About 5 years ago I stumbled across a website regarding Options Trading. It was a totally free website that offered the basic introduction to option trading. Many of my friends and co-workers knew very little on the subject, but the Internet was riddled with all types of information, positive and negative. However, what intrigued me about this website was its simplicity. The author maintained a great skill of keeping things simple. He didn’t describe anything using the common buzzwords of “shorting” this company and “long” this company. Most important, he covered the myths about options trading.
You see, options’ trading is no more risky than crossing the street, as long as implement a few rules. Bottom line, if you don’t look both ways, you are probably going to get crushed. Options’ trading is no different. As long as you employ some simple principles in every trade, you won’t completely eliminate any risk, but you will manage it successfully.
Of these last 5 years, this current year is the one I’ve been most focused on options trading. I have a simple 7-step process I follow for every trade, as well as a money management principle that I never break, regardless of whether it is paper money or real. The ironic part is that these same principles can be applied in just about any financial transaction.
What Are the Risks?
To cover some of the risks we need to first cover a few definitions of options. For those that don’t know what options are, in their simplest terms, options are contracts that give you the right or obligation to purchase a stock, ETF, or other security at a specified price. That is it. Nothing more and nothing less. There are only two types of options: calls and puts. However, there are several different strategies for trading those calls and puts. Depending on whether you sell or buy an option determines your risk. The best part of options trading is that you know your loss, or risk, before you enter the trade. One extremely important point to know is that options contracts expire at a specified date in the future.
There are a number of risks when it comes to options trading, but one of the best ways you can manage that risk is to paper trade. Paper trading is just like the real thing except you don’t utilize real money. This allows you to test new strategies without risking real money.
Money management is the next best principle in risk management. Money management ensures that you don’t risk your entire account all at once. It further prevents you from risking too much per trade. My money management principle is fairly simple. I never risk more than 2% on any trade and I never have more than 10% invested at any given time. Furthermore, it will help your overall return if all of your trades are equivalent in risk. To illustrate, let’s assume my 2% risk amount is $400 and my 10% account value is $2,000. I will try and match all my trades to have a max loss of $400 and I will never have more than 5 trades open at once. There is always the chance that all my trades will be losing trades, however, I will be able to recover a 10% loss much easier than a 50% loss. One other note is that I manage my trades on a daily basis. Each night after work, I check the market and the status of my trades. If I have some trades that are losing money and that loss has triggered my exit strategy, I will close the trade out in the morning.
This next item won’t seem like a risk management principle, but I promise that it will ensure you manage your trades while checking your emotions at the door. That principle is your trade plan. On a few occasions, my buddy has asked my advice on a trade he is in and each time I ask him what his trade plan is. This usually results in a blank stare. A trade plan doesn’t have to be cosmic. I have a trade plan for all my trades. In my trade plan I usually have at least two exit strategies at a minimum. Typically though, I employ three exit strategies: time, technical, and profit. It’s important to note that profit is both for loss and gain. Depending on how I am doing for the year, my profit may be conservative or aggressive. For example, last year at the beginning of the trading year I was down on my account by 8%. In order to manage my losses and maximize my gains, I adopted a conservative approach toward each of my trades. On any given trade, the moment I hit a 50% loss, I exited. If the trade was profitable, I exited once I hit a 75% gain. This was on top of my time and technical exits. I was able to reverse my loss and end the year with a 14% return. Although I missed my goal, it was encouraging to see a positive return rather than a negative.
These are just a couple of risk management principles to follow, but there are several more that I cannot cover in this article. However, I believe those three are crucial and a great start to help you maximize your returns and minimize your risk. There are several others to add to your arsenal, but above all: 1) have a trade plan, 2) Utilize money management principles, and 3) Paper trade all new strategies.
As I have stated in previous posts and will continue to state, education is the first place you have to start. I am not talking about getting a degree from your local college or university. I am talking about education from professionals that will teach exactly what they do. Don’t be misled when main stream media and TV hosts lead you down a path that they are not taking. Don’t think that you can learn what you need for skills by watching CNBC. These are great resources to be able to get the pulse of the market, but ultimately, to be successful with options trading, you need to be educated.
I will leave you with the site I started with and ultimately have ended up with to this day. LSOT
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