Do this! Don’t Do That!

OptionsHouse provides exceptional value to the self-directed active investors. We don’t give specific investment advice – so this missive should not be construed as such. However, I have traded stocks, options and futures for over 30 years and I have had some fantastic mentors over my professional career who have revealed many valuable insights to me that I gladly share to other self-directed investors. You might think of them as the Do’s and Don’ts of disciplined traders.

BASICS:

#1 Do: Be familiar with what you are trading.

This refers to two items. First, the underlying stock – Know what they do. Does the stock pay a dividend? When are earnings? Know what their market capitalization is. Analyze a price chart. Where is the stock’s price currently versus last month, last quarter and the last year(s). The most important characteristic of a potential investment is to make sure the security is liquid. To me liquid stocks should trade at least 1 million shares a day. Option bid ask spreads should be not more than 10 cents wide in the first month’s at the money (ATM) contracts. Higher priced securities of course will have higher bid/ask spreads. Equate higher priced stock’s bid/ask spreads to a 50 dollar stock – e.g. GOOGL at $800 has a 1 dollar bid/ask which is equivalent to 10 cent bid/ask in a 80 dollar stock – divide by 10.
Also be completely familiar with the strategy you are employing. If it is a stock investment why are you investing? Short term or long term? Price appreciation or dividend income? What are your goals? You need to have an exit plan determined before you initially enter the trade. With option strategies it is even more important. You need to fully understand the risks and potential rewards of the strategy and the probability of success in the trade you are considering. Again what is your goal? Defining (limiting) your risk at the onset of the trade is critically important either by utilizing spreads or by limiting the size (leverage) of your trade.

This leads to the first BIG Don’t:

#1 Don’t: DO NOT trade too large!

When used responsibly, options are strategic instruments which can change the risk profile of straight stock ownership. However new traders often over leverage when using long options which can lead to significant losses very quickly. If you were going to make a 10,000 dollar investment in Microsoft (MSFT 56.50) you could purchase about 200 shares and spend $11,300. I have seen first time option traders spend 10,000 dollars buying ATM (at-the-money) options on MSFT. The October 55 strike call can be purchased for 2.70. They get greedy thinking I could buy 200 shares for around 10K or better I could buy 37 contracts! This is way too levered and is risking 100% of the option premium between now and expiration. The option trade “controls” 100 share for each contract or 3700 shares of MSFT stock. That’s 209,000 dollars of exposure! Right size your option trade by using the equivalent number of contracts which control the number of shares you would buy. In this case 2 contracts would be the right number. You are still enjoying the benefits of levered, hedge exposure to the stock using 540 dollars to control 11,300 dollars of MSFT stock. You can use your excess trading capital to diversify into other symbols and strategies.

INTERMEDIATE:

#2 Don’t: DO NOT Concentrate your risk in 1 name or 1 strategy!

The number one reason for trading account blow-ups is concentrated risk. Retail customers for some reason seem to believe that they will always be successful if they trade high probability spreads. High probability is not the same as 100% probability. For example, when selling a far out of the money credit spread, if your maximum risk equals the amount of your entire account, you may win the first 9 times. In fact you may win 99 times. But if you continue to risk your entire account value, eventually you will lose. And when you lose, if you are risking it all, you will lose your entire account and be out of business!

#2 Do: Protect your investment capital at all costs!

Your number one job as a self-directed investor is to protect your investment capital. This is much more important than making a return on that capital for the simple fact that investment capital once it is lost, is capital which cannot earn a future return. Having the primary mindset of a capital protector should direct your strategies and dictate the size of each trading position. Your job description is a risk capital allocator. See 2a below:

#2a Do: Keep a significant amount of “Dry Powder” in your investment account.

This goes hand in hand with your job of protecting investment capital. No one drives their car with the gas pedal constantly floored. That would be suicidal – straightaways you would likely be fine, but eventually you will come to a sharp curve in the road and not be able to survive. The same is true even more so with your investment vehicle (pun intended). Investment results are not straightaways, there are twists, turns and bumps in the road. When you hit a bump, not if you hit a bump, you need to have additional capital or buying power, which can adjust and protect positions which have gone against you. Traders call this dry powder as in gun powder available to be shot when it has rained on your existing positions. The amount of dry powder to be reserved is up to each traders risk tolerances but for me 30% is a minimum.

ADVANCED:

#3 Don’t: DO NOT fall in love with a stock or a position!

The Stock market is a dispassionate entity and you need to be as well. Your darling stock doesn’t know that you own it, it doesn’t care that you own it or that you have made or lost money during your ownership affair. Too often I have seen seasoned traders lose discipline with specific trades or stock positions because the stock has treated them well in the past. If you ever hear yourself say the stock “owes” me a couple of more points… that should be a warning sign to close the position now! The stock doesn’t owe you anything. Buy and hold is fine, buy and forget is not a recipe for success.

#3 Do: Take a critical look at your positions each day. Would you open the trade at today’s price? If not close it!

There may be tax consequences and other reasons which may cause you to want to hold onto positions, but for active traders in liquid securities you should look at every open position through this lens: Would I buy (or sell) this position today if I didn’t have it in my position? If the answer is no, you should strongly consider closing it. This is especially true with short option positions. Fortunes have been lost trying to squeeze the last nickel out of a short option’s premium, trying to let it expire worthless, when there is no way you would have sold that same option at 8 cents if it was an opening trade. That short option now has all the risks and obligations of a short option with very little potential reward. It also has the same margin requirement which is costing you a real opportunity cost – draining your available buying power. The price you originally bought or sold is irrelevant at this time and at this decision point. If you do not close that position today it really is equivalent to you opening the position at today’s price. Again, if the answer is no, you would not open the trade at this price than you really should consider closing it. I realize that for many they figure I don’t want to pay a 5 dollar commission to close an option which costs 10 dollars. “That’s 50% commission!” Great news! We feel so strongly about this discipline that for short options, OptionsHouse will waive the commission on buy to close options with premiums of 10 cents or lower. There really are no excuses not to close down that “teeny” risk.

The above information is provided by OptionsHouse for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Results may vary with each use and over time. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.