Paul Oldani and I recently presented a webinar entitled New Year’s Trading Resolutions which brought the hammer down on several bad trading moves that can cost traders money and we felt need to be eradicated from retail traders’ practices. It was definitely a case of tough love, but I was surprised how well the audience responded to it. You can view the full webinar here, but it’s also worth highlighting some of the concerns we discussed.
We started with the fundamental rule of successful investing. Which is that for professional traders, Preservation of Investment Capital is the most important consideration and it absolutely should be for retail traders as well. When you are out of trading capital you are out of business.
There were 3 main themes we highlighted to stop doing in 2014.
1. Not having an Exit Strategy
Many investors consider themselves disciplined because they utilize stop orders on their stock and option purchases.
The problem with this approach is they have only set a goal to the downside with no goal or exit strategy to the upside. If you only have 1 goal, chances are you are going to have one outcome. Many newer option traders have this preconception that they need to hold their option purchase or sale until the expiration date. However, they don’t realize that they can close (sell) their option any time before expiration day.
2. Too much Concentrated Risk
Concentration risk is probably the number 1 reason investors lose their investment capital. Being over concentrated in one symbol—where one 20% adverse move could wipe out your trading assets—just makes no sense. Likewise, betting your entire account on one strategy is too concentrated. We see people spending their entire account value to purchase out of the money options—betting on a quick directional move. When it doesn’t occur, their accounts decay to zero. This may be a fine strategy on a small percentage of your account, but to risk all of your investment capital can only lead to large losses.
3. A lack of Portfolio Risk / Reward Management
Risking too much for too little reward occurs as well in retail trading accounts. Retail traders don’t share the same mentality that the professional trader uses for risk management. Retail traders actually open positions at prices that professionals would buy to close down out of the money risk. One example is when retail traders sell short dated credit spreads for mere pennies. The spreads seem far out of the money with only a small theoretical percentage chance of becoming in the money which makes many traders think that makes this a conservative strategy. However, putting the entire account at risk for a small credit, regardless how small the probability of the spread finishing in the money, is horrible and can only end badly. If you risk your entire account, eventually you will be wrong and being 100% concentrated means only 1 strike and you’re out. More traders leave risk on their sheets when they have already made 80% of the potential profit from the trade. I encourage you to risk manage those positions with the understanding that if you don’t close that short position marked at a nickel today, it is exactly the same as if you sold to open that position. The risk / reward is totally skewed to high risk, with very little reward remaining.
We go into much more detail and discuss tactics successful traders use as well in the full webinar. My hope is this New Year will be prosperous for all of our OptionsHouse customers. Make the resolution today to eliminate any bad habits that have crept into your trading.
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