Tales of a Technician: A Plea for Position Sizing
I spotlighted Petroleo Brasileiro (PBR) in the Options Report two weeks ago on account of its mouth-watering bull retracement pattern. Then the stock plunged some 13% overnight on the following news. This is an excerpt from a Fitch Ratings press release:
“Petrobras’ decision to reduce diesel prices by 10% for a 15-day period yesterday, in response to protests from truck drivers about rising fuel costs, highlights the continued ability of the government to influence the company’s policies and decidions in order to achieve political and social objectives…”
I can’t remember the last time I had this happen in a stock I owned, so I had to refresh my memory of how to deal with such a sucker punch. I’d like to share my methods with you.
First, proper position sizing is always what saves you in a situation such as this. When I hear new traders talk of trusting technical analysis so much that they would make a big bet on a single trade because they just know X or Y is going to happen, I shudder because I know the end game will be ruin.
There isn’t a snowball’s chance in Hades you could have known PBR was going to reverse its breakout in such spectacular fashion. Its price pattern was virtually perfect. And yet, it didn’t work. The first line of defense when the unpredictable strikes is proper position sizing. I carried naked puts into the plunge and guess what — I still only lost less than 1% of my account.
I’ll share the harrowing details of my paper cut. Perhaps you can learn a thing or two.
On May 22nd, PBR was starting to trend higher on its 5-minute chart. Since I already liked the daily trend and was waiting for signs of strength to justify my entry into naked puts, I sold a partial position (1/2 to be exact) of July $14 puts for 34 cents. At the time they were about $2 or 12.5% out-of-the-money.
My initial plan was to scale into the second half around 68 cents if PBR ended up pulling back further. In fact, I had a sell limit order at that price.
Then, two days later on the 24th, about ten minutes before the market opened I was scanning through my positions to see if they had moved after-hours. It was then that I become aware of the monster down-gap that would materialize in PBR at the open. Because I knew the puts would open way higher than 68 cents, I canceled my order.
With a gap like this, I like to let the stock trade for at least five minutes. Then, if we can rise above the five-minute candle high, I look to play a potential gap fill. In this case, I was willing to sell another batch (the 2nd half) of July $14 puts to raise my average credit and give myself a chance to recoup my losses quicker. When PBR started to pop back in the morning, I sold more puts for $1.39 and thus raised my average credit from 68 cents to $1.04. That meant I didn’t need PBR to rebound near as much to recoup my loss.
Now, at this point, I’ve doubled my size and was desirous to keep a short leash in case the stock’s gap fill attempt failed. Specifically, my plan was to bail on the entire position if we ended up returning toward the low of the day.
Well, sure enough, the snap-back fizzled as fast as it began and within an hour PBR had returned to the low of the day. I promptly exited buying back all the short puts for $1.55. That means I lost 87 cents on the first half and 16 cents on the second half. A sucky outcome to be sure, but not a career-ending one.
Here are my key takeaways:
First, scaling in saved me. Because I only had a partial position heading into the gap the damage was half as bad as it could have been.
Second, even though my double down attempt failed I’m still happy with the tactic. The risk on the second half was minimal (16 cents in this case) and the speed with which I would have recouped the loss was accelerated dramatically by the additional investment.
Third, exiting later in the morning was the smart move because PBR has continue to flounder since.
