Why Some Option Trades “Explode” in Your Face & What to Do About It
Have you ever had the feeling that some of your trades explode and turn into "massive" losing positions? They just never seem to go the way you thought it would and demand or steal your attention, right? Well, there's likely a couple of reasons why this happens, and it goes back to some of the most basic principles of options trading. In today's podcast, I'll walk through the psychology behind many of these "bad trades" and offer a strategy to help manage them.
- Traders get so wrapped up in these trades that are big losers or that are completely going against them.
- Their perspective is skewed, focusing on any trades that are moving into losing positions.
When a young child is learning to use a regular cup, they spill their cup of milk, which goes everywhere, all over themselves and all over the table. But, in perspective, spilling the small cup of milk is not nearly as bad as spilling the entire gallon of milk! That would be a major catastrophe. However, spilling a cup of milk for a young child is a big deal because they were in charge of this small cup of milk, which is now spilled all over. What your child will see as a massive failure may not actually be that big of an issue to you as an adult.
- In many cases, people behave very much like children when it comes to investing and trading.
- Many traders' psychology has not yet developed to the point of being a mature investor and trader in the market.
- People get stuck in the same childish psychological ways of focusing more attention on trades that are losing.
The Middle Child Syndrome
- Often the middle child feels left out and seeks unnecessary extra attention to compensate for their feeling "left out."
- In trading, people often get middle child syndrome with a trade that goes bad.
- When a trade starts to go bad, it's like none of the other trades exist; it's like they're in a vacuum, 100% focused on the thing that's going wrong.
- Markets are truly the ebb and flow of greed and fear.
- When you have a position that goes against you, immediately, your human instinct for fear kicks in.
- You start focusing just on that trade, and it's like nothing else exists.
Here are four steps we can take to avoid these issues and manage positions moving forward.
1. Position Size
- Position sizing is the number one thing you can do to be successful.
- Try to hit single, after single, after single; stop swinging for home runs.
- If the trade is a big loser, it means your position size is too big.
2. High Number of Trades
- Frequently, people are not trading enough.
- When you don't have the confidence to continuously enter trades, you might run into a series of trades that are just bad trades, a sequence of returns that just don't work out that well.
- When you increase your number of trades, you find that those bad trades start to average out.
- Having a lot of trades helps break the sequence of return risk.
3. Don't change the swing of your .300 hitter.
- Don't change the core fundamentals of what you know to be successful.
- Just because you had a losing trade doesn’t mean you should change anything.
- Recognize and anticipate that you will have losing trades.
- Don't adjust everything you've done just because one or two trades "blew up in your face."
4. Adjust, Roll, or Close the Position.
- You can do a lot with a trade that is going against you.
- Granted, you should be more patient rather than more anxious to adjust.
- Making adjustments later in the expiration cycle is generally better than making adjustments too early.
- If the trade is 30-60 days out, your default answer should be to simply do nothing. It is way too early in the expiration cycle to try to anticipate what's going to happen.
- This takes a lot of patience and understanding that the markets are dynamic and fluid, and anything can happen in a 30-day time period.
- When you get 1-2 weeks from expiration, you want to start making adjustments, rolling positions, or simply closing the position and taking the loss.
- This whole conversation around focusing too much on losing positions is straightforward to correct: entry, frequency, the mechanics of trading, and not taking full losses whenever possible. Control what you can control and forget the rest!
- If you take all these precautions, no trade can ever "explode in your face" to the point where you have a mental breakdown.
- You will have positions that go against you, and you will have trades that end up being losers--that's just part of the business.
- Understand how to move away and remove your emotions from that environment and manage the whole portfolio.
- At the end of the day, if everything else is profitable, one losing trade really does not matter.
- Often that losing trade added balance to your portfolio, allowing it to be profitable.