Trader Psychology
You may have heard that trading is a zero-sum game.  It’s a giant conspiracy by the 1% of the investing populace that seem to make all the money.  Your dollar lost is their dollar gained.  In truth, the market doesn’t care, so what you’re left with are a few simple rules of thumb…
Trading for the 99%? What the heck does that mean? Well, it doesn’t mean doing what 99% of investors do, which tends to be the same old thing. You know, trying to time the market and missing it. Trying to find the next hot stock but finding that it doesn’t outperform the broader market. Watching interest rates on savings or cash sit at near zero.

Lately, the news has been filled with stories about the “99%”—shorthand for everybody that isn’t a bazzilionaire. As a professional trader for the past 20-plus years, the 99% to me isn’t about the “haves” versus the “have nots.” It’s about the people who are building a logical, strategy-based portfolio, designed with the goal of having a higher chance of being profitable over time, versus those that aren’t. And the only thing likely separating these two camps is knowledge.

If you’re in the 99%, it may be time to challenge yourself to do better. To take control. Don’t just hand your financial destiny over to Wall Street. It might mean learning about the potential benefits and risks of incorporating a variety of stocks, ETFs, options, and maybe even futures and forex into your portfolio. Ultimately, it could mean getting smarter.

So, how do most investors get stuck in this 99% rut to begin with? Think monkeys and evolution.

CRO-MAGNON TRADER
Your evolution might look like this:

1. You start out buying stocks. Maybe you buy your first stock for its low price. Or it’s a company or product you like. Or you’ve done your homework, or taken a class, and some technical indicator or fundamental metric provided the rationale. Maybe you like an analyst’s opinion. What happens? Well, most of the time, the stock price moves up and down. Maybe you take a profit when it rallies, or suffer a loss when it drops. Maybe you start to learn about risk (i.e. losing money), and volatility (i.e. swinging stock prices). But you can’t wrap your head around those realities just yet. And you sense—or you hope—there might be an easier way.

2. You discover the “stop loss.” The next evolutionary step might be adding a stop-loss  order to a stock position to help protect it from a drop in price. But, at some point you place a stop too close to the current price, and the position gets stopped out for a small loss before the stock heads higher. Or, even if the stop were placed further away, you get whipsawed out of a position because of a volatile market, and the stock heads higher anyway.

3. You learn other strategies. Little by little, you begin to walk upright. Maybe you start to learn about more advanced trading strategies, including the use of options. Maybe you add a short call to a long stock position (a.k.a. a covered call). You might be using this as a hedge, or as a way to generate income from a stock position. That’s fine, but what that short call also does is reduce the cost basis of the stock position, and increase the probability of profit of the overall position. How? By reducing the cost basis of the stock position, the stock could actually drop a small amount and the covered call position could still be profitable—the stock doesn’t have to rally in order to be profitable. One potential problem? The short call on long stock limits the position’s upside potential. That is, in exchange for lower cost basis, the potential profit is capped. And you may not like that if you’re hoping your $10 stock will be the next $400 stock. You may be right, but the odds are against you, while you’re still yearning to leave the cave once and for all.

4. You feel the need for something more. There may come a time where you’re feeling friskier, and tempted to take on new, more complex challenges. Maybe futures or forex trading. You’re tempted to try what the pros are doing–the 1%. But perhaps you realize you’re not ready…it’s intimidating.

5. So, you go back to school. A few of you hit the books and learn about options—and the various types of options strategies that have bullish, bearish, or neutral biases. You learn about volatility, potential risks and rewards, and theoretical concepts like “the greeks” and probabilities. At this point, you are evolving. You use real matches to start your fires, and you start incorporating different option strategies into your portfolio based on potential risk, potential return, and probability.

One catch: if you start to use defined-risk strategies like butterflies, verticals, and calendars, where the maximum possible loss is known at the onset of the trade, you might wonder if it becomes a zero-sum game. Sure, your palette of strategies has gotten bigger, but you’re still just skating by. The trick is to stop trading like you’re still part of the 99%.

THE SECRET SAUCE
If you’re still reading, you’re probably somewhere along this evolutionary ladder. But no matter where you stand, the rules are the same for creating portfolios where risk is theoretically controlled:

1—Understand the strategy.
2—Manage the winners, not the losers.
3—Control your position size and risk.

Let’s see how this works in practice.

1—Understand the Strategy Stocks are unpredictable. Sure, you might think a stock could go higher, but if the broader market is sinking, it would have to be an unusual stock to buck the trend. Consistently picking the direction for any stock or market is impossible. That’s why strategy selection is so crucial. With options, there are other variables—i.e. time decay and volatility—that can work against you, even if the direction of the underlying is working in your favor. Choosing strategies that are designed to profit under more of such circumstances doesn’t guarantee success, but it makes sense to start on the right foot.

For example, you might be bullish on a stock that’s trading for $50. If you buy 100 shares, and the stock drops to $49, you’d be down $100 (plus commissions). But if you sold the 46 strike put, and bought the 45 strike put for a net .40 credit, that short-put vertical position can be profitable if the stock stays above $46 until expiration. The maximum loss would be .60 per spread (plus all commissions, contract and exercise/assignment fees*), if the stock drops below $45 prior to expiration. But that would compare to a $500 loss on 100 shares of stock without a hedge. And the profit is capped at .40 per spread (less commissions and fees) if the stock is anywhere above $46. If the stock is at $60, for example, the profit is still only .40 per spread (less commissions and fees*), compared to $1,000 (less commissions) profit for 100 shares. But is it likely the stock will reach $60 during the life of the options? There’s no way to know.

2—Manage the Winners, Not Your Losers How many times have you had a small gain in a trade, only to exit at a loss because you were trying to cut your losses short and let your winners run? “Letting your winners run” sounds great in theory, but stocks go up and down every day. Not just up. The market moves up and down in cycles, like a sine wave. So, on any given day after you put on trades you could show a profit or loss or you could be breaking even.

One useful approach: take profits when the market presents them rather than hanging on too long. This may fly in the face of the “let your winners run” mantra, but for certain types of strategies, it starts to make sense. To start, if you’re trading option spreads like verticals, and a position has made nearly as much money as it can, don’t try to squeeze out the last few pennies. For example, if you sold a put vertical for .50 credit, and now it’s trading at .05, you’ve made 90% of its max profit before commissions and fees. Does it make sense to hold the position to try to get that last .05? If the stock drops sharply, your gain could disappear.

Now, if the stock moves favorably to the position, it’s more likely the profit will be something less than 90% of the max due to time premium left in the options. In that case, when do you take it off, if at all? It’s a judgment call. But, consider why you put the trade on in the first place. Was it a speculation on price? On volatility? On a Fed meeting or earnings headline? Should the event you anticipate happen, consider capturing the profit.

In markets where volatility is higher, both beneficial and adverse price moves can happen  quickly. Have a profit target in mind that takes into account all factors, including commissions and fees. When the stock or index price moves “your” way, and the position hits its profit target, consider taking it.

In the case of the stock moving against you, if you’re using defined-risk spreads, the max risk is known. But let’s say you have that long put vertical and the stock rallies. The trade is likely going to be losing money, and maybe it’s worth only .10 now, down 80% of its original .50 purchase price. In this case, take a look at the time to expiration. The position has lost nearly as much money as it can. The additional percentage loss isn’t that great. If you have some time before expiration (maybe two or three weeks, for example), and your situation will allow the additional loss, you may consider holding the position a little longer to see if market cycles drive that stock lower again, to make the loss on the long vertical less, or potentially turn it into a profitable trade. Of course, there is that risk that the stock price stays there or moves higher and you suffer the maximum possible loss for the strategy.

3—Control Your Position Size and Risk Here’s a hard fact: Every trade you take will start out at a loss. If you buy at the ask, the best you can hope for at that moment if you want out is to sell at the bid; and thus, a loss. This means that no matter what, once you place a trade, any type of profit you might realize will take time. So regardless of the strategy you choose, you need to hold a position long enough for it to benefit from what it was designed to do, without having it create a margin call or large loss. That’s known as risk and capital management, and that’s why knowing the margin requirements of a position is important. You can see the margin requirements for different positions using the thinkorswim platform. (For a step by step of just how to do this, see the Margin Special Focus in the previous issue of thinkMoney, Winter 2012.)

Allocating small, consistent, amounts of risk per trade, even when your convictions strong, and keeping capital requirements low, lets you put on more, and smaller, positions. Even if a single trade has the same capital requirement and risk as a series of smaller trades, that trade could become a 100% loser and take you out of business. You can certainly lose 100% on a more, smaller trades, but before you blow out your account, you can stop the bleeding and preserve your capital by not placing the next trade. Bear in mind all the commissions and fees for each trade as well. Depending on the size of your account, these costs could compound your losses dramatically.

Defined-risk option strategies like verticals, calendars, butterflies, and iron condors provide a maximum possible loss before you trade for better risk management Allocating small,  consistent, amounts of risk per trade, even when your convictions strong, and keeping capital requirements low, lets you put on more, and smaller, positions. Even if a single trade has the same capital requirement and risk as a series of smaller trades, that trade could become a 100% loser and take you out of business. You can certainly lose 100% on a more, smaller trades, but before you blow out your account, you can stop the bleeding and preserve your capital by not placing the next trade. Bear in mind all the commissions and fees for each trade as well. Depending on the size of your account, these costs could compound your losses dramatically. Defined-risk option strategies like verticals, calendars, butterflies, and iron condors provide a maximum possible loss before you trade for better risk management. Just make sure the aggregate maximum loss of all your positions doesn’t exceed your comfort level. When you can “handle” the loss, you give a losing position time to recover. But again, there's no guarantee that it will.

As you build a portfolio, focus on strategies designed with a higher probability of success, with capital allocated more or less equally across positions— so any one position couldn’t have  excessive impact on your p/l.

Think about longevity in trading because you’re not going to join the 1% overnight. Trading well takes practice. Choosing trades based on defined risk, potential reward, low capital and margin requirements, combined with high success probabilities and taking profits when they present themselves, is a way for the rest of us to compete with the 1% by playing our own game.

By Tom Preston