“Heads I Win A Little; Tails I Lose A Lot!”
Larry Connors' Trading Lesson of The Day | September 19, 2024
In yesterday’s issue of my Trading Lesson of the Day, we looked at one of the most basic asymmetrical trades available for traders; long options. It’s one of the best “Heads I Win, Tails I Lose A Little” strategies to optimize for asymmetric returns.
When done correctly long options have the potential to create large outsized gains. At times, those gains can make your month, year, and in a few cases create generational wealth.
They, of course, come with risks. In exchange for those risks, you’re in the potential position of making many times your money over a number of periods of time.
We saw this with the example I showed with AAPL, a 100% gain in the stock (likely to be driven by them becoming the predominant force in B2C AI) would be an 800% gain in the long-dated call options I have a position in. In fact, the gain in the position is already up over 100% and I still have until June 2026 until it expires.
Today I’m going to teach you an even more important lesson; What Is Not Asymmetric Trading; otherwise known as “Heads I Win A Little, Tails I Lose A Lot”?
This is something no one talks about and it’s highly likely you’re trading this way or have traded this way.
We all do at one time or another. But by trading in non-asymmetric ways, you’re doing the opposite of the advice of the many great traders and hedge fund managers who were quoted two lessons ago. They all strongly advocate asymmetric trading is the path to wealth creation.
Instead of structuring your trades as “Heads I Win, Tails I Lose a Little” with asymmetric trading, you are likely structuring some or many of your trades as “Heads I Win A Little, Tails I Lose A Lot”.
Unfortunately, this is the way most traders and investors are taught. Few, if anyone ever points this out or teaches them otherwise.
Today we’re going to look at 5 “Heads I Win A Little, Tails I Lose A Lot” strategies used by the masses.
Once you see them, you’ll likely think hard before trading them again.
Tomorrow, we’ll then look again at additional asymmetrical trading strategies as we did yesterday. I’ll also cover a certain type of market order you’re likely using that you may want to replace.
Here are 5 non-asymmetric trades to avoid. Those who teach them may mean well, especially because a few are so popular. But now that you know what an asymmetric trade looks like, you’ll fully understand why these trades are “Heads I Win A Little, Tails I Lose A Lot”.
5 “Heads I Win A Little, Tails I Lose A Lot” Strategies To Avoid
1. Naked Short Options – Sellers of naked options are the anti-asymmetric trader. They take on insane risk making small amounts of money while potentially risking unlimited amounts, especially with short calls (a stock has no limit to how far it can run).
Most naked options are mostly done with far out-of-the-money puts especially when markets pull back and the Implied Volatility is often high in the options. Unless they’re cash-secured puts though, they’re in reality “weapons of mass destruction”.
Naked short options work well most of the time. It’s that one time that wipes traders out.
I’ve seen blood baths from others who played this game. Easy money for a long period of time but they’re always playing a game of Russian Roulette. I can share with you endless stories of traders and funds getting wiped out by this strategy. The veteran option floor traders can tell you even more.
I mentored a former floor trader who expanded his business upstairs and eventually became one of the largest private proprietary traders in the world.
He embedded the following great phrase/philosophy into his traders’ heads – especially his new traders, who wanted to trade naked puts.
He told them “There’s a bullet on its way to your head. It’s not a matter of if it’s going to take you out; it’s only a matter of when!”
It’s so, so true. Naked options are the epitome of “Heads I Win A Little, Tails I Lose A Lot”.
2. Short Selling – In my over 4 decades in the industry, and having gotten to know many professionals both on the private trading side, and on the professional asset management side, there is literally no successful long-term short-selling fund in the marketplace.
There are a few well-known former short-selling names – as far as I know, none are still around and none made money over a sustained period of time.
Why? The math is against them.
Go long a stock, you have the potential to make many times your money.
Go short a stock, and if it goes to zero (which is a very rare event), the most you can make is 1x your money.
I do believe short-selling has a place. Long/Short funds are quite popular and many hedge funds have been extremely successful being long/short. Most, if not all, are usually a lot more long than they are short.
Shorts can also be used to hedge out longside risk. Long a basket of AI chip companies/short a smaller dollar amount of a semiconductor ETF is a popular one.
Just remember that a short position can move an unlimited amount against you. Short squeezes are brutal. They destroy even the best of money managers including Julian Robertson, one of the greatest hedge fund managers in history.
After many years of incredible returns, he heavily shorted the internet stocks in the late 1990s. In 1999, those stocks ran, and ran and ran. Most had no earnings – in fact, many had no revenues!
Robertson, who was great at fundamental analysis, knew most of these companies were worthless. But that didn’t stop those stocks from running hundreds of percent higher.
Shortly after, he closed his fund. Retired to New Zealand. Had he had the ability to hold on another year, his gains would have been tremendous because the internet bubble burst.
Put the pieces together. The math works against you, no short fund exists today with a long-term record, and legends like Julian Robertson were forced into early retirement because mostly worthless companies had runs to the upside that wiped out a large portion of his world-class fund.
One Final Piece to Short Selling
Outright shorting volatility is even worse.
It makes money the majority of the time. But when volatility has large spikes, as occurred in early 2018 with Volmageddon, the losses are theoretically unlimited. They especially fall into the category “Heads I Win A Little, Tails I Lose A Lot”.
If you’re going short volatility, especially with the Exchange Traded Products like VXX, UVXY and UVIX, do so with long puts. They have limited predetermined risk with the potential of asymmetric returns.
3. Covered Call Writing – (yes the very popular covered call writing strategy!)
I’ve never understood the thinking behind this one. I questioned it 40 years ago and nothing has changed my thinking. Limited upside with unlimited downside? Where’s the logic?
In exchange for taking in a few bucks, you’ve completely lost the opportunity for a major move in the company.
Yes, I know it’s all the rage today (it’s the flavor of the month) and the market is being flooded with new covered call ETF products especially targeted to the Baby Boomers.
And yes, I’ve seen the various self-serving index studies that show slightly higher gains than buy and hold. But, it’s not Dhandho. It’s not asymmetric. It’s the complete opposite.
I’ve occasionally done some covered call writing, usually with far OTM calls that I felt had no chance to ever get my stock called away.
It’s often win, win, win, a few bucks, followed by giving up a lot of money. At least once it occurred in a buyout (sell the 35 calls for a small amount only to see a $58 dollar buyout offer made).
Another time, I was fully long-term bullish on a stock that the market was overlooking its technology.
I sold 1 month calls that were far OTM for 0.75. They looked like a sure thing (they always do).
Then the stock, out of nowhere, rallied and rallied and rallied. Those 75 cent short calls closed out above $50! In exchange for $75, I left over $5,000 per contract on the table. “Heads I Won A Little, Tails I Lost A Lot”
I do not know one professional trader who I’d consider highly successful who primarily trades covered calls. The logic of taking in a few bucks to lose the opportunity to make substantial gains, plus risking your capital if the stock severely drops, is not a smart game.
Think through the risk/reward of a covered call and you’ll correctly see why it’s not asymmetric trading.
The next two I’ll cover quickly because they each also fall into the camp of “Heads I Win A Little, Tails I Lose A Lot”.
4. Iron Condors – a neutral volatility strategy that wins quite often and then when it loses, it loses a lot.
In fact, one gentleman who was a researcher for me (a very good one) in the 1990’s was made a junior partner of an investment firm that primarily focused on iron condors. They did well for a few years – then got hit hard by a massive move in one of the futures options markets they traded in. Years of gains were wiped out in months.
Iron Condors seem so simple especially because their win rate is so high. But the story has been the same for decades. Lots of small wins, sometimes for an extended period of time, and then an unexpected spike in volatility gives back most if not all of the gains. And in some cases, wipes out accounts. “Heads I Win A Little, Tails I Lose A Lot”
5. Iron Butterflies – They have approximately the same risk/reward characteristics as Iron Condors. “Heads I Win A Little, Tails I Lose A Lot”
Do Not Be A “Heads I Win A Little, Tails I Lose A Lot” Trader!
Some or much of the above may be eye-opening. It’s not often taught or even discussed. It’s reality though.
There are literally tens of millions of retail brokerage accounts in the United States today. The turnover of those accounts is tremendously high, especially for the less educated crowd, and also the highly speculative crowd.
I once managed the money of a CEO of a well known futures firm. His name was one of the names on the door. Over the years as we got to know each other better he shared with me an eye-opening statistic. The average account lasted 3 months before either going to zero or getting closed out.
There are many reasons for this, including likely not understanding leverage. What many of these traders did was also play the game of “Heads I Win A Little, Tails I Lose A Lot”.
The brokerage industry today is still less transparent than I’d like to see about the success of their customers. Most have done a good job of providing continuing education for their customers. Some of that education, though, teaches some of the strategies above – strategies that may make money lots of times but eventually either doesn’t have any possibility of making asymmetric returns, or teaches strategies that make a little many times before blowing up.
Knowing what not to trade can be as important as knowing what and how to trade. The 5 strategies we covered today clearly are not strategies that offer the possibilities to make substantial returns on your initial risk. They’re strategies that are “Heads I Win A Little, Tails I Lose A Lot”.
Having this knowledge puts you in the position of strength compared to the millions of others out there that don’t have this knowledge.
I’ll see you tomorrow where we’ll look at additional asymmetrical trading opportunities!
Larry
For Every Issue of Larry Connors’ Trading Lesson Of The Day, Click Here.
2024 The Connors Group. All rights reserved.
Disclaimer: Nothing in this e-mail should be considered personalized advice. The Connors Group, Inc. (“Company”) is not an investment advisory service, nor a registered investment advisor or broker-dealer and does not purport to tell or suggest which securities or currencies customers should buy or sell for themselves. Although our employees may answer your general customer service questions, they are not licensed under Federal and State Securities law to address your particular investment situation. Hence no communication by our employees to you should be deemed as personalized investment advice. Furthermore, the analysts and employees or affiliates of Company may hold positions in the stocks, currencies or industries discussed here. You understand and acknowledge that there is a very high degree of risk involved in trading securities and/or currencies. The Company, the authors, the publisher, and all affiliates of Company assume no responsibility or liability for your trading and investment results. Factual statements on the Company’s website, or in its publications, are made as of the date stated and are subject to change without notice. Company assumes no responsibility or liability for any trading and/or investment results that you may obtain by using such information. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results of any individual trader or trading system published by Company are not indicative of future returns by that trader or system, and are not indicative of future returns which be realized by you. In addition, the indicators, strategies, columns, articles and all other features of Company’s products (collectively, the “Information”) are provided for informational and educational purposes only and should not be construed as investment advice. Examples presented on Company’s website are for educational purposes only. Such set-ups are not solicitations of any order to buy or sell. Accordingly, you should not rely solely on the Information in making any investment. Rather, you should use the Information only as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments.
You should always check with your licensed financial advisor and tax advisor to determine the suitability of any investment.
HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING AND MAY NOT BE IMPACTED BY BROKERAGE AND OTHER SLIPPAGE FEES. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.