Trading Rules are well and good, but sometimes it makes more sense to run for the exits, in as orderly a fashion as possible — without screaming; only whimpering allowed — but very, very quickly.
Such was the case with my DIS position, short iron condors expiring May 17. All went well, with the price within the profit zone, until April 12. In response to a news report, the price gapped up by nearly 10%, putting it almost $2 above the upper boundary of the profit range.
On that day, in words that now make me blush, I wrote, “the higher open was only $1.91 above the upside breakeven point, suggesting a good chance of recovery back to profitability in the 35 days left before expiration.”
The price kept slowly rising, and I took a heavy loss when I exited 17 days later. So sad. But I’m a self-correcting trader. Lessons must be learned. And that’s what I’ve been engaged in for the past few days.
On April 12 I was attempting to answer the question a trader must consider every day: “How high is high?” I got the answer wrong.
When in doubt, go to the math.
I define high by a metric derived from the options pricing: One standard deviation (1SD) of implied volatility, converted to a range of the share price adjusted for the number of days until the options expire. Nearly seven times out of 10 (68.2%), the price will close within the 1SD range at the target date. Most applications use the options expiration date as the target. I use 21 days before expiration, since that’s when I exit under my trading rules.
So it’s easy subtraction to determine how far from the profit zone the current 1SD boundaries are. I convert it into a percentage of 1SD that lies beyond the profit zone.
But 1SD distance alone is not the answer. There’s the matter of time — how many days would it take to get back to profitability.
The answer to that lies in a metric called the Rate of Change, which is the percentage change in the share price, generally over 14 days although that period is adjustable.
To calculate how many days it would take to return to profitability, calculate the distance between the current price and the boundary of the profit zone, and divide it by the daily rate of change (distance divided by the 14-day rate of change divided by the number days until exit day, that is, 21 days before expiration).
That gives me two metrics to consider in making my exit decision. For DIS, on April 12, 70% of the 1SD range was above the profit zone. I.e., the odds were definitely not in my favor. Moreover, it would have taken five days plus change to cover the distance back to profitability, at the pre-gap rate of change. Since share prices rarely move more than a few days with a retracement, that’s quite a considerable distance.
So, with those metrics at hand, I would have headed for the exit without hesitation, thereby limiting the damage.
I’m not putting this into my rules yet, but here’s my initial plan:
If more than half of the 1SD range is beyond the profit zone in the tested direction, then exit. If the number of days required for the price to return to the profit zone is greater than two, then exit.
All of my current holdings are within the profit zone, so neither of these metrics is in play at present. But I have the tools in hand in case of need, and we’ll see how well they match the real world.
By Tim Bovee, Portland, Oregon, May 4, 2019
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.
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