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Jay Kaeppel has been trading for 25 years and has developed a variety of well-known systems for trading stocks, options, mutual funds and futures. As a CTA and trading software developer, Jay has been featured in Futures magazine and Barclay''s Managed Account Reports. Over the years, Jay has published more than 25 articles in Stocks and Commodities and Active Trader magazines. Now an independent trader, he has authored several books on trading, including The Four Biggest Mistakes in Option Trading, The Four Biggest Mistakes in Futures Trading, and The Option Trader''s Guide to Probability, Volatility and Timing.

Speaking with Jay was a true pleasure as he discussed just how he approaches the trading business. This is the first part of that interview.

Optionetics: How did you first become interested in trading the markets?  

Jay: I was always a “numbers” guy, even as a kid. I knew everybody’s batting average, that kind of stuff. So when I was in college one day I picked up the business section and stumbled upon the stock page. The rest is history.

Optionetics: Do you ever use options and if so what are your favorite strategies?

Jay: Yes. Like most everyone else I started out trying to simply buy calls and puts in an effort to turn a little into a lot. Things have evolved a bit since then. Now I typically use options to do things that I can’t do by simply trading the underlying. Most commonly I look for stocks with low implied option volatility then among those stocks look for long straddles and strangles, backspreads and directional calendar spreads.

Optionetics: What are the things you like best about working with traders on how they mentally approach this business?

Jay: Well I chuckle a little bit at the question because things have evolved about full circle and a half for me over the years. At first I read everything I could get my hands on and soon realized that there is a lot of bad advice and useless information out there. So then I tried to avoid talking to others too much about trading in an effort to avoid outside influences. At some point I realized that there are a lot of knowledgeable people out there and that I could benefit from considering how and why successful traders do things. Eventually I ended up in a position where I talked to a lot of traders on a daily basis. As it turned out, the majority of these were “newbies” and I kept hearing the same ideas again and again. So I did some research and soon learned that these “popular” ideas did not work. It was sort of like the “how not to” lesson. The good news is that I was able to filter down a lot of that information and subsequently wrote two books titled, The Four Biggest Mistakes in Option Trading and The Four Biggest Mistakes in Futures Trading. I truly think that traders can avoid a lot of pain if they simply avoid the most common simple mistakes.

Now I trade at home and am back to having few conversations about trading. My wife’s eyes glaze over, the kids don’t know what the heck I’m talking about and the dog, well, at least she’ll tilt her head and try to feign interest. Recently I had the opportunity to work with Optionetics founder George Fontanills and the best part was when we just started bantering back and forth about trading and just letting the experience and knowledge flow.

So I guess in sum what I like best about working with traders on how they mentally approach trading is the challenge of filtering the good ideas from the bad.  

Optionetics: How do you recommend traders treat losses and how to go about establishing their risk tolerance before the trade is entered?

Jay: I often tell traders that the day that losing trades become a non-event is the day they truly become a good trader. By that I mean that it is typical for individuals to be upset when they lose money on a trade or series of trades. It’s human nature. Most people work hard for their money so when they started watching it vanish they tend to get upset. Perfectly understandable. Yet the fact is that anyone who’s been around for a while will tell you that losing trades are simply a part of trading. So getting upset each time one occurs is wasted energy. Its sort of like the captain of a ship getting upset every time the wind shifts direction. It’s the ocean. Of course the wind is going to change direction from time to time. Either learn to deal with it or get off the seas. For traders the key is to plan in advance to deal with losing trades and to try to keep them as small as possible.

I typically suggest setting some percentage of trading capital as a risk parameter for any trade. It might be 1%, 2%, 5%, whatever. Each trader has to make that determination for him or herself. One important consideration is the maximum number of losing trades you realistically expect from a given system or method of trading. If you are using a system with objective rules it is easy enough to back test to get an idea of your likely worst case scenario. If you are using a more subjective method, then you need to make as honest of an estimate as possible. If you expect at some point you might suffer 6 to 7 consecutive losses that’s way different then if you only suffer 2 or 3 at a time. If you are risking a large portion of your capital – let’s say in excess of 5% per trade – then 7 consecutive losses is going to generate a drawdown of somewhere between 30% and 50% of your trading capital. A drawdown of that magnitude can wreak havoc on even the most disciplined trader’s psyche and can cause them to throw out their trading method just when it is about to turn around.

New traders especially should start small, small, small. Most people get into trading focused on making money. Most successful traders who have been around a while tend to focus on not losing money. It’s a seemingly subtle difference, but the old adage is “if you take care of (minimizing) the losses, the winners will take care of themselves.”

Optionetics: Do you prefer long-term strategies or short-term strategies?

Jay: I use both. There are two basic schools of thought. One says to “specialize” the other says to “diversify.” There are pros and cons to each but the truth is that there is no right or wrong answer. Each trader has to go through the process of determining what works best for them. I know people who use one basic strategy trading one or two futures markets and are extremely successful. I also know people who do all kinds of different things and achieve success. But if they each tried to emulate one another’s approach they would both fail. So that’s really the challenge. To absorb as much information as possible and then ignore other’s opinions and determine what really, truly works for you.

The purpose of combining both long and short-term strategies is to attempt to smooth out the equity curve. In other words, while one method may be losing money, hopefully the other method or methods being used will generate an even larger profit. Fortunately, with all of the computing power available nowadays you can follow a lot more things than in the past. I have some money in stocks that I look at only infrequently. Futures and options positions however, typically need to be followed day-to-day.

Optionetics: Thanks, Jay, for sharing your ideas on the trading business with our Optionetics reading audience. 

Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff’s Forum
Listen to Jeff at www.ProfitStrategiesRadio.com

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