Time For an Options Strategy Change?

You know what it’s like when everything clicks. Those periods where your go-to strategy—a set of primary and secondary indicators, target volatility (vol) levels, and delta ranges—allow you to nail your entry and exit points. For a trader, there’s no feeling quite like it. You’re like a chef who’s finally perfected that secret sauce. Every meal is scrumptious. Then, one day, yuck. You zig, the market zags. And your secret sauce has a funny aftertaste.

What Went Wrong?

It might be the market; it might be you. It might be temporary; it might be something with staying power. You may decide to stick to your guns or make some changes. When tried and true turns to tried and died, there are three possibilities as to what might have happened. Learn how to identify them and how you may want to respond.

PROBLEM ONE: Temporary Slump

Statistics geeks have something called the law of large numbers. Here’s the gist: Flip a coin 100 times, and it’ll come pretty close to 50/50 heads versus tails. But during those 100 flips, you’ll likely see strings of heads or tails five or six times in a row. Flip it 1,000 times, and the heads/tails ratio should be even closer to 50/50. You might see even longer strings of heads or tails in a row—maybe up to 20 or more. In other words, just as markets don’t move in straight lines (which is why trading is exciting), trading successes don’t follow a specific pattern. Slumps happen, and in a slump, you may feel like you’re making the right moves, but the good-odds plays don’t pan out.

THE FIX

If you’re a “tails-never-fails” kind of person, watching heads come up 20 times in a row would surely leave a mark. It might (and perhaps should) lead you to reassess your strategy. But if you’re truly in a down period, even though your strategy and execution have been rock solid, you might want to downsize your positions. If you plan to keep yourself in the game for the long haul, consider keeping your positions small until you see things turn around. But note: If you find yourself in a slump, be sure to reflect and research. Review your trades—especially the ones where you felt the strongest conviction. Maybe you missed something. Perhaps there’s a larger issue at work, i.e., what looked like a temporary slump is actually an inflection point suggesting other leaks.

PROBLEM TWO: Style Drift

When’s the last time you refined your secret sauce? Do you make the occasional tweak along the way to adjust to a temporary market condition, but neglect to reset parameters when the market reverts? For example, suppose you use a moving average breakout as a primary entry-and-exit indicator and throw in a momentum indicator such as the Relative Strength Index (RSI) to help you confirm your points (see figure 1). But you also keep an eye on implied vol to help you select options strikes and expiration dates. Did you tighten up a strike width during a period of low vol but neglect to adjust it when the market started swinging? This is just one example of a style drift over time. You might have temporarily overruled your strategy to account for a temporary change in fundamentals, such as merger talks or another factor that caused short-term erratic price behavior. When things returned to normal, did your strategy revert as well?

THE FIX

If you’ve been the victim of style drift, you might want to hit the reset button and return to your initial strategy. Want to see how your original strategy might’ve fared had you reverted back to it earlier? thinkOnDemand comes to the rescue (see the sidebar, “Need a Memory Jog?”). With thinkOnDemand™, you can back test (evaluate a particular trading strategy using historical data) going all the way back to December 2009. On the thinkorswim platform, select OnDemand, and it’ll automatically set things to your Virtual Account. Type in the stock symbol, apply your original set of indicators—that go-to secret sauce—and watch the action as the sauce simmers. How did it taste? Is it time to revert back to the original recipe? Please note that the results presented in thinkOnDemand are hypothetical and there is no guarantee that the same strategy implemented today or in the future would produce similar results.

PROBLEM THREE: Fundamental Change

Let’s face it: Sometimes the financial ship sails, and it’s never coming back. Maybe the company made a fundamental change to its business that affected its price action, annualized vol, or another trade-flow dynamic. Maybe a change in its business model created seasonal trend that wasn’t there before. Circling back to the coin-flip analogy, it’s as if your coin was swapped out with a lopsided one that favored one side over the other. That’s why it’s important to backtest. Waiting for a failed strategy to bring you great returns is essentially throwing good money after bad.

THE FIX

If you think time has passed your strategy by, maybe you should find new parameters. Or even choose to change the products you trade. You may even find your tried-and-true strategy is perfect for another product. For example, suppose you have a high-vol strategy that pairs well with a high-flying growth stock, but that stock has matured into a stable cash cow with consistent earnings, regularly scheduled dividends, and a lower vol profile. Your strategy didn’t change; the stock did. So you might look at the new crop of high flyers and see how your strategy fares.

In the end, nothing lasts forever. The market is a moving target, and so are the secret-sauce strategies that seek to profit from that movement. But good chefs trust their taste buds. A bit of study and research can help you decide whether to dial back the heat on your trades, tweak the seasoning, or scrap the recipe entirely and start fresh.