Sunday, October 28, 2012

Trading vehicles

A downside of trend-following systems, such as the one I use, is that there are so many head fakes and damp firecrackers.

I have tools in place that help weed out the head fakes -- a trading signal that is quickly negated by the price action. 

Damp firecrackers, however, are a tougher nut to crack. A damp firecracker is where the stock breaks beyond its 20-day price extreme, only to meander sideways thereafter, usually a bit below my entry level, or so its seems.

Those patterns don't make for large losses, but they do produce small losses and otherwise tie up funds, producing lost-opportunity costs.

Vertical option spreads are a way around the damp firecracker problem. They make money even in a sideways market, and they also allow the trader some cushion between the entry point and the break-even price. They also limit losses to a defined level.

The cost of that added control and limit on losses is that gains are also limited.

So I've added a discretionary paragraph to my trading rules that gives the trader the choice of using vertical spreads for the initial position, upon breakout. However, if the price then becomes to trend, triggering additions to the position, the additions must be in the form of long calls or puts, or shares, both long or short, depending upon the direction of the trade.

The rule addition reads:
For positions based on the equity and exchange-traded fund pools, the initial position can be either long calls or puts, or short vertical spreads (bull put spreads, bear call spreads) with the break-even point set near or at the initial stop/loss point (2N from the entry price), at the trader’s discretion. Additions to the position must be long calls or puts.
In testing, I've founds that selecting the short leg of the spread from among strikes having deltas from 30 to 40 works well, with the long leg as close to the short as I can manage. Generally, the short strike will be close to the stop/loss level.

When I trade, I'll note in my write-up which vehicle I used and how I constructed it.

Some reading:
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

No comments:

Post a Comment