HOW TO FIX A BROKEN TRADE

A GOOD COMPROMISE WHEN EMOTIONS AND WILLPOWER COLLIDE.

Some professional sports like
skiing, surfing, and skateboarding—require
athletes to learn how to take a fall without
serious injury. Professional boxers learn how
to take a punch without getting hurt (well,
not too hurt). And professional traders don’t
just learn how to make a profit; they also
learn how to manage losses. Why tell you
this? Because falling is to skiing as losses are
to trading—inevitable. And the sooner you
accept that, the sooner you can begin formulating
your strategy on how to lose less when
you take your own punches.
I’d love to give you the perfect anecdotal
trade that I screwed up on to discuss for this
article, but there are just too many. I’ve been
whipsawed, stopped out, spooked out, and of
course, taken the all-too expensive coffee
break, only to find a tidy profit turn into a bum
loss in the course of 20 minutes. So instead of
focusing on my own loser, let’s focus on
yours—your next one, that is—and how you
might be able to fix it.
When Should You Adjust?
The reality is, every trade you take starts out
with a loss. When you buy at the ask, you can
only turn around and sell for a bid that’s less—
never more—than what you just paid. But
somewhere between your entry and your pain
threshold (i.e., stop loss), there’s probably an
opportunity to adjust your trade if your conviction
remains that the underlying will turn
back around.
Since every trade is different, under what
circumstances would you want to adjust a
trade (rather than simply close it out and put
on a different one)? It depends, but typically,
it’s when you still believe your analysis is correct,
but the trade is experiencing a short-term
hiccup. You’re down, but not out, so to speak.
Provided that hiccup is somewhere between
your entry and your predetermined stop loss
(you do have a stop in mind, don’t you?), you
can mitigate your risk, take back some of the
loss, and buy some time for the trade to turn
around.
One little caveat: trade adjustments on
options tend to work better for swing and position
trades that you’re holding for a few days or
longer. Because of the volume of trades and
small profit targets, intraday traders are likely
better off sticking to a tight stop-exit strategy
rather than to meddle with adjusting.
Adjusting a Long Call
Let’s start with a common scenario: Suppose
stock XYZ is trading at $50 in June. You buy
a number of August 50 calls for $4 each
(with a stop loss at $2). Over the course of
the next week, the stock drifts down to $48,
and your calls are now worth about $3
(halfway between your purchase price and
your stop loss). What’s the fix?
Obviously, you could simply get out, but
that would work against your trading plan
and foster a gambling mentality. On the
other hand, there is one simple alternative
that can appease your emotional need to exit
and your conviction to stick with your plan:
adjust the trade.
When adjusting a losing long call position,
look to sell something to take back
some of the losses incurred. One way is to
simply sell calls against your position at the
next higher strike, converting the long calls
into vertical spreads. Assuming
there is premium to sell at that strike, by
doing so, you will (1) help to mitigate, and
slow down, further risk, and (2) recoup
some of the losses. The downside? If you sell
calls against all of your longs, then you’ve
capped your profit potential to the difference
between the strikes and the total debit
you paid. One sneaky workaround for this is
to simply not sell as many calls as you own
(assuming you’ve bought more than one),
which leaves you with unlimited upside
potential on the unhedged calls.
IT’S IMPORTANT TO REMEMBER THAT
there’s nothing magic about adjustments.
The reality is you’re not really “fixing” anything;
you’re simply taking the trade from
what it was when you entered to what you
want it to be now, based on new information.
The adjusted trade is essentially a new
trade, and the technical and sentiment
backdrops should be reassessed to make sure
your original plan is intact. If not, then
sometimes the best adjustment is to simply
to bail out.

 

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