In the options universe, there are plenty of traders who are happy to share a new strategy that has either worked well for them in the recent past, or has backtested splendidly over an extended period of time. Regardless of whether these strategies have been developed by competent veteran traders or newer traders who have not experienced every type of market condition, I’d strongly suggest that you take things very slowly when adopting a new options strategy, no matter how successful it has been for the trader who has presented it. Why? Here are five good reasons:
- Every trader is a little bit different. Some have a high risk tolerance while others are highly risk averse. Many strategies only work if you have a high tolerance for risk . Adopting a successful strategy that does not fit your risk tolerance personality is a failure formula.
- The trader may be on a lucky streak. Some strategies actually have no merit. It’s just that the trader has adopted an approach which has just luckily worked out several months in a row. These strategies have a short shelf life, and you’ll find that if you check with the trader several months later, that he or she has abandoned the strategy completely.
- The trade was only suitable to a certain market condition. A lot of times a trade is legitimate when certain market conditions exist and will fail in other conditions. For example, some strategies tend to do much better when market volatilities are high, but fail when they are not. It’s possible the trade has been successful because it was traded primarily during high volatility periods and is destined to fail when volatilities return to normal.
- The trader may never have traded the strategy with real money! I’ve seen traders enthusiastically presenting concepts that have never actually been traded with live capital. They are purely theoretical concepts that have been backtested and paper-traded at most. Neither you nor the trader himself have any idea how the trade would really play out under live conditions, with real money at stake and real execution issues that backtesting and paper trading will not make apparent.
- There are nuances that no set of “rules” can capture. Most solid strategies have a set of rules or guidelines that are followed by the trader who has developed the approach. However, no set of rules can capture every issue that can come up in the course of a trade. A trader experienced with a particular strategy may make battlefield calls that would not be reflected in a set of guidelines and can definitely make the difference between a profitable trade and and unprofitable one in any given month.
Having said all of that, it’s healthy to adopt new strategies, adding arrows to your quiver of options trades. Next time we’ll talk about a common sense approach to incorporating new ideas into your mix of options strategies that you actively trade.