Monday, December 15, 2014

Failed Trades: Lessons learned

I closed two losing trades today, and like anyone, I gritted my teeth as I did it. No one likes to lose.

After taking two deep breaths and unclenching my teeth, I decamped to Wholesome Blends, my favorite coffee house in my home turf, Portland, Oregon, for a cup of Joe, a chat with a friend, and a thoughtful deconstruction of the trades with the goal of improving my game.

The failed trades are described in "INFY: Ceiling in sight, but it's a high one" and "Silver: Regaining the bling". In the discussion below I'll refer to the charts contained in those posts.

Both were very short term trades, triggered by breaks beyond the 20-day price channel which produced trading signals. The positions were both structured as vertical option spreads, sold for a credit and expiring in the front month.

Short term trades are based on the analysis of two factors: The likely direction the stock price will go during the lifespan of the position, and the odds implied by options volatility, which in turn dictate the strategy and the hedge.

The problem with these two positions lies clearly in the directional analysis. The price moved counter to my expectations prior to expiration.

I opened the INFY bull position on Dec. 1 for Dec. 19 expiration. The chart showed the price in an uptrend since July 2012. Very near term, the price had pulled back a bit from a peak set last month but paused and reversed before setting a lower low.

I interpreted that as meaning the uptrend was still in force. And indeed, it may well still be, but not at the time of expiration.

Arguably, I bought when intraday momentum was running counter to the trade. Better to wait for the momentum to be in my favor, and to pass on the trade if that doesn't happen.

Lesson learned: Don't anticipate. For very short term positions, require that current momentum match the direction of the trade.

I entered the silver play, SLV, on Dec.  10, for Jan. 2 expiration. The very near term momentum was bullish, in the direction of the trade. Yet the higher degree trend was bearish.

Because it was a very short term trade, I gave greater weight to the very near term trend. In doing so, I ignored an important divergence.

Lesson learned: When there a divergence between a very near term trend and the larger trend, pass on the trade. Require that they support each other.

I think those lessons should apply entirely to trades based on price channel breakouts or other trading signals.

Trades based on earnings announcements, such as the trade described in today's post, "PAY: Volatility play", are different beasts entirely.

Trader's are intensely focussed on the earnings event that will happen that evening or the next morning, giving outsized importance to the very near term trend. I think divergences are quite acceptable in analyzing such trades.

For very short term trades, I require that implied volatility on options for the next week be greater the the 60th percentile of the range of the uptrend that brought volatility to its higher levels. INFY met that criteria at entry, with implied volatility in the 69th percentile. SLV did not, with volatility in the 46th percentile.

I broke my rule for SLV. In my thinking, a successful trade is one in which I followed my plan, whether the position makes money or not I didn't follow the plan in this. It was a failed trade.

One question to keep in the back of mind is whether the 60th percentile is too low. Should it be raised? The jury is still out on that.

A third question lies in the calculation of the range implied by volatility, which guides my structuring of the trade to provide a hedge. Generally, I want to hedge all of the one standard deviation range, which encompasses 68.2% of trades over the next week.

Why a week? The trades are for two week or more. I think my hedging would be more realistic if I calculated the volatility range for the actual duration of the position until expiration.

Finally, there's the whole notion of trade duration. INFY and SLV were both potentially three-week trades. Is that increase time risk to unacceptable levels?

Time risk is the idea that the longer I'm exposed to the market, the more likely I am to get hurt when something happens, one of the inevitable little surprises that make trading such an interesting occupation.

One week out is generally too close to expiration to get a decent risk/reward ratio and, indeed, a decent fill on my order. Two weeks out, however, will generally work. Should I implement a two-week maximum duration rule for my very short term trades?

The jury is still out on that one as well, but it's something I shall keep in mind.

The two enemies of trading are fear and hope. Failed trades fuel fear. I deal with the fear by cultivating a short memory and, through lessons learned exercises, cultivate a view toward the future. I don't plan to remember those trades tomorrow, which is, to coin a cliche, another day.

However, the new day brings new opportunity and also new hope, which can lead to reckless trading. This lessons learned exercise, by focusing my attention on the practical business of improving my system, is the best antidote to hope that I know.

-- Tim Bovee, Portland, Oregon, Dec. 15, 2014


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here. My volatility trading rules 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 decisions for his or her own account, and take responsibility for the consequences.

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