| Survival Mode Posted: 23 Sep 2011 07:01 AM PDT  Bunker As I sit to type this blog, my aluminum foil hat is getting really uncomfortable. The NASA satellite is re-entering the atmosphere somewhere this afternoon, Europe is approaching financial meltdown, Ben Bernanke is out of ammunition, and gold prices have retreated from their recent multi-year high. Even the VIX has awakened from its slumber and is hovering around multi month highs. Assuming the satellite doesn't take me out this afternoon, what can I do to deal with the increased risk of the current environment? Remember that capital preservation is paramount in times like these. Here are a few suggestions to keep in mind: - Take a break. You don't have to be in the market at all times. Recognize, as farmers have always known, that sometimes it is just too wet to plow. It will get easier.
- Trade small. Valuable skills can be learned in fast markets such as these, but they only benefit those who survive with their capital intact. Cut your trade size in half or to one-quarter of your usual size.
- Trade only the most liquid issues. Liquidity traps are subtle- they draw you in with a reasonable negotiated price but they don't let you go without inflicting pain. I find the list of underlyings that trade weekly options to be a great screen for finding the most liquid candidates.
- Recognize and deal with elevated implied volatility. When planning trades, allow for the probability that current inflated volatility will revert toward its mean. Neutralize this effect or turn it to your advantage. In optionspeak, use vega neutral or vega negative trade structures.
- Use limit orders. The two cardinal changes in markets adapting to uncertain market conditions are increases in implied volatility and widening of bid-ask spreads. Never ever use market orders to enter positions. As a corollary, remember that you may have to use these type orders to exit in emergency conditions.
- Reduce the number of positions you have open. It is easy to overlook positions that need attention in the heat of battle. This is not the time to baby sit the neighborhood.
- Use defined risk positions. Some option positions, for example naked short puts, have substantial potential risk. This is not the time to depend on the Black Swans remaining in the nest.
- Plan your trade and follow your plan. Deer in the headlights have a very short life expectancy. So do traders in current market conditions who lack a plan or ignore the plan.
- Remember that option position risk is defined in terms of time and implied volatility as well as price. Certain positions, for example call ratio back spreads, have risk defined in terms of time as well as price. Don't miss the forest for the trees.
- Remember to breathe. This too shall pass. It does get easier.
Life will return to normal. The foil hats can come off soon. We'll need the time to get ready for whatever the Mayans were trying to tell us about in 2012. Join our free public forums at http://forums.sheridanmentoring.com.  |
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