Drawdowns and Losses.
Finally, a good week. Not before time. And we absolutely deserve it. So now is a good time to review the decrease in our accounts that we made in the 3 previous weeks and how we coped with them.
Should we have bailed out?
I imagine that two weeks ago some of you were on the point of dumping your positions. That’s understandable. It’s hard to watch your account balance go down and down, to the point where you are thinking ‘I can’t take any more pain’ and just want to sell everything and head for the hills.
But is anyone NOT glad they didn’t?
I certainly am glad I told myself ‘you haven’t reached your ITM OUT signal, you know ITM works, just because everyone else is panicking doesn’t mean that you have to, stick to the strategy.’
Panic Selling
If you want evidence that people were panicking all you have to do is look at the volume of trades in a downturn.
Yes, panic is catching, and when traders see everyone else dumping their positions the immediate response is to dump yours too.
Getting out at the bottom
If we had got out at open on August 5th (the lowest day) we would have sold at $517.38. As we entered the trade at around $440 last November then we would be sitting on a nice profit of 35% (at 50% strike) or over 40% if you used a higher strike.
Not to be sneezed at! BUT – look what you would have left on the table.
Hanging in there
SPY closed at $554.31 on Friday – less than 2% below its all time high.
By staying in you have traded a 7% rise, which means that you would be sitting on an extra 14+% profit. I’d rather not leave that on the table.
Drawdowns & Losses
I know we are in uncertain times and that a lot of you are concerned about drawdowns and possible losses. Just so that we are clear about the terms:
Drawdown: the decline from a peak in the value of an investment to its lowest point.
Loss: the decrease in value from the purchase price.
In this particular trade we cannot have a loss unless something catastrophic happens and SPY plunges 20%+ in one day. As our OUT signal is currently above $500 and we got in at $440 we are going to make a profit.
Drawdowns are a different matter. We are always going to have drawdowns; ITM is not designed to identify the top of the market and give a signal to get out. No-one can identify the peak of the market except in hindsight, and then, of course, we have ‘experts’ telling us that they knew it was. Yeah, right.
So, we have to get used to drawdowns happening, to not get caught in the panic and to have a plan about how we are going to deal with it.
Protecting your capital
As I mention in the ITM books you are going to have to deal with drawdowns. It happens to every trader. And I suggested taking away some of the leverage to make sure that you can sleep at night
In the current environment where things are uncertain and volatile it would be a good time to consider your leverage. If you are in for the long haul then all OK, you know that ITM wins. But for those of you who have a shorter term outlook and need to protect your capital I suggest that you take away some of the leverage.
How much can you afford to lose?
Work out how much you can afford to lose without it being catastrophic, then separate your account into two parts: with the first keep your money in straight SPY shares. Then with the rest of the account do ITM. But possibly keep a small amount aside to flutter on an OTM option. This will help compensate for the leverage you are losing by holding the straight shares.
You could have, say, 50% in SPY, 48% in DITM, and 2% on OTM. Or, if you have a larger account, you might feel safer with 75% SPY, 20% DITM, 5% OTM. You will have to do the arithmetic for yourself and see what you are comfortable with in your own account(s).
Just until the election is over!
I am not suggesting this for the long run; ITM has been tested through all market conditions. Just that I am a bit twitchy about the next 3 months until we know what we are dealing with. We have never before had a candidate enter the race so close to the election, and we don’t really know what her policies are going to be.
I am hoping for a business-friendly government that will enable the stock market to go up and for us to make lots of lovely money!
Volatility crush
Some of you may have noticed something funny in your accounts last Thursday and Friday: the market went up, but your account may have lost money. Mine did. Annoying. Why does this happen?
It’s called a ‘volatility crush’.
We know the VIX spiked hugely last week, and the daily charts show it at 36 (check), and a couple of eagle-eyed readers alerted me to the fact that it had spiked at 68 in after-hours trades. That is enormous, almost as much as the Covid spike.
It is because of implied volatility, which is the market’s expectation of future volatility. As panic set in and things were becoming heated the implied volatility spiked, making options more expensive. Then as panic subsided, the volatility dropped, making options cheaper.
So, although SPY had gone up, the price of the options had gone down and we got caught in a volatility crush.
To the markets . . .
Last week was a good week. The week before had improved after the initial disastrous Monday. But the three weeks before that were not pleasant, coming as they did after 3 months of a steadily rising market. Let’s check the charts:
SPY Charts
You can see that on Monday 5th SPY dropped right through the support line we had drawn at the highs of March / April, and stayed there for 3 days. There was tentative support / resistnce at 540, but this week SPY just sailed through it and is now approaching the all-time high that it made in July ($565). I expect that this will provide some resistance this week and that SPY will bounce off it before continuing up. That is if there are no major dramas, and there is a fighting chance of a business-friendly government.
On the weekly chart we see that it has bounced off the uptrend (although slightly overshooting) with a very strong uptick.
SPYG Charts
SPYG suffered more than SPY because of the larger representation of tech stocks. It is recovering nicely, but not quite as close to its all-time high. There was a hint of support at $76, but now SPYG has sailed right through that and is trading 4.6% below its all-time high.
And on the long term chart we can see how it has bounced off support at the high of Dec 2021. It always surprises me (even after all these years) how accurate something so simple as support / resistance can be. And I am not drawing these lines ‘after the fact’. If you check through previous blog posts they have been drawn in for months. It is NOT hindsight.
QQQ Charts
As we saw last week, QQQ was hammered much worse than SPY. The tech stocks really took a battering. Was it deserved? Personally, I don’t think so; I think it was an overreaction to the press claiming that they had gone up too far and that a correction was due. Traders got nervous and dumped.
Well, they got their correction (more than 10% drop); but look what has happened since. To be sure, it hasn’t gone up as much as SPY, but it has still recovered to just over 5% of its all-time high.
The weekly chart is interesting. We have been in ‘blue sky’ territory since las year, so support / resistance doesn’t mean much at this level. Instead, I have drawn in 2 trend lines. Remember, trend lines depend very much on the time scale you are drawing them in (In Reading Stock Charts I give some examples of this).
The royal blue trend line started at the end of 2022, and you can see that it is significant for QQQ. I have also drawn in a trend line (navy blue) from November last year (when ITM told us the bear market was over and the bull market had started) and you can see that this is a possible trading range. After dipping through it 2 weeks ago it is now back in range.
VIX Charts
Well, after saying for weeks how bored I was with the VIX chart, it is now very interesting. Here are 2 VIX charts for the same period, 2020 – 2024. Look at the difference.
What do you think? The top one is the weekly data, and the bottom is daily data. If we had hourly data that included after hours trading it would be completely different also. I’ve tried AI to get one, but it is stumped. If anyone can send me a chart or a link that would be great.
In any case, both the weekly and daily charts show the VIX dropping back to low volatility levels.
ITMeter
The week ahead
The earning season is almost over – with the exception of NVIDIA which will be major, and is due on August 28th. This week there is nothing of great import. Hopefully the Fed will just shut up for a while and give us some peace!
Futures
The futures are up a little, but it is 11 hours to market open. It’s worth noticing the VIX – 15.68! Low volatility territory.
And back again . .
So, I’ve come home to winter – rainy and dreary. Was so annoyed with being stuck inside a couple of days ago that I booked my flight into Paris for April next year – yeah! Planning on spending a month in France, then Scotland (I am originally Scottish – not that you wouldn’t guess from a name like Heather!), then NY, then – exciting – Greenland, Iceland, the Arctic circle and Norway!
To give you an idea how awful the weather is, here is what the beach next to my house should look like:
And this is what it actually looks like (radar) – rain right up the coast.
Oh well. C’est la vie (practicing my French for next year)
Fingers crossed for a good week (it worked last week!)
Heather
P.S. time to show off – can anyone name the famous painting which the top image came from?
20 Responses
Hi Heather, As a newbie, I am wondering about your opinion of the idea of when executing A DITM call of SPYG or SPY, would it be a good or bad idea to simultaneously purchase a protective put with the same or similar dollar price as the call and also the same expiry? Example: At Schwab, I simulated a SPYG DITM Trade with the market price of about $80, then purchasing a Call strike of $40, with espiry in 6 months, 1 contract, and costing $4020. Next, I simulated the purchase of a protective put of $40 and expiring at the same time as the call, price at only $370. Seemed like it would be worth the money if SPYG fell significantly. What say you? Thanks, John
Hi John
protective puts are great in theory – it is making them worth it in practice that is the problem. Every time I look at them I decide it is not worth the investment.
BUT – I could be wrong – I shall have another look at it with the parameters you mention, and I will put it in next week’s blog as I am sure that quite a few readers would be interested in it.
h
Dear Heather,
Thank you for your weekly blog updates. Regarding the painting that you are asking us, I am taking a guess that it reminds me of Goya, the Spanish painter. It reminds me of a story of Odysseus / Ulysses by Homer or James Joyce about the one eye Cyclop. Anyways, I am taking a wild guess at answering your question. Please remember to take good care of your health always and I don’t really care about how the stock market goes up or go down since I am a forever investor.
Sincerely,
George Halongton
HI George – you were close – I was originally looking at Goya’s ‘dark’ paintings for a face I could use but decided they were all too scary and gruesome. So remembered that right at the bottom og The Last Judgement by Michelangelo there was a damned man being harassed by demons and contemplating his fate so I used that.
All legal – well into the public comain by now!
Nice to hear from you!
h
I bought 2 DITM QQQ contracts about 2 weeks before QQQ peaked. I could have let my emotions get the best of me but stuck to the plan. Why? The DITM strategy has outperformed the market in the past 30 years. I know I will have losses but the strategy should allow me to maintain higher returns over time. I’m one of those in for the long haul. But going forward, I will likely stick with DITM SPY contracts only and buy QQQ shares if I don’t have enough to buy a SPY contract.
Hey Jason!
Just looked at the chart and QQQ is trading slightly above where it was in late june, 2 weeks before the peak – so you should be at break even now? I hope so.
And as long as we keep our losses small and our profits big then yes, we win in the long run.
h
Yes at break even now. I have existing SPY contracts but wanted to give QQQ a try.
good – glad you are at breakeven! I do like trading QQQ but haven’t put it in the books because I wanted them to provide a simple, backtested strategy.
h
For many years I bought indicators for Metastock and in Tradingview, took courses, and had great years and terrible years. I found none of the indicators or courses worked consistently.
I then purchased your book, and I was not sure if it made sense or not. I became kind of punchy as to whether to trust anything again. I watched from the sidelines for quite a while just watching.
On Tradingview they have a feature called replay. It allows you to go back to any date or even the beginning for any stock, fund, or ETF. I then went back to the SPY, SPYG, QQQ, and others, went back to the beginning, then individual years to see how each fared.
You see the cross, click buy, and when it crosses again, click sell or flatten. It allowed me to see for myself how I would do long-term and for each individual year. With that I saw how effective ITM is and would recommend doing this for anyone who has doubts.
I was always one who would get nervous and get out too early, but by seeing the results for myself, although I hate seeing the drawdowns, I can say to myself that I saw firsthand in my Tradingview replays that it works, just be patient and trust the process.
Though I still do some short-term calls, puts, and vertical options, I can sleep well at night doing my DITM options based on your books. I wish I had used your methods much earlier as I would be much more financially comfortable, but even this very healthy 67-year-old knows that over the years this will make for an even better retirement, with more travel and living the life I want to lead.
Thank you for your great books and sticking it out here on your blog.
Thank you Jeff – your kind words are really appreciated!
Re doing the backtesting manually on tradingview – great that you have done it and proved it to yourself I started out doing it manually, but when testing various combinations of indicators it was incredibly time consuming so I bit the bullet and made the backtesting system so now I can plug in any variables I like. The decumentation on how to do it it on https://heathercullen.com/backtesting/ if you want to recreate it!
I sometimes wonder why I am doing the blog, but then I get lovely comments like yours and I know!
thank you
heather
The painting is from “The Last Judgement”?
yes, you are right! The damned man from The Last Judgement by Michelangelo. Who said we traders were philistines?
Well done!
h
A Clarification about leap selection. Your example is of a 50 or 60 percent strike of the current, Correct? When I have been wise enough to use a leap, I settle on a delta 80 -90 so my time decay would be minimal. Can you comment about why one might be better from the other and by what consideration the percentage of current price is more effective, please.
Robin
HI Robin – it is for simplicity. It is easy to work out a 50% or 60% strike in your head, whereas using delta means there is one extra factor you have to look up.
It is essentially doing the same thing, just in an easier way.
Hope this helps
h
Hi Heather, I’ve been following your “Bull Market In the Money” strategy and appreciate your insights on leveraging deep in-the-money calls during strong uptrends. I understand that this strategy is typically applied to stocks in a bullish environment, but I’m curious about its potential application to other assets. Specifically, I’m wondering if this strategy could be effectively used on TLT (iShares 20+ Year Treasury Bond ETF). Looking at a chart of TLT now, it would appear as if a “buy” signal happened in mid-June, but it is just starting to take off. I’m interested in your thoughts on this. Thank you for your time, and I look forward to your insight!
Pat
Hi Pat, ITM could well be used on any stock or bond – but I don’t know the result. I have only backtested SPY and SPYG. I use ITM on QQQ but I haven’t actually backtested it, that’s whi I don’t include it in the books.
You would have to backtest TLT to be sure it worked. Firstly, you need the historical data – I would try Yahoo Finance to see if you can get it from there. The backtesting is not technically different, and you can find the methodology i follwed on the website, here’s the link: https://heathercullen.com/backtesting/
The Backtesting Documenation gives you the details of how to back test.
The say goodbye to your family, pour yourself a strong coffee and settle down for days of staring at a screen!
h
Hi Heather!
In your section titled, How much can you afford to lose?, I agree with you in some aspects that this could be a good move. However my account is small and only affords me to hold one option for SPY and one option for SPYG (with $150 in cash leftover). In this case, is there a way to still follow your thought in that paragraph? Thanks!
Hi Eli – if you are hanging round for the long run then I would stick with your current positions.
I was really trying to answer some questions from people who were near retirement and / or had very large accounts.
If you had a $1m account and you lost 10% that would be $100k – and to some people that is not acceptable, so I was suggesting ways they could limit their drawdowns. Of course, by following the ‘straight share’ strategy you limit your downside – but also your upside, which is why I suggested they flutter a very small amount on an OTM options(s) which, if the market rose, would offset the lack of leverage in the shares but provide limited downside.
Hope this makes sense?
h
Goya ?
WOW you were quick off the mark – but, no. Although I did look at a few of Goya’s paintings for a suitable face and decided they were all too horrible! He was really dark!
Next guess?