Kaeppel's Corner: Getting By With a Little Help from My Friends

Jay Kaeppel, Optionetics.com
March 29, 2011

One key to long term investment success is deciding which information to consider and which to ignore. It is not as easy as it sounds. For example, if you are “feeling bullish” (or bearish as the case may be) it is easy to find plenty of information to confirm your preferred point of view. What is not so easy is to interpret all of the information available and make a correct diagnosis. Likewise, given that there are so many investment vehicles and trading strategies available today, it is important to listen to the good ideas and discard the rest.

But how to know what’s really good and what’s not? A trusted source is essential. And even then you cannot simply take someone else’s word for it. You have to absorb information from sources you trust and then figure out what does and does not work for you personally. this too is not an easy process, but fourtunately, is well worth th effort.

As a member of the Optionetics team for the past seven years I have to say that as I look back I have learned a heck of a lot from my colleagues. So here’s a short list of some of my favorites:

Simplicity versus Complexity (George) – from George I learned that there is a time for simplicity and a time for complexity. The 10-day/30-day moving average crossover is simplicity itself. Does it accurately time every twist and turn in every tradable security? Does anything? The point is that a simple method such as this forces you to objectively designate the trend of a given security as “up” or “down” and to then act accordingly. This simple step keeps us “geniuses” from imposing our own will on the markets. A subtle, but huge step for many individuals.

From George I also learned about the out-of-the-money butterfly spread. One of the great advantages of pursuing this little known strategy is that so few others do. Thus when you find a good opportunity you essentially have it to yourself. This strategy offers the ability to risk a small amount with the potential for substantial profits.

A Systematic Approach and Regression to the Mean (Tom) – From Tom I learned the importance of adhering to a systematic approach. So many traders go wrong by “trusting their gut.” Tom’s emphasis is to encourage people to back test, to find a strategy that actually works and then –and only then – to employ it in real time. This differs greatly from the more “traditional” approach of “learning by doing” (more commonly referred to as “losing money”).

I also learned from Tom the value of employing “regression to the mean.” Every tradable security will occasionally move to the extreme in one direction or the other. And more often than not, from there it will “snap back” in the other direction, often in a hurry. Trades willing to jump in enjoy the potential for quick profits. And there is something about a quick easy profit that is tough to beat.

Analyzing the "Numbers behind the Number" (Clare) – I learned from Clare the importance of “rocket science.” Well, not exactly, because if it truly were rocket science I would stand no chance of keeping up. So to put it more accurately, I learned from Clare the importance of analyzing the “numbers behind the numbers.” As a prolific number cruncher and curve fitter I could routinely come up with systems that looked like absolute world beaters. At least until I used them in real time. Then I would come to find that I had not actually created anything truly robust.

As Clare teaches in her writings it is not only important that a system make money but that, a) there is some reason why it makes money, b) there is an element of consistency in the returns, c) risk controls are in place for when the inevitable “rough patch” hits, and d) there is some objective reason to believe that the system will continue to make money in the future. All of this can take time, and isn’t necessarily “fun.” But it is all critical to long-term success.

Risk Control and Money Management (Mitch) – Mitch taught me about risk control, money management and the Modidor spread. Risk control and money management principles are like the ugly sister of the investing world. Virtually any trader will agree that risk control and money management are absolutely key to long-term success, but very few people ever want to spend much time talking about these things, and sadly, even fewer spend the time to do these things right.

This part of trading is not nearly as “sexy” as a trading system or technical indicator which generates buy and sell signals and therefore the potential to “make money.” But how you allocate capital and how you go about dealing with losing trades (not to mention when to take a profit on a winning trade without getting out too soon or too late) is what actually separates the winners from the losers.

How and When to Adjust an Option Trade (Nick and Christina) – Nick and Christina taught me the importance of learning “when and how to adjust an option trade.” I come from a futures trading background, where the mantra is “when in doubt, get out”, or more accurately, “when your trade doesn’t go the way you expected it to, run like a sissy.” (so you can see why “when in doubt, get out” became the popular phrase of choice).

In trading options this is not necessarily the case. With many, many option strategies the initial position is just the first step. As the trade evolves the position can be altered (by buying or selling existing or new option positions in various quantities). As a result, it is possible to lock in profits and/or reduce risk or increase profit potential beyond the initial position. From Nick and Christina I learned that herein lies the real power of option trading strategies – finding a good opportunity and then exploiting it to its fullest.

The Garbage Trade (Gustavo) – From Gustavo I learned the “Garbage Trade.” Many traders may know this concept also as the “Black Swan” trade. In general terms, Gustavo’s version involves buying a (ridiculously) low priced out of the money butterfly spread in the opposite direction of a recent big move in a given market. The theory is that sooner or later that market will swoon – even if only for a short period of time – and the ultra cheap “insurance policy” offered by the Garbage Trade will pay off in spades.

While I cannot honestly say that I have actively pursued these trades since first learning about them, I can honestly say that I regret having not done so.

A Better Way to Trade Long Straddles (Steve) – From Steve I learned a better way to pursue long straddles – a strategy that simply involves buying a call and put option simultaneously and waiting for the underlying security to make a big move in one direction or the other. One of the psychological problems in trading straddles is that if the underlying security “goes nowhere” for awhile, then every day you watch your position lose a little more money.

As I mentioned before I came from a futures trading background. As such when I first traded long straddles I had a tendency to want to “cut my losses” on a long straddle position if I saw a loss accumulating. Murphy’s Law being what it is you can probably guess what happened time and again after I “wisely” cut my loss due to impatience – the stock would either swoon or soar, but it didn’t really matter because I was already gone. From Steve I learned a better way to zero in on the best opportunities and a better way to manage those positions.

Using the Most Powerful Software Tools (John and Ray) – In the 1990’s as a software developer I helped create an options analysis program that I have to say I thought was pretty darn great. It was my “baby.” Interestingly, I don’t use it anymore. That is because once I started using Optionetics Platinum software I realized that there were many useful tools that I was not availing myself to (and sadly, that I wasn’t smart enough to develop on my own). Now have I access to these tools on a daily basis. John and Ray and their brains made that possible.

Summary

So here is the paradox. As a trader or investor it is critically important that you “think for yourself.” At the same time, there are a lot of people out there with a whole lot of knowledge that you may not have thought of yet. So every once in awhile it is important to “open your mind”, take in what people whom you respect are saying and then ruthlessly cut away the parts that don’t “click” with your own “trading personality.” The good news is that what’s left is usually something pretty useful.

So to my colleagues – Thanks Guys (and Gals).

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ You’re Options Education Site

NOTES:

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