Wednesday, February 08, 2006

PD Story

As promised, here is a play by play of our PD trade. As a disclaimer, this story isn't about options, it's about being a trader. Also, there isn't anything special about this story as we go through such situations all the time, but I think I should share this common lesson with you.

On Monday, Feb 6 PD rallied to challenge it's recent new high of 167 on about half the volume of Feb 2nd - the day it opened at all time high and quickly sold off. This particular setup happens to be one of key ingredients for our model's probability distribution of future near-term prices. Directionally, PD had great odds of moving higher.

Seeing Feb credit put spreads at 150/145 strikes paying nearly 10% in premium we legged into the trade at a maximum capital allocation (meainig, we were fully weighted).

On Tuesday, Feb 7, PD opened lower and proceeded to fall nearly 13 points in an almost arrow- straight line to close at around 152. Our spread by then widened to show a significant unrealized loss. This event had a roughly 12% chance of occuring as estimated on Monday.

Today, Feb 8, PD continued its fall to reach 148 by 10 am EST. Right after the open we liquidated the short leg of the spread (150 short put) and continued to hold on to the long 145 put. At 10 am (which happened to be the reversal bottom) we liquidated the long leg.

All of it at a loss.

Every kind of pain has a theshold. It either makes you pass out or you stop the pain yourself when you can no longer handle it. If it's the former, you will either end up in financial death or you'll make good money. If it's the latter, you are guaranteed to experience a controlled loss.

That's an important difference to realize. It think anyone would agree that having a control over one's losses is better than not having one, even if such control always guarantees a loss. Mathematical expectancy of controlled losses points to an overall profit, assuming all other parts of the trading strategy are sound. On the flip side, the expectancy of an "all-in and close your eyes" approach is distinctly negative, and in a very short term.

We chose to end the pain and take the loss. While it may now look foolish by seeing PD tick at 154, it was the only correct thing to do. The other correct thing to do was to exit the trade last night before the close as we didn't expect to see PD down 5, 7 or 13 points at any given point. But that's mostly hindsight.

So, as much as I'd like to be exiting the trade at 154 now, I'd rather exit it the way we did.

Why?

Because even after doing this 100 times I'll still be around to make a trade.

Cheers,
/Dmitry

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