Reasserting the importance of foundations and honest risk tolerance

The Problem

Over the past few weeks, I've had many (not a few, but many) people contacting me with photos of their accounts getting wrecked. Sometimes, they're 50+% losses accrued during a short duration. 

In most cases, it is the result of someone's vertical spreads getting blown out. Occasionally, someone will suffer a big loss when their naked options go ITM. 

We are Theta Gang traders, so our natural inclination is to sell options. Given that we are mostly obsessive addicts, we probably sell more options than we need to, or we enter spreads with more collateral than we should.

Since I am supposed to be guiding you all in your investing, this is also a failure on my part to help the newer investors get started, and to keep older investors focused. 

We are all adults here, so someone's decision to trade 950x iron condors is on them. However, I still want and need to share my thoughts and help refocus those who are getting off track.

We need to focus on our foundation first, before we start making oversized bets on spreads and naked options.

Earlier this year, I made this post about structuring a portfolio. I have drifted somewhat more aggressive this year, but it is a good starting point as well.

The Impact of Risk Tolerance

When the market is going up, everyone thinks they have a high risk tolerance. We all convince ourselves that we have the willingness and the patience to wait out downtrends, to meticulously roll options as needed, and reinvest on the way down. We all think we are robots.

Once the market starts going against us, we do dumb shit. We sell covered calls at too low of a strike. We sell our long-term positions at a loss. We fail to reinvest appropriately. We might even revenge trade. Almost everyone I know, myself included, overestimates their own risk tolerance.

Again, we all overestimate our risk tolerance. 

To keep a level head and avoid doing impulsive things that cost us more money, we need to establish a foundation of buy-and-hold positions.

Risk Tolerance Zones

I think I have a medium-high risk tolerance. Since I am aware that I am overestimating, I must recognize that my actual risk tolerance is low. I have made up the following zones to describe how I behave when I start seeing losses.

You don't need to thoroughly evaluate your risk tolerance, but I encourage you to go through some reflection and determine, in general, how your behavior changes as your losses mount.

Where do your numbers start to match this behavior?

No Blink: I can watch my portfolio swing $4,000 without blinking. That's a slow day for me. But while the raw number is relatively high, that's only about 0.5% of my account. This is my "no blink" level of tolerance. Some of you guys can lose 12% of your account in the "no blink" zone. That's not me.

In this area, I am not feeling pressured to change my trading approach or make bad trades. This is just a Tuesday.

Butterflies: A $16,000 loss in a day disturbs me. That's about 2% of my account. At this level, I start suffering some butterflies. Most of you probably have a much higher tolerance than this.

At this point, I have to consciously stop myself from spontaneously sell covered calls against my buy-and-hold positions even though I shouldn't. I am probably not selling buy-and-hold shares yet or entering revenge trades, but I have to control myself to avoid such mistakes.

Struggle: By $40,000 loss, I am struggling. That's about a 5% loss. If I lose 5% of my account, I start really feeling pressure to turn things around, even though the right move is usually to stay calm and hold.

In this zone, I am selling ATM covered calls against buy-and-hold stocks, selling OTM puts on margin, and rolling my spreads 6 months out. I overcorrect on my options and double-down on bad trades. I'm likely to avoid spending $4 on lunch because I need to save money. I consciously need to remind myself that a 5% pullback is normal or I will act strangely and manage poorly.

These are my risk levels that dictate my behavior: 0.5%, 2%, and 5%. Any losses beyond that are likely to exacerbate that "struggle" level. As evidence, I point to the fact that I sold GOOG covered calls during the 2020 crash until I got assigned, and didn't reinvest the premiums into shares. I have a relatively low risk tolerance.

Some of you might protest: When you are talking about large portfolios, a 5% loss is a larger bite than a 5% loss in a small account. It is no wonder I have a lower risk tolerance than those dealing with smaller numbers.

Personally, I found that my risk tolerance scaled pretty evenly with my portfolio size. I have found that my behaviors have tracked the same percentage change levels back when my portfolio was $300 eleven years ago versus where it is now. 

Everyone is different, but for me, I think the percentage has had a larger effect on my behavior than the raw number change.

Practical Foundations Based on Your Zones

Even the most risk-loving investors should have some buy-and-hold positions. The only person I have every talked to that invests without holding shares is Tom Sosnoff: the owner of TastyTrade. Even then, I secretly suspect that he has something in shares, or at least a pile of cash.

These shares will be the foundation of your portfolio. If you are trying to build a house, you don't start with the fun stuff like sunrooms and hot tubs. You start with a foundation. Likewise, we must use a stable foundation of shares as a base upon which to add Theta Gang strategies and speculative positions.

Having this foundation underneath you will help you remain calm and focused even when thigs turn against you. Many times I have retreated into my dividend payout list to refresh my mind when my speculative stocks tank. The mental effects should not be discounted.

Depending on your risk tolerance, you may need a large foundation. If you are risk-averse like I am, you need a large blend of indexed ETFs and dividend stocks. If you may not need such an abundant foundation.

Here are some practical steps that I recommend, but use your judgement, keeping in mind most people overestimate their risk tolerance:

Step 1) Get 100x shares of SPHD and either 100x QYLD, XYLD, or RYLD. 

SPHD is the S&P 500's high-dividend ETF. It has a beta of 0.56 and a dividend yield of 4.23%. With such a low beta, the ETF moves at about a 56% pace vs the market. Still, it has made sizeable gains in the past 2 years. With a 4.23% yield, you get a solid dividend.

The others are dividend ETFs with no growth. A lot of people hate these because they underperform the market. But you know what else underperforms the market? Trading like shit. Read more about these ETFs here.

2) Grow a stack of indexed ETFs, at least $6,000 and then 25% of your portfolio thereafter.

The US indexes tend to do very well over the long term. If you are in want of money, buy indexed ETFs. The major indexes: NASDAQ, S&P, Dow, and Russell are raging rivers flowing forever in one direction. Don't fight a river, and don't fight the indexes.

I favor the tech sector, so I buy QQQ like I discuss in every portfolio update post. I also hold LEAPS on SPY at the $250 strike that I will very likely execute when they expire in  Dec 2022.

Having at least 25% of your portfolio in indexed ETFs gives you a rock solid foundation to ensure there is at least some growth in your portfolio long-term, even if you trade like shit.

3) Start your Theta Gang plays, but reinvest 25% of your premiums into indexed ETFs or dividend stocks.

Make it a rule. When you have a foundation you're comfortable with, you can start trading your iron condors and vertical spreads. But when you profit, take at least 25% of the gain and reinvest it into dividend stocks or indexed ETFs. 

When you own shares of low-beta, dividend-yielding stocks and growth-oriented ETFs, you virtually guarantee yourself a growing stream of passive income even if follow-on trades fail.

Too often I see people doubling down on every successful trade, going back in with their initial investment + the profit from their previous trade. They continue until they get wiped out (MonkeyDew). In the end, they got nowhere and wasted a bunch of time. This is even more dangerous when people start eyeing their margin allowance for vertical spreads.

If those traders had reinvested a portion of their profit into shares, they would always come out on top in the long term, and would likely trade more calmly with that stability underneath them.

4) Continue to invest some of your deposits into shares, not options.

You're likely to continue making deposits for many decades, even when your entire paycheck ends up being <1% of your portfolio. 

People who only trade options get excited about the dry powder and dump it into more spreads. If those trades fail, then your deposit is wiped and you make no progress.

Do what I do: invest something from every paycheck into shares of low-beta positions or wheels (the premium from which buys shares). 

Unlike a home, the foundation of your portfolio should keep growing as you add the spreads, gambles, and moonshots to your portfolio.

Final Thoughts

- If you have trouble keeping your foundation safe from your impulses, keep a separate account for it. Make a point to invest in that separate account with your deposits. I keep a separate account in Webull in which I only trade just under 10% of the account. The rest is in a blend of dividend stocks that pay me out like clockwork.

- Don't underestimate the effect of deposits. Even if you can't deposit more than $100/month, this will add up over time. At the end of 5 years, you would have $6,000 plus capital gains, which will only continue to grow.

- Freeload! Join me on the adventure, and invest your free money into shares or crypto. Alternatively, use it as play money. Do not underestimate the impact of a few thousand dollars per year of freeloaded money going into your accounts. Productreportcard.com is the gateway drug for freeloading.

- It's about to be a new year. There is no better time to cut losing positions for the tax deduction and start with a fresh mind and rebalanced portfolio.