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Wednesday, March 23, 2016

Frustration

As traders we constantly re-evaluate our decisions. What did we do wrong? How we can get better at our craft? Sometimes however, we can't avoid being blinded by frustration when our trading style has failed to make consistent profits for a certain period of time. When this happens it is important to conduct a serious assessment before jumping from system to system, only to see the old environment return, leading the previous trading style to consistent profits, while the recently adopted one miserably under-performs.

As traders it is our job to evaluate whether the system failed us, or whether it was our lack of discipline. If it turns out we were disciplined, and it is clear that our rules haven't worked for a while as we would have wanted, then the next question is: What type of market environment has the system faced in that period? Has it been the typical environment where WE KNOW our strategy won't perform well? Or has it not performed well even though it is the type of environment where our strategy should thrive? If the answer is the latter, then our trading style is asking for a revision. However, if we have followed our rules correctly; if we have been disciplined and the market environment simply has been the most unfavorable one for our strategy, then we simply accept the fact that all systems experience inevitable draw-downs at some point. We move on, aware of the fact that eventually, a different type of environment will emerge, and for now we need to focus on surviving the chaos and the hardship to the best of our ability, minimizing losses until the next period of bonanza arrives.

Every option trading strategy has its weakness. Every trading strategy, not just option related ones, has its killer environment. There is no single strategy that prints money out of the market indefinitely whatever is thrown at it. A trend following strategy will suffer on a sideways market, constantly getting stopped out. A contrarian suffers if the prevailing trend persists. A scalper suffers when liquidity dries up and spreads widen. A long option strategy sucks when the market goes nowhere or moves against you. A delta neutral trader is killed by sustained rallies or severe market sell offs. A penny stock trader loses... all the time... A beta male cries when he finds out the true reason why his wife dumped him was boredom and excessive stability. She, after all, likes the "bad boy" ....but I digress.

In the last seven months we have experienced four wild swings of more than ten percent each:

What is really amazing is the verticallity of these moves. In other words, how fast they have developed.

This persistent burst of directionality happens to be the worst environment for an Options seller with a contrarian/neutral-ish type of approach, where the market seems to constantly run against his positions no matter what.

How have we done by comparison?
Have we experienced large draw-downs to the point of no recovery?

This is the month to month performance of yours truly from August 2015 to March 2016 (March is not over yet as of this writing):
We have gone really no where in seven months. August was a positive +2.92%, but then we started to experience a draw-down that has lasted months. And that my friends, leads to frustration. The sensation that we are just wasting our time. The market is down about 3% in the same period, so we have slightly under-performed the market. But if we look at it, we have held our ground decently well. Our draw-down has been very manageable, and much smaller than those painfully experienced by the S&P500 Index. And since the first loss (August-September period) to the present, we have only lost 1.7%. That is, we're down 1.7% since September expiration of last year.

The market hasn't gone too far, and, in the process, it has been a really nerve wracking ride for the index, experiencing significant draw-downs, from which it has recovered, yes, but eventually that recovery may take years and that draw-down may be a deeper one that wipes out a third or half of your life savings. Nonetheless, yes, it is a bit frustrating to experience draw-downs that last several months when you are using other trading approaches than just passively investing in an index.

The next question then is: Is this normally expected for our strategy during a period such as the one we have lived? And the answer is YES. With those four 10% plus moves in both directions, yes, the Delta Neutral/contrarian Index Option Seller is bound to suffer. Our style has simply faced one of the most challenging and adverse scenarios. All trading strategies have their weakness. We know that ours will perform well during relatively calm markets, and even when the market is moving in one direction, but not so violently. So, these results, my friends, are expected.

How to mentally deal with this frustration of seeing your trading account going nowhere?

One way is to internalize that draw-down periods will exist; that your strategy will not always yield profits and negative environments will show up from time to time. That understanding, that knowledge, is the key to staying patient and disciplined.

Another way I personally alleviate these trading frustrations is by using different tactics with my capital. Yes, this site mostly focuses on Options Trading. It is entertaining. It gets girls horny at cocktail parties. Plus so much has been, and is constantly being said about buying and holding Coca Cola, that frankly, I find there is not much interesting to add. But apart from Options, I do buy and hold blue chip companies for the long run that reward shareholders with growing dividends every year, both Canadian an American companies. I also trade Forex, using pure, good old fashion trend following strategies to trade the Euro and Gold. You can also add a more passive investment to the mix and follow an index, of course. The Vanguard Total Stock Market ETF (VTI) for example is a good choice for this purpose. (My recent piece against passively following an index, had a central point which was to not make an index following approach your only weapon. It was my case against leaving your entire financial destiny at the mercy of Allah by using a single vehicle/strategy, but of course, adding it as part of an arsenal, without your life depending on it, is fine, perhaps better when combined with other sins, like the Vanguard REIT Index Fund (VNQ), and the Vanguard Total Bond Market ETF (BND), etc)

In my view, it's better to attack the market from different angles. When my Options trading system is suffering with a short Call position threatened during an unstoppable bull rally, my long stock investments are making a killing. There's always something to be happy about. Part of the capital is producing gains that mitigate losses somewhere else. If my trend following systems  are not doing good because of the lack of trends in Gold and the Euro, it usually means a quiet stock market environment and therefore improved health for my Iron Condors and Credit spreads. And so on, you get the idea. It's the leveraging of different strategies with positive long-term expectancy (I think), and that are not too correlated.

- Deal with frustration by putting emotions aside and evaluating your system objectively.

- Avoid jumping from system to system every month.

- Learn as much as possible about the financial markets. Options, Stocks, Bonds, Real Estate, Indexes, Forex, trend following, buy and hold, neutral trading. The more you know, the better you will spread out risk and understand how it is all interconnected and the better off you should be in the long run.

Wow, I'm talking like an old experienced, multi-millionaire. Apologies. But I have a feeling that, frustration and emotions won't take you anywhere, and that being a one trick pony comes with added risk. A deep understanding of the game in all its magnitude. Knowledge. That, that can help you.

Cheers,
LT

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