Timber!!!!! Look out below! Our mock trade from last week is getting crushed!! Or is it? Last week we put on a mock trade in AAL and the premiss was that the stock was going to break to the upside and bring us in a nice fat profit!!! Well, if you have been watching AAL at all then you would know that it is falling faster than Justin Trudeau’s approval rating across the great white north!! If the above reference is not familiar then you may have been fortunate enough not to be part of the train wreck known as the Canadian Prime Minister, consider yourselves lucky. LOL
Let’s dissect this trade to see if it is a good or bad trade? First, we need to define what makes a trade good or bad. One of my mentors used to say the only bad trade is one in which you didn’t follow your own rules! This makes a lot of sense because the reality is that rules come to pass for a reason and typically that reason is that they are necessary to prevent bad things from happening. In the case of trading, bad things are blowing up accounts or revenge trading. In the case of this AAL trade, it is both good and bad. First, the good, we followed the rules when we entered this trade. We respected the time rules and our position sizing rules as well. We went out far enough in time to give ourselves a chance to be right and we also made sure that our max risk did not exceed our pain threshold. That makes this a good trade. What makes this a bad trade is there is one rule that we did not follow and that is the rule of confirmation. I didn’t wait for the stock to breakout before placing the trade. I did this because I wanted to get a trade on that we could track for educational purposes. To be clear, I and we must wait for confirmation and that this was only done for
In all fairness, this result was actually better than the result we were actually looking for because we get to learn from the trade and in my experience, I always learn more from the losing trades than I do from the winning trades. So what can we learn from this trade? Well, I can think of a couple of things. First, we can get real evidence that most of the time it’s better to use this kind of trade that has a defined risk and an unlimited reward than to use a trade that has unlimited risk and unlimited reward. Let’s take the stance that if our thesis was bullish, which in this case it was that we could have used long stock instead of a back ratio. Let’s run the numbers on the current trade to see how this would be playing out.
Current State of Trade
BACK RATIO – current loss = $62.50
LONG STOCK (with no stop loss) – current loss = $224 (Entry – Current = $35.47 – $33.23 = $2.24 per share (assuming 100 shares)
ATM CALL (with no stop loss) – current loss = $129 (Call Premium – Current Premium = $2.70 – $1.41 = $1.29 per share = $129)
We have talked about how the back ratio can reduce our overall risk but by the example above you can see it reduces risk during the trade as well. This is a benefit of not putting on as much initial risk. The other striking thing about this type of trade is that since we have defined risk we needed worry about stops if we accepted the max loss of the initial trade and moreover we can sit back now and wait and see if AAL makes a reversal and a run to the upside, however unlikely that might seem we have time to wait. If one so desired they could close this trade early and take less of a loss which is ok as well but this trade gives us choices that we don’t typically get with other types of trades.
Run this scenario through your thought processes and see if it becomes clear that there are more efficient and better ways to trade when we increase our trading IQ and then get on over to TACKLETRADING.COM and start increasing that IQ by attending the shows and reading the reports and getting in the clubhouse and asking questions!
Trade Well All!!!
Coach Holmes
