Plans aren’t meant to be broken.
Sunday, August 19, 2007 | chaos_nantuko Is this Spam?Generally, sticking to the plan is important (as is having a plan, but that’s another story). Changing a well thought out plan due to mundane emotions such as fear, or greed, can cause a highly profitable strategy to become unprofitable. This is exactly what I did, and its exactly what led to a great loss during this recent correction.
8 months ago, I began paper trading. Being more risk-tolerant than most, I used almost exclusively stock options. After losing the first month, I devised a simple system which was remarkably effective over the next 7 months. I found that all I had to do to rake in a decent profit was find fundamentally sound stocks at their 30-day moving average, and then look to see what they did last time they were at that moving average. If every time in the last year they approached the 30-day moving average, they bounced upwards again, then I would buy an option spread based on the expected move and time frame. I usually had more trouble finding stocks that did this downwards instead of upwards, and there was always the risk of a market correction, so I hedged the whole portfolio with an out of the money bear spread on the index, which would gain 200-300% in the case of a major market correction. After 7 months of fake profits, I decide its time to trade my system.
So late July, 2000, $$$ goes into the market. And I see things going well. Very well; splendid in fact. I was forecasting over 20% for the month! But the hedge was approaching worthlessness, and I gave in to emotion. Why make 20 to 30%% this month, when I can ditch the hedge and make 30% to 50%? So I bought in to greed, and sold my hedge at a 50% loss. And then the market dropped, almost completely wiping out my portfolio. And the hedge? It would’ve been up 300%, taking my portfolio to almost break even.
The lessons?
The most obvious would be don't let greed get the better of you, and perhaps "don't abuse the power of leverage" would also be a good one. Another mistake I made was not taking profits. Every position I had was at one point up at least 10%, and every position I held tanked.
Yet the biggest mistake in my eyes was changing a functional plan based on greed, not rationality.
While I'm not against improving a plan, always consider the pros and cons of the new plan compared to the old one, and ultimately, ask yourself, whats the worst that's likely to happen over the next month, year, and decade? In my case, portfolio devastation was the answer.
Aside: Many people are likely to be critical of a portfolio strategy that’s almost exclusively options. I would say that for 95 out of 100 people, its too risky. That being said, I’m 16, so while large losses are a blow to my ego, its money I can lose.
