5 Ways to Handle a Draw Down
Posted by Pete Stolcers on October 26, 2009
Option Trading Question
How should I handle a decline in the value of my trading account?
Option Trading Answer
Let’s say you are doing everything right and you experience a 10% drop in your options trading account, how do you handle this? The draw down is the amount of the decline in value of a trading account, expressed either in dollars or as a percentage, between its highest and lowest points. Here are a few ways to handle a draw down, something you’re bound to face in option trading at some point.
1. Most of the time a loss is contingent upon overall market conditions; it is imperative to identify the nature and character of the loss. For instance, a draw down can be expected if you go against the market in the process of positioning yourself. Getting into position early and being ready when it happens is your consequence for the draw down.
2. Define the nature of the losing trades and if you can get any follow through on a stock. No follow through means it is time to adjust and wait for a pullback. A pullback in stocks is a drop in price after there is an impulsive move up. Option traders can use a pullback as an opportunity to initiate a new position.
3. Review your market bias, are you over-weighted on one side? Applying a mix of longs and shorts can balance a position making it more neutral. This is a good technique in option trading anyway.
4. If you find yourself weighted in a sector that is hurting you, unwinding positions that have caused you to ‘marry’ a sector can be your best option. Marrying a stock is considered holding a stock for a long period regardless of other investment opportunities or indications that the security should be sold. Becoming this attached to your options is unwise, because an investor’s needs and the desirability of a particular stock will change over time. In options trading, you need to stay on top of things and get rid of options that are no longer useful.
5. Sometimes an option trader can find themselves at the wrong place at the wrong time. When money is being made elsewhere in the market; unwinding positions as much as possible can help remedy the situation.
Overall, draw downs are a part of option trading. They can result from a plan consisting of going against the grain as you look for a sharp reversal, unbalanced market bias or the need to re-evaluate and re-group and begin again. Options trading is always a balance.