Never Take Your Eye Off the, Er, Bull

The various shades of defense are not particularly important of themselves;we apply defense as necessary. What is important is that we keep our eye on the bull. Whether in El Toro Grande or toro poco, one premise of the trade
is that the bull market, great or small, will not resume violently. If the premise happens to be incorrect, which it historically never has been for the big bull given our adherence to the entry condition, but might be so for the mini-bull,we take steps —immediamente—to limit our risk.

In a violently moving market,the principle of self-preservation when wrong is simple: bail or fail. If we’re wrong in a trade in such a market, no matter the strategy we’re using,we must admit it right this minute and take an appropriate action to preserve our capital. We have precisely zero interest in becoming bullfighters.At bottom, this decision process for defense works out to be a matter of nothing other than our good judgment.

After all, we would not enter a trade in which we did not have an historical or statistical advantage, or both, at the point of entry. Doubtless, a couple or three times in ten trials, we will make a less-than-optimum selection of option strikes, or the market’s behavior will contradict our view. Such eventualities are not problems, unless we let them become so. To minimize these occurrences, we simply exercise a good degree of caution when we enter the trade, and, not surprisingly, by doing so we also generate better results.

Actually, given only that we’ve been disciplined in selecting an entry point, the problems we are likely to encounter are much more tactical than strategic. Curiously too, the big bull, El Grande, is less likely to expose us to tactical snags than is his little brother. When a runaway bull market has failed, as long as we refrain from being greedy, it is literally child’s play to turn a profit. Toro poco, though, as a rule is a product of less-well-defined market conditions, which, in turn, make our subsequent market decisions somewhat more difficult.

Now, I don’t want to misrepresent anything to you. The few opportunities I’ve had to spear a fading runaway bull market as it starts to die have proceeded exactly as outlined, very profitably and with well-controlled risk.My practical experience with defending El Toro Grande is exactly zero. The defensive tactics previously discussed are therefore only theoretical. In the next such trade, if defense becomes necessary, I’ll probably defend even more conservatively than indicated here.

Enhancement to toro poco trades is situationally less dangerous, assuming only that we can establish the call ratio-spreads with a nice, wide differential between the striking prices. Defense in an enhanced trade, at least theoretically, should be an easier proposition, and to my experience to date,it usually is. However, one trade, in May 1999 soybeans in late 1998 caused some problems on defense. I was a little early in enhancing the trade, and May soybeans rose a dime or so above the recent toro poco high.

Margin requirement approximately tripled in about a week, using up the initial cushion,and out the window I could see our old nemesis, capacity risk, coming down the street. I was a little lucky in that I had some extra free capital in the account at the time, only because I hadn’t happened to find very many good trades over the preceding month. My fault entirely, of course; I was both a little early and a little greedy even when entering the trade.

I did not—and this is a mistake, pure and simple, don’t do it—wait for the market’s volatility to begin to decline. Had I simply been disciplined in entering and enhancing the trade, the capacity risk monster would never have made it into town, let alone been strolling along my street. Two weeks later, the mini-bull became seriously arteriosclerotic and I was able to scramble out of the trade with a tiny profit.

Not worth the aggravation, I guarantee you.This is definitely not the way to implement or enhance a toro poco trade. A disciplined trader would have waited until the market volatility started declining, entered the trade as described, and cashed out both sides, perhaps having to roll out one or two put options for a month, a minor nuisance. A dandy profit was there for the taking, but the greedy trader, your humble servant, didn’t even get a sniff of it . . . and didn’t deserve it, either.

The last chapter of Peter Bernstein’s scholarly and marvelously readable book, Against The Gods: The Remarkable Story of Risk (Wiley, 1998) is titled,“Awaiting the Wildness.” When we want to be picadores, we want to first await the wildness in a market, then await the beginning of its passing, and then help ourselves to a hefty profit. You may wonder a little bit that this chapter is comparatively short, but there you have the reason for it.