5 reasons trades go wrong - safe option strategies...this question speaks specifically to...

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5 REASONS TRADES GO

WRONG …and how to fix them.

Written By: Jeffry Dunyon, CEO Safe Option Strategies


Forward:

“Why are my trades going wrong?” Have you ever asked yourself this question? Maybe you have

asked it to your broker or money manager. Maybe you have asked it to your spouse who handles all

the investing. Having traded stocks and options for over two decades, and having taught complex

option strategies to hundreds of investors in the United States and around the world, this question, or

some variation of it, may be the one I hear more than any other from my students and potential

students. It is often accompanied by, “and how do I fix it?” In fact, the “how do I fix it” part of the

question is likely what led you to this publication. It has probably led you to looking at online

education in some form or other, and maybe even purchasing someone’s education program.

In an attempt to help identify what might be causing the struggles with the individual I am talking to at

the time, I found that I was always starting the conversation with the same five questions. In most of

these conversations, we would never make it past the first question. If we did, it would often be the

second or third question that would end the conversation. In the rare case that we got to the last

question, the result was often the same answer…. It was just not a good trade to be in.

Based on these many conversations, and with a sound understanding of what makes up a good trade, I

decided to define the answers to these five questions by tying them into the 5 Reasons Trades Go

Wrong. I did it this way because not every person will ask the questions in exactly the same way, but

however they word the questions, they ultimately lead to the 5 reasons.

It is also important as you read this to know that I completely understand that no two investors are

alike; that trading styles and methodologies vary greatly; that risk tolerance is high for some people

and extremely low for others; that short term and long term financial goals are rarely alike for any two

people. If your trading style is significantly different from mine, and therefor different from what I

teach students at Safe Option Strategies, you can still take valuable information from this. You may be

persuaded to try a different method of trading, or you may simply apply these principles to your

current style. Regardless of style or methodology, I believe that these reasons trades go wrong must

be addressed for any investor/trader, before they can begin to fix what is plaguing them, and become

as profitable as the markets will allow.


It is also important to note that there are no perfect answers to all of the questions that plague us

when it comes to trading the US markets. No technical indicators or chart patterns are perfect in

predicting the direction a stock may move. No amount of fundamental soundness guarantees the

price of a company’s stock will rise. Bad news is not always perceived as a reason to sell, and good

news is not always seen as a reason to buy. Stocks go up and stocks go down. It is a fact of life as sure

as knowing that being born will lead to your eventual death. In the market, we act on the very best

information we have, and do so knowing that whatever we do is based on an educated guess.

Any time you put together a trade you have to ask yourself five hard questions, because how you

answer these questions will lead directly to whether or not you fall victim to one of the 5 reasons the

trades go wrong. The questions are:

1) Did I do my homework on this trade? 2) Did I define an exit strategy?

3) Can I adjust the trade if I’m wrong? 4) Can I live with the worst case scenario?

5) Is it a good trade.

This may seem and oversimplification, but these questions you must ask lead directly to the reasons

the trade goes wrong and loses money for you:

1) You did not do your homework. 2) You did not define, and stick to, an exit

strategy.

3) You do not know how to adjust trades. 4) You set up a trade with too much risk.

5) You placed a bad trade.

As we explore each of these reasons in detail, and come up with the all-important “fix” to them,

consider the trades you have on now, or have placed in the past, and how these things would have, or

could now change them. Consider that using a trading methodology different from what you are

currently doing now could show you different, and perhaps, better results than what you have been

getting in the past. Consider that if you can successfully address these 5 things, you could sleep better

at night, knowing that you are not subjecting yourself to as much risk in the markets.


Contents 5 Reasons Trades Go Wrong…and how to fix them. ..............................................................................................1

Reason 1: You did not do your homework. ................................................................................................................5

Know the companies you trade: .........................................................................................................................5

Know their competitor: ......................................................................................................................................7

Know their history: .............................................................................................................................................8

Know what is happening right now: ................................................................................................................ 11

Reason 2: You did not define an exit strategy. ........................................................................................................ 13

Setting up your exit strategy. .......................................................................................................................... 14

Reason 3: You do not know how to adjust trades................................................................................................... 20

Can I Live With the Worst Case Scenario? ........................................................... Error! Bookmark not defined.

Is it a Good Trade................................................................................................. Error! Bookmark not defined.


Reason 1: You did not do your homework.

This question speaks specifically to fundamental, technical, and sentiment analysis. Too many

people trade without being as thorough as they need to be in their analysis of the company

they are trading. They take a cursory glance at a chart, remember that they are trading a

company that makes a lot of money or is a common household name and WHAM….they’re in

the trade. What could they possibly have missed?

a. Often times they forget to look up when the next earnings report is.

b. They forget or simply do not care to read current news and events surrounding that

company. They see a bullish or bearish trend forming but do not look farther back on a

chart to see what past trends could teach about how the stock price moves around

certain seasons or events.

c. They do not know how or they do not bother to look at put/call ratios – short, medium,

and long term – as a means of gauging investor sentiment.

In short, they just do not do enough homework before they enter the trade and then scratch

their heads and wonder why, when things do not work out. Our suggestion is to:

Know the companies you trade

Know their competitors

Know their history and

Know what’s happening right now- today- that could affect the companies

Let’s look at these items one at a time and make sure we are understanding what needs to be

looked at:

Know the companies you trade:

There is a lot more to knowing a company than just know the product or service they

provide. A great example of this is The Boeing Company (BA). Most people think Boeing,


and they automatically think Jet Airplanes. While that is certainly true, it barely scratches

the surface of what The Boeing Company does. From the website finance.yahoo.com, this

is what The Boeing Company describes itself as doing:

The Boeing Company, together with its subsidiaries, designs, develops, manufactures, sells,

services, and supports commercial jetliners, military aircraft, satellites, missile defense, human space

flight, and launch systems and services worldwide. The company operates in five segments:

Commercial Airplanes, Boeing Military Aircraft, Network & Space Systems, Global Services &

Support, and Boeing Capital. The Commercial Airplanes segment develops, produces, and markets

commercial jet aircraft for various passenger and cargo requirements, as well as provides related

support services to the commercial airline industry. This segment also provides aviation services

support, aircraft modifications, spares, training, maintenance documents, and technical advice to

commercial and government customers. The Boeing Military Aircraft segment is involved in the

research, development, production, and modification of manned and unmanned military aircraft and

weapons systems for the global strike and vertical lift, mobility, surveillance, and engagement. The

Network & Space Systems segment is engaged in the research, development, production, and

modification of electronics and information solutions; strategic missile and defense systems; space

and intelligence systems; and space exploration products. The Global Services and Support segment

offers a range of products and services comprising integrated logistics, including supply chain

management and engineering support; maintenance, modification, and upgrades for aircraft; and

training systems and government services, such as pilot and maintenance training. The Boeing

Capital segment facilitates, arranges, structures, and provides financing solutions, such as equipment

under operating leases, finance leases, notes and other receivables, assets held for sale or re-lease,

and investments for its commercial airplanes customers. The Boeing Company was founded in 1916

and is based in Chicago, Illinois.

That is impressive to say the least. It also demonstrates that The Boeing Company does a

lot more than commercial jet airplanes. It also tells us that there is much more that could

affect the price of the company’s stock than just what Airbus does with their next

announcement. What if BA loses a big government contract for military aircraft or missile

defense? What happens if NASA loses government funding and has to cut back on the

number of private contract employees it uses? If you thought all Boeing did was produce


commercial aircraft, the dismal release of the 787 Dreamliner would have put the company

under instead of just causing the stock price to mildly suffer for a short period of time.

Know their competitor:

Now that you know more about what The Boeing Company does, who would their

competitors be? And, why would that be important? What market share are they fighting

for, and with whom? Do you know what happens to the price of their stock when one of

their competitors does something good, or what happens to their stock price when their

competitor does something bad? You should.

Let’s answer the second question first. In a highly competitive global economy, good or bad

news from a competitor could spell good or bad news for a the company you are trading. If

Airbus announces it has perfected a lithium ion battery that doesn’t overheat, and can

operate for longer periods of time, while at the same time BA is having test flights of its 787

catch fire due to overheating lithium ion batteries, wouldn’t it be logical that BA could see a

deeper hit to their stock price.

Maybe a better, or at least more widely known, example would be Apple, Inc. (AAPL) and

Samsung Electronics Co. Ltd. (SSNFL). Apple news affects Samsung and Samsung news

affects Apple. Due to the rivalry of their respective leading cell phone handsets, the two

companies are inseparable, like it or not. In a recent search of news headlines, the

following information came up:


Want to take a guess as to which of the two companies the search was done on? Does it

matter? It illustrates our point. The news of one company can affect the stock price of the

other and vice versa.

Know their history:

What does a company’s history really tell us about the company? After all, don’t we

overuse the cliché “past performance is never an indicator of future performance.”? We

are going to dispel a myth in the markets right here and right now. History is a very good

indicator of how a stock could perform in the future; it is just not a guarantee.

It is crucial to differentiate between indicator, and guarantee. History is always one of the

best indicators we have on what could happen in the future. It is never a guarantee. It is an


indicator, because, (are you ready for this?), there is ample history to show that history

repeats itself.

Let’s look at a different stock to illustrate this. The following is a three-year stock chart of

Caterpillar, Inc. (CAT). As you look at this chart, notice that at the bottom we have circled

the largest volume spikes in the day to day trading of the stock. Notice also that the volume

spikes we are circling are very evenly spaced apart. That is because each of those volume

spikes takes place on the day following an earnings report for Caterpillar, Inc.

If you look closer at this chart, something else might manifest itself to you as well: More often

than not the directions changes in the stock price come after those same earnings reports that

cause the volume spikes.

Consider another chart that shows us how history has the tendency to repeat. Below is a stock

chart of Apple, Inc. from December 2004 to July 2007. Circled on the chart are the respective

runs up in the price of the stock in January of each of the years represented. In each case, AAPL


saw a big move up just before their Mac World conference they held each year (they have since

stopped holding this conference). As you can see, history repeated itself as the investment

community drove the price of the stock up in anticipation of a new product or service. In early

2007, if an investor had used history as part of their equation in determining a good play on

AAPL, they would have done great in early January 2007 with any strong bullish play on the

stock.

There are literally thousands of examples that could be added to drive this point home. And it

must be emphasized yet again that history does not guarantee anything. But, since we have

already established that any trade we place is based on an educated guess, wouldn’t it only

make sense to use history as part of that educated guess?


Know what is happening right now:

What is the current political climate like right now? Is there a heated presidential election

going on? How about other world events? Is Russia invading Crimea? Is Italy or Greece

filing bankruptcy? More important than any of these questions would be this one: “Is there

anything going on right now in the world that could have a significant impact on the

markets, and more specifically, on the stocks I am trading?”

Take a glance at some recent news headlines: If you were trading Toyota (TM) or Amazon

(AMZN) would it not make sense to at least be aware of what is going on in the news and

how it could affect the price of your stock? On the day of these headlines, Toyota Motors

was trading down, and Amazon was trading up. Did the news of the day affect the price of

the stock? Could the most recent news possibly affect the longer-term price of the stock?

Why would you trade any king of position on these companies without paying attention to

the news surrounding them? Since we have already established that any trade is based on

an educated guess of what we hope the stock price will do, than it would be logical to have

as much education as what is readily available. In this modern, instant information age, all

we need to know is right at our fingertips. Trading with less emotion and with more logic is


simply a better, smarter, and more effective way. It begins with doing your

homework….before you open a trade!

DO YOUR HOMEWORK!


Reason 2: You did not define an exit strategy.

This has to be said in very simple English here, so there is no possibility of

misunderstanding: If you are not defining and following a very specific exit

strategy you are being greedy and will lose money in the markets.

Have you ever watched a trade you are in make money and then wish you had gotten out with

that money before the stock price turns and the potential profit is gone? If you are reading

this, the odds are that you have experienced this, and probably more than once.

Early in my trading, I was up 90% on a bull call spread on AAPL. Every time the stock price went

up another day, I got greedy and stayed in. When the stock price started to drop, I was sure it

would be a short-lived pull back and would eventually rise. I watched and watched as the stock

price dropped day after day. By the time I actually got out of the trade I had made a scant 10%

over 2 months. I had a loosely defined exit strategy (I wanted to get 100% net return), but did

not have a time frame on it, and was not really willing to stick with it. I had several thousand

dollars in this trade, and at this time, doubling that would have been fantastic for my portfolio.

A 50%, or a 30% gain have would have done that for me as well, but I was not satisfied with

that. I wanted more. I was greedy, and it cost me!

While a lot of potential profit was lost due to my greed and lack of discipline, I did learn some

things that have made me a lot of money since:

1. Greedy traders seldom do well in the end.

2. Defined exits - that are strictly adhered to - will serve you well repeatedly.

3. Well-defined exits are realistic exits.

Setting up realistic exit strategies is the easier part of the process. Disciplining yourself to

follow your exit strategies can be somewhat more difficult. Let’s deal with setting them up

first.


Setting up your exit strategy.

To successfully set up the right kind of exit strategies there are several things you need to

understand: 1) the rule of 72; 2) the concept of reverse engineering; 3) realistic expectations.

The Rule of 72

The rule of 72 is a way to figure out how long it will take to double your money, if compounding it

monthly. Investopedia.com describes it this way:

Definition of 'Rule Of 72'

A rule stating that in order to find the number of years required to double your money at a given

interest rate, you divide the compound return into 72. The result is the approximate number of

years that it will take for your investment to double. (Investopedia, n.d.)

Another way to understand it is by stating that an annual return of 72% (if compounded

monthly) would double your money in one year. A return of 36% annually would double your

money in two years; 18% would double your money in 3 years and so on. To further illustrate

it, we put together a simple Excel spreadsheet to demonstrate:


In this illustration, we put in an annual interest rate of 72% (row 3, column D) and divided it by

12 months giving us 6% monthly return (row 4, column D). Row 8 shows our starting balance in

January of $10,000 (column D) and the growth of $10,000 at 6% for $600 return (column E).

Our starting balance for February (row 9) shows the $600 return, added to the $10,000 starting

balance for a February starting balance of $10,600. We then repeated this process through

each month of the year. As you can see, we had a starting balance one year later in January of

just over double what we started with the January before (row 20, column D). There you have

it. Doubling our starting balance in one year with 72% annual return. To further illustrate (but

without all the explanation) here is what 36% annual return looks like:


In this case, we grew the portfolio by almost 50% in 12 months with only a 36% annual return

(because of compounding the interest). Look at one more example of the same return rate

over the two full years, which the rule says will double our money:


In January of the second year, while we were a little short of 50%, because of the continued

compounding, we were just over 100% return by the start of January of the third year. You will

apply this concept as you set up your goal for your portfolio, but through reverse engineering,

you will also use it to define your exit strategies.


Reverse Engineering

Have you ever heard of reverse engineering? For our purposes, it means working backward

from your end goal, to set up each individual trade, or more specifically, your exit strategy for

each trade.

Suppose you have a portfolio which you would like to grow 36% annually (if you want to start

one step farther back, you would ask yourself how much money you need to retire on, and at

what age you want to retire, and then determine how much you need to grow your portfolio

annually in order to reach that goal). According to the rule of 72 this would double your

portfolio in two years. If you reverse engineer this, you could say that you want to get 3% each

month (36% divided by 12 months). You would then calculate how long each trade is open and

how much of your portfolio the trade is going to represent. This would give you an idea, if not

an exact dollar amount the trade needs to make. Then you would be able to determine how

realistic it is for the trade to make that amount of money, and in what time, and thereby set up

an exit strategy.

Here is a step by step way to reverse engineer the target return you need for your average

trade, and therefore a great way to establish your exit strategy (for easy math, we will use a

$25,000 portfolio):

1. Determine the timeframe in which you want to double your portfolio (2 years)

2. Apply the rule of 72 – 72% divided by 2 years = 36% divided by 12 months = 3%

per month return.

3. Multiply your starting balance by your desired monthly return ($25,000 X 3% =

$750) and this is the sum total you need your trading to produce each month.

4. Now divide your needed monthly return ($750) by the number of open trade

you are comfortable managing in a month (this could be a number of trades

running simultaneously, or one trade a week for 4 weeks in a row, or some

combination). If you chose 5 trades, each one of your trades only needs to

make $150.


This perfectly segues into our last part of setting up exit strategies: being realistic.

Realistic Expectations

I started this chapter with a true story about a trade I blew on greed. Remember the trade I

was up 90% on, and then watched all my profit melt away because I had such an unrealistic

expectation? I really let greed get ahold of me. However, I also blew it by not having a well-

defined and realistic exit strategy. It taught me a lesson for sure, but it still bothers me when I

think about it. It bothers me because while I have always been ambitious, and have always had

a desire to succeed, I never thought of myself as greedy. It also bothers me because, more than

the money I felt like I lost, I just felt plain foolish. And this after I had already been in the

market of over 10 years. I should have known better.

It happens to us all. We get greedy. We fly too close to the sun, and often times we get

burned. Greed is one of the biggest killers of consistent profits in the markets.

Greed is controlled by setting realistic expectations, and those expectations can vary greatly

from one type of trade to another. For example, if you had a spread trade like a bull call

spread, with a maximum possible profit of 80% return, a realistic expectation would be 30-35%

ROI. If you owned stock and knew how to collar trade it over time, 100% return in a year may

not be an unrealistic expectation.

Safe Option Strategies puts out a weekly subscription newsletter. Follow it and see us

repeatedly set conservative exits and then often exit early when we have gained half or more of

the original targeted profit. This is because more than anything, we have learned that the only

way to control greed is to define a reachable target ROI (primary exit) and then stick to it OR be

more conservative and get out early.

Never enter a trade without knowing exactly how and when you will exit.


Reason 3: You do not know how to adjust trades.

This question goes way beyond “do I know how to adjust it?”… The question is “CAN” I adjust it.

Ask yourself these questions to go along with the primary question:

a. Will it cost me more money to adjust it?

b. Do I have the money to adjust it?

c. Do I have the will power to put the adjustment into action when the time comes?

d. Do I know how to adjust the adjustment - or in other words - if my adjustment changes

my trade from one type of trade to another type of trade, can I start over and answer all

the same questions on the new trade?

The whole reason we do what we do at Safe Option Strategies is so that even if we are wrong,

we could still be right (and still profit) … that’s what adjustments are all about!

Reason 4: You set up a trade with too much risk.

We all know, stuff happens! Stock prices can turn on a dime, for reasons we will

sometimes never fully understand, and even the best planning won’t always protect us. Every

time you enter a trade you have to ask yourself…

Can I live with the worst possible loss this trade could produce?

You have to look at the net effect on your portfolio as well …


Will it devastate you? Will it affect your confidence going into your next trade?

Even if you know how to adjust a trade- you can’t always do it in time to save a loss. It’s kind of

silly to say, “Don’t trade money you can’t afford to lose”, because not many people can really

“afford” to lose anything! However, it’s not silly at all to ask yourself on any one given trade…

Can I live with losing on this one as long as I know I won’t lose on every one?

Do I have the ability to adjust most of my losses into wins?”

The worst case scenario will eventually get you. Know you can survive it or don’t do the

trade.

Reason 5: You were not willing to walk away from a bad trade.

This is the one that might seem overly obvious, but some of the best trades are the ones you

walk away from. If you don’t have a good risk to reward ratio, can live with the worst case

scenario, have the money and the knowledge to adjust, or know you have done your homework

so that you are making the most educated guess possible (never forget every time we place a

trade and pick a direction it is nothing more than an educated guess) then walk away from the

trade. We are big believers in the cliché that you miss 100% of the shots you do not take.

However, when it comes to being a smart, profitable trader, we are also into the cliché that you

will never lose money on a trade you do not place. Do not sit on the sidelines; just make sure

you can answer 5 hard questions before you place a trade.

5 reasons trades go wrong - safe option strategies...this question speaks specifically to...

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