In my experience, the longer we try to defend a trade, the less likely we are to achieve a desirable outcome. We prefer to defend, particularly in the case of straight option writes, for no longer than a month, two months at the outside if very specific market conditions are present. Longer-term defenses,whether using a hedge, a flip, or any other tactic, tend rather solidly to end up being too expensive.
These are expensive not only in terms of absolute dollar cost, but also in terms of aggravation, more trading decisions required, and a possible resultant loss of opportunity in other trades because some of our capital is tied up. This increased expense is why condition 2 exists in the chapter on non-seasonals (Chapter 6), and the disadvantages of long-term defense are broadly present in any option-writing strategy.
How do we tell when the time is right to defend a trade? This decision involves some degree of personal taste, clearly, but there are several principles that are universal, as far as I’m concerned. First, if the market moves sharply against our trade immediately or almost immediately, say within the first week, and the trade is a standard-term WOOM option write, we have just two reasonable choices.
We can exit the trade and accept the loss or we can accept more risk and move the goalposts. The practical questions we must ask here are, one, how far can we manage to move the goalposts and, two,has some important supply/demand factor undergone a sudden change?If the answer to the second question is yes, we exit the trade right now.Our original information about supply/demand conditions in this market, or our reading of them, was evidently in error, and we almost certainly have no practical way to determine how far the changed market condition will move the market.
Nor is it correct to execute an early flip or roll defense in this situation, for again we are in the position of not knowing, and any defensive decision we might make has a nasty component of guesswork embedded within.If, however, the answer to the second question is or appears to be no,then we’ve some work to do in order to determine whether to fold the trade or defend it.
Using the previous June coffee trade as an example, we can see that one key facet of applying the move-the-goalposts defense was the relative ratios of the width of the straddle to the time remaining in the trade, before the defense and after its implementation. One other broad point about defense needs to be mentioned. You’ve probably noticed that all the example or putative trades we’ve looked at have involved positions of at least five option contracts.
There is a very good reason for this, but be prepared to accept another chunk of heresy regarding traditional trading theory. Unless you are willing to use only roll and flip defenses, you will do better overall when writing options to set a minimum position size of three contracts, and five contracts is better still. “Huh! What are you saying, that I should trade a position larger than I want? Nobody recommends that I should take too big a position for my account size, that’s just insane.”
You’re right, of course, about one thing. It can’t be correct to enter positions that are too large for your account size,but I’m advocating no such thing. In the first place, the SPAN margin requirement is usually pretty low when we write WOOM options. Even with a smallish account, we should be able to handle two or three 3-lot positions comfortably. In the second place, we by design commit three times the SPAN requirement to the trade, therefore, if we don’t have sufficient free capital in our account to support a new 3- or 5-lot position, we don’t enter the trade.
It’s called discipline, my friend. Why fret about missing a trade? Another good opportunity will come along shortly, no matter what.The reason we’d like to set a minimum position size of at least three options is that, if we don’t, if we only trade one or two lots at a time, our defensive choices become limited. A disciplined hedge defense that adheres to the preconditions is literally impossible, for we will spend too much capital,by definition, for the first defense.
A spread defense, which is rarely our best effort, is also difficult here, though less risky in absolute terms. Moving the goalposts will involve writing more than one or two options in almost every case, and if we don’t want to trade more than one or two lots in a market at a given time, we can’t use this tactic either. The roll and the flip are the only two defenses remaining to us. There’s nothing wrong with rolling or flipping; they’re excellent defensive tactics, but why are we voluntarily surrendering our ability to use other equally fine tactics? Where’s the advantage in that?