Friday, January 12, 2007

Managing a Losing Position vs Taking a Loss

Probably the most controversial aspect of my trading plan is that I choose to manage losing positions rather than taking a loss. This goes against conventional wisdom, but then I'm somewhat of a rebel remember ;-)

Probably the best way to explain why I choose to do this is to show an example where I recovered a losing position and compare it to taking the loss instead. For this example, I'll use the PPC position, which was posted here in Nov 2006.

On 9/19/05 I bought 100 shares of PPC @ $35.17 and sold an Oct05 35 call @ $1.19. My breakeven point was $33.98. This was when I sold front month options and before I changed my criteria to 12% downside protection and 24% annualized return if called.

The Oct05 option expired so I sold a Nov05 35 call @ $1.99 on 10/24/05 and now my breakeven point was at $31.99. The stock closed that day at $36.47 so the option was ITM and the position was looking good.

The Nov05 option also expired so I sold a Jan06 35 call @ $0.64 on 11/13/05 and now my breakeven point was $31.35. The stock closed that day at $31.67 so the option was OTM and I still had a slight profit if the price stayed the same until expiration.

By Jan06 expiration the stock had dropped to $25.43 (27.69% below the purchase price) and the Jan06 option expired. At this point I was looking at a loss of about $592 on the position if I sold the stock. The stock lost $974 ($2543-$3517) but I received $382 in premiums ($119+$199+$64) for a net loss of $592 ($382-$974) or 16.82%.

Let's say I decided to sell the stock and take the loss. My back to cash amount would have been $2925 ($3517-$592). Now, in order to just get back to breakeven I would have needed to make $592 or 20.24% on my next trade. Remember, it takes a greater percentage gain to recover from a loss. Now, let's look at my new criteria for establishing a position, which requires 12% premium and 24% annualized return if called within 6 months. With $2925 I could receive $351 premium at 12%. This is less than I needed to recover from the loss and since I usually sell ITM calls the return if called would've been even less.

Instead, I decided to continue with the trade and 9 months later, by dollar cost averaging twice and selling lower strike calls, I was able to finally close this position for a $331 profit or 4.07% return (4.12% annualized). From a buy & hold standpoint this position was down $641 or -18.23% (-18.43% annualized), so I did much better than buy & hold.

This wasn't a great return, and not one of my better results, but I turned an unrealized loss into a realized profit by following my trading plan. Also remember, my goal is income generation, and this position generated $958 of income during this period, which was reinvested into other positions.

Now, some might say I should have closed the position and taken the loss. Then reinvested that money, and the money I used to dollar cost average this position, into other positions. I could have then put on from 1-3 new positions, depending on the stock price. I would have had $2925 from closing this position and $2392 from the first dollar cost averaging and another $2218 from the second, for a total of $7535. This could have returned $904 at 12% premium, which would have offset the loss by approximately $312 ($904-$592), if these new positions worked out as planned. Taking the entire amount invested of $8127 that would have been a return of 3.84% (3.88% annualized), which was less than I made by continuing with this trade.

However, what if those new positions were also losers? How long would it take me to recover from more than one loss? My opinion of this company hadn't changed, so why change horses in the middle of the stream? They were going through a rough patch, mainly due to the bird flu scare. I figured that would pass and the stock would eventually recover, which it did. It just never got back to where I originally bought it, but it didn't have to since I lowered my cost basis. I could have continued with this position and possibly made a better return, but by that time my opinion of the company had changed so I let the stock get called away.

So far, I've closed 120 positions since May 2005, and haven't had to close any for a loss, which satisfies my goal for capital preservation. Will I ever take a loss? Maybe, it depends on the situation. However, if I can avoid a loss by following my plan and still meet my return goals, I'll continue to do so.