Alternative to Managing Losers
Oct 20, 2016
We never enter a trade thinking it will result in a loss. But the reality is, we have losing trades. There are a couple different approaches when it comes to managing losing credit-based trades. We can manage losses based on the trade P/L or we can manage based on time.
Some traders look to manage credit trades once a loss reaches a certain dollar amount. Managing losers at anywhere between 1 and 5 times the total credit received is one approach. Another way to manager losers is based on time or days until expiration (DTE).
The Partysquad, also known as the Research Team, took a look at managing strangles in SPY based on P/L going back over a decade. What they found was that managing strangles based on a negative P/L of anywhere between 1 - 5 times total credit received was not a good strategy. In fact, when strangles were managed this way, trades underperformed a simple buy and hold strategy in SPY by 40%. Based on this, it is very reasonable to conclude that managing a strangle based on the size of its loss is an ineffective strategy.
The team also looked at managing strangles based on how much time was left in the trade before expiration.
When we sell premium we take on short gamma risk. As an option approaches expiration its gamma increases - meaning, its deltas are more sensitive to change. And since deltas tell us how much an option’s price will move based on a $1 move in its underlying, you can see how increasing gamma puts an entire trade at greater risk.
If we open a position with 45 DTE, our gamma risk begins increasing right around the half-life of that option or around 22 days. In this study, it was found that the biggest losing trades took place within about 21 DTE. In other words, losses tend to accelerate as trades near expiration. However, by managing a losing trade before it breaches that 21 DTE mark, we can better mitigate losses.
Managing a losing trade early is much like cutting down a diseased tree in your backyard before that disease can spread to other trees. As one tree becomes sick, it affects two other trees which affect four more and so on. There is an exponential rate at which the disease spreads. That is essentially gamma risk. A losing or “diseased” trade tends to get worse as it approaches expiration. However, if we manage a losing trade based on time, we can significantly improve our P/L.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.