Doug Ashburn is not a representative of
TD Ameritrade, Inc. The material, views, and
opinions expressed in this article are solely those
of the author and may not be reflective of those
held by TD Ameritrade, Inc.
For more on the risks of trading and trading
options, see page 38, #1 & 2.
bleed? Or, put another way, what’s the
stock’s implied volatility (IV), and how
does it compare to historical volatility (vol)
levels? Second, what caused the loss? Was
it a trend breakout or reversal that turned
out to be a false positive (“head fake”)? Or
is there news that could impact the company’s fundamentals, such as a scandal or
“accounting irregularities”? In other words,
does the reason for the adverse move
change your overall objective?
Next, it’s time to build the final layer.
Consider a list of possible next moves (see
decision tree, lower left):
Hold the position. Maybe you weren’t
wrong—just early. This trade is a marathon, not a sprint.
Sell a covered call against the stock. This
can help you reduce the e;ective cost
of the stock, but you’ll limit your upside
Buy a put option. You’ll give yourself a
level of protection on the downside (for
a limited amount of time) and maintain
the upside potential if the stock recovers. But you’ll be risking the entire
amount you spent on the put (the premium plus transaction costs).
Place a stop order. If the stock keeps
going south, you’ve got an exit strategy
in place at your point of maximum pain.
But a stop order won’t guarantee execution at or near the activation price. Once
activated, it will compete with other
incoming market orders.
Close the position.
You now have two scenarios outlined: small
loss and big loss. And you have five ultimate
choices for each scenario. But each one has
di;erent probabilities based on price action
and vol. Now it’s time to
review your goals and ask
yourself whether owning
the stock can get you across
the finish line.
Using a decision tree can
WHAT’S THE PROBABILI T Y?
help you take the emotion
out of the trading process,
especially when you’re fac-
ing a losing trade. When the market goes
against you, consider following the tree.
Want to take game theory to the next level?
Try assigning dollar values to the outcomes
of your scenarios. There are no guarantees or
exact probabilities, but the market does o;er
some clues. For example, the IV of a stock is
the market’s best guess of the stock’s potential price range. Historical vol is a measure of
a stock’s actual variability over a specific time
period. You can find both measures in the
thinkorswim® platform from TD Ameritrade.
Look at the Options Statistics at the bottom
of the Trade tab. (For more on how to use
these statistics, see “think Tank” on page 10.)
This can help you define the parameters—
winner, small loser, big loser, and so forth—
and assign an annualized level of vol.
For options positions, you can use options delta to approximate the likelihood of
a position finishing in the money or out of
PLAY THE GAME IN REVERSE
When planning an exit strategy the game theory way, build each node to the end, then play the game in
reverse. Want to shift into reverse for real? Fire up the live trading screen on the thinkorswim® platform
and try out the thinkOnDemand backtesting tools. You can backtest stocks, options, futures, and forex,
right down to the tick level, all the way back to December 2009.
Want to know how your trading strategy might’ve fared during the 2016 election? Make sure you’re
using your virtual account (paperMoney®), then roll the calendar back to November 2016, place your
simulated trades, and watch the action unfold (see Figure 2).
FIGURE 1: Roll back the clock. With thinkOnDemand, you can backtest any strategy for any time period
going back to December 2009. Source: thinkorswim from TD Ameritrade. For illustrative purposes only. Backtesting is the evaluation
of a particular trading strategy using historical data. Results presented are hypothetical, they did not actually occur, and there is no guarantee
that the same strategy implemented today would produce similar results.
1. Select OnDemand.
2. Choose the date and time from the calendar.
3. Select the Play button and watch how price changes. You have the choice to step forward, step
backward, fast-forward 3x, and pause. To go back to real time, select the OnDemand button again.
the money. (For more on delta, turn to page
26 in this issue.)
LIFE WOULD BE MORE FUN IF ALL TRADES
were winners, but that’s not the way it works.
If you can define the possible scenarios,
probabilities, and your best move at any point
in time with a well-thought-out decision tree,
you can keep your emotions in check. And let
the “theoretical” game play itself out.