The Due Diligence Cycle | OptionsANIMAL
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The Due Diligence Cycle

Think your due diligence ends once a trade is placed? Thank again! The OA 6-step method requires a trader to carefully examine an equity technically, fundamentally and sentimentally in order to develop a reasonable expectation for how that equity will move in the future. A proper expectation is far more than simply, “bullish” “bearish” or “stagnant.” A solid expectation incorporates all aspects of the due diligence process and covers various time frames.

For example, I might say that my expectation for a given equity is “short term stagnant to bearish due to technical weakness on the chart and profit taking in the overall market, but long term moderately bullish because of improving fundamentals and ongoing opportunities for expansion in third world markets.” Once I have a finely tuned expectation, I can use the options instruments to craft a trade that optimizes every aspect of it. For instance, in the above example, I might set up a Call Calendar designed to profit from a stagnant to slightly bearish short term move, and leave me with a less expensive long call in place to take advantage of the subsequent move up. However, I do not simply run out and place this trade. I first create a comprehensive plan detailing how I will enter, and most importantly, I establish primary and secondary exits to help me close the trade.

The primary exit is, usually, the easy part. I decide in advance that I will close my trade once I have earned a predetermined percentage on my risk. Making that decision up front helps assure that I do not let greed keep me in a trade too long and turn a winner into a loser. The more difficult step is crafting what we call the “secondary exit” – that is – deciding in advance how I will adjust my trade to maintain profitability if things do not work as planned. If I enter a trade with a bullish expectation, I should decide in advance what steps I will take if the equity goes stagnant or bearish. Taking this proactive step ensures that I will not freeze like a deer in the headlights when things go awry. It also ensures that I have capital set aside to fund any additional instruments that my adjustment may require. For example, my plan might require me to turn a bull put into a ratio spread. If so, I had better be willing and able to buy the additional puts.

What many people miss is that the same analytical rigor that helped craft the trade is required prior to making any adjustments to the trade. In other words, the due diligence starts all over again. Until recently one of my trading plans might have said something like, “if bearish, add additional long puts to compensate for the positive delta of the bull put and scale into additional long puts if needed.” I now realize that while that was a great start, it unintentionally skipped that most important step – employing all of the techniques of due diligence to create a reasonable expectation. It is not enough to simply say, “if bearish…” There are too many different types and flavors of bearishness. For example, my response to a bearish technical move should be vastly different depending on whether the move is caused by a crippling fundamental announcement by the company or by a rumor that spooked the entire market. The first instance might cause me to eliminate my bullish instruments and turn the trade very bearish. The second instance might be a buying opportunity prompting me to make the trade even more bullish. Without doing my technical, fundamental and sentimental due diligence prior to making that adjustment, I can’t possibly know the best way to react.

I now incorporate the need to investigate fully prior to adjusting, into my original trading plan. For example, I recently placed trade on Facebook as one of my OA weekly trades. The trade was designed to perform well in a stagnant or bullish trend but would be in trouble if FB turned bearish. It was also designed to be closed prior to FB’s upcoming earnings event. My trading plan addressed the possibility of FB going bearish for several different reasons. It stated in part, “If FB is going bearish due to a downturn in the general market or on some sentimental news, I may simply hold the call through earnings and adjust afterwards, depending on the results of earnings.” In fact, that is exactly what happened. Shortly after I placed the trade, the market fell over 200 points, and FB fell with it. I followed my original plan and did nothing to the trade. Several days later, the market rebounded and I was able to close the trade at my primary exit.

Incorporating the need to investigate and diagnose the move prior to taking action can prevent you from making unnecessary and possibly harmful adjustments to your trades. The market may be open from sun to sun, but a trader’s due diligence is never done!

Jodie Lane
OptionsANIMAL Instructor

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