I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Tuesday Book Club, I share an idea from a book.
From Trading in the Zone by Mark Douglas:
We have to be rigid in our rules and flexible in our expectations. We need to be rigid in our rules that we gain a sense of self-trust that can, and will always, protect us in an environment that has few, if any boundaries. We need to be flexible in our expectations so we can perceive, with the greatest degree of clarity and objectivity, what the market is communicating to us from its perspective. At this point, it probably goes without saying that the typical trader does just the opposite: He is flexible in his rules and rigid in his expectations. Interestingly enough, the more rigid the expectation, the more he has to either bend, violate, or break his rules in order to accommodate his unwillingness to give up what he wants in favor of what the market is offering.
I’m working on revising my options wheel trading rules. To be honest, I have not followed any rules with consistency. But I have started following some, and now I’m revising them based on what has happened.
My main goal in revising my rules is to reduce the risk of large losses that offset my regular wins. Because I don’t use leverage, and I only allocate up to 50% of my cash to the wheel, I’m not in danger of suffering a total wipeout. The risks are instead that if I face large drawdowns, especially in the form of getting assigned shares far below their cost basis I’m missing out on the opportunity to (1) continue earning yield via the money market where I keep cash that secures my short puts and (2) I’m also missing out on the chance to allocate that money to a trade (perhaps another short put) that would make a profit.
Repeat after me: You can’t predict the market’s direction
I’m having a hard time getting through my head that I should be trading probabilistically, not predictively. I wrote already about Douglas’ contention that learning more about the market — about individual tickers, about technical analysis, about macroeconomics — doesn’t help with trading.
Instead, the most successful traders base their trading on something like his five fundamental truths:
- Anything can happen.
- You don’t need to know what is going to happen next in order to make money.
- There is a random distribution between wins and losses for any given set of variables that define an edge.
- An edge is nothing more than an indication of a higher probability of one thing happening over another.
- Every moment in the market is unique.
That things can’t be predicted doesn’t mean that you can’t add to your edge with an understanding of one stock’s fundamentals, or charting techniques, or what the Fed might do next and how that could affect the S&P 500. It means, instead, that predictions are less important than setting up rules that give you a probability of wins more than losses, and with expected value (that is, the probability of win multiplied by the likely profit/loss) that is positive for each trade.
My tendency to do the exact wrong thing
I’m like many investors in that when I’ve suffered losses and positions are looking poorly, that’s when I want to get out, or at the very least do something to stop the bleeding (e.g., putting on a long put as a hedge).
But that’s more likely the time when I might see a reversal. It’s not always the case that a position that is down will come back up. But it’s often-enough the case, because financial asset values show mean reversion, or coming back to their average trend line. That’s the case whether they are below or above that trend line.
If a stock has been up, up, up for a few days, it’s likely to take a breather soon. Not always – because there are parabolic run-ups where some asset prices just go up, up, up to the moon. But most often that is the case, so it’s something you can build an edge on.
Similarly, if a stock has been drawing down for a while, even if the overall trend is down, after some period of time, it’s very likely that the sellers will take a rest for a while and buyers may step in.
That’s the case with semiconductors yesterday and today, which had been in a serious drawdown through last week.
Of course, I got scared and closed out many of my short puts on semiconductors. I had been overloaded on them, which was the real mistake. I didn’t stick to any reasonable rules about diversification. And I didn’t even make explicit rules about it.
Updating my rules
Again and again, I get FOMO about stocks or sectors that are doing really well, and get scared about my positions that are doing poorly. This is despite the fact that the likely direction of the stocks and sectors I have FOMO about is up, and the likely direction of the positions doing poorly is a reversal.
However, when I’ve suffered the most from this behavior, and this tendency, is when I allowed it to override my rules!
My rules have, to be fair, been a bit of a moving target, as I adjust them for what I’ve learned since I started options trading in April. But even as they’ve been moving, I’ve not made them rigid enough. And then I’ve not even followed the loosey-goosey ones I did establish.
I’ve started building a web app to manage my trading. My Google Sheets trading manager only goes so far in expressing rules around my options wheeling.
The next step in my development as an options trader is to get that web app built, and make it express a rigid set of rules, and meanwhile I’ll work on developing flexible expectations for the market.