My Worst Trade Ever!
By Ed Hecht, Optionetics.com
11/08/2000 5:00:00 PM
During the course of my trading career, I've had quite a few good trades and quite a few bad ones. I must admit, I've paid an enormous tuition for the education I've received from the bad trades! This year alone, I've "spent" more in my trading "education" than the entire cost of my MBA. However, I've probably learned more about how to succeed in the markets as a result than had I not received this "education." To keep the mood light, I've at times referred to myself as having "pushed a few Porsches off of cliffs!" To be honest, I'd have been happy to keep winning and maybe not gotten the "education" this year-but if it would have eventually come and perhaps it's better to get the pain out of the way and learn the lessons early. That's the way I look at my mistakes-as opportunities to learn and become a more seasoned trader as a result. As a result, I can say that I don't make the same mistake often (I just get creative and make new ones!).
So why am I telling you all this? Because there is much you can learn from the experience of others. I want to arm you with information that, if heeded, will prevent you from "pushing Volkswagen's, Acura's, or (perish the thought!) Porsche's off of cliffs".
Another reason for sharing this story with you is that I think it's important for you to understand that most, if not all, successful traders get there by surviving the agony of bad trades, picking up the pieces, and continuing on the journey. Anyone who trades consistently over a period of time will have their horror stories The ones who succeed are the ones who don't give up, get back to basics, analyze the reasons for the failed trades, and vow to learn from them. I don't want you to think I've had a string of successes, because it's not only inaccurate, it also distances me from you. Sharing my foibles with you makes all the other information I have to share with you in previous and future articles much more valid, don't you think? I feel this way because I know what I want to hear from the people whose columns I read-I want to hear that they are like me: They stumble, then they pick themselves up, regroup, vow to succeed, and keep pressing on until they do. I've adapted that approach, and I hope you will, too.
I should tell you that the trade I'm going to share with you was not the single largest loss I've ever incurred in one trade-far from it. In this trade, I only lost about 20% of what I've lost on my largest single losing trade. However, the reason I categorize the trade I'm about to explain as my worst trade is because:
I lost the entire trade within a few days-it happened very quickly!
I lost the entire trade because I wasn't paying enough attention to the news surrounding the stock. I should have known better!
Here's what happened:
In late August, I was watching for put calendar spread opportunities. That is, buying a put with lots of time left in it, and selling another put at the same strike with little time left in it, creating a very small net debit. The effect of this type of trade is that it creates a nice zone of profitability both above and below the target, or "strike" price used for creating the trade. Thus, if the stock stays within a range either above or below the "strike" price, there will be profit in the trade. And, if the stock finishes the option time period very near the strike price, there will be tremendous profit in the trade!
I was doing a scan on Optionetics' Platinum web site (Options Analysis) and found a trade on a company called Consolidated Paper, trading at the time under the ticker symbol CDP. I noticed I could buy the January 2001 40 put and sell the October 2000 40 put and my net debit would be just one dollar. Looking at the risk profile of the trade, I was risking one dollar with the potential of making a profit if Consolidated Paper stayed between about 34 and 48 at the expiration of the October short put (the one I'd sold). The stock was at 39 when I placed the trade. Everything looked like it was a set-up for a perfect trade. The volatility skew between the option I purchased, and the option I sold, was quite large as well, which typically increases the potential of being able to exit the trade early (before the October expiration date of the short put) for a quick profit.
I placed my trade and it was filled. Everything seemed fine.
Two days later, Consolidated agreed to be taken over by another company at 44 dollars per share and my trade lost all value! How could this be, you may ask? The answer is that when Consolidated agreed to be taken over at a specified price, all uncertainty about where the price of the stock would move, both in magnitude, direction, and time frame, was eliminated-the answer was that it would move to 44, and it would happen within a few weeks. There was no more question about the stock, and no more volatility or time value in the options.
In a merger/takeover situation, once all parties have approved the transaction, all options immediately assume their intrinsic value as if the option were at its expiration date, regardless of how much time is left in the option. This was a disaster for my trade for two reasons:
In a calendar spread, the net debit is really the price you're paying for the extra time between the short option's expiration and the long option's expiration. In this case, I was buying 3 extra months (from October to January) of time value for a very low net cost of just one dollar. However, all time value fell out of both options with the announcement of the merger agreement, thus my one-dollar investment became completely worthless instantly! Zero, nothing, nada!
The agreed takeover price was 44. The strike on the options was 40. Since the options were put options, what's the value of being able to force someone to buy something at 40 when you can sell it on the open market for 44? Exactly zero! Yet, even if I had used the 45 strike price and had an intrinsic value of 1 (45-44), the option I'd shorted (sold) had the same strike price, so the trade still would have had a net intrinsic value of 1 minus 1, or zero. In fact, even if the trade were done with calls, the same result would have occurred.
I've just explained my first reason for considering this my worst trade ever. The explanation behind my second reason for nominating this as "my worst trade ever" is that I should have spotted this as a suspicious trade. I'm a seasoned enough trader to have recognized the relative pricing of the October and January options was suspicious. In fact, since this time, I've spotted other trades that looked suspicious and avoided them-my antennas are up now! Still, even without that "sixth sense," I should have realized that in placing calendar trades with the same strike, the cost of the trade is strictly in extrinsic (time and volatility) value. News about the stock must be checked to be sure that events don't occur that wipe out the potential time value. I didn't do this; but if I had, I'd have spotted the takeover stories and avoided the trade. It cost me a lot of money to be reminded of this crucial step in the calendar spread game. If I had checked the news, there are other trades I could have placed on the stock that would have allowed me to profit handsomely from the takeover rumors, and the takeover itself.
As I stated earlier, I didn't lose a lot of money on this trade, but because I left out important steps in placing the trade, I lost enough to have taken a very nice cruise for a week with a girlfriend, or to have purchased a brand-new home entertainment system, or new furniture for my living room. I try to view my losses in terms of what they could have purchased in tangible terms, because it's too easy to see the losses merely as numbers in my account and not accept the reality of what the mistakes really mean. For instance, I'll drive down the street to save a nickel on a gallon of gas, and then if I make a mistake in the markets, I'll lose enough on one trade to have purchased gas at the expensive station for the life of the vehicle! I don't do this "equating" to make myself feel worse, but to force myself to learn the lesson(s) and not repeat the mistakes.
It's my wish for you that you'll educate yourself as much as you can, and that you'll be well aware of all news events, rumors, and general market factors before you place any trades. I hope you'll learn from my mistakes and the "tuition" I've paid this year, keep your own "tuition" in the trading school of hard knocks to a minimum, and vow to be a smarter trader with each trade.
Happy (and careful) trading! |
