Managing Winners (Part 2)

Today I want to conclude my discussion on managing winners.

I can imagine something like the following if I were to start managing winners. Placing trades daily, I would see some days where number of open positions would decline precipitously. Over the next couple weeks I would build back toward a maximum number unless other positions had been managed in the interim. The big losers would be unaffected. Smaller losers would have a better chance at being flipped because they may at some point hit the profit target (think probability of touching). Management of winners (e.g. at 50% max potential profit) means the average win would be smaller.

Taken together, persistent big losers, higher win rate, significantly smaller average win, and equal number of trades all strikes me as a recipe for disaster.

One thing I observe in daily trading without managing winners is a mix of “in-play” and “out-of-play” positions. Recently placed trades are in-play with responsive position greeks. Older trades often carry unrealized gains approximating max potential profit. Even big market moves are unlikely to affect these older, “out-of-play” positions due to negligible, unresponsive deltas, gammas, and thetas. With the exception of MR, the total portfolio acts as if these out-of-play positions were already closed.

Reflecting on these observations makes me thankful the market hasn’t made any large, adverse moves as of late. Such moves tend to increase the number of positions in play up to 100% (managing losers—perhaps with a SL—can decrease total number). I am grateful for the trading experience that allows me to make and analyze these observations because at some point, volatility will return in a big way marking the return of stressful nights [hopefully not for very long]. My goal is to factor all this into the trading system development.

Reflecting on these observations also makes me think that carrying some out-of-play trades is part of the whole design (i.e. perpetual scaling and time diversification). I could close out-of-play positions to cut risk, though. Indeed, I strongly suggest other option traders “do the right thing” and adhere to such a guideline. In effect, closing out-of-play trades is managing winners albeit much less aggressively (e.g. 80%-90% max potential profit as opposed to 50%). The impact on performance metrics is therefore going to be different than that profiled in many of the TT studies.

I will wrap this up with an empirical question for the future. As a more conservative way to manage winners, exiting out-of-play positions may also be conceptualized as buying back-end insurance. How does this compare, I wonder, to buying the insurance up-front in the form of being net long [DOTM] contracts or buying a small number of NTM hedges?