Tuesday, March 23, 2010

Adjustment Thinking and the Salvation Syndrome

One of more prevalent ways many novice traders cut their teeth learning options is purchasing call and put options. While buying a directional call or put can provide large profits when right, they can be downright painful when wrong. It's rare to find traders who can rake in consistent profits when buying options is the only weapon in their arsenal. One would certainly have to be adept at forecasting a stock's price direction; a feat much easier said than done. When attempting the occasional long option trade, I've found increased success when using various adjustment techniques. Adjustment thinking in general helps with adapting to changing market conditions. The two primary objectives of adjusting are locking in gains and reducing or shifting risk.

When entering the realm of adjustment thinking one must be careful to avoid what I call salvation syndrome. This insidious disease can potentially rack up trading costs and compound losses. It's primarily characterized by traders who are constantly adjusting losing trades in an attempt to salvage some type of gain. They've got a bad case of the fix-its and rather than just exiting when trades go awry and moving to greener pastures, they attempt continual adjustments which often compound their problems. Consider the following example:

Suppose you sell an April 55-50 put spread on a $60 stock you deem bullish and expect to rise over the coming month. After 2 weeks of lackluster price action, the stock falls to $55 threatening to breach the higher strike of your put spread. Not wanting to lock in a loss, you decide to roll the put spread down and out to a May 50-45 put spread in an effort to make money back if the stock stabilizes or rallies. After making this adjustment, the Trading Gods unfortunately decide you need a better appreciation of Murphy's Law and therefore proceed to take the stock lower. As the stock approaches $50, you once again decide to "salvage" the trade by rolling to a June 45-40 put spread. Sensing that you're failing to learn the lessons, the infamous Trading Gods once again knock the stock down. Rinse and repeat...

In this example your adjustments merely served as salt to the wound, insult to injury, a compounding of your losses. Sometimes the best course of action is to simply exit. Let's be clear- there is nothing wrong with adjustments when used properly; there is something wrong when used improperly. I'll review a few such proper examples in subsequent posts.

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