Paul recently published a great post called the One-at-a-Time Portfolio. In it, he showed how struggling options traders can build consistency by holding only one unhedged trade at a time. It’s a great approach. It helped me, and I highly recommend it to anyone who is struggling to find consistency in their options trading.
But what if you’re not inconsistent? What if you’re consistently losing? You’re equity curve is trending down. If this is you, I’d like to suggest something that helped me and may help you:
Stop trading options. Trade stocks instead.
Not forever. Just for a little while. Think of it as a diagnostic.
If you can’t be consistently profitable trading stocks, it is vanishingly unlikely that you’ll be consistently profitable trading options. Options are derivatives of their underlyings, and the same technical analysis, risk management, and psychology necessary to trade underlyings is also necessary to trade its options. These are the fundamentals. To those fundamentals, options add complexity and leverage. Those nuances can be used to your advantage, but only if your fundamentals are sound.
And the thing is, since options trading is so nuanced, it’s easy to think that your problems lie somewhere in your options technique. So you keep studying options, adding more and more techniques to your toolkit, convinced that one of them will solve your problem. It probably won’t.
Trading stocks gets rid of all of that. Analyze chart. Set stop. Buy as many shares are your rules allow. One share = one delta. There is no expiry series to select. No strikes. No spreads to construct or manage. No gamma, theta, vega, or implied volatility. Your shares don’t expire. They can’t be exercised. Liquidity is generally better. Spreads are generally narrower. Better yet, if you do this experiment in a cash account, there is no margin magnify your mistakes, and T+2 settlement times will force you to slow down.
If you’re like me, this exercise will quickly shine a spotlight on fundamental problems with your process that you hadn’t seen before. Fixing those problems will make you a better trader and give you a clearer sense of what you want to accomplish with options trading.
[And in the meantime, continue perfecting the technical analysis techniques Vega Options teaches. Those simple tools work just as well with trading stocks as with trading options.]
If your process isn’t working, don’t add new things. Instead, strip away everything you possibly can and prove to yourself that you can be effective at the most basic level. Only then should you add new assets, tools, and techniques. Add them one at a time. Use your P&L as your guide. If an addition to your process increases your profitability or improves your consistency, keep it. If it doesn’t, let it go. This way, you iterate from a foundation that you know is sound.
At the end of this process, you’re likely to find that your analysis is simpler, your trades are fewer, and your P&L is better for it.
Just wondering how a DH strategy could translate over to stocks. Here’s an example – set a stop, set profit target, sell part of the position once target hit, reset the stop on remaining position so as to lock in the profit for the overall position. Since positive profit locked in then let the remaining position ride as high as possible. Is that kind of “DHing for stocks”?
Great question, Alf123. The strategy you describe is an important part of position management when trading any asset, including options. It’s definitely related to delta hedging since it allows you to lock in profits, reduce margin, and trim delta exposure. Those are all essential trading skills, but they aren’t really “hedging.” Hedging is combining short and long positions (or spreading different underlyings) to create multi-leg positions that play off each other (aka “hedge” each other).
In my opinion, hedging provides a few things that traditional position management doesn’t: First, hedging allows you to remove your original risk without trimming your original position. Let’s say I open a long position by buying 10 vertical spreads. I can then hedge that position by selling strikes above the vertical without “taking profits” on any of my original position. Of course, sometimes I do take profits by either closing units or rolling long legs, but hedging provides other options as well.
Second, delta hedging allows you to create structures that reverse your original directional thesis without closing your original position. The only way to do that trading stock is to close your original long position and flip short.
Third, delta hedging allows you to create positions that profit (from theta or vega) while price goes nowhere. You can’t do that with stock at all.
And fourth, delta hedging allows you to build massively leveraged positions far beyond the leverage you can obtain with stocks or even leveraged products like futures. When you buy stock, the cost of that stock is debited from your account. There is no way to avoid that. If you want to free up buying power in your account, you have to close part of your position. That limits your leverage. But as long as you use a net-neutral structure, you can DH an options position in such a way that you can continue to hold your original position while eliminating the debit from your account. Once you do that, you’re free to recycle that buying power to add a new position to your portfolio. Rinse and repeat. If you can get into sync with price action for a while, this strategy allows you progressively build massively leveraged positions while never exceeding your trading rules about maximum capital at risk. Now, price action doesn’t always cooperate, of course. And when it doesn’t, you use other tools to close, trim, or hedge your position. But when things are really clicking, you can build some amazing positions that simply aren’t possible when trading stock alone.
Much appreciated info, thanks Travis!
Hi, I was reading your website, great content. What is a stock trading version of DHing? Here’s one example – set stop, set profit target, profit target hit and sell part of the position, reset stop on remaining position to lock in profit. With positive profit locked in, let the remaining position ride higher and manage as required. Is that a long stock version of DHing?
Please note I posted this question twice by accident! See Travis’ great response just above to this question.