Losses Are Truth

In the past week, I had the pleasure of taking small losses on two of my positions. I say pleasure, not because I necessarily enjoy losing money, but rather because it keeps me real.

I am no savant with all the answers, I take positions that end in a loss, I am human.

All I can do is manage my losses. I can control the severity and impact of losses on my overall portfolio. And this is exactly what I did... very well in both positions.

Both of these positions on which I took a small loss were in the form of long-dated put options, so the risk control was precise and very effective. It's a perfect example of why I love options more and more with each trade.

I followed my signals on the entry, but the market reversed. This means I had to exit the position. Simple as that.

The first position was a long-dated put option on IYR—a U.S. real estate ETF—which had a strike price of $75. I opened my position on December 18, one day after this sector experienced a pretty good drop.

By Christmas Day I looked like a true genius as my trade was “in the money” and up over 50 percent. However, as we know, the broader U.S. stock market turned around and has come back strongly since that time and IYR was no different. The signal changed and I exited my position for a small loss of a few thousand dollars.

A similar experience occurred with my long-dated put option trade on UNG—the U.S. natural gas ETF. I chose a strike price of $25 on a long-dated put option on December 18, once again betting that UNG would fall in value.

Again, as we rung in the new year this position was well “in the money” with a 60 percent gain. This week, however, natural gas prices jumped and I had to exit. I dropped the position for a tiny loss and moved on.

In total, I closed these positions for a loss that was far less than the maximum amount of money I am willing to risk on each trade. I simply followed my signals and I got stopped out. The cash is now in the bank and ready to deploy on a new trade.

Fear of Taking Losses

The events of this week got me thinking about the sentiment which I read so often on the internet and hear so often from my peers. I’m talking about the fear of crystallizing losses. The idea that a loss is not a loss unless it is realized—by that I mean the position is closed.

The fact is that a loss is a loss whether it is realized or not. Your equity has dropped. Your net worth is lower.

Riding a position down to extinction is not going to keep your from being poorer just because you refuse to sell. There is a vast graveyard of worthless stock certificates in the nation's dusty attics.

But this concept goes well beyond the world of stocks and financial investments. It can be your over-leveraged house (which is not an investment), it can be your dismal job, it can even be a relationship with a toxic individual.

When the facts change, or when you're in too deep, you need to take a step back, analyze the situation, and get out. Cutting your losses is critical to moving forward.

Keeping an Eye Ahead

When you really analyze the big picture, you realize that the past doesn’t matter. That doesn't mean we should behave in a manner that's oblivious to the past.

As people, we can certainly learn from the past. We can try avoid repeating the past mistakes we make or those we observe others making. But we shouldn't tie ourselves to the past. Instead, we should always look forward to the opportunities that lie ahead to improve our well-being.

For the investor in us the concept is no different. We use trading systems to try avoid the catastrophic errors made by ourselves or others, but we ultimately look forward.

That means the best way to manage your money each day is by trying to make sure you are invested in those assets which are likely to be the most profitable going forward. Investing is about making profits after all.

Everyday, or every week, or every month, depending on your particular trading strategy, you need to scour the investing universe for the best place to invest your money today. Figure out how to control the risk and place your bets.

I could easily be wrong on the trades I made. IYR and UNG might stop their upswings and once again begin to fall. That’s okay! Provided the risk parameters are right, I will get right back into the trade themes and try again.

The key is that I am willing to change my mind when the evidence shows me that I’m wrong. Even after I was initially right!

If you have losses, realize them quickly, try keep them as small as possible, and move forward.

Comments & Questions

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8 Replies to “Losses Are Truth”

  1. You don’t see many of this articles around. Thanks for sharing Daren.

    Question: what stopped you from crystallizing gains when you were in the money?

  2. Daren (Editor) says:

    Just following my signals; in a fast changing market it would happen often where my exit is at a loss. It works out to about 40-50 percent of all trades. This is because volatility is typically higher around signal changes. I’m currently testing trading systems that could possibly hedge this using VXXB options, VXZB options, or VIX futures.

  3. Thanks for the article Daren – good read.

    A few questions:
    – you talk about managing losses with the long options you bought, but what risk is there – either they are in the money or they are not and you lose option premium amount correct? Or were you selling options?
    – not sure how many option contracts you bought of either ETF, but why do you not exercise or take profit once you realize a certain % gain on one or several of the options?

  4. Daren (Editor) says:

    Good questions!
    1) I never write options (ie. hold a negative position), I only purchase options or sell the options I already purchased. With most options, they can be held until maturity, exercised at any time on or before the maturity date, or sold back into the market. If I buy a LEAPS option expiring January 2020 that is out-of-the-money, the only value in the option is the “time value”, or a value assigned to the probability that the option is in-the-money at the maturation date. This means I can buy an out-of-the-money option today and sell it back into the market tomorrow, even though it is out-of-the-money.
    2) This would be a form of profit-targeting which is very dangerous in trend investing because it limits your gains on the big moves. A trend investor needs to ride big moves all the way because this is where the real money is made. The small moves up and small moves down sort of cancel each other out.
    There may be an exception to the avoidance of profit targeting in one market: upside volatility. This is because volatility has strong, short moves that quickly mean revert. I am still exploring this market in better detail, so I can’t speak a whole lot to it at the moment.

  5. Good answers, thanks!
    1) Your answer touch on another point I had meant to mention, being that if you are buying long dated options why would you re-sell when there is so much time remaining for it to become in the money? Seems you may have answered – if you do not believe it will end up in the money then you can take advantage of the remaining time value to re-sell and reduce the premium paid?
    2) Interesting – I suppose it somewhat depends on one’s interpretation of big moves. In my mind a 50-60% profit is big, and if I had bought several options I would look to sell some. Perhaps somewhat analogous to dollar cost averaging with profits if that makes sense…
    3) Do you also look at options for individual stocks – i.e. if you had felt Netflix was well undervalued around Christmas, purchase a long call or do you stick to ETFs and commodities?

  6. Daren (Editor) says:

    -Yes exactly, it allows me to recover most of the premium I paid and keeps my losses tiny.
    -The 50 percent profit might be big in relative terms, but not in absolute terms. For example, if I risk 2 percent of my total capital per trade and make 50 percent, that is only a 1 percent return on my total capital. I need returns that are more like 5 percent of my capital on the big moves to make profits.
    -I’m just sticking with some ETFs, several commodities, and a few currencies for now. There are definitely opportunities in stocks, but I can’t monitor too many securities and work full-time and write and live a good life outside of this world. Something has to give.

  7. To your second point, if you require 2% of your total capital to yield a return equivalent to 5% of your total capital you would need a 250% return. How often does that occur? Perhaps more than I may realize?

  8. Daren (Editor) says:

    4x or higher gains occur quite often on out-of-the-money options. The key seems to be running with an uptrend, using LEAPS so the position can be held for some time, and betting on multiple markets to increase the chance of having a winner.
    If you go on Marketwatch, you can test current options on stocks and ETFs from the time they became active (about 1 year back on March, June, September, and January options).

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