Thursday, July 16, 2009

07/16 SPY Double Diagonal Decision Making

Before I even begin, let me repeat my new trading mantra:

"In trading (and in life), no matter what you do, there is always a possible outcome that will prove you wrong. Be not afraid of being wrong."

So, like in any other business venture, success is a matter of making better decisions at least 50% of the time, being wrong is just part of the game. That being said, Yesterday I was debating between either closing the trade, adjusting, or simply doing nothing. Instead of going into an eternal battle in my head about each option, I used an objective decision making tool called "decision tree".

In a decision tree, each branch is a course of action, for each course of action you may have one or more outcomes. Each outcome has a probability of happening, and a monetary outcome for when it happens. Ok, ok, it is confusing I know, it is easier by looking at the charts:

The first picture, shows the results for a scenario using the probability of touching my stop loss point in 1 Week, it also displays the max potential profit if we stay in range during this 1 week. As you can see, doing nothing has a higher possible outcome, becausing adjusting will cost me money, money I won't see back in 1 week.

The same result is true for 3 weeks:


For 4 weeks, assuming that I'll get out with my target profit if I don't adjust, the adjustment scenario wins, this is because the probability of touching the max loss is a lot bigger when you consider the SPY will have a lot more time to run around
What was my conclusion from this excercise? First and foremost, that both options are valid and can potentially prove you to be a genius or...Not! :) It all depends on your time-frame and willingness to accept a higher risk of hitting stop loss.
For me, it helped me to see that rolling the CALL spreads will only pay off at the end of the trade's life. It is a longer-term decision, therefore, I should not expect to be up in profits really quickly. I also saw very clearly that if price retraces tomorrow or next week, not adjusting would be the best option. One way or another, I know I'm risk averse and would not like to see price approaching my stop loss point without me doing anything about it. This let me to keep with the plan and make the adjustment.
Now, it also showed me what I knew in the back of my mind: Closing the trade and locking in the loss is not a good option in any time-frame. Why? Simply because you guarantee 100% probability of losing the money, the other two options will at least give you some probability of making some money. That's what the game is all about, isn't it? Making Money?

No comments: