How important is picking the right stock market direction when trading options? Depending on how you trade, it can be either vitally important or not important at all. Today’s podcast offers some insight and examples of why higher trading frequency and why averaging down (or up) around the market creates an environment in which market direction becomes more irrelevant the longer you trade. As retail traders, we want to try to replicate more and more frequent “resets” of our overall break-evens which in turn lead to less dependence on the market direction for profits.
Key Points from Today’s Show:
- Trade frequency and high probability trading is so critical.
- The idea of sequencing risk means that you do not know, even in a high probability system, when you will be faced with a sequence of favorable trades or not favorable trades.
- No one knows that the sequence of their next 10 trades will be.
- Sequencing is random, and you do not know what the distribution of profits will be.
- This is the sequencing risk that nobody accounts for in trading, and one that most people fail to truly understand.
Let’s say you have a 50/50 system – 50% chance of winning and 50% chance of losing. Even this system can result in wildly different payoff diagrams over the course of time. There is no way to know what the sequence of returns is going to be. The random distribution of results caused by probabilities can sometimes be very different. However, as you make more and more trades, the results should start gravitating towards the expected probability.
- The biggest problem with investing is that all of an investor’s trades are focused on a few opportunities per year.
- When you focus all of your trades on a few opportunities per year, it makes those dates in time critically important to your success.
- Are those dates in time when you decide to make a trade randomly going to be good dates or bad dates for the underlying that you traded.
If you only had one opportunity every year to invest all of your savings in a stock or some ETF or market, how important is that one single date to your long-term success? It because extremely important. If you randomly pick the top of a market, that could cripple you for the rest of your life. By allowing the market and its timing to be the random factor that you can’t consider, you are setting your strategy up to fail.
- Increase your trade frequency, so much so that wherever the market moves, so do you.
- If the market moves up by a dollar, then your next trade entry all your strike prices are up by a dollar.
- If the market moves down by a dollar, then your strike prices are down by a dollar.
- When you cut down your trade entry over the course of the year into very small, very consistent bite-sized chunks, then market direction becomes meaningless over a long period of time.
- Over the long-haul, the market volatility swings will feel less and less meaningful because your trade frequency is so high.
- Since your risk is cut down into small chunks, now you are spreading your entry out over 100’s of thousands of trades over the course of your trading career.
- This allows you to get faster and more accurate expected results based on what you are trading.
Using Market Direction to Your Advantage
Assume you enter a trade where the stock is trading at $100. You sell the 105 call options and 95 put options, creating a very simple short strangle. The trade has an 80% chance of success, but remember, this is the probability if the trade was entered multiple times over the course of many years. Expecting the 80% chance of success on one single trade leaves a lot up to random chance and random sequencing of returns.
Instead of putting all of your capital towards that one trade, only invest 1% of your account in that trade. If two days later the stock goes down by $2 to $98, take another 1% of your account and add a new short strangle. This time using new strike prices – adjust strike prices down by $2, selling the 103 call and the 93 put. Now you have averaged down with the market, so your blended strike price on the call side is 104. On the put side, the blended average strike price is 94.
Another couple of days goes by and the stock continues to go down, all the way to $96. You again move your strike prices down for the next 1% sequential entry, and sell the 101 calls and the 91 puts. Now your blended average goes all the way down to 93 across all of your strikes on the put side and down to 103 across all the strikes on the call side.
- When you increase trade frequency and reduce your trade size, you begin to ebb and flow with the market.
- The market has no bearing on your ability to be successful or not in a high probability options trading expectancy model system.
- Although the market can sting with a huge move, your portfolio has a better chance of recorrecting where its strike prices are with more frequent entries.
- Every day, wherever the market is, adjust and move your strike prices to reflect the new market price.
- This is approach is based on the statistics of high probability law of large numbers and does not leave it up to random chance and sequence of return.
Free Options Trading Courses:
- Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
- Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
- Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
- Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
- Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
- Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
- Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
- Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
- Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.
Option Trader Q&A w/ Charles
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Charles, who asks:
I currently plan on starting trading very soon. I just opened up a couple of trading accounts; one with Charles Schwab and on with Fidelity, just to take a look at which one I would prefer. I want to use the Option Alpha IV Rank tool and also join as a $99 member on a monthly basis. My question is, the options that you currently have placed for us to view, at some point are there some that we can follow or use as we begin practicing? Or are those just dedicated to you?
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
PDF Guides & Checklists:
- The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
- Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
- Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
- Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
- When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
- 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.
Real-Money, LIVE Trading:
- EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
- VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
- DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
- COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
- TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
- MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
- IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
- TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
- XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
- COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
- EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
- IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
- SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.
Thank You for Listening!
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