Friday, November 16, 2012

Zombie Attack!

The market has stabilized on Friday (so far -- knock on wood) ending a week that overwhelmed my trading operation with bear signals.

I'm always suspicious of signals that come during a general market rout. I find price movements that are specific to an individual stock, or perhaps a sector, are more reliable than those that are part of a general rush to the exits.

The week was useful in uncovering a problem with my current practice for initial positions.

Beginning last month, I began hedging the first unit of each trade in an attempt to mitigate the damage from false positives -- breakouts that soon reverse their direction rather than charging onward to glory and profit.

My description of and rationale for the new practice, which allows for the opening position to be a vertical spread rather than shares or simple long options, can be found here.  

The problem is this: At what point should a trader close a vertical spread if the stock moves opposite the spread's profitable direction?

The philosophy behind a spread is quite different from that underlying a simple directional play involving shares or long options, which have unlimited potential in the direction of the trade, and unlimited loss down to zero going the other way.

Spreads, by contrast, have both limited and defined maximums for profit and loss. When I open a spread, I know what the best and worst outcomes can be, and I have the ability to structure both so that the level joy and pain are acceptable.

The trade-off is that spreads by their nature are much less dynamic than simple directional positions. Spreads benefit from the passage of time when they're profitable, so there is a bias against closing the spread. They tend to be buy-and-hold for the month or so of their lives. However, a vertical spread that is unprofitable loses from the passage of time.

Simple shares and options need to be sold at a reasonable stop/loss level to avoid the potential for catastrophic disasters.

But what happens when a stock not only withdraws from a breakout but gives a signal in the opposite direction? What happens to a bullish vertical spread that's still hanging around when the stock gives a bear signal?

I encountered that situation with Discover Financial Services (DFS). It gave a bull signal on Nov. 1, beaking above the 20-day high of $40.86, and I opened a bull put vertical spread for a credit of $25 per contract, with a break-even at the price of $39.75 and a maximum loss at $38.99.

The price fell below the break-out level two days after I opened the position, and on Nov. 15, the price gave a bear signal by falling below the 20-day low of  $37.90.

The spread expires Dec. 21. If I close now, I will take a loss but it will be less than the maximum.

My choices:

  1. Hold the bullish spread in anticipation of a reversal
  2. Sell the bullish spread
  3. Sell the short leg of the bullish spread, retaining the long put to profit from the bearish breakout.
Choice #1 leaves me with a zombie position, a loser just waiting for expiration to put it out of its misery. In addition, if I take advantage of the downside breakout, the zombie will act as a drain on any profits.

I've have had zombies that lived a long time in my accounts, generally because I made a bad trading decision, wasn't nimble enough to get out, and was reluctant to face up to my loss.

Zombies are the children of love. Any trader who falls in love with a stock and a direction is certain to end up with a zombie at some point.

My position in Facebook (FB) was a zombie for a long while, until its decline reversed and I got out  with a loss, but with a smaller one that I would have faced earlier.

I still hold a zombie Fannie Mae (FNMA) position, drooling and lurching through my portfolio as a bad memory of a brief flirtation with penny-stock prices.

Zombies are to be avoided.

Choice #3 has a problem with time. In the case of DFS, the long put expires in December and is losing $2 a day on each contract, a rate that will continue to accelerate until expiration.

Also, simply retaining that one put would muddy the clarity of my rule-based strategy. An initial position is supposed to be a long option expiration in four months or so, or a vertical spread. A long option expiring a month from now is neither.

The rules I'm operating with have enough complexity that I don't need to add to it by trying to bring a zombie back to life.

So my decision is to go with choice #2 -- sell the spread -- and the question is when.

The classic Turtle Trading rules have two stop/losses. Initially, the stop/loss on an opening position is set at twice the average daily trading range  below the entry price. In the case of DFS, at the time of the signal the average range was 79 cents, and so the stop loss was set at $1.58 below the entry level. 

I set up the vertical so that the stop/loss was the break-even point, so selling there would be little or not loss on the position.

However, one goal of using verticals is to avoid whiplash exits but allowing the stock more time to roam. 

In Turtle Trading, once stop/loss level has fallen below the 10-day extreme price in the direction of the trade, then that 10-day level becomes the point at which a trade should be closed.

In my daily chart analysis, that 10-day extreme marks the end of a bull phase or bear phase, meaning I'll set alerts for new breakouts.

A third possibility would be to wait until a 20-day breakout in the opposite direction, and then sell the vertical and enter into a new position if it meets the tests contained in my trading rules.

At this point, I've decided to use the 20-day breakout in the opposite direction. That way, I give maximum leeway for the stock to fluctuate, while avoiding a zombie position acting as a counterweight to an opposite trade.

In the case of DFS, the $39.19 bearside breakout on Thursday is above the maximum loss point, and closing there now cuts my potential loss in half.

I've updated my practice in the Exits section of my trading rules to include this change.

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.

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