Fight or Flight – How I Decide Whether a Trade is Worth Fighting for?

15 min read

When an option writer’s trade goes horribly wrong, they are pretty much left with two choices:

Choice 1: Take a pre-set loss & exit

Choice 2: Defend the loss-making trade by using adjustments

While both the choices have their own pros & cons, yet there are schools of thoughts that strongly advocate one over the other. On one hand, stop losses tend to over-simplify things for the trading instruments as complex as options and on the other hand, too many adjustments can sometimes over-complicate things for a trader.

Stop-Loss: A Mixed Bag

I can understand the logic of stop-losses in simpler instruments such as Stocks, CFDs and even Futures to keep a trader in the game for longer. I also support the process of stop loss discovery often backed by data and/or charts. Stop-loss in my view is as much an art as it is a science and active learning as well as experience plays a huge part in selecting the appropriate exit levels. It is also not uncommon for beginners or even traders with intermediate experience to fret over being stopped out too early from a trade. Stop-losses indeed are a mixed bag of emotions as sometimes we are thankful on being stopped out and on other occasions, the underlying reverses right after kissing your stop loss thus leaving us in an overwhelming state of remorse. Yet, the seasoned professionals stay humble in the face of the fact that stop losses can often act arbitrarily but one should never regret for being disciplined in their trading.

Stop-Losses in the World of Options

Because of the complex nature of Options and the fact that their pricing (among other factors) is derived from the price of the underlying asset, makes stop losses in option trading an altogether different ball game. For option buyer, the criticality of stop loss increases even more as they are not only competing against the price, but the time too plays a major role in determining their profitability levels. It is also not uncommon for options sellers to struggle in identifying right way of assigning stop losses if at all they choose to do so. They often regret as well when stopped out too early rather than allowing price reversal or theta (time) decay to come to their rescue.

One of the major reasons an option trader chooses to take the sell side is the benefit they get by selling an asset that wastes away in value with each passing day, all else being equal. Therefore, some option writers oppose the idea of using stop loss and rather rely on repairing their loss-making trades by way of adjustment. However, those relying on adjustments must sharpen their skills to a level where their account manages to survive & thrive even in the absence of the loss-capping cushion offered by strict stop-losses.

My View

I personally believe that it is neither a matter of picking one choice over another nor should the two choices be considered as mutually exclusive. The primary goal of an option writer when challenged in a trade is to always look for ways to minimize the losses first and then decide which option suits the best in the given scenario. It is not too rare either to see both the choices being deployed on the same trade at the same time or with some interval. Whichever choice a trader ultimately chooses to go with, the decision making to adjust or book losses should be done in a systematic and pre-determined manner by taking into consideration, all the possible moves of the underlying asset and their impact on the trade position.

It also makes no sense to adjust when the max potential losses are too low for the size of an account, and it is even more absurd to book losses (without putting up a fight) when they are big enough to put the survival of an account in jeopardy. However, the answer to fight (defend the trade) or flight (exit with stop-loss) is usually much more complicated than letting the quantum of losses dictate whether to defend or surrender. Therefore, it is imperative for option writers to build and stick with a system that helps them decide objectively whether they should be repairing or cutting loose their loss-making trades.

Fight or Flight – My Methodical Approach for Decision Making

As mentioned earlier, if the ultimate goal of the option writer is to minimize the losses, then it does not matter which route he takes as long as he eventually succeeds in achieving it.

Adjustments may let traders run their trades longer thus blocking the capital which could have been used elsewhere on high PoP (Probability of Profit) trades whereas booking losses early pushes a trader out of the game even if there were good chances for the tables to turn from the very next session/candle. However, when looked closely, both the choices offer same outcome, yet the means are different.

The only area where the choices diverge are when a trader goes with one choice only to realize later that picking the other choice could have been more beneficial. In my opinion, the traders who typically find themselves in such situation are the ones who either lack the skill of picking appropriate stop-loss levels or they haven’t yet learnt the art of adjustment.

This blog aims to help such traders stuck at crossroads and often scratching their heads whether to fight or flight a loss-making trade.

Factor 1: My View on the Underlying

If my positions are directional (bullish/bearish) or neutral (sideways) and they start troubling me then I like to go back to the very fundamental reasons why I had the taken that view on the underlying and what has changed since I took on the position. It involves a top-down analysis to unearth the unknown or factor-in the new development that could catch me off-guard if not brought into my attention in a timely manner:

• Changes to the macroeconomic factors impacting the underlying (more appropriate for headline index like S&P 500, Nasdaq 100)
• Any industry (systemic) or company (specific) development pushing the underlying asset into the unanticipated direction
• If there are no news or event-based action (identified from the above two) that appears on the surface, then I move on to the charts to see if my assumption on price movement (e.g., one way move against the anticipation of sideways movement) or the support & resistance levels are turning out to be wrong.

Often, this top-down approach followed by chart analysis helps me find the unknown or simply leads me to the realization that my assumption on the stock has gone wrong. It is also not uncommon for me to find absolutely no meaningful answer and then I let the other 3 factors pitch-in for my fight or flight decision. Know that this factor is only an information collection stage and the actual decision making begins from the next factor.

Factor 2: The Quantum of Loss

This factor is a decision-making factor i.e., after taking the quantum of loss into consideration, I may decide to fight or flight accordingly without going to the remaining two factors. If the max losses are not huge enough for me to sit up and do adjustments, then I usually let the trade run its course till expiry or just book the losses to move on. However, it is not as simple as I made it sound. A lot goes into deciding whether the loss amount is acceptable or not and I take a principles- based approach to take a final call.

So let me consolidate the 2 principles that I follow for decision-making:

Don’t manage trades, manage portfolio: I prefer to look at my profitability at portfolio level and on a monthly interval basis. Note that portfolio here means a group of all trades in my respective account that are expiring or have already been closed in the current calendar month. If my overall portfolio has had a decently profitable month then there are very high chances that I won’t bother with the losses that may have relatively smaller impact on my overall monthly returns. The inputs from the first factor i.e., ‘my view on the underlying’ also helps me decide on the next course of action. Sometimes if a news/event makes me change my view on the underlying and the losses are still small – even in such scenarios, I either exit or let the trade run till expiry while betting on price reversal and/or theta decay. Sounds simple? Not even close, here comes the twist in the tale.

It is not always that I ‘choose’ to exit a trade when other trades have been going well for me. Sometimes I book the loss even when most of the other trades are also challenging me at the same time. When faced with challenges from most of my trades in the portfolio, the trades running with least losses are closed out immediately to stop further damage and allow myself to concentrate on the positions with higher max loss potential. It is like handling a bunch of babies at the same time and the baby crying loudest gets the most milk. As you can imagine, it becomes a matter of survival with so many trades going wrong but there is another reason as well to book losses on small loss-making trades which I will cover in the fourth factor on buying power rationing.

Trade Type Matters: There are some trades that make me happy even when they go deep in red. Think of covered calls where am eagerly waiting to part from a stock or naked puts where I can’t wait to get assigned and finally add that high- flying asset into my portfolio at a very attractive valuation. Needless to say, I let these trades run their course and eventually achieve the desired outcome.

Factor 3: The Time to Expiry

Rather than being a decision-making factor, the time to expiry is a ‘decision- enforcing’ factor. If the time to expiry is less, then it severely restricts my ability to perform adjustments. This is because less time means that am only left with the universally known/adopted adjustment option:

1. Roll the losing trade out in time for same strikes – close the trade and enter another one with same strikes but for expiry further out in future.
2. Roll the losing trade out in time and Roll Up/Down in Price – close the trade and enter another one with different strikes and expiry further out in future.

As an option trader with a decent experience under my belt, I have come to the realization that rolling out in time and/or price only makes sense in very specific conditions. If those conditions are not met, then rolling only adds on to an already loss-making trade.

Therefore, I try not to let ‘time to expiry’ factor restrict my adjustment to rolling only and prefer to decide much early on the fate of the trade. The other way to avoid being caught into such situation is to trade in longer duration options i.e., anywhere from 6-8 weeks & beyond. This factor is also the reason why I try to stay agile in my trade by booking profits early, taking proactive action on anticipated move on the underlying, sticking with the underlying assets that am well versed with and lastly, protecting profits in highly volatile underlying by using trailing stop losses.

Factor 4: Rationing the Buying Power

Regardless of the size of the account, we all have limited capital to play with. And therefore, it becomes even more important to utilize our capital judiciously. Most of the adjustments I undertake are capital intensive i.e., I put on more trades to defend the original trade and that requires allocating more capital in terms of buying power/margin requirement. While not taking loss is the utmost priority, one should also avoid blocking the entire capital to defend just a handful of loss- making trades. Even if the trader in such scenario may have managed to exit at break-even, yet his return on capital for the same period would be zero. Instead, had he booked a small loss and reallocated his capital elsewhere, there are greater chances that he could have come out on the other side with returns at least higher than zero. Therefore, for option traders, capital management is just as important as risk management.

This factor works in tandem with the second factor on Max Loss Assessment. As mentioned in the second factor, I sometimes prefer to book smaller losses if am also running other trades that have potential to induce even larger losses. And the reason for doing so distills down to buying power rationing.

You see, bigger losses also imply bigger trades that usually involve either high priced underlying or wider spreads and even both in some cases. Nonetheless, defending large trades require same sized adjustments and most of these adjustments are capital intensive. Therefore, it becomes imperative to cut out some of the loss-making trades to not only free up some buying power but also narrow down my focus on the number of trades that I can defend without much hassle. Because even if I would have chosen to fight out on all the losing trades, chances are I may still end up losing on some of the trades anyway and if victory in defending every trade is not guaranteed then why not focus only on the ones where I can potentially lose the most and therefore, are worth fighting for.

Buying power rationing also helps you run your profitable trades longer. When strapped for capital, you would often rely on closing out the profit-making trade to free up some buying power. This may limit your total profit potential especially on the trades with high PoP where you already know that you are booking the profits pre-maturely. Yet, closing out profitable trade usually remains the only way out if you fail to allocate your capital prudently. Furthermore, you should always have some profitable trade running all the time. Not just for buying power reserves but it is also good to keep your moral and confidence high enough to keep you battling for the losing trade and therefore, some trades going in your favor even in the face of uncertainty helps you keep your balance.

Lastly, it is a human tendency to concentrate on things that can or are going wrong. Our centuries old survival instinct keeps diverting our focus on the things that have the most potential to induce physical or emotional harm to us. And having a big and losing trade in our portfolio engulfs us so much that it is not uncommon for us to lose track of other small loss-making trades. It is also very tempting to never book loss especially when we have enough buying power to stay in the game and keep fighting. However, take it from someone who has been more wrong than right in making fight or flight decision: choose your battles wisely. Not every fight is worth picking and sometimes you must let go to keep your powder dry for defending the bigger trades and to pounce upon the new high PoP trades that markets may throw your way. It is equally painful to realize in hindsight that you missed out on some great trades because you were either too occupied fighting elsewhere or had no more fire power left in your arsenal to enter into fresh high PoP trades.

Before wrapping up this factor, I would like to pre-emptively answer a question that may have crossed your mind. That is, why keep buying power a separate factor rather than adding it as one of the principles under the second factor on quantum of losses. While this argument does have merit, yet it also undermines the importance of buying power management. Buying Power Rationing has been added as a factor of its own to not just stress upon its criticality but also showcase its veto power on deciding the trades to be defended or dropped. Consider a scenario where factor 2 spells out a certain number of trades that require adjustments, but the factor 4 trims that number down due to limited buying power available in the account. At times, it becomes harder to estimate how much buying power will be blocked by the broker on supplementary adjustment trades.

And one can only find it out by doing the adjustments one by one. Especially during heightened volatility environment, only a handful of adjustment trades end up eating into most of the available buying power leading to forced loss-booking in other trades even though they too may have been strong candidates for adjustments. In order to avoid booking larger losses due to this phenomenon, I’d advise first defending the trades with highest max potential of losses and gradually making your way on to the ones with lower loss potential. This will save you from booking larger losses when strapped for capital.

Let me reproduce all the 4 factors in a succinct manner for you to adopt this methodical decision-making approach more easily:

Taking all or some of these factors into consideration, I try to answer THE QUESTION: Should I salvage the trade by deploying adjustments at this stage?

Once the verdict is out!

If the answer comes out to be an emphatic NO, I humbly accept my mistake, book the loss, and move on. No hard feelings, no regrets, no revengeful intentions and absolutely no love lost between me and the underlying asset! It just did not work out “this time” because I wanted it (underlying) to stay put or move in a certain direction, but it was under no obligation to comply and decided to exercise its right to move as desired. So, like two professionals in a combat, I accept my defeat, shake hands with my opponent (underlying asset) to conclude the fight and we go our own ways happily with a promise to meet again for another professional bout.

On the other end, if the answer to my trade salvation question comes out to be a resounding YES, then I choose to fight it out by carrying out my adjustments in a methodical manner that I have devised and fine-tuned over past few years.

At the risk of sounding too dramatic, let me share how I feel when the verdict for going to the war to defend the loss-making trade is announced. A subtle yet powerful wave of adrenaline rushes through my vein, propelling me into the world of fearlessness. At this moment, my potential losses have already been computed, every base has been covered from the risk & capital management point of view, and I feel ready to draw the first blood while defending my position.

A word of caution

I must add that no system is perfect, and neither is my 4-factor ‘flight or fight’ system that you have gone through above. A bad trader can pick an extraordinary system and yet may only manage to generate average returns whereas a good trader can generate extraordinary results even with an average system. The point is, as long as there is a human involvement in your system, achieving 100% objectivity in your decision making would always be a challenge. But a trader with all his might should aim to bring as much objectivity in his decision making as he can and that’s exactly why I decided to build my 4-factor ‘fight or flight’ system. There is no guarantee that this system always offers 100% correct answers when used with 100% objectivity. In fact, there are no 100% correct answers in stock markets but only probabilities & averages which is what this system is based upon. Therefore, feel free to tweak this system by either adding your own objective refinements or choosing to superimpose your own views in a subjective manner before taking the final decision to fight or flight!

No more than 5

The process of deciding ‘fight or flight’ may seem lengthy & complicated but it is worth spending some time to master it. As you become experienced in logically following these steps, you would find that the entire process does not take more than 5 minutes. Even with the entire portfolio comprising a large bunch of losing and winning trades, you would know exactly what to do with each of the trades.

Hoping you would find this system useful in your own trading going forward.

Blue skies,

Sanjeev Kaushik