What Buffet Can Teach About Adding Size

[Predictor 11]

Adding more size, taking more risk, when one has a greater advantage is one reasonable way to increase profits and the ability to do successfully is thought to differentiate the great from the good. Livermore popularized the concept of adding to winners and this approach has been used successfully by many traders.

 

Unfortunately, there is always a great deal of uncertainty in the market and traders tend to get the most bullish (bearish) at the worst times. And, it is very likely that the day trader who tries this approach risks outsize profit turning into loss and this will happen more frequently then one would expect. Larger and faster profit and loss swings are more likely to elicit stronger emotions and may make it more difficult to trade optimally.

 

I've experimented with many ways to add to my winners on the day trading time frame. I've found that Warren Buffet surprisingly offers some great lessons in this regard. His primary concern is what his risk is. He focuses on making deals where he can't lose (or is very unlikely) and he lets the profits come to him. It may seem contrary but focusing on risk is the first step in successfully sizing up winning trades.

 

But, first I should share what hasn't worked for me which is adding at new intraday highs. Even if prices only comes off a little then it cuts into my profits and puts me at risk and when price reverses then it can be devastating.

 

One way I've found to add size is to buy slightly OTM spreads. First I should mention, I trade at NADEX which offers both options and futures-like products (spreads) for the small retail trader. Even so, the concepts should apply equally well to options offered via traditional brokers such as ThinkOrSwim or OptionsExpress. When I buy a slightly OTM option then I'm able to increase my leverage with relatively little dollar risk. Additionally, I am selective in buying the OTM position and will typically buy on a pullback because I'm typically already in the move and am only trying to increase my return with limited risk. While I haven't tried it, I imagine this approach might work equally with longer time frame trades. If you are in a trade that you feel very confident about then you may want to look to buy slightly OTM options or spreads to juice your returns. The advantage is you can do this for very little dollar risk. The disadvantage is that options expire and the move may not play out in time. One other note, I will scale out the higher cost spreads when they reach 2nd or 3rd targets when possible before the close so that I don't lose the premium.

 

The other approach I will use intraday is to put on larger size for relatively short periods of time and constantly take the risk off at high probability targets. The goal with this approach is to manage the extra risk by limiting my time in the market. Unfortunately, it still leaves one vulnerable to market reversals and, also, tends to increase the number of trades and associated costs.

 

I'm interested to hear how others seek to maximize their best trades while managing to keep the associated risks in-check.

 

Hope this helps,

Curtis

The Market Predictor

Edited July 16, 2011 by Predictor

[Tradewinds 12]

One way I've found to add size is to buy slightly OTM spreads.

Hope this helps,

Curtis

The Market Predictor

 

Could you give a brief explanation of OTM spreads? I found this on investopedia:

 

Out Of The Money (OTM) Definition

 

Here is an interesting video for OTM:

 

Understanding Out Of The Money Options - Investopedia Videos

[Predictor 11]

You could simply buy call options too. A spread is when you are long one strike and short another strike. This is known as a vertical spread or bull or bear spread. It caps your risk and reward. You would buy a call and sell a higher call (I believe) for a bull call spread, the call/put is interchangeable via call/put parity. Exactly, Out-Of-The money means that the options you buy are above/below the current market but only slightly. As an example only, Intel is trading at 22.37. Let's say you were very bullish, you might buy the 23 call option outright x10. This cost for the strike/month I chose at random was $400. You reduce your risk/reward by selling the 25 strike which reduces your cost to around $300 and caps your reward at 25. As an aside, many traders sell spreads to generate an income, as well (with the hope they expire worthless).

 

You might put the position on initially as an in-the-money spread or have an outright position open. The reason you go slightly out-of-the-money is because you don't have as much dollar risk if the position were to reverse against. For example, for the $300 you have the leverage of 1,000 shares with the 23/25 spread your max loss would be the $300 and max return is $1690. One other benefit is that that if an option expires in-the-money then you get the value for it. This means you can stay in the trade even if it goes against you temporarily -- unlike with a stop.

 

Could you give a brief explanation of OTM spreads? I found this on investopedia:

 

Out Of The Money (OTM) Definition

 

Here is an interesting video for OTM:

 

Understanding Out Of The Money Options - Investopedia Videos

Edited July 17, 2011 by Predictor