Stock Market Direction Becomes Irrelevant when You Average Down

This podcast offers some insight and examples of why higher trading frequency and averaging down (or up) around the market creates an environment in which market direction becomes more irrelevant the longer you trade.
Stock Market Direction Becomes Irrelevant when You Average Down
Kirk Du Plessis
Apr 30, 2018

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. 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.

Example:

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.

Example:

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.

Solution:

  • 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

Example:

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.

Solution:

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.

Conclusion:

  • 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.
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