Friday, August 15, 2008

Fed Straddle Update--Lessons Learned

Just before the Fed interest rate decision was issued last Tuesday, I put on a virtual OTM (Aug132 call/Aug122 put) straddle on the SPY for a net credit of $0.71/contract. I closed out the call side the same day for a net credit of $0.13/contract and held onto the put side since I felt the trade would be profitable (or almost breakeven) in the next day or so. Two days later, the market did indeed take the predicted breather, but I chose to hold the puts for another day on the assumption (based on market indicators) that a better price would be had at Friday's open. Alas! This was not to be the case as the market shot straight out of the box, never looking back taking my profits along with it. I was in a dilemma: Should I close out the puts at the closing price of 9 cents/contract and accept a 22 cent loss on the spread, or should I wait it out for a few more days and hope for a huge market decline?

Fear, greed, and hope
There are three emotions that act as stumbling blocks on the road to trading profits--fear, greed, and hope. I read a study that named fear as the number one emotion that trips up traders. Many traders have low risk tolerance (read: fear) which forces them to exit trades before they have a chance to become profitable. Greed is the number two factor and it acts to either force traders into taking profits too quickly or to ignore price collapses thus watching profits fade away. The last part of greed is usually taken over by hope--hope that somehow the winds of fortune will blow again in their favor. All three of these factors formed the mass zeitgeist of the tech bubble.

Let me illustrate with a true story.

Bobby is a friend of mine who loaded up on a bunch of tech names in the late 1990's, midway into the tech boom. His profits were catapulting into the stratosphere along with everyone else's until the summer of 2000 when the bubble finally burst. Looking at the failing charts that represented his holdings, I told him he should get out completely or at least lighten up. But would he would hear of it? Uh-uhn. A zombie to greed and to the pervailing belief that the market could never fail (remember the Dow 50,000 hysteria?) he flat out told me he'd never part with any of his pet stocks. Ever.

Of course, most of you are familiar with the rest of the story. Not only did Bobby lose all of his substantial profits, but he finally exited his positions at an uncomfortable loss. He even went so far as to watch some of his tech darlings go belly-up. So disgusted was he with the stock market (it was the market's fault, not his!) that he vowed never to buy another stock again, and to my knowledge, he hasn't. By letting fear cloud his perspective, he missed out on the 2003 bull market in energy and commodities.

Greed, hope, and that order.

Be realistic in your trades
Most folks pretty much know which of the three emotional horsemen steers them in the wrong direction. If you keep a trading journal, you'll quickly find out which is your nemesis. My downfall is that one emotion that Pandora didn't let escape from her magic box--hope. Don't get me wrong. Hope is indeed the savior of the human condition, but it is the enemy to profits. And it tripped me up, big-time, in this trade. I knew that I should have gotten out of it after at most one day, and if that meant taking a loss, then so be it. It'll be recorded in my trading journal, and after analyzing what went wrong, I'll vow never to make the same mistake again. (Or at least two more times. Let's be real here.) I mean, to even break even on the put side of the straddle would have required a large drop in the index, an unreal expectation given that the market is in a definite uptrend.

What I learned
I finally faced facts this Wednesday and exited the put side at 6 cents/contract giving a total loss in the trade of 25 cents/contract. Good thing I didn't risk any real money! But we can learn a lot even from a failing paper trade--in fact, it's from my failures that I tend to learn the most valuable lessons.

So, what did I learn?

1. I learned that thinking through the trade first is worth it, even if it requires a little backtesting. Yes, thought and research take time, but paradoxically I found it saves more time in the long-run, not to mention frustration. If the method is unprofitable or too risky, why paper trade it in the first place? I'd rather put my time to better use researching safer strategies with greater profit potential.

2. Paper trading a new strategy is essential. I know I keep harping on this point, and as you can see from the failure of my straddle trade, it can't be emphasized enough.

3. I learned that out of the three emotions that cripple traders--fear, hope, and greed--hope is still my downfall. Although I did have good technical reasons for holding onto the put position, I knew that holding onto OTM expiring options for more than a hot minute is foolish as time decay is my biggest enemy, and if I had even thought about it for more than five seconds, I wouldn't have even considered putting on the trade...but I wouldn't have had a chance to write this blog, either. At least something positive came of it!

This month's options expire in a few minutes and so does my blog for this week. Now back to watching the Olympics...

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