Welcome back all, we have been talking about being happy with our trades even when they go against our initial thesis. We have talked about ensuring that our bet size is small enough that is doesn’t cloud our judgment or stir up emotions that would cause us to freeze and sit and hope that our trade reverts to the original direction or worse we adjust the trade in a way that introduces more risk. As we said in last week’s blog our number one job is to ensure that we reduce the risk as much as possible. To reduce our risk after the initial trade is on we have to be prepared to make an adjustment that reduces our risk in the right way for whatever the market presents to us.

If we think about this for a moment there are lots of different scenarios that can come our way. Let’s examine a couple of different ways the market can present challenges to us and this will highlight the theme of this weeks blog and that is that we need to plan for all scenarios and if we do this correctly then the level of confidence we will have in trading will elevate to a level that we can be happy with whatever becomes of our trades.

We are going to use the same example as last week, buying 10 shares of a stock which we believe are going in a bullish direction. The first scenario is that the stock goes nowhere for an extended period of time. On the surface, you may be willing just to hold on until it moves, because we are using stock you may think there is no cost to this waiting around but there is something most don’t think of and that is opportunity cost. While we are waiting for the stock we chose to move in a certain direction we could be missing out on opportunties to profit elsewhere in the markets. So if we think about this, is there a way that we coould change the trade so that if it is not moving the way we planned when we expect it to could we do something that would still benefit us? I can think of a couple of different things we could do, one would be that we could close the stock and find another candidate that would give us what we want. We could also turn this into a cashflow trade and perhaps sell some premium against the stock, provided we had enough shares of that stock. These two examples can alleviate the problem of time versus direction.

Here is another scenario, what if the stock we bought goes the exact opposite way we planned, what can we do about that issue? Again there are different things we can try to lesson the damage. First and easiest would be to stop out of the position, but this doesn’t leave us the opportunity to still prosper from the position should it reverse and run in our intended intial direction. Last week we talked about buying a put option and riding through the downturn and profitting when the stock reverses to the upside. These two scenarios also demostrate the ability of changing postures and what it can do to turn a bad trade into a not so bad trade and possibly even a winning trade in some cases.

The above scenarios should raise a very important question and underscore the importance of planning. The question I am referring to is when? As in when do I change the intial trade? From our first example, how long should we let the stock sit until we make a change? Should we wait a week, a month, a day or two? Or do we have some other critieria? Is there a price level along with a timeframe? These are the important things we must know in advance. The second scenario is a bit easier to understand the “when.” If the trade goes in the opposite direction then we just need to know “when” we believe that direction is changed? I said this might be easier but in some cases it may not be that easy.

To answer the question of “when” we need to plan for price level changes, time parameters and also in the case of option swing trades we also need to plan for changes in volatility. This is where we fall back onto our technical analysis. We need to determine levels that where if the price is to breach that level that we will take action and we need to plan that action in advance. For our sample trade, if the stock where to fall below a certain price level then we would need to either close the trade or perhaps throw on some protection like the put option we talked about. In addition to the price level we may decide to leave the trade on for only a certain length of time before we add a covered call or pick another stock trade. Its these levels and decision points that can make the difference between a winning trade and a large expense trade.

You should be able to see from the above that planning our exits is of massive importance, so much so that it can ultimately make the difference between being a profitable trader and a not so profitable trader over time.

It is a good practice to think through all the scenarios you believe a trade can present before entering the trade and then reviewing those situations on a regular basis to ensure the parameters haven’t changed since your intial rundown.

Take a moment to think through this and in the coming weeks we will go over examples to demostrate how we plan and what we need to go through before placing a trade sucessfully.

Trade Well,

Coach Holmes