Good Day Rookie Traders,

Last week tested the constitutions of even the most seasoned traders and was especially tough on a lot of rookie traders.  I had more than a few phone calls from rookie traders asking me what to do about this increased volatility and what might be happening next?  These questions and more importantly the feelings that come along with this type of market action usually stems from trading things we don’t truly understand or trading bigger than we are ultimately comfortable with.

Each time I meet a new trader I always ask them the same question, how much risk can you handle?  I usually get a number of different answers, ranging from the totally outrageous to the reasonably conservative.  Inevitably all the answers tend to be a multiple of what the real answer should be.  The reason that the number is usually different when I ask people rather than what the real number is when the market is tanking is that when I ask the question there is usually no real money at risk and people have time to think about the answer and try to give a rational answer and this is the exact opposite of what happens when the account value is plummeting.  When markets start to fall and traders are overleveraged the flight or fight type emotion takes over and people can be irrational, this is called panic.  When panic strikes clear thinking is usually lost in the shuffle and then people really find out how much risk they can handle.

A good example of this phenomenon is the strategy we use called credit spreads.  See the way we use credit spreads is we go quite far out of the money to give ourselves a good chance to be right, this can be termed the probability of winning.  The only issue with being a big favorite to win is that it comes with a dark side and that dark side is the cost of having a losing trade even if it only happens once in a while.  Let’s take our current GLD trade in this blog.  We set up a bear call spread on GLD with the expectation that gold would remain beaten down.  With the overall markets turning down gold has rebounded and broken a very important resistance level.  This meant that our spread started to work against us.  Now, our initial risk was the width of the spread minus any credit we got and for us, we were risking $0.85 to make $0.15 per share with an approximate probability of winning around 80%.  As I said at the outset of today’s blog people get panicked because they either don’t fully understand the risk of a particular strategy or they go to big.  In this case, the major risk is letting the spread goes through our short strike to the long strike which would mean a max loss of $85 per contract.  For a lot of people $85 isn’t the end of the world from a trading standpoint but if you did too many contracts it might be a lot more painful then you can imagine.  In our case, we did 5 contracts in our mock trade and this would translate to a $425 loss if we allowed it to go to max loss.  Now, for some folks, $425 isn’t a big deal, or at least they say it isn’t a big deal until its actually happening and the losses are piling up in the account and then we see if this is a painful amount or not.  If you have an emotional threshold instead of a logical threshold this is when it will show up and you will know by your actions or inactions that your emotions have taken over and this is a sure sign that your position sizing was too big.

The best way to ensure proper position sizing is to start small and work up to what you believe is your logical pain threshold.  You may find during the move towards your pain threshold that there is a spot where you stress levels increase and this is most likely your actual pain threshold.  Also, we need to keep market conditions in mind when trading as well.  For example, if things get crazy in the markets then a good idea is to cut your position in half and then move it up slowly as you get a firmer grip on the pulse of the markets.

Trade well my friends,

Check out the video below for an update on our GLD trade.

Happy Trading!