[Options] What Not to Do

Sean McLaughlin
March 13, 2020

Risk management has to be our number one focus right now. This is no time to be lazy, hoping, or praying.

Yes, if you're willing to wade in carefully, there can be some great opportunities for premium selling. But even then, we still have to be extra vigilant in protecting our capital.

I bring this up because I received an email from someone recently who didn't follow his rules, and now finds himself severely underwater and wondering what to do next. We've all been there. Something unexpected happens, and now we're like a deer in the headlights too frozen with indecision and unwilling to make any move whatsoever because we're afraid we are going to compound the situation for the worse. It sucks.

Here's the situation my friend finds himself in. Let's learn from this.

He's a subscriber to ASO and followed along with our short strangle trade in $XRT back on February 7th, where we sold the March 42 puts and March 47 calls for a combined net credit of 74 cents. Our goal was to close this trade down for a profit at a 50 cents debit.

Fast forward to February 18th, and $XRT was doing more or less what we had hoped -- nothing -- and our resting limit order to close at 50 cents was hit (that was quick!). You can visualize all this here:

Here's where my friend messed up.

I believe he was traveling and not putting in much screen time at the time our profit target in $XRT was hit. Fine. We're not all glued to screens 24/7 over here either. But in times like these -- especially when we know we're going to be away from our screens for an extended period of time -- we must leave resting orders open to exit our positions at our profit targets. Most trades we put on are not "set-n-forget." They need to be checked in on, at least once daily. For me, I almost always leave resting limit orders at my profit targets open.

Ok. Well that didn't happen. So lets move on. Still plenty of time to correct this error. Or was there? Here's what happened next:

$XRT started getting weird, first starting to breakout higher, then immediately doing a hard reverse lower. No bueno.

On February 26th, $XRT closed below our short 42 put strike. This was our exit signal to get out of the trade at or near the open of the next trading day. At this point, the loss stings due to the fact that this trade could've been exited for a profit just a handful of days prior. But that is no longer the reality here. It hurts, but remember, risk management is job number one. Take the exit and live to fight another day.

Unfortunately, that is not what happened. Frozen with indecision and likely overcome with the infliction we traders refer to as "hope disease," my friend took no action and rolled the dice.

And now here we are:

What started out as a profitable trade (good), transitioned into a manageable loss (bad), and now has turned into a calamity.

The lessons here are these:

  1. Have a plan for our exits before we get into the trade.
  2. Leave resting good-till-canceled (GTC) orders open at profit targets. I might get filled when I'm away from my screens!
  3. When we have a position with theoretically unlimited risk (in this case naked short calls and puts), we must not play with fire. Stops must be honored and acted upon immediately. Yes, I might get caught in a whipsaw once in a while and wish I held on. But I promise you, the price I pay for that more than makes up for getting caught in a situation like this $XRT trade. Over time, I'll come out WAY ahead by faithfully honoring my stops.

Look. We all make mistakes.

When we turn mistakes into lessons and carry it forward in our trading, we improve. And trust me, I'm 22 years into this game and there is always still room for improvement. It never stops.

~ @chicagosean

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