Today, I’m going to tackle a question that many traders and investors face at some point: “Oh no, how do I defend against irrational moves? What should I do?” If you’re here hoping for a magical solution to salvage your account after a downturn, I must disappoint you. The truth is, there are no quick fixes or secret formulas. However, I’ll share some valuable insights and strategies that I’ve learned from the experienced trader and investor, Tom Sosnoff. Trust me, these nuggets of wisdom are gold. They’ll help you navigate through the market’s wild rides and come out the other side even stronger.
Most of the time, markets exhibit a reasonable level of efficiency. However, can we accurately predict their movements? No. Can we always quantify market behavior? No. Does the math behind trading strategies work most of the time? Yes. In order to provide efficient two-sided tradable quotes for stocks, futures, stock options, and futures options, pricing models are essential and fortunately, they deliver. Nevertheless, there are instances when markets, across all sectors, can become erratic. In such situations, the moves cannot be defined, rationalized, or modeled.
So, how do we defend against the indefensible? Over the last years, I can think of several non-standard, non-quantifiable moves that serve as examples. These include major market indices in March 2020, the VIX in April 2020, crude oil in May 2020, Tesla later in the year, just to name a few. None of these moves were defensible in any way. It didn’t matter how good of a trader you were or how much you knew or anticipated. You couldn’t buy the dip or sell the rallies. All the necessary trade indicators were suggesting opportunities. There was high implied volatility, high IVR, and abundant strategic liquidity. If you can’t see the danger or the risk, which remains invisible, what can you do? Although there may always be red flags, there are no indications of extreme moves.
To start, be consistent and keep your position size and number of contracts small. Apart from sticking to the mechanics, this is your only pre-trade defense after establishing a position and when the move has breached standard defensive adjustments. For example, a standard defensive adjustment involves rolling up or down the untested side, rolling out in time to the next month, and potentially going inverted.
So, what’s the next move? This is the dreaded “oh no” moment, the point where you come to terms with the fact that you’ve lost control of the situation. It’s important to note that this happens to every trader. It’s simply a part of the equation. We can’t accurately measure the extent of the problem. To help you navigate through these challenging times, let me share Tom Sosnoff’s expert advice, based on his extensive experience. You can place your trust in his step-by-step guide to effectively manage such situations.
Step 1. Do Not Add to the Position
Do not add to the losing position you already have. Resist succumbing to your ego. In times of account downturns, it might be tempting to seek refuge by purchasing protective options like puts. However, this approach is akin to buying house insurance when your house is already on fire. Not only would it be expensive, but it’s unlikely to salvage your situation significantly. Instead, concentrate on understanding and managing your risk effectively from the outset.
Step 2. Reduce Your Size
Reduce your unit or contract size by at least 25 to 33%. While it may initially feel uncomfortable and perhaps even painful to shrink your exposure, this adjustment is necessary to create a buffer and enhance your ability to effectively manage the situation. By reducing your position size (if possible), you not only mitigate potential losses but also gain valuable flexibility in adapting to rapidly changing market dynamics.
Step 3. Hedge with Static Delta
Hedge at least 20 to 25% of the position with some sort of static delta, such as stocks or futures (but not options). By using instruments, which have a fixed delta value, you can effectively neutralize the delta risk associated with your options positions. This means that as the market moves, the gains or losses from your options will be partially offset by the gains or losses in the static delta instruments.
Step 4. Establish a Loss Threshold
Set a reasonable loss objective. At this point, profitability is probably not an option. Focus on limiting further damage instead. By setting a predetermined loss threshold, you ensure that emotions don’t cloud your judgment and maintain a disciplined approach to risk management. Remember, the goal is not just to make profitable trades but also to preserve your capital and maintain resilience in the face of market uncertainties.
Step 5. Avoid Correlated Assets
Stay away from similar or highly correlated products until things normalize. When one market experiences upheaval, it can trigger ripple effects across related markets. To minimize exposure to potential cascading risks, temporarily avoid trading similar or correlated products until stability returns. This step allows you to gain a clearer perspective on the market and avoid compounding losses.
Step 6. Keep Moving Forward
Try to move forward with other trades. As premium sellers, we thrive in high volatility environments. While transitioning from low to high volatility can be unsettling, it’s during these times that our opportunities are most promising. So, don’t step back from the market. Capitalize on the increased volatility and leverage it to your advantage. Remember, the best way to benefit from high premiums is to keep trading strategically and consistently.
When the market delivers a blow to your portfolio, it’s essential to approach the situation with a level head and a growth mindset. How we respond to the most difficult situations ultimately shapes our ability to build on our successes. Sometimes, situations are simply not defensible. Therefore, always keep your size reasonable, use your risk assessment mechanics, and know how to quickly mitigate the damage. This is how you build for success.