Good Day Rookie Bloggers, this week we are going to focus on one of the most important parts of trading and that is planning or more importantly having a plan for each trade. Here at Tackle, we are big fans of making plans for trades and this is because we have learned over our many years of trading that having a good solid plan can mean the difference between being a profitable trader and losing piles of money. It is easy for most people to understand why having a plan is a good thing but what might not be as easy to understand is that having a backup plan is possibly more important. If you have been trading for any length of time then you know that at some point trades are going to go against you and how you react to them is paramount for success in trading. In this week’s blog, we are going to talk about a popular trade and what can be done if our best-laid plans go awry.
The popular trade that we are going to discuss is the diagonal spread trade. This trade goes by many names such as the calendar spread or the poor boy’s covered call. This trade involves buying a long option further out in time and then selling an option at a nearer expiration. This trade gives us a couple of ways to profit and those are both from a move in the chosen direction and also the passage of time. This is how this trade looks.
This trade can be very lucrative if all things work out the way we expect and this is what we would want to plan for when making a trade plan for this type of trade but the question remains what happens if this trade goes against us? What is the backup plan if we are wrong on the direction? These are important questions that need to be answered as anyone who trades knows that trades will and can go against us at any time. We are going to answer these questions for this particular trade.
As stated above this trade has a directional component but if this trade goes in the opposite direction then we are going to start to see a negative draw in the account. This drawdown will elicit some emotions and should elicit some action to fix this trade or as we talked about above a move to a backup plan. The backup plan for this trade only has a few choices and they are as follows.
- This choice for the backup plan is the most simple and probably the most popular way to deal with trades that go wrong and that would be the stop loss. Using a stop loss on the entire trade is the most straight forward approach to dealing with this. The drawback to this choice is that whatever the risk between the entry point and the stop loss will be the cost of the trade or the overall loss of the trade. The good news about this choice is you get to decide how much risk there is by picking the stop loss level.
- The second choice for this trade is to let the trade ride and see if the direction reverses at some point. This is the most reckless choice of the three options and it requires hope that the trade turns around and this is not the best way to trade. The biggest drawback to this choice is that whatever the cost of the trade is at inception is going to be the max loss of the trade and usually with these types of trades it can be a significant cost. For some traders the loss is acceptable but for most this is not a good idea or even necessary to wait for a max loss.
- The last choice is to plan out a strategy in which the trader uses the time between entry and expiration of the long option to sell more short-dated options to offset the cost of the long option. This choice does not ensure a profit but it can reduce the overall loss of the trade by being patient and should there be a change in direction in the near term could still be a profitable trade. The downside to this trade is that is requires lots of trade management and more costs incurred due to commissions and any other trading type fees.
Here are three very different choices for when this type of trade goes against us and each has its own pros and cons and requires specific steps to be planned and put in place during the life of this trade. One needs to decide which one of these choices will be used before the trade is put in place so that the steps required are put into place and followed without letting emotion derail the plan.
At the end of the day when a diagonal or any other type of trade goes awry having a well-thought-out plan is necessary and when it is put together well can make up for challenges that are presented with any trade. More importantly, having a plan can help us Trade On when things don’t necessarily go our way.
Trade Well,
Coach “Old Money” Holmes
