Next week is our annual Irrational Economic Summit and I’ll be giving two talks, including one on trading options.
I gave this “Options 101” talk at last year’s conference and it was a hit. I had a number of attendees tell me how it resolved for them one or more concerns they’d had about getting into options. The primary one being the thought that options are “too risky.”
As I see it, almost anything can be “too risky” when used irresponsibly. And conversely, if you know how to account for an investment vehicle’s drawbacks, you can invest in almost anything responsibly and with confidence.
That goes for options trading, of course.
One of the drawbacks of buying an option contract is that there’s a fairly decent chance the contract will at some point in the near future be worth nothing. That’s right, you stand to take a “total” loss on that specific investment.
Indeed, we’ve taken a handful of these full losses in the seven years I’ve been running my Cycle 9 Alert options service. But since I’ve always shared with readers why it’s “OK” for that to happen occasionally. And how my system is designed to account for, or “absorb,” those losses… thousands of my readers have been able to confidently trade options and earn handsome net profits over the years.
Today, I want to share with you a story I first shared with my Cycle 9 Alert subscribers earlier this week. It speaks to the philosophy of position-sizing, which is simply a fancy way of saying “how much should I invest in this one position?”
Accounting for the Risk of Ruin
My wife and I were recently discussing where we’d want to build our “forever home,” if that’s what we ended up wanting to do.
We’ve been serial renters for the past decade or so, taking full advantage of my ability to work remotely and enjoying the flexibility that comes with not owning a house.
We’re currently in a small beach town just north of South Beach, in Miami, FL. And while we love being three blocks from the beach, and close to dozens of fabulous restaurants and things to do, we’re still searching for a place to call “home,” permanently.
We love the American southwest. We eloped in Joshua Tree National Park, and over the years have enjoyed exploring the deserts of Arizona, New Mexico, and Utah.
But we also love the Caribbean islands. And we could easily see ourselves living a long life of adventure somewhere in the Bahamas, Puerto Rico, or the U.S. Virgin Islands.
Hurricanes and “Total” Destruction
Of course, the topic of hurricanes comes up every time my wife and I have this discussion.
“No hurricanes in the desert,” she coyly reminds me any time there’s a threat in the tropics.
“No crystal-clear water, though,” I rebut.
During our most recent round of debates, my wife made a great point about how much we’d likely want to invest in a Caribbean home. She considered the fact that it could eventually go the way of the hundreds of homes in the Abaco Islands in the wake of hurricane Dorian.
Specifically, she said:
“In the Caribbean it’d be all about security. Not aesthetics. You build the sturdiest home possible, for the least amount of money possible. And you’d just bank on potentially losing it all, at some point.”
In the desert, we could invest more… restore an old Spanish revival and make it really pretty. It would last forever out there.”
The thought-process in her words struck me like a bolt of lightning, because it echoes a principle of investing that I’ve long known and shared with you.
That is, generally, how to avoid what traders call the risk of ruin.
How to Not Lose it All
Think of it this way…
When you buy a U.S. Treasury bond, the odds that you’ll lose 100% of your initial investment are as close to zero as you can get. You might lose 10%, 20%, even 30% of your money. But hell and highwater would have to come to cause a total, 100% loss.
And knowing that, folks routinely plow large sums of money into U.S. Treasury bonds.
On the other hand, option contracts have expiration dates and rather high odds of total, permanent capital loss. Many, many option contracts go to zero. And that’s why you don’t see anyone parking capital in options, as they do in Treasurys.
To bring this back to my wife’s keen observation about the life expectancy (or inversely, the risk of ruin) of a desert home versus a Caribbean island home…
U.S. Treasurys are the desert home (low risk of ruin), and options are the Caribbean home (high risk of ruin).
And by now, I hope you can see how even my wife’s intuition guided her to a smart decision, about how much to invest in each of those homes, based on their respective risk of ruin.
You invest a “little” in the one with the “large” risk of ruin, and vice versa.
Why Am I Telling You This Story Today?
Well, our positions have gone against us in the past couple of weeks.
Even though we all know options are volatile, and routinely go through drawdowns of 50% or more, it never feels comfortable holding a portfolio of option plays that are suffering. The natural inclination is to do something — anything to “stop the bleeding,” economically, and stop the pain, psychologically.
I’m a firm believer in risk management, of course. But I’ve talked before about how using stop-losses on options doesn’t make much sense. And since “routine” volatility often leads to drawdowns like the ones we’re experiencing now, you sometimes just have to weather it bravely.
As I’m sure you know by now, the targeted holding period of all Cycle 9 Alert trades is two to three months. That’s the “sweet spot” of my system’s buy signals. That’s the window of opportunity that gives us a high-probability trade. Whereas anything short of two months, or longer than three months, gives us only average probabilities, at best.
Where Does this Holding Period Come into Play Presently?
Well so far, only one position has matured enough to warrant even a consideration of selling. We’ve been in this play for about two-and-a-half months, so it’s nearly time to move out of it. Not today. But be on watch for a sell alert in the coming weeks.
Otherwise though, our other positions are far too new to exit. That means we should continue to hold them, to ensure we give the trades a sufficient amount of time to reach their high-probability outcomes, which is a “win” roughly 70% of the time, based on Cycle 9’s long-term win-rate.
Of course, since we’re down 50% to 60% in two of these plays, we are risking the possibility of “total” losses on these positions.
But that’s OK.
We’ve taken a number of total losses on individual options positions in the seven years I’ve been running Cycle 9 Alert. It’s an outcome that can’t be avoided or fully protected against.
Like hurricanes in the Caribbean, it’s just a fact of life… and something a wise person will account for.
Prudent position-sizing is the only foolproof method of limiting losses, particularly when dealing in an investment vehicle that historically has a high risk of ruin (as with options, and houses in the Caribbean).
This is what allows us to occasionally take total losses on individual positions, and still “live to fight another day,” as traders say.
I’m of course hopeful that one or more of our open positions will bounce back between now and the end of our targeted holding period. We’ve certainly been down 50% or more of past positions, only to see a recovery to profits once the fat lady has sung.
But even if we aren’t so lucky, we’ll be just fine in the end. Remember that with systematic trading, your long-term success depends more of the efficacy of your model and your ability to stick to it with discipline more so than the result of any one trade.
Stay the course, my friends.