Question
Money management with low balances. I read a lot about managing accounts by limiting the percentage of your balance you risk on any individual trade. However, if a person wants to get into trading, but has a limited amount of capital they are willing to risk, say $2000 – $4000, it seems that one has to risk a substantial percentage to make any gains when all the fees are added in. If you were to only risk 20% or less on any one trade, you would have to almost double your money a large percentage of your trades and trade short term OTM options. It seems that risking a larger percentage on a longer term deep ITM trades on quality companies would be safer. How would you approach trading if your account balance was less that $5000?
Answer
Your statements would have been correct five years ago when minimum commission charges for stock options were much higher. Now, there are at least three or four firms that I know of that offer commissions as low as one dollar per contract with no minimum.
When minimum commission charges were $30, you had to take larger positions because your profits would be eaten up by your transaction fees. For instance, if you sold a five point OTM put credit spread for $1, your commission costs would be $60 (2 x $30). A one contract spread position would net you a $40 profit ($100 – $60) if it expired worthless. If it did not and you had to buy the spread back, your commissions ($120) would exceed your potential profit ($100) and you could only lose money on the option trrade.
This same spread could actually return a nice profit of $98 ($100 less commissions 2 x $1) with a $1, no minimum online option broker. Consequently, you are not locked in to any one strategy and you can spread your capital across many trades.
With regards to the best option trading strategy, $5000 is not much capital to start with. Assuming that you have read books on option trading and technical analysis, I suggest starting with out of the money bullish put spreads or bearish call spreads. If you think a stock is going to rally from $50 to $55, consider selling the $45 puts and buying the $40 puts. The stock can pullback 10% to $45 and you will still make money. Evaluate your forecast and adjust your timing based on how well you did. Place a stop to buy in the option spread at the short strike price. By playing on the frindges, you are increasing your probablity of success and you are building a positive experience. If you consistently nail the direction and the timing, consider buying options.
When you buy options, scale into postiions and buy lots of time premium. You will never pick the perfect entry point and scaling in/out will keep you in control. You will also be able to average your cost. Again, a discount online option broker is key. By buying lots of time, you will be able to watch the behavior of the stock and hone your timing skills.
Timing and risk management are the most difficult skills to develop. Options are a wasting asset and they move quickly. Start slow, build gradually and spread you capital over as many trades as possible. As your option trading skills develop, you can construct option strategies that mirror you opinion on the direction, magnitude and duration of the move.
