Understanding Option Trading
The Smart Profits Report: Issue #286
Friday, February 24, 2006
Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run
By Jim Stanton,
Advisory Panelist, Mt. Vernon Research
From my early days of option trading, I can’t remember the number of times I said to myself, “I was right and still lost money.” I would be correct about the direction of the underlying stock but not the timing. My options expired worthless.
Not long after my misfires, I discovered what all experienced traders realize: If you don’t know how to manage your money, you won’t be in the game long.
This is especially true for options trading because of the inherent time limitations. Not only do you have to decide on the strike price, but also on the expiration date. It’s also important to know how much money to put at risk. Today, let’s get into understanding option trading and how to apply money management to your benefit…
Take A Step Back From the Cliff
It’s human nature to have a “feeling” about a trade. Sometimes you’ve landed on a decent risk/reward play. Other times, a trade appears too good to be true, one in which you “can’t lose.” When that feeling washes over you, my advice is to step away from the cliff. That’s because the “can’t lose” trade usually means risking more money. After all, if you can’t lose, why not score big? Big mistake.
In fact, there are so many variables in options trading that even if it feels like one of those “no lose” situations, you can never be sure, before the fact, which trades will be profitable.
Understanding Option Trading: Your First Money Management Decision
The first money management step you must take is determining the percentage of your portfolio that will be allocated to speculative option trades. Depending on your experience and how comfortable you are in the options arena, I would suggest 10%-20%. For this discussion, we’ll assume a total portfolio value of $300,000 with $45,000 (15%) allocated to option trading, which is the same percentage used in my clients’ portfolios.
Understand first that diversification is the most important aspect of any money management program…but especially with regard to option trading. That’s because, unlike normal stock investments, options are much more volatile and generally have a lower success rate.
So, what is the right percentage that you should allocate to each option trade? I advise 10%, but no more than 15% for each trade. Since we are allocating 15% ($45,000) for options trading, I would suggest using 10% ($4,500) for each trade. That way, if the first trade is a total loss, the drop in the value of the entire portfolio is just 1.5%. These percentages can be higher or lower according to your risk level. But the key is recognizing that you should use the same percentage of available funds for each option trade.
Be Aggressive Without Undue Risk
“Cut your losses and let your profits run” is an old Wall Street adage, but very good advice for option traders. Option traders usually have a lower winning percentage than stock traders. But by sticking with their winners and cutting their losers quickly, they remain in the game.
Once you accept that your winning percentage could be about 50%, you should also realize that at times you might put together a string of losing trades. To withstand a losing streak, there is one final step in money management.
Here’s How To Lower Your Exposure:
Let’s say your first four option trades are losers. Using a fixed amount per trade of $4,500, the value of your option account has now dropped by $18,000, which is a 40% loss. You now have $27,000 remaining in your options account.
What I tell clients is…maintain your 10% trading position. That will lower your risk, but allow you to engage in the same level of options activity. In other words, if you find your portfolio has dropped to $30,000, then drop your option trade to $3,000 (down from $4,500). That reduces your exposure, but permits the aggressive trading that rewards good trades. Similarly, on the way up, if you find your account has blossomed to $60,000, then it’s time to increase your individual option trade to $6,000. This constant emphasis on percentages is the best way to mitigate losses and it will take you less time to become profitable.
I cannot emphasis enough how important money management is in understanding option trading. You’ll come to realize there are many variables beyond your control. But if you can stick with a good set of money management guidelines, half the battle is won.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- For an excellent discussion on how to control your portfolio, see Smart Profits # 263, Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio, by my colleague Karim Rahemtulla. He reveals that investors are sometimes prey for predatory and corrupt corporations, but by using position sizing within your trades you can control your own portfolio’s fate.
- Need a refresher on puts and calls? Visit our free Smart Profits Glossary.
Related Articles:
- “Textbook” Trades Don’t Always Win
- How to Use Puts and Calls: For Systematic Short-Term Profits
- Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
