Discipline: This character trait makes or breaks traders. I know for a fact that this is true, yet after 36 years as a professional trader, I still have difficulty maintaining excellent discipline. Looking at a current iron condor trade (Sep 25 and 26, 2012) presents a clear picture of how a trader may be thinking. The specific details are not important. What matters is the trader’s approach to managing risk.
To me, there are two extreme mindsets, and most of us fall between these extremes. One mindset is healthy; one is not.
The situation: Trading RUT options. It is Tuesday afternoon and the options settle Friday, using prices from the opening trades of the day. The short put option is about 9 points out of the money (delta is 23) and the short call is more than 30 points ATM.
Trader A: “I want to get out of this trade. The market is falling Tuesday afternoon and I do not know the reason. Perhaps it is more rioting in Spain or perhaps it is just fear of more rioting. But I do know this: there is a decent chance that things will get worse - and very soon.
However, I hope to make a profit. If this trade gets to where I can exit for a small gain, I’ll grab it. I’ll be thrilled to get out. Perhaps I can make an inexpensive adjustment instead. For example, paying a small debit to cover my short put spread and sell another – this time it will be one strike price further OTM. Sure, that roll-down may bring nothing but more trouble if there is a big downside opening, but…
I’ve been trying to get out. I’ve been bidding 5-cents for the put and call spreads all day. However, those bids are apparently too low, but I am not going to raise the bids. I would like to profit and because the market often reverses direction overnight, I think I’ll just sit with this trade. The overnight time decay will be very beneficial.”
Trader B: “I want to get out of this trade. The market is falling Tuesday afternoon and I do not know the reason. Perhaps it is more rioting in Spain or perhaps it is just fear of more rioting. But I do know this: there is a decent chance that things will get worse and very soon.
I can cover the iron condor by paying 85 to 90 cents. Sure that’s a loss (I collected 60 cents when I opened this position yesterday), but does it really matter whether it is a gain or loss? No, it does not.
Here’s what I do know. If I pay that 90 cents I’ll be out of jeopardy. If I do not pay it, then I will own the position overnight – and I have no idea what will happen tomorrow.
My choice has nothing to do with whether this trade is profitable. It has everything to do with this: If I hold, I can earn no more than earn 90 cents (from where I am right now) per spread. If I hold, I can lose another $2 or $3 per spread – and if the worst happens, I could lose another $4.10. This is madness. The market is threatening my trade. I’m outta here and I’ll live to play another day.
I’ll bid 85 cents (the midpoint between the bid and ask), and if not filled in 5 seconds, I’ll bid 90 cents. And even 95 cents if necessary.”
One comment: Trader A may be bidding 5-cents (good plan), but that is not really ‘trying’ to exit.
Mark D Wolfinger
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