CLASS I – Introduction To Money Management
Congratulations! you’re about to embark on one of the most misunderstood, yet highly profitable investment tools, Options Trading. Options trading is shrouded in mystery because of it’s seemingly complex structure. It is for this reason we will start from the beginning and break it down step by step. When we have concluded I think you’ll agree the veil will be lifted.
Far too many investors lose money trading options simply because they don’t understand what they are doing. Some hear the tales of an investor making a killing on an option trade and dive in head long… usually to disastrous effect. Most avoid options altogether because they find the terminology confusing, are unsure of the risks or just generally skeptical of how the game is played. This is a mistake. Options can be risky, but no more risky than any other type of “investments.”
The problem begins with the investor looking for the “easy money” or “quick killing” and follows the crowd into the next hot investment. This is usually the proverbial kiss of death as they follow the crowd right off the cliff. Having been scarred by their first taste of options trading they retreat back to the safety of the investments they’re more comfortable with, probably buying stocks & bonds. In reality, since buying stocks & bonds require a much larger capital investment, it would seem apparent that the risk of loss would be greater… and it is.
Options can be as speculative or conservative as you want them to be and the use of complicated strategies is not necessary to make over-sized profits. In fact, it’s quite normal to routinely make double, triple, even quadruple net gains trading options. Since you’re reading this, I can say with certainty, cashing in has never been easier.
MONEY MANAGEMENT
Money management is without question the most important aspect of option trading. This is not meant to downplay the importance of having a successful method of locating winning option trades, but without proper money management even the best stock picker will lose money. The correct use of money management techniques makes the difference between a winning option trader and a losing one.
Whether you are trading stocks, options, currencies or commodities, there are many schools of thought regarding the best ways to manage your trading dollars. Some have many similarities in common while some may seem abstract bordering on the extreme. Before we breakdown the specific guidelines for successful money management methods, it is important to have a fundamental understanding of the types of buy and sell orders that can be placed.
Definition: An option is an investment that gives the investor the right, but not the obligation, to buy or sell a specific security at an agreed price (strike price) within a set period of time (expiration date).
You can buy options on the American Stock Exchange, Chicago Board of Options Exchange, New York Stock Exchange, Philadelphia Stock Exchange
TYPES OF OPTION ORDERS
Market Order
A market order is placed to buy or sell a stock or asset at the current available market price. The only advantage to a market order is that you are guaranteed that it will be filled and filled quickly. Using market orders when buying is not recommended since there is no guarantee at what price your order will be filled. The only time a market order is used is when trying to exit a loosing trade that is quickly moving against you. Under these circumstances it would be foolish to risk using a limit order getting out of the trade in the hope of saving a few decimal points. The limit order price may never be hit which will leave you trapped in a losing trade.
Limit Order
A Limit order is used to buy or sell a stock or asset at a better price. A limit order guarantees your order will be filled at the price you have chosen or it will not be filled at all. This may cause you to miss an occasional trading opportunity but the advantages far outweigh the disadvantages.
Call Options
A call option is purchased in the belief that a stock’s price will rise. For the cost of the premium paid, the call option gives you the right to control a 100 share contract of a specific stock at a “strike” price of your choosing. The strike prices that are traded are designated in the “options chain.” To profit from a call option the underlying stock price must rise above the strike price which you have chosen before the expiration date (which you have also chosen at the time you initiated the trade). The fee or Premium paid for the option varies greatly depending on the closeness to the strike price and the time remaining until expiration. The strike price and time until expiration are the two primary factors that will affect the price being paid for any given option. The closer the strike price and the farther out the time until expiration, the costlier the option premium.
Put Options
Put options are purchased in the belief that a stock’s price will fall. In simplest terms, if the share price declines in value, the value of the put option increases. You are buying the shares at their lower price in the future and than selling them at your strike price (the strike price you locked in when you bought the put option). Your profit is the difference between those two values.
Bid, Ask, Spread
The ask price is the price you pay when buying the put or call option. The Bid price is the price you receive when you sell (or close) the put or call option. The Spread is the difference between the bid and ask and is the premium you pay for the right to control the option contract.
CONTROLLING LOSSES
Limiting Risk… The Percentage Stop
A percent stop is used to determine what percentage of the overall investment one is willing to risk on a given option trade. An example of this is: 1 option contract (100 shares) of stock ABC are purchased at $5. The total of the investment would be $500. If the option investor is comfortable with a risk/trade of $150.00 on the original $500 premium paid one would be setting a 30% stop loss. To estimate the exit price, divide the risk amount by the number of shares (100) to arrive at the number of points the stock can move before the exit price has been triggered. Subtract this number from the purchase price ($150~100= 1.50) this is the point decline that would trigger a stop loss sale. A 30% stop loss on an option trade is reasonable and I have often used it myself, but each individual trader must decide for themselves the amount they wish to risk on each trade.
Chart Stop
A chart stop is determined by deciding where on the chart to place your trade exit. This is where “support” and “resistance” points are used as possible turning points. We will be discussing support and resistance in a coming chapter.
Time Stop
A “Time Stop” keeps the trade open for a predetermined amount of time at which time the trade is closed. A time stop enables the trader to manage a trade that isn’t working so that funds can be re-deployed to other trading opportunities. Money tied up in a trade that is not working is considered “dead money” and an options “time decay” will eventually destroy the value of the option. It is best to exit an option trade if it is not working and put it to better use.
TRADING STYLES
Time Frame Trading
The different styles of trading can be broken down into time frames. That is, the expected holding time that the option trader in “in the trade.”
The first is “SCALPING.” Scalping is trading for a very short period of time. This can be measured in seconds to a few minutes. This type of trading is extremely difficult for experienced traders, for beginners or intermediate’s it is definitely NOT recommended.
Next is “DAY TRADING.” Most people are familiar with day trading. This type of trading ranges from a few minutes to a few hours. A true day trader will not hold any trade overnight. Options Day trading is also very difficult and is only recommended for highly skilled traders that can devote a full time effort. While we don’t advocate day trading, as one’s experience grows they might want to test the waters by consulting intra-day charts to look for entry and exit points. Case in point; a $.10 difference in a trade can be worth thousands dollars over the course of the year.
“SWING TRADING.” Swing Trading is initiating a position lasting from a few hours to a few days. All options traders apply some type of swing trading in their trade positions at one time or another. Swing trading is a useful tool providing the trader has sufficient time to devote to monitoring their trades.
“POSITION TRADING” is holding a trade from as little as 2-3 days to 2-3 months. This is the most advantageous time frame and the one we prefer to operate in for the majority of our trades. Since the trade will be held for a longer period of time, the exact entry point will not adversely impact the trade. The position trader is attempting to profit from a larger move in the stock price. Position trading does not require one to monitor the stock movement on an intra-day basis and it is not recommended that one does. Position traders also have reduced trading costs from commissions as their profit margins tend to be larger and their trading is less frequent.
“LONG TERM POSITION TRADING” has a holding time from 3-6 months and the strategy could potentially extend a full year or longer with the inclusion of “LEAPS options.” This trading style is used when one plans on doing less trading, more investing in undervalued assets, and would still wish to take advantage of the leverage of option investing. If more traders took a longer outlook on their trades and selected from “out of favor” stocks and sectors, there would be a lot more very successful options traders. With this style of trade the entry point is less important as you are positioning to take advantage of large market moves.
Dollars At Risk
In determining how much to risk on each trade, we are referring to the percentage of one’s total account that would be lost if the trade was not profitable, not the total amount of equity in a given trade. There are many different schools of thought pertaining to maximum allowable risk per trade. Among professional traders and money managers, many feel that no more than 3% of the total account value is correct. Some say 2% while others recommend 1% of account value. As a percentage of one’s total trading capital, these amounts are to be considered reasonable and safe. If one has too much risk in any given trade and it goes against him/her, they risk damaging their overall capital in play and their ability to continue trading. You need to conserve your trading capital in order to stay in the game. That is the only way to weather the losses and emerge successful.
There are several choices of risk management you can use. I do not like to use a starting $100,000 account size as an example. It is more likely that the average beginning option trader is starting with something closer to the $2,000 minimum account size, so let’s use that as our example.
This scenario allows one to trade 10% of your total account size. In this instance you would be risking $200 per option trade with a stop loss of approximately 50%. This would give you 10 trades and the opportunity to build up you account balance without having to worry about any one loss being able to prevent you from continuing to trade. Actually, using a 50% stop loss would permit 20 trades and a good chance of returning a sizable profit while being able to absorb an occasional loss.
As you can see, this is an aggressive strategy. It is recommended that as you build up your account size, you reduce the percentage of account value at risk. As the size of your account grows, the dollar amount being traded will also increase accordingly.
PSYCHOLOGY 101
While the trading mechanisms and individual securities that make up the markets are emotionless, the individuals that trade those securities are very much emotional by nature. It is the human emotions of fear and greed which move prices up and down. Being aware of what drives the markets allows the trader to understand how to position themselves to profit on the right side of the trade. Human emotion very often causes investors to make rash decisions, that in the end wind up being the wrong, or in many cases, the worst decision they could possibly make. W.D. Gann, in “How to Make Profits in Commodities,” said it best;
“If you will only study the weakness of human nature and see what fools these mortals be, you will find it is easy to make profits by understanding the weakness of human nature and going against the public by doing the opposite of what other people are doing. If you buy near the bottom on knowledge and sell near the top on knowledge, while other people who are just guessing do the exact opposite, you will profit greatly. Time spent studying price, time and past market movements will give you a rich reward.”
Here W.D. Gann reveals a very plain truth. Simply stated, “smart money” buys into a trend early, while “dumb money” buys into the trend as it is about to end. Most traders have been led to believe that “the trend is your friend.” They feel it is a smart trading strategy to trade with the trend, regardless of where it is in the cycle. The problem with this “trending” strategy is that once a clear trend can be identified on a stock chart so as to confirm the direction of the trend, the trend is most likely over and about to reverse direction.
To make money trading a trend, the investor needs to be able to identify the Trend Reversal point early in the trade cycle so they can be positioned with the “smart money.” It is more than likely you will be closing out your position with substantial profit at the point where most of the “dumb money” is starting to pile into the trade. It is this example that makes our case for buying “weakness” and selling into “Strength,” anticipating trend reversals.
The majority of trading systems are trend following. They attempt to capture profits by buying into strength and selling into weakness. The problem with this method is that by the time the trade signal is generated the trend has already been in place and the “easy” profits have already been made.
Many times I have seen the signal generated just as the trend is about to reverse or it will come as the current trend is due to pullback creating a situation known as trader’s “whiplash.” Being caught in a “whiplash” trade can shake your confidence in any trading strategy to it’s core so as to create such uncertainty that the trader falls back on the method they are most familiar with, emotional trading… or death by 1,000 cuts.
