Why Am I Losing Money on This Option Trade?

06/30/2010 12:01 am EST

Focus: OPTIONS

I have received many different e-mails from students with their trades asking for advice on what to do, yet seldom do I share their painful lessons with the general reading audience. It is only when the e-mail sender agrees to let me share their trade that I do so, keeping their identities anonymous, of course. Meanwhile, I obtain all the relevant specifics about the trade, and also their perspective at the time of entry, as well as their forecast for the trade. Usually, my in-depth analysis of their losing trade provides them with a valuable learning lesson.

Most of the time, the student doesn’t understand why the trade has moved negative and is looking for answers. Here are the facts on one of those trades, which was initially entered on June 7, 2010 with the small size of two contracts. The contracts were for the July 38 put on EEM. The premium was $2.83, while the underlying was trading at $36.60. The reason for entry, according to the e-mail, was a possible retest of the $35.50 support; basically, just over a whole point lower.

At the time, EEM was trending down, but the very next day when the underlying bounced up, the July 38 put was trading for $2.43, or 40 cents less than the day before. At that point, the trader had purchased an additional 15 contracts, bringing the total to 17 contracts. At this point, it is essential to discuss the size of the trader's account. An account with 25K provides the option trader with the ability to daytrade, meaning to enter and exit a position in the same day. The size of this trader's account was a bit above 25K, but he had (at the time) most of his 25K tied up in various other trades, the EEM trade being just one of many in his account. When asked about the largest contract size in his account, the reply was "Never more than ten contracts." Supposedly, this was one of his rules. I must say that I didn't think much about his reply of ten contracts max until I observed that he was already at 17 contracts two days into trading the EEM. I pointed out to him that his rules are as good as he is at keeping them. There is no outside police that will come by and enforce his ten-contract max rule. To make matters worse, the position had gone against him and he had added more contracts to his losing position. At that point, EEM was taking out the high of June 7, 2010, the high being the place where the stop loss should have been ($37.50), yet he had none placed.

What he basically did was average down. I e-mailed asking if he had any rule that states how much of the capital at any given time he could invest in any given trade. I have never gotten the reply to this inquiry of mine, which leads me to believe that he probably didn't have this rule. (I am hoping that our students do have a maximum limit amount invested per any given trade. Even if the amount is a range, let's say 3K to 5K of invested capital, it is alright as long as the max amount is specified, and not a penny more should be thrown at a trade.)

As his trade evolved against him and he did not have a risk management component in place, he did something unbelievable. He closed his winning trades on other equities and reinvested the profits from them into the EEM trade. To make things worse, he did not do this once, but three times on three different days. On June 10, he added another ten contracts, but this time, he only paid $1.79 for the July 38 put, while EEM was now at $38.61, a dollar higher than where his stop loss should have been. Then the next day, June 11, the candle was red, so he added 20 more contracts at $1.67. Unfortunately, there was no follow through on the EEM move down toward his initial target around the $35.50 zone of support.

To step back and assess the picture, one might recall that initially, he was going after a one-point move down. The entry was $36.60 and the target was $35.50. Within a few short days, the issue was at $38.61, which was twice as much of a loss as the profit that he was initially targeting, and he was still in the position with a total of 47 contracts.

Once again, by buying more contracts at the lesser price, he might have been under the impression that he was getting a deal, yet that is not the case. When EEM was at $38.60, his July 38 put was out of the money, whereas when EEM was at $36.60, it was in the money. By the time he had accumulated nearly 50 contracts, it should have been obvious to him that the trade was getting disproportionately big. Once trades are oversized, they tend to control the trader. Just like Frankenstein was not able to be controlled by his creator, so too was this trader unable to control the beast/monster that he had created.

It is only when he added the very last penny of his 25K account, reducing it to below $700 on June 15 by buying an additional ten contracts for 94 cents, that he chose to e-mail me for help. At that point, all I could do is what I am doing right now and analyze what went wrong.

His main question to me was "Why am I losing money on this trade so rapidly?" The simplest answer would be because the price action had gone opposite of his forecast. Secondly, because the options that were purchased were expensive due to high implied volatility, as EEM rose and the implied volatility decreased, the extrinsic value of the premium proportionately decreased as well, and since the puts were completely out of the money at this point, there was no intrinsic value in the puts at all.

In conclusion, this article shares a painful lesson from which a lot can be learned. Hindsight vision is always 20/20, for it is so much easier to analyze someone else's trades and make objective comments. Nevertheless, it is much more difficult to step outside of oneself and evaluate one's own trade. This trader could not clearly comprehend what he was doing because his ego got in the way. For this reason, we the traders all must master the mental game before we can move on to the next level.

By Josip Causic, trader and instructor, Online Trading Academy

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