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Trade Decisions: Risk or Profits?
Mark Wolfinger posted a article in Trading BlogAfter all, option positions are usually held until something happens. For example, the stock moves or time passes, or volatility changes etc. Any decision to exit (or hold or adjust) the position should be based on the current risk of the position. In other words: If you want to own the position as it is, then own it. If risk is too large, or profit potential is too small, or it you are not comfortable with the current trade, then do something: adjust, reduce size, or exit. If that play locks in a loss, so be it. That is not of primary importance. Any position that you hold must have the potential to earn enough cash to justify the risk associated with holding. Estimating the probability of success is one factor to consider when making the hold/fold decision. As long as risk is not too high – and that's most of the time – traders who sell time premium (trading iron condors for example) collect their profits as time passes. To be a profitable trader, you take your profits as they come, accept losses when that's the best decision, but don't concentrate on those factors. Instead, the key, and the most important item on which to focus is risk. That's the risk management skill that prevents large losses. That in turn translates into exiting risky positions, regardless of whether they are profitable or currently under water. Being willing to do whatever is necessary to get out of dangerous positions is the winner's mindset. Those who do not agree argue that failing to pay attention to whether a position is profitable before exiting gives the trader little chance for success. The thought is : If you don't trade for profits, how can you ever know when to exit a position? Here is a note from Christopher who takes the other side of my argument: *** Mark, The theory that profit and loss doesn't matter naturally assumes that you have a "perfect" assessment of the odds of a given trading position. In an imaginary world, whereby "current risk" can be measured to perfection, prior gains and losses never matter because we can always mathematically control our risk of ruin. In the real world nobody can perfectly gauge "current risk" and hence ignoring prior gains and losses can lead to ruin. Stop losses should be employed when we have reason to believe that our measure of "current risk" is in error. If you disagree, look up "Long Term Capital Management" for further evidence. Christopher Cole from Artemis Capital *** Hello Christopher, In discussing what role current profitability should play in deciding when to exit a trade, I was offering my opinion on how traders should manage position risk. The idea is that the inexperienced trader would benefit by following this advice because it overcomes a common blind spot. I was also hoping that the experienced trader may discover something he/she had previously overlooked. My point is simply this: Do you want to own any given position, right now, at its current price and under current market conditions? Nothing else matters. If you have no desire to own it, I strongly recommend closing. If that results in a loss, then that's the way it has to be. That's far better than continuing to hold a risky trade – planning to exit as soon as the trade turns profitable. I noticed a very timely blog from Felix Salmon regarding the US Government's decision to sell some of its shares of General Motors at the IPO price: "The next big tranche of bailout repayment funds, of course, is going to arrive tomorrow, with the upsized GM IPO. The size of the stake that Treasury’s selling has been growing impressively, and at this point it looks as though taxpayers are going to end up owning just 33% of GM, down from 61% right now. The more shares that the government sells in the low $30s, of course, the harder it’s going to be for Treasury to realize an average price of $44 per share for its stake by the time its last share of stock has been sold. That’s the point at which the government breaks even on the deal. But I’m glad that Treasury isn’t letting such considerations stop it—holding on to stock just because it’s trading below some arbitrary 0% return figure is simply speculating in the stock market, and it’s not Treasury’s job to be a stock-market speculator." You don't have to agree, but this discussion is hardly comparable to LCTM. I'm not talking about adding to the trade in gigantic size. They were absolutely certain that they were correct in their assessment. They grew the position size. They refused to believe that what they were seeing was real. And they had no real conception of risk because their risk-evaluation model was flawed. In their (brilliant) minds, they ignored one very basic principle for traders: "Markets can remain irrational longer than you can remain solvent." [John Maynard Keynes] Every trade eventually requires a hold/exit decision. When using options, an additional choice becomes available: hold through expiration. I don't believe it's a good idea to hold a loser, just because it is a loser. There's a time to own a position (potential reward justifies the risk) and there is a time to get out (risk too high when considering potential gain). I am certain that you recognize that not every trade can be a winner. Thus, holding losers with the hope of making every trade profitable is not viable. First, it will never happen. Second, traders would hold any poor (risky) position simply because he/she refuses to take a loss. I believe that a good trade decision does not have to take into consideration whether the current trade is showing a profit or loss. I'm not saying that you must ignore that factor (I ignore it), but it should not be the primary factor in your exit decision. Nor does the decision have to depend on an accurate assessment of future prospects. However, current risk is easy to measure when a trader adopts limited risk and limited reward strategies. I always know the best and worst possible scenarios and trade to avoid the worst case. To me, decisions cannot get any easier than that. How else can a trader manage risk? I either want this position in my portfolio or I don't. I may be unable to make a perfect assessment of the probability of winning, but I know how much can be won and lost. Why hold a trade when you have a negative opinion of future prospects? Just so you don't have to lock in a loss? That makes no sense to me. Here's an example of my bottom line: You can exit a specific trade by paying $100. How can it matter whether you sold this position and collected $200 (and would have a profit) or $50 (and would have a loss)? Do you want to own it or not. The price is $100 right now. Nothing else matters.. Christopher, I believe this is a matter of perspective. And apparently we have different perspectives. There's nothing wrong with that. Thanks for writing. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
Mark Wolfinger posted a article in Trading BlogThe problem arises when those mindsets, developed over a lifetime, are in conflict with habits that are required to succeed in the new endeavor. For some it's a relatively short lifetime of experience and for others it quite lengthy. Nevertheless, bad habits are difficult to overcome, and that can make it very difficult to succeed as a trader. I often write about the importance of good risk management and money management. Someone who has spent years running up credit card debt, living beyond his/her means, or buying things to impress the neighbors obviously lacks the discipline to be careful when managing money. I'm not suggesting a trader must be frugal. But trading discipline is not easy for someone who spends carelessly and does not understand the importance of avoiding debt – especially at high (credit card) interest rates. Being careful with trading dollars and getting your money's worth from the commissions and fees you pay contributes to success. The frivolous spender may have a difficult time with that aspect. On the other hand, it's possible that the too frugal trader may not be willing to invest money in insurance or in making adjustments. It's certainly not frugal to take excessive risk, but an inclination to watch every penny can get in the way of trading decisions. Maybe this is one reason why so many who advocate a frugal lifestyle also prefer passive investing. Unless you own a portfolio of very conservative positions, occasionally (more often for aggressive traders) you find yourself in a risky situation. It's far better to make decisions based on common sense, previously made plans, and the ability to think well under pressure. Individuals who are accustomed to being ruled by their emotions are not going to do well under these conditions. Thus, if you have a mindset that allows those important, spur of the moment, decisions to be made when emotions are in control, that's deleterious to your chances of winning the trading game. Those who have their emotions under control, are far better placed to make a good decision under pressure. Do you have the mindset that allows sloppiness in your daily life? Can you overcome it and become more disciplined when trading? Do you think of trading as dealing with Monopoly money? Is trading a game to you? Or do you have the mindset of a gambler? That's not the mindset of a serious trader who understands that taking big risk, and losing, can be ruinous. Do you have an understanding of where your comfort zone lies and the importance of trading within that zone? That's a positive mindset because it makes it easier to know when to take your profits or adjust a position. My suggestion is simply to be aware of the recommended characteristics of a successful trader (you can find various opinions online) and be certain that you are aware of any habits that are in conflict with those desired traits. Being aware is the first step towards not allowing those habits to interfere with your quest. Here are some related comments from other bloggers. From Dr. Brett, warning investors to lose a mindset that suggests that each individual trade is a battle that must be won. He warns traders not to become emotionally attached to the results of each individual trade, but instead to focus on the longer-term objective: "For a successful trader, a trade is like a single pitch to a hitter. It is one part of one at bat, which is part of one inning, which is part of one game. The goal is to win the game, not to "win" on each pitch… I focus on being profitable for the week and month- not on each trade, or even each day. For the active trader, there are many trades in a day and there are five days in a week. As long as you don't lose too much in a trade, you can turn the day around. As long as you keep daily losses reasonable, you have a chance for a green week. And as long as a week doesn't dig you into a deep hole, you can still be profitable on the month." The goal is to have a successful season: that view makes it easier to shrug off the pitches that get away from you and focus on what is truly important." This is good advice and corresponds to my admonition that proper risk management is the key to success. Do not take too much risk at any one time – either when the trade is made, or after an adverse move in the market. Your goal is to have a profitable trading/investing career. Larry Swedloe, writing the Wise Investing blog at CBS MoneyWatch, discusses the idea of re-balancing a portfolio. This is a technique used by many investors who adopt asset allocation as the major method for managing risk. (As you know, I much prefer owning collars as a method guaranteed to preserve assets.) Quoting David Swensen, Larry posted: “Dramatic bear markets signal the need for significant purchases of losers, while extraordinary bull markets call for substantial sales of winners. When markets make radical moves, investors demonstrate either the courage or the cowardice of their convictions.” It's not so easy for the average investor, with his/her emotions at their peak (euphoria or despair), to be selling into surging markets or buying when everyone else is panicking. Yet, for true believers in asset allocation, unemotional trading is a necessity. Most investors have the wrong mindset and get excessively bullish when markets are toppingand bearish when they are bottoming. For anyone who likes the idea of asset allocation, re-balancing is an essential part of that methodology and the 'buy the top' mindset must be eliminated to do the job properly. That's difficult for many investors. John, writing The Essentials of Trading, offers this: "The following was posted by a trader on a forum recently. It’s a question which comes up fairly regularly, if not in print then certainly in the minds of new traders wondering at their prospects for success: (slightly reworded) 'I heard a lot of people say 90% of traders lose money. I wonder how long and roughly how much the trader loses before becoming one of the 10% winners.' Of course there is no one answer to this question. How long it takes someone to reach consistent profitability has a lot to do with how much time and effort one puts into it. The more dedication to the task the faster it will tend to happen." I find that many traders want to know how long it will take before they begin making money or before they achieve a specific trading goal. That's the wrong mindset. It assumes that success is coming and all the trader has to do is put in his/her time and the profits will appear. Trading is not a job in which seniority does any good – unless you use the time on the job to learn and understand what you are doing. The proper mindset, in my opinion, is wanting to know where the trader can find information so that he/she can read about, study -and especially – practice, various aspects of the new job (trading). This mindset recognizes that work is required to develop the skills necessary for success. Related articles Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash Want to follow us and see how we trade options while reducing the risk? 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