Wednesday, May 04, 2005

Keep risk per trade constant!

Friday evening I checked out the CBOE equity put/call ratio. It looked really high to me (.78 I think). Normally I would not want to be long puts with such a high put/call ratio. Sure enough Monday morning my SPY puts were down around $0.30. I offered 1/3 of the position 15 cents above the bid. I should have waited for that offer to get hit, because it would have in the next 30 minutes....but I panicked as SPY started to drop a little, so I hit the bid for all of my contracts. That is the problem with bigger positions. I get panicky and impatient which causes me to trade poorly. I probably could have halved my losses to 15 cents per contract if I had been more patient.

This loss erased my previous gains from trading the QQQQ's this month, and will take a good bite out of my profits from the May Portfolio (assuming I end up with any). I think one of the most important rules to follow in trading is to keep the amount risked per trade fairly constant. I didn't follow that rule this time and my % return this month will suffer because of that. It's interesting. I have a bookshelf full of books about the stock market and trading, but I can only think of 2 books that specifically mention this rule, although many implicitly state it when they discuss money management ideas. Maybe this idea is too obvious to be mentioned in most books. It certinately wasn't obvious to me as a beginner, and I frequently changed my bet sizes. I first read this rule explicitly stated in Practical Speculation. I remember reading it and thinking how important a principal that this was at the time. The only other book I can think of that explicitly states this rule is also one of my all time top favorites: The Zen of Gambling. This is kind of a hokey book, and it is written in an extremely simple style, but it is full of profound insights about what it means to be a contrarian. I should re-read these books.

On Tuesday I opened up a position in Pepsi. I bought some out of the money Dec 05 calls. This is a very small position. I'm going to be looking to establish a small portfolio of long term out of the money options in companies I like that have a good theoretical edge. I almost always sell volatility, and I need to get past my phobia for buying volatility. Most of these positions will be total losses. I need one or two to gain enough to overcome the losses on all of the rest. Hopefully I can get a feel for what it's like to buy options it instead of shorting them without losing too much money.

I'm not being exactly truthful to myself. I definately do have a feel for what it's like to buy volatility. I lose most of the time and it sucks. That's why I have the phobia! Basically I think trading methodologies come in 2 types.

Type 1: High probability of profit per trade. Losses are bigger than winners. These are your countertrend/reversal, and option premium selling methodologies.

Type 2: Low probability of profit per trade. Winners are bigger than losers. These are your trend-following systems, and premium buying methodologies.

I'm more comfortable with type 1 systems. Most of the time you are making money, and that feels good. The chalenge with type 1 systems is not to go broke when positions move several standard deviations against you. Fat-tails in the price-distribution curve are the enemy of type 1 systems. If you read my blog much, you've probably figured out that one of my favorite authors is Niederhoffer who is a type 1 trader and he busted his fund! Type 2 systems are harder systems to trade because most of the time you are losing money, which makes you doubt yourself. Type 2 traders benefit from the rare extreme moves. The chalenge with type 2 trading is to keep your losses as small as possible, while waiting for those extreme moves where you make all of your money.

One of the best books I've read this year was Fooled By Randomness, by Taleb who is a type 2 trader. Reading this book caused me to start thinking about buying option premium. I am not sure who is right Niederhoffer or Taleb, but I would like to learn to trade in the type 2 style just to expand my arsenal.

I have never been very disciplined when buying option premium. I think my main problem with buying premium is that many times I've put too much capital in individual positions. Since most of these positions will be losses the position size must be small.

I'm guessing that Time Warner's earnings were good. It was up big today. Now all of my May short puts are in great shape, for the time being. I could close all of my positions for 2/3's of the maximum possible profit right now. Two and a half weeks to expiration... I need to start thinking of some ideas for June/July expiration.

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