Lesson Overview

Importance of Adjusting & Hedging Options Trades

Hedging and adjusting options trades that move against you is important, but frankly it's not as important as entering the right trade with the right strategy in the first place. In this quick video, we'll prove why correctly entering a trade is 100X more important than adjusting one.

Show Video Transcript +

In this video, I want to talk about the importance of adjusting and hedging option trades. Everyone loves to talk about option trade adjustments, hedging, protection, etc. as important concepts in your ability to generate consistent income, and they are important, but in my honest opinion, and what we're gonna prove here today, is that correctly entering a trade is 100 times more important than properly adjusting a trade.

I believe people are focusing on the wrong thing. I think that people assume that adjusting trades kind of fixes everything so that it can fix a wrong order entry, but I don't think it's the case. I believe that you can still put lipstick on a pig, but it's still a pig, and that's what I think people end up doing when they try to adjust trades that they shouldn't even have entered in the first place.

That's why we spend a lot of our time here at Option Alpha on teaching you how to place the right trades, how to price them correctly, how to be on the right side of volatility because that's 100 times more important than any adjustment technique that you can use. Again, if you don't do it, it's like putting lipstick on a pig.

Making trade adjustments incrementally improves your performance by reducing losers and minimizing risk. It does not become the "Fix-it-all" glue for all trades that we entered poorly, either through implied volatility or being on the wrong side of pricing.

Let's use a hard example here that can kind of prove this point, and we're going to look at a TSLA Put Credit Spread at the time at the time that we're doing this video on March 30th here in 2016. You can go back here and check these dates and prices if you want to, or whatever the case is.

If we entered a Put Credit Spread on TSLA, and we basically sold the 185/180 Put Credit Spread in TSLA, and we could price the trade correctly at a $100 max profit and $400 max loss, based on the probability of winning and losing, we would end up with a trade that basically is gonna win 80% of the time and make $100, and lose 20% of the time and lose $400 when it loses.

This is assuming we let all of our trades go all the way through expiration; we don't adjust, we don't manage, we don't exit, we just let the probabilities and the numbers kind of play out just a little bit.

Great order entry and pricing leaves you open to adjusting, or not, and still, have multiple ways to win long-term based on the IV actual move versus the IV expected move.

Remember, if you place this trade, and you price this trade exactly at the probability of losing, and that risk that we've talked about before in options pricing, and you place it and price it just like this, it becomes on the outside what looks like a net zero sum game, meaning that the winners exactly offset the losers, and that's what most people think.

But again, the reality is that if that were the case, you would still never lose money and not make money. But we know that we're going to win a little bit more than 80% long-term because implied volatility always overstates the expected move.

If we price this trade correctly, we know that we're gonna have a slightly higher win rate than 80%, okay? And that's gonna help us increase our win rate and the amount of money that we make.

We also know that if we close out trades early, we can potentially reduce this potential loss and increase the number of times that we win, increasing our potential gain on the trade overall. Then, we also know that if we can cut some of our losers.

Let's say that we can cut one of our losing trades by half by learning how to manage or reduce risk in hedging trades. Then, again, it creates an opportunity for profit overall. Even in this scenario, if we just cut one trade by half, we are profitable overall even before factoring in that implied volatility hedge that we talked about, or even managing or closing trades early.

But it all starts by placing and pricing the trades correctly. Instead of pricing this trade correctly, let's assume that you take the same trade with the same probability of winning and the probability of losing, but now you enter the trade incorrectly, meaning you don't price the trade correctly, as we've talked about before.

So, when you make money, you make $75 80% of the time. When you lose the other 20% of the time, you lose $425. Now, in this scenario, you're starting out $250 in the hole just based on probabilities and poor pricing.

Sure, you could still win a little bit more than 80% of the time, but that's not gonna overcompensate for the $250 you're now in the hole based on these ten simulated trades. If these ten trades played out, or 100 trades, or 200 trades, and you won exactly at the probability that you should, you're gonna start out $250 in the hole for every ten trades.

You can see how difficult it is that now, even after adjusting or hedging just one of the losers and cutting the loss by one-half ... so take this $425 loser and cut the loss by $200. So, okay, not exactly half, but just to use round numbers. You're still in the hole $50 on this overall strategy.

Now, the requirement is to be able to adjust trades correctly and reduce risk, and it's not always gonna be the case where you can adjust to cut a loss by half. What's the point, right? Well, yes. Adjusting or hedging trades will help increase your overall returns and reduce risk.

There's no doubt about that. But no, it doesn't overshadow or mask the effects of poor strategy selection or pricing, as we've already proved in this video. Listen, you can't adjust your way out of something that is a bad trade, to begin with, okay?

And it doesn't matter how good the trade looks, or what the setup is. If you're using the wrong strategy, and you enter with a bad pricing or wrong pricing, it's just not gonna work. You can't just your way out of those. It's so much more important to just enter trades correctly than it ever is to adjust rates.

We're gonna talk a little bit more in depth about how to adjust trades, and the entire process of doing it, but I first wanted to introduce this concept and this thought process to you, so that you have some context as to how we think about adjusting trades. Yes, it's important, but it's not as important as trade entry.

Again, you can't adjust trades that go bad, just like you can't put racing stripes on this car, right? This is an ugly car that, usually, nobody wants, and just by putting racing stripes on it in pink and white makes it, apparently, to some people maybe more attractive, but it's just not the case, right?

It's like a trade that you enter that's just wrong and bad. You can't put lipstick on a pig. You can't fix trades that shouldn't have been entered in the first place. Thank you so much for checking out this video. If you have any comments, or question, or feedback, please let me know.

If you loved this video, thought it was helpful, please share it online. Help spread the word about what we're trying to do here at Option Alpha, and until next time, happy trading.

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