New Dr. Brett Series on Lessons for Developing Traders

If there is one blog on the web where I never seem to find the appropriate amount of time required to digest all the nuggets of wisdom it contains, that site is undoubtedly Brett Steenbarger’s TraderFeed. Filled with insights that range from quantitative analysis and system development to what is arguably the best collection of content on the web in the realm of trader psychology, TraderFeed continues to be – at least in my opinion – the top all-purpose investment blog on the web.

For this reason, when Brett mentioned in Lessons for Developing Traders: What Moves Markets that he is “going to write about topics that no one told me about when I was learning the ropes,” I thought that instead of waiting until the series is finished to highlight it I would flag it now for anyone who is not already on the Steenbarger bandwagon.

This new series also got me thinking to about the three things I wish I had been told (assuming I was smart enough to follow that advice) at the beginning of my trading career. The answers are personal ones, but I believe they capture insights that led to quantum advances in my trading:

1. Standardize on one time horizon…and make it consistent with your trading approach and personality
   
   
2. Make research and analysis of risk management at least as important as R&D on stocks, indicators and strategies
   
   
3. Focus more time on developing expertise in managing (and exiting) existing positions than on discovering new high potential entries

For the record, a close fourth in this exercise was understanding the tenets of behavioral finance and the associated decision-making pitfalls that investors should learn to avoid. Those who wish to get a better sense of how I see the learning process for developing traders may wish to investigate my trader development stage model.

Readers, feel free to use the comments section to spell out the 3-4 things you wished someone had told you when you first started trading.

For more on these subjects, readers are encouraged to check out:

• Trader Development Stage Model – Version 2.0
• On Trading Rules and Guidelines

Disclosure: none

Position Management for SPX Short Straddle

I suspect that when most investors make the jump from stocks to options, the most difficult issue for them to come to terms with is position management. With stocks, it is easy for an investor to reason that if a particular stock rises to a target price of X, he or she will take the profits and exit the position. By the same token, if the stock falls below Y, this means it is time to cut losses.

For options, the process becomes much more complicated. One of the complicating factors is certainly the potential for extreme percentage changes in an option position. It is not uncommon for an option to double in value for several consecutive days; alternatively an option can lose half of its value several days in a row.

Given all the questions I have received about how to manage options positions, going forward I have decided to share some of my thinking about position management using real-time case studies of options trades.

Let me offer up a taste of what I had in mind using a recent short straddle trade on the SPX that I first talked about on August 20^th in The Sideways Play.

First, while I did not go into detail about the rationale for the trade at the time of the original post, one of the technical factors I found appealing was the possibility of the 1000 serving as a consolidation point, with SPX potentially trading in a narrow range that was defined by 978-1018 at the time. The chart below shows that following the initial post (black arrow), SPX subsequently rallied as high as 1040, closing a little over 1030 on August 27^th. When SPX subsequently fell back below 1000 last week, there was reason to believe that the 1030 (closing) and 1040 (intraday) levels might serve as resistance. As described in SPX Short Straddle Still Hugging 1000 Level, the trade had started to yield some meaningful profits at this stage.

[graphic: StockCharts]

Recall from the original post that the short straddle will be profitable if the SPX option settles (on September 19^th) anywhere in the 950-1050 range. At the moment, with SPX in the upper quarter of the profit zone, the biggest risk is a breakout to the upside. I considered the risk to be reasonably well contained as long as SPX did not take out the August 27^th closing high of 1030.98. Leaving a little wiggle room, I set a mental stop of 1032. With yesterday’s close of 1033.37, therefore, I would close half of the straddle by buying back the at risk portion of the position, the calls. Ideally, this would have been done just prior to the end of trading yesterday or perhaps at today’s open.

The graphic below is a snapshot of the position as of yesterday’s close. The original premium was $5000 per contract. At the close of trading yesterday, the position could have been closed out for $3820, yielding a profit of $1180 per contract. This is down from a profit of $1490 a week ago today when the SPX was still hugging the 1000 level. The change in profitability in the past week has been largely the result of directional movement (delta) in the form of a 30 point jump in SPX more than offsetting the time decay at work over the course of the week.

[graphic: optionsXpress]

I see no reason to cover the short put side of the straddle, unless the SPX were to make a sharp move down. Using 1030 as resistance turning into support, one could plan to exit the puts if the SPX were to close below 1030. A lower SPX target might also make sense if I wanted to squeeze out some extra time decay (theta), from the short puts. If I were to take this approach, I would probably use a close (or perhaps intraday violation) of 1000 or below as my exit signal.

Note that in setting up my exits, I am completely ignoring the price of the actual options and prefer to focus on the underlying. In future posts, I will talk about a more holistic approach that encompasses not just the underlying, but also options prices, position Greeks and other factors.

For the record, the previous posts in this SPX short straddle series are:

1. The Sideways Play
2. SPX Short Straddle Still Hugging 1000 Level

An earlier two-part SPX short straddle case study may also be of interest:

1. Is the SPX Going to Stick Close to 900?
2. SPX Straddle Case Study Update

For additional posts on these subjects, readers are encouraged to check out:

• Straddles vs. Iron Butterflies
• One Approach to Volatile Sideways Markets
• The Options Opportunity Matrix