Sunday, June 16, 2013

Anatomy of a failed trade

Weyerhaeuser Co. (WY) was without a doubt the worst failed trade I've had this year, producing a 64% loss on the amount risked in a leveraged position.

A failure of that magnitude requires an autopsy.

The backstory -- my initial decision to enter and details of the results -- can be read here.

WY broke above its 20-day price channel at $32.40 on May 20 and confirmed the bull signal in trading the next day.

I opened a position on May 21 at $32.52, structuring it as bull put spreads, a vertical options spread that I sell in the hope that it will be without value at expiration and so I won't have to buy it back. Instead, in the ideal case, I get to keep all of the premium I've received. The spread were to expire on June 15, with June 14 being the last day they could be traded.

The next day, the price rose past a trigger point and I added to it, as my trading rules dictate.

Thereafter, WY went bad quickly. The initial stop loss was set at $31.22. On May 29 the lower boundary of the 10-day price channel crossed above the stop loss to $31.28, the level that would have become the new exit point on May 30.

However, that same day -- May 29 -- the price dropped 5.2%, among the worst performances that day in the S&P 500. News reports attributed the decline to reports that mortgage applications had fallen and market interest rates had risen.

The decline pierced both the initial stop loss and the lower 10-day channel boundary, triggering an exit signal. The stock closed that day at $31.28.

The next day, May 30, the price fell below the 20-day price channel at $30.06 and closed at $29.66, producing a bear signal that was confirmed in trading on May 31.

From there, the price continued to drift lower, closing Friday, June 14 -- the day I closed the position -- at $28.29.

What to make of all of this?

What jumps out at me is how rapid the decline was. The close on exit-signal day was already down 3.8% from my entry price, and the day after, when the exit was confirmed, the price closed down 8.8% from entry.

Essentially, by the day after the exit signal, most of my losses were locked in.

If I were a day-trader, eyeballs glued to the screen from the opening bell to the close, then I might have had rules that would have allowed me to avoid the loss. But that's not how I trade.

Option spreads differ from shares in that they have a defined maximum gain and loss, and often do better when held to expiration then when sold off in the intervening days. It all depends upon where the price stands in relation to the break-even point.

But the key point is this: The reward/risk ratio on any day for an options spread can be calculated with a great deal of precision.

Because of that property of spreads, rather than exiting them willy-nilly upon a signal, I've adopted a tactical approach. I get out when the I have more to lose than to win. I calculate where I stand in relationship to gain and loss at boundaries that, the volatility implies, can be expected to encompass 68.2% of trades between the current day and expiration. That percentage is, in statistics, one standard deviation.

A detailed discussion of how I do this, with a sample spreadsheet, can be found here.

In the discussion that follows, I'm using dollar figures that refer specifically to my position in WY, which consisted of two collections of bull put option spreads expiring in June, six contracts short the $32 put and long the $30 put, and seven contracts short the $33 put and long the $31 put. I had entered initially with the six contracts, and added the seven after the price rose past a trigger level.

On the day of the exit signal, at the upper boundary, I stood to gain $190, compared to a loss of $1,386 if I exited immediately and a loss of $2,123 if the stock stood on the lower boundary at expiration.

Keep in mind that the chances of the being at the upper boundary or the lower are identical.

So the distance from my current risk to the upper boundary at expiration is $1,576, and to the lower, $737. Expressed as a reward/risk ratio, it works out to 2:1. That means that, the odds of expiring in either direction being equal, I have twice to gain than to lose by waiting.

The next day, May 30, the reward/risk ratio had moved to 3:1, and the day I exited, June 14, the ratio stood at 4:1. In other words, the lower the price went, the greater my incentive to stay in the position.

This may seem like a perverse incentive, but I would argue that it is not. On May 29, I had even odds of improving my position by $1,576 and gaining a $190 profit  by waiting 24 days, compared to a certainty of losing $1,386 immediately, or losing an additional $737 by waiting.

If I weren't a gambler, I wouldn't be a trader. The two vocations go hand in hand. I'll take 2:1 odds any day of the week.

As it is, I gambled at lost. Specifically, the exit cost was $2,183.

How could my rules be improved?

I have no problem with holding the position after the May 29 exit signal -- the cross below the 10-day price channel -- because the odds described above.

However, the break below the 20-day price channel on May 30 arguably ought to have prompted me to exit, whatever the odds.

Under my rules, the May 30 break below the 20-day price channel was a bear signal. If I hadn't already been in the position, I would have been considered going short.

To continue to hold a bull position, based on the reward/risk ratio, while simultaneously getting a bear signal is a logical inconsistency.

My new practice, then, will be to continue to hold a spread after an exit signal if the reward/risk spread  shows greater rewards from holding than selling, unless a break below the 20-day price channel, confirmed the next day, produces a bear signal. In that latter case, I'll close immediately.

In this instance, following that course would have reduced my losses by $510, getting me out at $1,673 rather than $2,183.

And that answers my initial question: The failure was about 75% inevitable, and 25% amenable to a fix.

My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

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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