Saturday, January 19, 2013

What lessons can we learn from failed paper trades

Since the completion of initial January non-directional option income paper portfolio on 11-20, SPX has risen from 1350 to 1480 on last Thursday, a 130 points or a 9.6% rise in about 2 months. The paper portfolio finally ended on 1-17, the index option expiration day, with major losses.

After the initial exit 13 days before expiration, the paper portfolio had an upper break-even point of 1470 and delta of -24, when SPX was at 1450. On Saturday Jan 5, SPX had risen 16 points to 1466. The P&L chart indicated either adjustment or closure actions had to be taken with about 11 days to expiration.

To continue my adjustment strategy tests, I placed a couple of butterfly adjustment trades which got filled the next Monday morning. The balanced butterfly, which was not expensive in my opinion, extended the upper BE by 5 or 6 points, reduced delta by 3 points. I thought the rising market was close to a retracement since it was in overbought condition. The new P&L chart is shown below.
The best time to close all positions after that was probably 1-7 where SPX dropped for a couple of days. This is also evident in my trade log by trading dates here.  But I let the remaining positions to the expiration date and then closed out all positions with a major loss.
So, what can we learn from this failed paper portfolio this month, even if it was a dramatic rise in years for SPX?

  1. Adjustment strategy: I have identified one improper adjustment strategy of butterfly in a prior post.
  2. Exit time: It's best to exit before 10 days to expiration when there is a chance (regardless of profits).
  3. Handling trading error: If trading errors like improper adjustments are identified for current month, the expected return of the month should be reduced. This means the portfolio should be closed sooner than usual. I'll creat a rule to handle trading errors in my system.

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