In today’s option trading blog I will address some important concepts for the novice option trader. Options trading gets so much press these days that it’s hard for traders to determine where to go and who to trust. I believe there is a natural progression to the whole process and it can’t be rushed. Options are not a get rich scheme that you can jump into. Do people make a lot of money trading options? Yes, they also lose a lot of money. The risk and reward is elevated and every mistake is magnified. Here are some points to consider if you are just getting started.
1. Become a good stock picker first. Before you can become a good option trader, you need to be able to analyze stocks. Options are merely an extension of your stock opinion.
2. Read, read, read. I would start with books on technical and fundamental analysis. John Murphy and Martin Pring have authored excellent books on technical analysis. Peter Lynch, William O’Neil and Warren Buffet have written excellent books fundamental analysis.
3. This is hard work and only the top 5% of you will succeed. Be prepared for long hours and extensive research. If you think you can pay $3000 and park butt in a seminar for a weekend to learn all you need – guess again. Spend the money on books, data feeds and research tools and you will be better off. Trust me, the guy lecturing at the nearby Holiday Inn does not have all the answers.
4. Learn all that you can about option trading. Larry McMillan is the best known author for option trading books. He is a close friend and I consider him “the authority” on option trading. The CBOE also has some great free infomation.
5. Trade options as an extension of your portfolio. Options give you the flexibility to structure risk and reward. They don’t have to be a speculative “take a shot – make a lot” instrument. Use them to hedge and generate income.
6. Keep the strategies simple. You should not engage in these strategies: delta neutral, gamma neutral, back-spread, ratio back-spread, iron condors, butterflies, calendars. They are Market Maker strategies that DO NOT work on a retail basis.
7. Be properly capitalized. If you do not have $10,000 of speculative risk capital, you should not be trading options. The $10,000 should represent no more than 10% of your total portfolio. I shutter when someone with a $2000 IRA asks me how to get started in option trading. Options are not a newly discovered vehicle to financial freedom. They are a complex, dynamic product that will strip you of everything the second you let your guard down. If this describes your situation, keep putting money into your IRA and read trading books while you save enough to get started.
8. Set realistic expectations. If I make 25% a year (regardless of market conditions) I’ve met my goal. If I do better than that it is a banner year. Asset Managers would kill for these types of returns. Can I achieve them because I’m smarter than they are – no. I’m smaller and I can get in/out of positions quickly without driving the price. I am also willing to take small lucrative positions that would not generate enough of a return to make it worth their time. You will hear people talk about making 20% per month. Before you sign up for their advice/mentoring, ask them for the last two years of brokerage statements. You’ll hear lots of excuses and you won’t see one account statement. My favorite is, “I’m so busy teaching I can’t trade.”
9. Be prepared to lose money. After 17 years I still have a ton of losing trades. It’s just part of the process. In the beginning you might have a losing year or two before you get in the black. This is the easiest business to start and the hardest one to grow.
10. See both sides of the market. If you aren’t comfortable shorting, you might as well try to become a one-armed professional golfer. When you see both sides, your perspective is much clearer and your confidence is kept in check. You need to be able to make money when the market is going up or down.
11. Spread out your capital and never allocate more than 10% to any one trade. When possible, scale into positions. After you climb aboard the “leverage train” you’ll realize that it’s actually a roller coaster. Diversification and dollar cost averaging will help you control your emotions.
12. Establish solid resources. Yahoo Finance, Earnings Whisper and CBSMarketWatch are all I need for news. eSignal and RealTick are my trading platforms. These are a few of the blogs I visit: The Kirk Report, Trader Mike, Alpha Trends, The Daily Options Report.
13. Take inventory and build a system around your schedule, knowledge, prior success, risk tolerance and investment objectives. I have written an entire blog on this subject.
This option trading blog may raise as many questions as it answers. If that’s the case, use the Ask Me feature on the menu bar and submit a question. If I highlight yours, you’ll get an answer and you’ll be able to select a free one month subscription to the OneOption research product of your choice.