decay. This leaves you open to having a profit on a trade only to see the trade reverse and give back that profit – and even possibly move into a loss!
The mistake that many traders make is they take their winning spreads off at 50% profit, but leave their losing trades to lose 100%. If you do this, you will need a long-term win/loss ratio above 75% to be profitable, which is pretty much impossible.
So, if you do something before expiration on verticals, make sure that it is equal on both sides. My own personal rule is that I will take profits on a vertical spread at 80% of the max potential gain if there is more than 2 weeks left to expiry. The premise is that I can take that capital and reinvest it in a trade for that same month. At 2 weeks or less to expiry, my rule is that everything goes to expiration (unless I need to make an overall change in the portfolio’s bullishness/bearishness).
Specifically, on your CAT trade, I suggest that you look at weekly options if you find yourself good at calling 1-2 weeks, but are not confident on your abilities after that.
Hope this helps.
Robb
* NOTE: Some original wording has been modified for legibility.
