July 20, 2021
by Peter Seed
The Lesson of the Max Loss Threshold
Since I am a short-option trader, so I like to collect premium. Often feel like I am just raking in the money. I routinely close positions at 50% max profit. But every once in a while I get “tested” – sometimes by a lot.
One short-strangle trade worthy of sharing was with symbol GSX. In November 2020, I put on a short strangle on GSX. There was one short contract per side – 20 strike on the put side, 40 strike on the call side. At the time, GSX was trading at $30 a share and I collected about $500 in premium. All good, I thought.
Within a matter of days, GSX when to $120. And there I was… holding a 40 short call.
Yes, I made all the standard defense moves, but there was no stopping this black-swan, three-standard-deviation price move. Months later, I eventually took a $14,000 hit – a 28X loss. And it was a sobering event.
I learned a super-important lesson from this trade: You should always respect a loss threshold — beyond which you will mechanically close the position – no matter what. My close threshold is this: Whenever there is a 4X loss (unrealized) off the basis equal to the total amount of premium collected on a position, I close the position.
Inexperienced traders tend to treat a hard-close signal like this as a guideline rather than a rule. That once included me.
With the GSX trade, I did not have the benefit of an application that flagged my 4X loss – three days in. (I made that trade through Schwab). If I did have that flag, I would have closed the position after three days. Absent that, I was in for a bumpy ride.
From now on, using UpTrade, I will always exit a position whenever that prompt shows up – even if it pops up one day after I put on a trade.