GLD Lessons Learned

Whenever I have a losing trade, I like to look at it to see how, or whether, the results could have been improved.

History

The bearish GLD position that I entered on Nov. 19 was in the form of a narrow bear call spread with December expiration: long 111 strike and short the 110 strike. Shares were selling at 112.30 at the time of entry.

I bought a 118 strike December call on Nov. 25, during the Thanksgiving holiday week, after GLD spiked upward to 116.79. The calls were sufficient in number to insure about one-third of my position against a further rise. I chose to buy the call in part because light holiday trading volume had rendered the markets relatively illiquid, making it difficult to sell my spread position. I sold the insurance call the next day after GLD opened down nearly 4 points, at 113.08.

Shares rose throughout Nov. 26, and continued thereafter, making new highs each day. I closed the position for technical analysis reasons today, Dec. 2, with shares at 119.07.

Entry

I entered the position using two technical indicators in tandem: Bollinger Bands and the Money Flow Index. My method was one described by John Bollinger, who developed the Bollinger Bands indicator as a way of measuring whether a stock was high or low in terms of standard deviation from a central moving average. He recommends not using the bands alone but coupling them with a momentum indicator. The Money Flow Index measures momentum.

Specifically, GLD had opened outside the upper band on Nov. 16, closed back within the bands, and had moved sideways with increasing distance from the rising band for days thereafter. On Nov. 19, the Money Flow Index, which was in overbought territory (a bearish position) had sharply moved downward. Altogether, it was a classic bearish entry signal, which I took.

Contrary to that analysis is the fact that GLD was near all-time highs, the 20-day moving average was still moving upward, and the bands were widening, which generally suggest the continuation of an existing trend.

Also, very-near-term prices showed downside resistance at 110 and no upside support. In terms of reward vs. risk: My reward was potentially about 2%, and risk was unlimited.

Vehicle

My choice of a bear call spread indicated a strong bearish bias that was unsupported by the analysis in light of the contrary elements described above. I selected the 111/110 pairing for my spread because they were at the resistance level, a conservative positioning. But with no support on the upside (what I call a "blue sky" position), it was in fact quite risky.

I had several alternatives, such as an iron triangle, which would have let me set up a profitable range on both the upside and the downside of the price. Or I could have done a calendar spread, that would allow me to pick a price that I thought the shares would be near, and then make money selling options against long options at that price.

The time until expiration was also an issue. I chose to trade the December options, which cease trading at the end of business on Dec. 18. That only gave about 30 days for shares to reverse the upward trend. Had I traded the Jan. 15 options, that would have given more time for things to work out in my favor.

Mitigation

I was correct in attempting to mitigate the position by buying calls as insurance. I was incorrect in closing the insurance so quickly, and also I should have chosen calls that were further out (March rather than December) to eliminate price decay. Had I bought longer-term calls and held them, the losses would have been minimal.

Position sizing

My loss on this trade, total, was about $600. Nice money, but not crippling, or even cringe-inducing. It's certainly far less than most people lost in their 401(k) accounts last year.

This part of the trade went right, and it points to the importance of always sizing your trades so your stomach doesn't churn with the loss.

Lessons learned

I usually don't mix technical analysis methods, but I think it's worth noting that the other analytical methods I use didn't confirm the Bollinger Band/Money Flow Index analysis.

The Person's Proprietary Signal was relentlessly bullish, as was the classic Stochastic/MACD/30-day Moving Average method.

I take these lessons from the trade:

1) After reading the signals, look at the chart. If the signal is wildly at variance with what the price is doing over a longer term, then moderate expectations. In this case, lower my bearish expectations or even forego the trade.

2) Pay better attention to support and resistance levels. I mean, 2% reward vs. unlimited blue-sky risk? You've got to be kidding. (Sad shake of head.)

3) Having moderated bearish expectations, choose a more moderate vehicle. An iron triangle would have been better than the bearish spread that I used.

4) With less certain expectations, choose a more longer time frame. In this case, trade January options rather than December.

5) Be more deliberate in mitigating a position. That is, remove the mitigation at the first sign of trouble. This is a garden, not a casino.

Ultimate question

Ultimately, the GLD trade calls into question my fundamental strategies for selecting stocks.

The Person's Proprietary Signal and the Bollinger Band analyses are both trend reversal indicators. Fundamentally, they are used to try to call tops and bottoms.

Less risky are the trend following strategies: Look at what the share price is doing, and then do the same. In practical terms, this would involve looking at the overall trend, and playing only in that direction.

A trend consists of rises and falls. No stock (well, hardly any) moves in a straight line in any direction. So the trick in trend following is to buy at the low wiggle in price and then ride it up as it fluctuates.

This GLD trade sought to peg a reversal, and thereby went contrary to the trend.

In fact there are very few entry opportunities using our present batch of signals that move in the direction of the trend. The Money Flow Index confirmation rules especially rule that out. So the next task, I think, will be to develop some rules for trend following strategies, and see how that improves outcomes.

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That's it. I'm poorer but wiser today. I'll take the poorer, as long as I get wiser in the process.