Hey everyone. This is Kirk here again at optionalpha.com and welcome back to the daily call. Today, we’re going to be answering a question that a member sent in which is basically, “What are my options when a trade goes against me?” I’ll read the question that somebody sent in and that way, it will help bring some context around it and then, we’ll talk high level about what choices you have or options (no pun intended) you have when a trade starts to move against you. They said, “Thanks, Kirk, for the quick reply. I could sure use the Theta right now because APC is hitting me real hard and I would appreciate your take on the situation. I originally sold a 52.5 put and last week, sold a 50 call to hedge, but my breakeven is around 49.25. I keep telling myself it can’t go down 4% to 5% per day every day, but apparently, it can. How do you handle this kind of situation? I was hoping to unload it before the FED talks later this week, but I'm afraid it will be at 40 by then and I’ll lose a couple of thousand. Thanks as always for your help. This is so much easier when things go right.”
Now, full disclosure, this is not a trade that we made. We don't make trades in APC. I don't think we traded APC for a long time. But it was a coaching client that I had that was sending in a question and wanted my help on it, so I figured it would be a good also use and case study here for the daily call. But the end result here is that the first thing I noticed in doing all this and we’ll say as a blanket statement is that when you're afraid of trades going against you, it’s going to happen. Trading is a two-sided coin, meaning you’re going to have losing trades and you’re going to have winning trades, so prepare for that in advance. You prepare for that by having your position size in check ahead of trade entry. I know I harp on this so much and many of you who have probably heard this here are like, “Yes, Kirk, I get it, I get it.” But it's so important that you have position size in check because in this case and what I didn't show in most of the email that was going back and forth, the correspondence going back and forth was that this person was really freaking out and it was mainly because their position size was too big and they were trying to fix a trade that was going bad, but the problem at the core was that the position was too big and they were losing sleep over it. If you have a position on and it could potentially go bad and you have analyzed the trade and see that the risk in the trade is more than 1% to 5% of your account, you need to cut back on the position size. Even if that means closing right now for a loss, you don't want to hold it till expiration.
Now, when a trade goes against you, you do have a couple of choices. One, you can do nothing which is a choice. You can start to hedge the trade or you can exit the trade. Those are really the three main choices that you have. Let's work a little bit backwards on this. Exiting the trade completely is something I don't necessarily suggest. When I say exiting the trade, that really means executing some sort of stop-loss, whether it’s a mental stop-loss or a physical stop-loss. A point, 100%, 200% increase in premium, whatever it is, we generally don't see that stop-losses generate more winning trades and reduce risk in your account. We've done numerous case studies on this not only in our profit matrix research, but also on the weekly podcast. You can check them out. Just search stop-loss on the website. I don't suggest stopping out of the trade. Hedging the trade can be a good decision if you are in a position where you're getting closer to expiration. One of the things that I use as a benchmark and it's a general guidepost is that if we are in the month of expiration that you have those contracts, you should probably start hedging the contract. You sell the opposing spread, you roll contracts closer, you reduce the width of the spread. There's a number of different things you can do to hedge positions, but I don't usually do it until we’re in the month of expiration.
In this person's case, when they sent me this email awhile back, they were trading December contracts and it was November and at that point, I would say don't do anything because it's too far out. If you're right now, like right now is May, if we’re trading contracts in June and something happens right now in May, I probably wouldn't do anything until we get into June expiration. Until we start physically trading in the month of June, then I would start telling myself, “Okay. Maybe we need to start hedging this.” That brings me back up to my first one which is do nothing. In many cases, actually doing nothing and letting the probabilities work themselves out is probably one of the better things that you can do. This is assuming that everything else is taken care of, like position size, balance, all the stuff that we harp on at nausea all the time. As long as you take care of those, sometimes doing nothing is actually the best. Let the market have a little bit of wiggle room to move. We know markets aren’t going to move exactly where we want, when we want. There’s going to be an ebb and a flow to how stocks and ETFs move. Give yourself a little bit of wiggle room and give yourself a little bit of cushion that you can withstand positions that go maybe in the money a little bit or go underwater on a paper loss and then come back around.
My assumption is always to do nothing first. Can I do nothing? Am I okay doing nothing? And that gets back down to position size and neutrality, the question. And from there, am I at expiration or getting closer to expiration, so that I need to start hedging because I'm running out of time. And if that doesn't work, then we go to the last step which is – Okay, if it didn't work and now, we’re at expiration or the last week of expiration, now we need to close or roll the position. That’s the thought process behind it. Hopefully this helps out. Hopefully it answers the question. As always, if you guys have questions, you can get them in. It’s always first-come, first-serve for the questions that are submitted at optionalpha.com/ask. Until next time, happy trading.