- The first question to ask in any option trade is how much of my capital could I lose in the worst case scenario not how much can I make.
- Long options are tools that can be used to create asymmetric trades with a built in downside and unlimited upside.
- Short options should only be sold when the probabilities are deeply in your favor that they will expire worthless, also a small hedge can pay for itself in the long run.
- Understand that in long options you have to overcome the time priced into the premium to be profitable even if you are right on the direction of the move.
- Long weekly deep-in-the-money options can be used like stock with much less out lay of capital.
- The reason that deeper in the money options have so little time and volatility priced in is becasue you are ensuring someones profits in that stock. That is where the risk is:intrinsic value, and that risk is on the buyer.
- When you buy out-of-the-money options understand that you must be right about direction, time period of move, and amount of move to make money. Also understand this is already priced in.
- When trading a high volatility event that price move will be priced into the option, after the event the option price will remove that volatility value and the option value will collapse. You can only make money through those events with options if the increase in intrinsic value increases enough to replace the vega value that comes out.
- Only trade in options with high volume so you do not lose a large amount of money on the bid/ask spread when entering and exiting trades.
- When used correctly options can be tools for managing risk, used incorrectly they can blow up your account. I suggest never risking more than 1% of your trading capital on any one option trade.
Archives of “managing risk” tag
rssBest Practices for Traders
1) Preparation to start the day and week: Having a clearly formulated strategy to guide trading decisions;
2) Keeping score: Using a trading journal to structure learning, document progress, and sustain positive motivation;
3) Managing risk and maximizing opportunity: Trading with more risk/size when trading well and clearly seeing opportunity and pulling back risk when drawing down, trading poorly, and perceiving little opportunity;
4) Taking breaks: Stepping back from markets periodically to gain fresh perspective, reformulate views, and tweak strategies;
5) Treating trading as a business: Limiting overhead, having a clearly defined plan to move toward profitability, focusing on distinctive areas of strengths and opportunity.
So much of what makes traders great is what they do between market sessions, how they do it, and how much of it they do.
Market Truisms and Axioms
Commandment #1: “Thou Shall Not Trade Against the Trend.”
• Portfolios heavy with underperforming stocks rarely outperform the stock market!
• There is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.
• Sell when you can, not when you have to.
• Bulls make money, bears make money, and “pigs” get slaughtered.
• We can’t control the stock market. The very best we can do is to try to understand what the stock market is trying to tell us.
• Understanding mass psychology is just as important as understanding fundamentals and economics.
• Learn to take losses quickly, don’t expect to be right all the time, and learn from your mistakes.
• Don’t think you can consistently buy at the bottom or sell at the top. This can rarely be consistently done.
• When trading, remain objective. Don’t have a preconceived idea or prejudice. Said another way, “the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes.”
• Any dead fish can go with the flow. Yet, it takes a strong fish to swim against the flow. In other words, what seems “hard” at the time is usually, over time, right.
• Even the best looking chart can fall apart for no apparent reason. Thus, never fall in love with a position but instead remain vigilant in managing risk and expectations. Use volume as a confirming guidepost.
• When trading, if a stock doesn’t perform as expected within a short time period, either close it out or tighten your stop-loss point.
• As long as a stock is acting right and the market is “in-gear,” don’t be in a hurry to take a profit on the whole positions. Scale out instead.
• Never let a profitable trade turn into a loss, and never let an initial trading position turn into a long-term one because it is at a loss.
• Don’t buy a stock simply because it has had a big decline from its high and is now a “better value;” wait for the market to recognize “value” first. (more…)
MANAGING RISK
Well, perhaps the best way is to emulate some of the trading principles used by the pundits of yesteryear who beat the stock market no matter the emotions and mechanics of the institutional herd. For instance:
Bernard Baruch – Some 70 years ago, he would research a stock, buy it, and then each time the stock rose 10% from his purchase price, buy an additional amount equal to his first purchase. If the stock began declining he would sell everything he had bought when the drop equaled 10% of its top price …
Baron Rothschild – His success formula was centered on the famous quote attributed to him – “I never buy at the bottom and I always sell too soon.” …
Jesse Livermore – This legendary speculator profited enormously by calling the various 1921 – 1927 advances correctly. In 1929 he reasoned that the market was overvalued, but finally gave up and became bullish near the top in the fall of that infamous year.
He quickly cut his losses, however, and switched to the “short side.” Livermore listed three major points for his success:
1. Sensitivity to mob psychology
2. Willingness to take a loss
3. Liquidity, meaning that stock positions should not be taken that cannot be sold in 15 minutes “At the market” …
Addison Cammack – A stockbroker from Kentucky who swore by the two-point stop-loss rule. “If you’re wrong,” he said, “you might as well be wrong by two points as ten.” He followed this method successfully and was one of the few bears to make a fortune on Wall Street and keep it …
Interestingly, all of these disciplines have one thing in common. They all adhere to Benjamin Graham’s mantra, “The essence of portfolio management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”
Well, perhaps the best way is to emulate some of the trading principles used by the pundits of yesteryear who beat the stock market no matter the emotions and mechanics of the institutional herd. For instance:Winners Trade to Win
As you already know, I am not a slave to conventional wisdom. It is my belief that most popular beliefs held by the masses are not wise at all. This applies to all walks of life, not just the stock market.
The latest bit of unwise conventional wisdom is the idea that one must “focus on not losing money in order to make money”. Play it safe and protect your capital has been a popular mantra over the past month. What a load of crap.
You know what happens when you focus on not losing money? You lose it. Either that or you make meager gains (all hail consistency, as in consistently average!). It’s akin to an athlete playing not to get injured. That is when you get hurt. The team that plays not to lose rarely wins.
In trading, playing not to lose will cause you to pass up on good trades and scare you out of trading volatile, yet lucrative markets. If you have put in the blood, sweat and tears that accompany hard work and dedication, know what you are doing, and have a sound methodology and edge, don’t ever play not to lose.
Note that this doesn’t mean you throw caution to the wind. On the contrary, a trader must be vigilant about managing risk, position size and ones emotions. These three factors, along with having an edge, allow one to play to win, rather than lose, and put on winning trades.
Its all about managing risk
Trend Following is all about managing risk. As Trend Following is not about prediction, we do not know when we enter a trade whether it will be profitable or not, so we take calculated risk and put a position small enough not to hurt us bad in case the trade is a loss trade.This small risk taken over a lot of trades ends up in the right side of the balance sheet, which makes Trend Following a good strategy.
Risk Management strategy is called Position Sizing or Money Management (MM).
We have made our business managing risk.
We are comfortable with risk and we get our reward from risk.”
We are comfortable with risk and we get our reward from risk.”
Art Huprich’s Market Truisms and Axioms
Raymond James’ P. Arthur Huprich published a terrific list of rules . Other than commandment #1, they are in no particular order:
• Commandment #1: “Thou Shall Not Trade Against the Trend.”
• Portfolios heavy with underperforming stocks rarely outperform the stock market!
• There is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.
• Sell when you can, not when you have to.
• Bulls make money, bears make money, and “pigs” get slaughtered.
• We can’t control the stock market. The very best we can do is to try to understand what the stock market is trying to tell us.
• Understanding mass psychology is just as important as understanding fundamentals and economics.
• Learn to take losses quickly, don’t expect to be right all the time, and learn from your mistakes.
• Don’t think you can consistently buy at the bottom or sell at the top. This can rarely be consistently done.
• When trading, remain objective. Don’t have a preconceived idea or prejudice. Said another way, “the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes.” (more…)
Five Trading Virtues: Best Practices for Traders
1) Preparation to start the day and week: Having a clearly formulated strategy to guide trading decisions;
2) Keeping score: Using a trading journal to structure learning, document progress, and sustain positive motivation;
3) Managing risk and maximizing opportunity: Trading with more risk/size when trading well and clearly seeing opportunity and pulling back risk when drawing down, trading poorly, and perceiving little opportunity;
4) Taking breaks: Stepping back from markets periodically to gain fresh perspective, reformulate views, and tweak strategies;
5) Treating trading as a business: Limiting overhead, having a clearly defined plan to move toward profitability, focusing on distinctive areas of strengths and opportunity.
So much of what makes traders great is what they do between market sessions, how they do it, and how much of it they do.
No Risk-No Gain
Trading is ALL about managing risk and probability. The risk part is easy, you can quantify your risk by setting a stop on all your trades. Yes, a stock can gap through your stop overnight, so we can’t know are risk 100% for certain, but setting aside major overnight announcements and earnings, we can get a pretty good idea. The probability part is a little more difficult. I don’t have empirical evidence to support the patterns I trade on both the long and shorts side, other’s have done a decent amount of research, and I have read some, but at the end of the day I have always believed that so called voodoo of technical analysis is a different religion for everyone. Technical analysis, being little more than the study of the psychology of the market, is interpreted by everyone differently, and therefore should not be seen quantitatively to a large extent, but as more of an art. It’s just like a psychologist, you can go to 4 different guys and get 4 different answer to your issues, they will approach you in different ways, ask you different questions, it’s a feel thing.
Anyway, I want to make the point in this post that you’ve got to understand and accept the risk you are putting on when you make a trade. I will review a trade of mine where I made a terrible mistake and foresake this principal, and it has cost me quite a good deal of profits over the last few weeks, especially give that my thesis was correct. It’s not enough to have good ideas, you must execute them properly.
G. C. Selden Trading Psychology – Hunches And Gut Feelings
Recently most traders probably have spent a great deal of time managing risk and emotions. I know I have. When it comes to correctly gauging and dealing with emotions it is paramount to analyze your reactions in a detached way. The best way to get objective insight is to imagine taking a step back and then ‘watching yourself.’ It’s as if you were your own mentor or trading coach. This is not an easy task. Good results require emotional detachment, a lot of experience and the ability to honestly assess the degree of trading proficiency you have attained. Ultimately it will tell you what those gut feelings you are occasionally experiencing really are worth. That’s exactly what G.C. Selden addresses at the end of his classic trading book : ‘Psychology of the Stock Market’ which was first published in 1912. Here’s an excerpt dealing with ‘hunches and gut feelings.’ Lots of additional and valuable insight for traders is provided. Enjoy!
An exaggerated example of “getting a notion” is seen in the so-called “hunch.” This term appears to mean, when it means anything, a sort of sudden welling up of instinct so strong as to induce the trader to follow it regardless of reason. In many cases, the “hunch” is nothing more than a strong impulse.
Almost any business man will say at times, “I have a feeling that we ought not to do this,” or “Somehow I don’t like that proposition,” without being able to explain clearly the grounds for his opposition. Likewise the “hunch” of a man who has watched the stock market for half a lifetime may not be without value. In such a case it doubtless represents an accumulation of small indications, each so trifling or so evasive that the trader cannot clearly marshal and review them even in his own mind. (more…)