We want to begin today with a look at a technical phenomenon that’s rarely, if ever seen.
But before we do, a bit of trading advice.
Normally, we don’t tell anyone how to manage your money, except for some general rules that we believe it important to follow. But because we received a number of related questions on how much to invest in any particular trade we recommend, we believe it’s worthwhile to go over the matter in a bit more detail.
And it goes like this –
Generally speaking, on the options trades we suggest, it is recommend that you commit no more than 1% to 2% of your total portfolio. Therefore, if you have a $100,000 in your trading account, and we offer a hypothetical CALL purchase on FreeLove Inc. (NYSE:AIDS), most experts agree you should spend no more that $1000 or $2000. If your account is $50,000, no more than $500 to $1000.
But what if the trade we recommend is a long/short trade, or a spread, or one of our favorite zero premium options trades, in which the cost to you to initiate is literally nothing? How much should you commit? How many pairs should you trade? How many spreads? It’s not an easy question.
Let’s have a look at a zero premium example to help you understand the principles involved, so that cash management issues don’t arise on such occasions.
The oil sector is rising along with the price of crude, but Penguin Oil & Gas Inc. (NYSE:COLD) has been having strike problems with its Antarctica operation. You go long CALLs on the sector using the Select Sector SPDR Energy ETF (NYSE:XLE) and short CALLs on Penguin, expecting the spread between the two to increase as oil prices lift the sector and Penguin continues to suffer from the chill between management and its tuxedo-clad union.
The XLE CALLs cost $4.00, and the Penguin CALLs can be sold for $3.97. Every pair (net commissions) costs you just three dollars to put on. And you wonder, legitimately – how many pairs should I be trading here? If I want, I could trade 100 pairs for just $300, 500 pairs for $1500. And assuming you have enough margin in your account, you would be right.
But trading 100 or 500 pairs of options in a zero premium or a spread – or any other trade, means an enormous amount of leverage is in play, and any false move, any slight zig or zag in the wrong direction and a man could be left penniless and pauper-stricken in a matter of hours, not to mention damned depressed, to boot.
So what to do?
To understand best practice, it’s important first to understand the reason why we limit trades to one or two percent of our portfolios. And the answer is simply that we seek to avoid a catastrophic loss.
Simply put, it’s a wipeout. A loss that leaves your capital damaged irreparably and your spirit crushed for any longer than your next meal’s arrival, is considered, by us, to be catastrophic and must be avoided at all costs.
And that means we have to limit our losses.
In some cases we can do that with a ‘stop sell’ or ‘stop buy’ order, and if it’s available, it must be used. But often our brokerages don’t give us that option. If not, we must monitor our own trades and bail out of them the instant our one percent (or two percent) loss threshold has been reached.
So, for instance, if our portfolio is worth 100K and the XLE/COLD spread starts to move against us, the instant the loss surpasses $1000, we close the trade.
We don’t ask questions. We don’t make excuses. We don’t wait for the trade ‘to come back’.
We close it.
If you have any questions or comments, please throw ‘em our way (EDITORS NOTE: Always consult your personal financial advisor before making any trades)
In the meantime…
The chart we include below is representative of a technical phenomenon we call a ‘flatline’ formation. We call it thus because it bears more than just a passing resemblance to an EKG when the heart stops a’pumpin’.
A Significant Event in the Making
The chart itself is of the broad financial sector, as represented by the Russell 1000 Financial Services Index, and here it is for the last six months –
As you can see, volatility on the financials has slowed markedly over the last three months, moving in an ever-tightening range as the weeks pass (blue box).
At the same time, RSI and MACD indicators (in black) have bound and gathered themselves to their respective waterlines, producing the above mentioned ‘flatline’ effect.
And what’s it all mean?
We’re in for a whale of a move in very short order.
Play it however you see fit.
Many happy returns,