Rolling With the Punches

by John White

Many of you have heard me say that successful trading is not based on the "best" strategy, but instead revolves around a solid workable trading system.

Often when you speak to traders, the first topic to surface is profit. How do you find it? How do you make it? How do you keep it? However, these same people rarely raise the issue of how you should react when things go wrong. This commonly overlooked area of managing "bad" trades is one that must not be brushed aside for those who intend on being in the trading business for the long haul versus simply having a short lived trading hobby.

Let’s take a look at an example of what I’m referring to.

Above is an example of a bull put spread. Keep in mind that a bull put spread is a type of credit spread where the trader sells an option and then buys an insurance option. In this example the 350 put may have been sold for $1 and the 340 put may have been purchased for 20 cents, resulting in a net credit of 80 cents. And as long as the $OEX stays above the 350 level, the entire trade will expire out of the money and we’ll keep that 80 cents which equates to an 8.7% return.

As long as things go smoothly, we should have no problem making our full return on this position. However, how would you react if the $OEX started to approach the 350 level, threatening the trade? One popular choice a trader has is to "roll" the trade.

In this example a trader could exit the original bull put spread that has become threatened and immediately "roll" down into a new bull put spread and take in addition credit. Let’s say that you paid a debit of $1 debit to exit the original bull put spread. After subtracting that debit from the 80 cents credit you first received on the trade you are left with a negative balance of 20 cents.

However, let’s assume that "rolling down" into the new 330/320 bull put spread (sold the 330 put, bought the 320 put) resulted in a new credit of an additional 80 cents. Adding that new credit of 80 cents to the negative balance of 20 cents not only put the trade back in the green by a positive 60 cents but making this move also placed the new bull put spread further out of the money which translates into more safety and less likelihood that the new position will be threatened before expiration.

In other words, by exiting a "bad" trade and getting into a new one, we have maintained our profitability while also allowing the $OEX much more room to move further down without causing us any concern.

These types of "rolling" repairs are just one of the many things you will learn at my live on location Spread the Wealth class. To learn more about all aspects of this type of trading get to the next live class, scheduled for June 20 in Philadelphia. What could be better than learning how to improve your trading in the City of Brotherly Love!

If you can't make that, please check out my Non-Directional Diamonds online seminar. That four-hour class will be May 23 starting at 10 a.m. I can help show you how to put the odds on your side of the table.