Stock-market trading can play tricks on you rmind. The key is to control as much as you can to reduce the risk of what you can't control.
It's true. Trading can play tricks on your mind. The key is to control as much as you can to reduce the risk of what you can't. How do you control bad decisions driven by emotion? Ditch the head games and trust your technology. Here are four common mistakes traders make and what to do about them using the tools you already have.
When the signals or conditions to do a trade are there, but you don't act.
The lesson: I remember most of my trades, in the same way a lot of baseball fans know every batting statistic for the last 40 years. By September 1997, I was off the trading floor and running a futures-and-options trading fund. On the morning of September 15, I didn't have any S&P 500 positions on, and I was looking to get long on a sell off below $900 as a contrarian bet. The S&P 500 futures sold off sharply, below $900. But I couldn't bring myself to buy any. The market was dropping much faster and sharper than I thought. Pick your metaphor—I had visions of catching falling knives, stepping in front of a train. I didn't implement my strategy and didn't do the trade. Of course, the S&P 500 rallied the next day without me, and I missed out on what could have been one of the best trades of the year.
The wisdom: Forget trying to figure out why you get scared. You choke because you think you could lose a lot of money. How do you tame those demons? Stress test your strategy on the Analyze page of the thinkorswim® platform before you route the order, and well before your signal is met. See what the loss might be with a different stock price, volatility, and days-to-expiration scenario. If you can't handle the potential loss on that trade, consider a lower risk strategy.
Your directional bias proves to be correct, but your position loses money.
The lesson: Back in the early ‘90s, I was calling in orders and working as a clerk. I hadn't been trading options for very long. But the shop I was working for had a Schwartatron—one of the first electronic-quote delivery systems. It let me pull up what passed for option quotes from time to time. At $430,I had a hunch that the S&P 500 might go higher. So, I bought a 460 call with three weeks to expiration as my bullish strategy. As the S&P 500 went down, it took my call with it. But lo and behold, the market rallied and took the S&P 500 up to $455 soon after. I pulled up the options on the Schwartatron, expecting to see my call up significantly. I had my broker on speed dial, ready to sell and take profits. But wait a second—the 460 call was lower. The S&P 500 was up, and my call was down? Yup, time decay and a vol crush took the value out of my option and cost me about two weeks of a meager salary.
The wisdom: You probably won't learn about how time decay, volatility, and stock or index-price movement all happen simultaneously in your M.B.A. program. But you should take advantage of the educational resources that TD Ameritrade offers. Daily presentations in the Chat Rooms is one such place. Three hours of live trading banter, five days a week, with guys in the trenches, could help you avoid some of the rookie mistakes I made.
A position looks like it can't lose and you take it way too big.
The lesson: A trader I once knew did this. A reversal is an arbitrage position of short stock vs. synthetic long stock (long call/short put). You try to buy the synthetic long stock for less than the price for which you sell the actual stock. Because it doesn't have much market risk, the margin requirement—especially for institutional traders—is pretty low. They mostly trade for debits. So when this trader saw a reversal set up for a $. 15 credit in a stock close to expiration, he bought 2,000 contracts, thinking he could make at least $.15 per spread in a couple of days. He figured it was a lock. He showed it to me on expiration when the stock dropped by $.30 and it looked like a profitable trade. “Did you check for dividends?” I asked. “Huh?” he answered. He hadn't investigated why the reversal was trading for a credit. He took what little he knew about reversals and figured he'd found a position that couldn't lose. Turns out, the stock was going ex-dividend the day after which he put on the position. A few weeks later, when the dividend payment date come up, he saw a huge debit for the dividends he owed in his account that wiped out his $.15 per spread credit. All of it ate up a couple years of profit.
The wisdom: Avail yourself of the TD Ameritrade Trade Desk at 800-669-3900 the next time you think you've found something too good to be true. It's staffed with associates who have seen just about every kind of trade and strategy ever done. They can help you spot the potential risks and rewards of your trade ideas. It's not that your idea is necessarily bad, but it doesn't hurt to have an experienced pro take a look at it. And, for the love of Pete, do it small.
Starting your market analysis with the answer already in your head and shutting out results to the contrary.
The lesson: One of the tasks I had at my first trading job was to build an index-arbitrage system for the S&P 100 and S&P 500 indices. The idea was to trade the synthetic index (long call/short put) vs. the stocks in the index. But it was hard executing 100 stocks trades at once, let alone 500. So I looked for subsets of the stocks to see which ones had the highest correlation. If I could find, say, 30 stocks of the S&P 100 that mimicked most of the price movement in the index, we could trade those 30 stocks instead of 100. If you include all the stocks in the index you get 100 % correlation. If you use less than all the stock, you get something less than 100 % correlation. Theoretically, 95 % or even 90 % correlation might sound good. But I had seen some divergence in the historical performance between the high correlation subset and the index. I chose to ignore the basis risk inherent in doing a subset of the index and went ahead because I believed that the historical correlations would continue in the future. One expiration's worth of a losing index arbitrage system disabused me of that notion. And I went back to the drawing board.
The wisdom: You might not be doing index arb, but whatever strategies you do use, numbers don't lie. You can test various entry and exit signals using the Strategies feature found in Edit Studies function of thinkorswim® Charts (in the upper right of any chart follow click path Studies > Edit Studies > Strategies. Then you can click to see a report of the potential profit and loss for that strategy. Don't kid yourself like I did, and figure that the risk that the data showed wouldn't happen in real life.
I may be showing my age when I say, “if I had the tools when I was young that you have now...” but it's true. TD Ameritrade's thinkorswim trading platform is packed with functionality that can help you avoid the mistakes I made, and speed up your learning process. And best of all, it's just a few clicks away.
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Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades. Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request. It is not possible to invest directly in an index.
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