What happens when a trade falls by the wayside? We always talk about the trades that can make a trader great. The trade that sets someone up for life. That one home run we can brag about long after the season ends. (Ironically, the season never ends for most traders, but you know what I mean.) The truth is, that's not what makes a trader great. It's humility. It's knowing when to admit you're wrong.
I went through a period where I refused to admit I was wrong. It wasn't ego, it was frustration and embarrassment. And I didn't just sweep the trades under the rug. I added to them -- aggressively. I believed so much in my thesis, thinking that even if I were only half right, the stock or index would change course at least a little and I could get out of the trade flat or even in the green. Two dollars in the green would have served my purpose. I just wanted my two dollars.
Throwing good money after bad. Most of us have been there. It's a painful lesson we often learn in slightly different ways, but when the pain grows we eventually avoid repeating it. The flipside is burying your head in the sand and ignoring a bad trade. In my view, this happens more from the long side, and Doug Kass has touched on a good point about short puts, as I believe the "Ostrich approach" rears its head there more than anywhere else.
Here's my thinking. Perhaps it's a bit rudimentary, but much of trading is. It's about size and liquidity of shorting puts vs. buying stock. While we love to talk in terms of percentages when discussing winners and losers, most of us focus on the big numbers: the size of the trade and the value of your account.
Looking back at Lumber Liquidators (LL) a year or so ago when 60 Minutes trashed the company, the stock took a huge hit. At the time, I, like several others, went with the notion of shorting puts. Premiums were high due to a huge pump in the implied volatility. It was designed to be a short-term trade and a short-term trade only. Right or wrong, I kept it as such and I was right -- for about two days.
After taking some profits when the stock bounced a bit, LL resumed its cascade lower and I was forced to close the remainder in the red. Overall, there is nothing wrong with that trade. I had a thesis. It didn't work, so I walked away, but what about those who looked at this situation as a short-term issue for a strong longer-term company? They likely chose to buy stock or sell much longer-dated puts, and this is where the issue can come into play.
If the stock is at $40, a trader commits $20,000 to the position assuming 500 shares. They see this this number --big for some, small for others -- bounce around throughout the day. Assuming it's a big enough number to catch your attention (if not, imagine $200,000 and multiply everything by 10), here's the rub: If LL dropped by 10%, you'd probably take note of the position now being at $18,000 and when it dropped to a value of $15,000, down 25%, you'd likely really start to feel edgy. If you haven't pulled the plug yet, you're at least adding an extra coat of deodorant each morning before pulling up the opening quote. However, what if you shorted a long-dated put? Things could look very different.
Let's assume you got $8, or $800 for each short put and shorted five. Well, now you have a position that prints -$4,000 (likely red for most folks). The stock drops the same 10%, but the puts aren't moving quite as fast. Hey, we're only at -$4,200. It's not too bad. But then the free-fall starts and the stock has dropped the same 25% as previously noted in the stock example. The puts hold up a bit better and we're only down $800 at $-4,800. The leverage has served us well. No problem --until the stock keeps falling. Before we know it, $40 has become $11. The short puts are now at -$15,000, a drop of $11,000, but hey, it's still better than owning the stock, right? It is thanks to the premium, but if you had owned the stock, this may not have happened.
You see, we are hardwired to look at the big number, the positive number. Few traders are accustomed to seeing negative values in terms of a stock's position, only in terms of P&L. The short put value can lull us into a fall sense of security. The number, net of the sign, is growing as we are losing. We should see a loss of $800 when the value goes from -$4,000 to -$4,800, but our brain sees the increase from $4,000 to $4,800. It's an easy habit to fall into for many traders if they position the short put long term. By the time many of us realize the damage, we shift to a head-in-the-sand mentality and pray the stock will come back.
Unfortunately, when you find yourself in a stock down 75% from your entry and only have six or seven months left to expiration, you're past praying and only left with the option to make a deal with the devil if you want to get out even, but no trade is worth selling your soul.
