Rules of Engagement
Vol #118 - February 23, 2023
Taking yourself out of the mix is often the best way to get a sense of what’s going on.
Shower thoughts are infamous for this reason. Your best ideas come when you’re distracted by soap, water, and hopefully a little vocals.
Driving brings this out for me. Alone on the open road, and with a great album playing (albums are made for road trips - save the Pandora shuffle for the office), I have just enough distractions in terms of passing cars and exit ramps to let my mind find insight into a problem I’m working on or a direction I’m seeking.
These unexpected revelations therefore come when you’re least likely to have a notepad. For a number of years I rented a tiny ski cabin on a Christmas tree farm in Vermont. If no one came with me, I was in for three hours of wide open thinking. I have a lot of notes garbled by the early iPhone dictation tool.
It’s ski season once again, and with that I had some time to get away and think differently. My brilliant revelation didn’t come while thundering down the mountain (that’s a little too much distraction), but instead doing something I do every day at home - making eggs and broccoli.
I can’t remember the first time I cracked an egg, but I do remember sometime in high school practicing doing it with one hand only. Generally this is a skill that you learn how to do, and since it’s good enough for government work, it doesn’t merit much honing.
I’m not sure what tipped in my brain on Monday morning, but I added an extra twist, that made for a much cleaner result. This might be admitting I’m a simpleton, but I’d always gone for a single clean crack, and then pried apart the two sides. If instead I added a twist after the first break and cracked the shell again, most of the circumference was broken, and there were far fewer shards.
Realizing even my egg game needed constant revision, I had a lightbulb moment about the missing element in a list I’d been drafting for my website. Trading is a complex engagement. There’s no single recipe for how to do it correctly. It’s more of a journey than a destination. Cracking that egg made me realize the most important lesson - that particularly in trading one must always be adapting and learning.
The best traders I know are the horseshoe crabs of finance. They tweak and adjust their processes constantly, consuming new information, adapting new techniques, and do whatever it takes to survive another geologic age (roughly two calendar quarters).
The online version is here, but I’ve also included my thoughts on “How to Trade Opportunity” below. Happy trading everyone.
ALWAYS BE CHANGING
Edge is ephemeral, and the markets are constantly adapting. The best traders observe as these dynamics shift, and adjust their strategy.
There is no recipe for success, but the process of reviewing and refining your technique supports continuous improvement.
OBJECTIVES
Your trading strategy should reflect your goals. Beware of taking too much risk with money you need in the short term. Conversely, taking too little risk on long term investments may create a shortfall.
SIZING
Position sizing is as important as pricing. Your size should represent not only your confidence in the trade, but your ability to withstand a loss or drawdown.
Preserving capital to trade another day is an absolute priority, and bad sizing is the fastest way to lose this.
Metrics like the Kelly (or half Kelly) criterion are useful to frame the question, but also recognized as simply an estimate. The real world is path dependent.
WORST CASE
Always pay attention to the worst case scenario. Using spreads helps keep risk bounded and defined. The worst case scenario happens more than you want it to, and the best case far less often.
GREEKS
Understand all the dimensions of your trade, as risk can sneak in from many angles. A time spread can be a bet on the implied volatility difference between two months, but if constructed using only calls or only puts it also represents a directional bet.
There is no such thing as a risk free trade, but a well constructed position seeks to isolate a single factor and limits the number of ways you can lose.
KNOW THYSELF
Every trader is different, and your strategy must reflect this. If you can’t sleep at night, or regularly close out early, you’re taking too much risk.
If you are a detailed oriented trader, focus on exploiting opportunities like mispricing or arbitrage. If you have a strong fundamental background, use options to leverage your position and manage risk.
EVENTS
Events are a double edged sword when trading. Volatility is typically elevated around expected events like Fed announcements for macro news or FDA approval announcements for pharmaceutical stocks. This makes it more expensive to buy options, and riskier to sell them.
Earnings tend to bring significantly higher volumes and tighter spreads, which can be good for entering a position, but traders must also be aware of the volatility crush and reduced liquidity afterwards.
EXTREMES
A stock that has fallen 90% can still fall 90% again. Putting on a position when a value, level, or spread has hit an extreme often looks like a good opportunity, but it can always extend further.
Volatility might be mean reverting but it is often a choppy ride down.
LIQUIDITY
The LIQ Index tracks liquidity because it is the most important factor to consider when trading. Liquidity is what gets you the best price on entry, and the ability to close your trade on exit.
Liquidity is demonstrated in markets that are both tight and deep. Tightness refers to the difference between the bid and ask spread, and depth refers to the size displayed.
DURATION
The duration of your trade should be a reflection of your thesis. Longer term trades have more time to go right, but also to go wrong.
Be sure to have enough capital to float the trade for the entire duration, and not be forced out for early closing.