Editor’s note: Jeff is on the road today. He’ll be back in the action this Monday with a new issue of the Market Minute.
In the meantime, check out the essay below. It’s a great reminder of how to trade options the right way.
When you talk about options, most people think of risk… Dangerous leverage… Speculation… Gambling…
I guess there is that aspect to it, if you don’t know what you’re doing.
See, most people don’t understand options. The reason they were created in the first place is to reduce risk. In fact, the original options were designed to help investors hedge their portfolios against bad moves in the market. Unfortunately, what’s happened over time is what happens to a lot of good ideas on Wall Street…options have morphed into a commission-generating vehicle they sell to folks as a way to get rich quick.
If you think trading options will help you get rich quick, I’ve got some bad news for you. While using options can make you a lot of money, it’s not going to happen overnight. Trading options is a process. And if you want to be in the options market for any length of time… you have to do it the “right way.”
Learning the “right way” to use options might involve a little extra effort on your part if you want to trade in the market successfully. But I can help you master the basics… I’ve traded options for nearly three decades. During that time, I’ve also been teaching folks just like you how to reduce their risk with options and add a little bit of “pop” to an otherwise conservative portfolio.
But before you get started, here are a few things you must keep in mind:
Truth No. 1: Buying and selling options is about the least risky and potentially most rewarding game on Wall Street.
Options master Victor Sperandeo racked up a nominal rate of return of 70.7% without a losing year between 1978 and 1989. With his astounding track record, we’d be foolish not to pay attention to what he has to say:
“Options are, many say, the riskiest game in town. Certainly they are by far the most challenging, flexible, and potentially profitable financial instruments available. But if you trade them prudently, if you apply sound principles of money management, trade only when the risk/reward ratio is highly in your favor, and execute your trades with diligence and patience, then in all likelihood you will be profitable over the long term. I can say, conservatively, that at least 40 percent of all the returns I’ve made in my life have been with options.”
Truth No. 2: Want to be a winner? Watch your losers!
To succeed in trading options, you really need to limit your trading to opportunities that have at least a 3-to-1 payout. A 5-to-1 reward-to-risk ratio, of course, is better. But at minimum, you want to have the potential to pocket $3 in return for every dollar you risk.
You accomplish many things by forcing a minimum 3-to-1 discipline on yourself. For one, it forces you to think in terms of reward and risk, which is extremely important. Most failed options traders, even ones that may have had good trading systems, fail because they didn’t pay enough attention to risk. If you’re willing to lose 50% on a position, you’d better be expecting a gain of 150% or more – at least. That’s a tall order.
If you’re willing to lose it all (meaning have the potential for a negative 100% return on a position), then you’d better be expecting a 300% to 500%-plus gain in that position.
When you see it in terms of risk versus reward, and you realize that 500% winners don’t come along every day, you can see that “risking it all” is a bad bet.
Options are a lot like poker. Your hand is only a small portion of the battle. Betting appropriately for the entire game is really what’s important, which leads us to…
Truth No. 3: Big winners make small bets.
You’ve got to know when to hold ‘em and when to fold ‘em. But you’d sure hate to fold ‘em and take a total loss with a big bet on the table… So don’t ever put yourself in that boat. Limit the size of your positions. You should only have 2%-3% of the money you’ve set aside for trading at risk on any one trade. We really can’t imagine any combination of circumstances where you should consider putting more than 10% of your trading money on one play. Don’t do it!
To end up like Vic Sperandeo over the long run, you’ve got to stick to the program. Limit the size of your positions. And limit your downside by never allowing a small loss to turn into a big loss. Traders who follow this have a chance of being winners in options over the long run. Those who don’t do this will be quickly drummed out of the club, taken for every penny.
Best regards and good trading,
Editor's note: If you have any ideas or suggestions for the Market Minute or the Delta Report, make sure you send them right here. Jeff reads every email that comes in, and he’ll answer the most frequently asked questions here in the Market Minute.