In this article, we are going to discuss how to deal with, and fix losing trades.
Around three times a year, we end up having a position that becomes deep in the money.
While you can win up to 98% of your trades you’ll still have an occasional trade that you’ll need to manage and fix in order to reduce trading risk.
The primary difficulty when selling options is that you have to minimize losses and mitigate portfolio volatility during periods when the actual volatility is more than the expected volatility.
Trading During a Bear Market or Recession
When the market pulls back, there's usually a large volatility expansion. As a result, your existing options will likely show a loss.
For example, if you sold a position when the VIX was trading at 15, and then the VIX increases to 30, then the position that you sold previously will show a large loss even if the current market price of the stock is far away from the strike price of the option.
The volatility component during a large downtrend is likely going to be one of your biggest enemies.
It’s not necessarily the “in the money” positions that cause option sellers to lose money, but more so the volatility expansion, and the correlation risk, that causes an increase in option prices which will reduce your buying power and may force you to close existing positions.
Correlation risk refers to having most of your positions be highly correlated. As a result, if one position shows a loss, then many others may show losses too. When trading options, the volatility expansion and correlation risk can often lead to a margin call even if your positions are out of the money.
This is why you must ensure that you always have excess buying power, so that you do not have to close out positions at the most inopportune time.
The best way to prevent this from happening is to trade vertical credit spreads.
By trading a spread, you're inherently protecting yourself against a large volatility expansion event.
Additionally, you can actually make money during market crashes by purchasing options during times of complacency and when the VIX is low.
I also prefer to trade strikes that are further out of the money while also trading underlyings that have strong brands like Amazon or Apple (or even stocks that are resistant to a recession like Dollar General).
Trade options on indices or futures, like SPY, SPX or /ES, is also a good choice since there tends to be less volatility in indices.
How to Manage and Trade around a Challenged Position:
Sell Call Options
If you have a challenged put position, you can sell calls to collect more premium.
You can then allocate this premium to roll down your short put strikes.
Be Patient & Trade Later in the Day
Wait until the last 10 or 15 minutes of the trading day so that the day’s trading action has revealed itself.
During recessions, the market tends to sell-off during the last two hours of the trading day.
Additionally, if you have an expiring option that is trading close to the money, you can wait until expiration day to manage the position because there will be almost no extrinsic premium left on that option. As a result, you can roll that position to a more advantageous strike price.
When volatility is high it's relatively easy to roll positions because there's so much extrinsic premium baked into future option prices.
However, when trading spreads, it's oftentimes best to simply close out the entire position and not manage it. You can try to manage it by selling call spreads and allocating that premium to the vertical put spread, but it's difficult to narrow the width of the put spread just by extending duration because you'll need to roll the long put option as well.
Summary
Trading during a recession requires discipline, especially because many of your positions will get challenged.
The best way to trade during a recession is to buy put options during bull markets, this will protect your account during a bear market.
During a bear market, it's important to be less aggressive with your strike selection, and trade later in the day.
Another good strategy is to sell call options on stocks that you perceive to be overbought.
You can also sell calls on your existing positions and use that money to roll down your put options.
Overall, it's a good idea to sell vertical credit spreads so that you avoid black swan events and have defined risk with your trades.
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Frequently Asked Questions (FAQs)
What's the best way to fix losing trades?
A few things you can do is:
1) Trade vertical credit spreads (the defined risk will eliminate tail risk)
2) Buy puts during bull markets to protect yourself against future bear markets
3) Sell calls against your ITM put positions and allocate that premium to your put position
4) You can also set a stop loss at ~3x - 5x credit received on the short put to automatically close out the position
Should I try to manage and roll my vertical credit spreads?
You can, but it's not necessary. Since it's a defined risk trade, you do not have tail risk.
Also, it's much harder to roll and manage a defined risk trade simply by extending duration.
If you have an ITM put spread, you can sell call spreads against it and allocate that premium to adjusting the ITM put spread.