11 Rules to Improve Your Trading: Rule # 8

The purpose of this series of posts is to provide a manageable list of fundamental trading rules to help you improve your trading process - regardless of your experience level.  I will also explain the rationale behind each rule and highlight its significance.  Here is the 8th in a series of 11 rules that will help you improve your returns and reduce your trading losses.

Rule #8: Only Trade Strategies and Securities that You Fully Understand

This rule might seem obvious, but I see it violated all the time. The fact is that every time you do a trade, someone else is on the other side of that trade. Many times it is a professional trader who spends 50, 60, or even 70 hours each week expanding their market knowledge, evaluating proprietary research, and honing their trading skills.

Does that mean that you should throw in the towel?  No, but it does mean that you should evaluate your knowledge and abilities objectively and stick with proven investment strategies that you fully understand.

Not surprisingly, the biggest mistake that I see are retail investors who trade complex derivative securities, particularly options, without even understanding their basic characteristics.  Options are sexy and exciting and offer the potential for earning very high returns.  However, they are also risky and behave very differently from their underlying instruments.

Below is an OptionVue analytical graph of a bearish calendar spread on the Russell 2000 index.  The horizontal axis represents the price of the underlying index.  The vertical axis denotes the return (left) and the profit (right) for the strategy.  The profit and loss function is shown for five different dates using five different lines.  The dates range from today (T+0) to the expiration date of the September option (T+23).

As you can see from the graph, this is a complex position that behaves very differently depending on the price of the underlying index.  For large increases or large decreases in price, the directional calendar spread strategy loses money - even up to 100% of the value of the position. However, for modest price declines, the strategy does well, but only after sufficient time passes.

In fact, the passage of time actually helps the strategy, but not when prices increase or decrease by large amounts.  In those scenarios, the passage of time would hurt the strategy.  Changes in implied volatility also greatly affect the value of the strategy.  This important relationship is not depicted on the chart, but is reflected by the value of Vega in the table of "Greeks" below the chart.

Figure 1: Bear Calendar Spread (OptionVue Software)

I included this example to demonstrate the complexity of option strategies and to reflect the level of knowledge and experience required to trade options successfully.

If you limit your trading to securities and strategies that you fully understand, you will greatly reduce your losses and save yourself a lot of frustration

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Brian Johnson

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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