When markets crash, tactics that used to work don’t and those that used to not work do. But before you go hog wild embracing these once-unfavorable-but-now-favorable techniques, you need to recognize something. Once the world turns right side up again (and it will) these seemingly smart ideas will become stupid once more.
Like Monday’s Tales of a Technician post, the inspiration for today’s musings come from the clubhouse. Ryan discussed his recent experience with a misbehaving credit spread. As with all bull-put-toting traders, October upended his 75/70 credit spread on WWE. Rather than scaling-in to more contracts or simply exiting when the short strike (75) was breached, he legged out.
That is, he bought back the short 75 put at a loss but kept the long 70 put in hopes that continued weakness in the stock would allow him to rack up additional gains on the long leg. In doing so, he flipped the trade from bullish to bearish. This was his rationale:
“Rather than buy back the long put, I let this ride for the following reasons: negative news affecting price, post earnings, and below 10, 20, 50 day MAs. My exit strategy could consist of a trailing stop or buying back above previous high.”
The idea of legging out is a legitimate one. When it works, it makes the wielder a wizard whose sorcery turns losses into gains. Such was the case with WWE this go around. Because the downside follow-through was swift this month, any traders who legged out of bull puts likely reclaimed their positions from the jaws of the defeat.
But here’s the rub. Just because legging out worked this time doesn’t mean it works most of the time. October was an outlier. It’s not common for the market to plunge as swiftly as it did. Almost every other market pullback this year recovered quickly. And if you legged out in those scenarios then the tactic would have added insult to injury. You would have peeled of your short put at a loss and then seen the market rebound over the ensuing days to steal the gains from your long put.
But wait! Ryan’s idea was to use a stop of some sort to protect the gains on the long leg if the market were to snap back. Would that not have helped minimize the damage on the long leg?
Sure. However, sometimes the market gaps up the next day. Even if it did trade higher in an orderly manner, you’re still likely giving back some of the profits you had in your long put even with a stop loss.
As with all adjustment ideas, whether or not legging out is a technique you should resort to comes down to your skillset and management. If for every October that makes you like look a genius there are five other instances where the market rips higher after you legged out, then it may not be worth it in the long run. Keep a journal to record the overall results. Then and only then would I decide if it’s worth using.
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