The Rookie’s Guide is now an eBook

I’ve been asked to do it many times, and I am happy to announce that the Rookie’s Guide to Options, 2nd edition is available in eBook format.

At this time, the only versions available are Kindle and pdf.

The new eBook and the paperback version were updated (minor changes) Sept 11, 2014.

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My Take on an Advisory Service

As a general rule, I am not a fan of services that predict where the stock market is headed next. Nor do I believe that most advisory services can steer their clients into profitable trades. However, the quality/integrity of services differ and today I’d like to mention one that I think is worth consideration.

Please understand that past performance is no guarantee of future returns. Kim Klaiman runs SteadyOptions and it is clear to me that he cares about his membership and operates SteadyOptions with integrity.. His trades are transparent and he explains the rationale behind each trade. In other words, it is an educational service ion addition to being an advisory. He is willing to teach subscribers to make the trades alone and reach the point where his services are no longer required.

NOTE: SteadyOptions uses a non-directional approach. They seek opportunities that do not depend on predicting market direction.

SteadyOptions

SO is an options trading advisory that uses diversified option strategies and has produced positive returns under all market conditions. The stated objective is to target steady and consistent gains with a high winning ratio and limited risk. If this sounds like the typical iron condor advisory, I assure you that it is not.

What I like about this service is that it offers a combination of a high quality education along with actionable trade ideas.

What makes SteadyOptions different?

    Impressive performance – a track record of making money in any market.

    –The track record includes every trade, both winners and losers. They hide nothing.

    –Complete transparency – the performance is based on real fills, not hypothetical performance.

    –A complete portfolio approach. In other words, trades are not initiated without considering how they fit in with the entire portfolio.

    –First priority is capital protection.

    –The performance of the model portfolio reflects the growth of the entire account including the cash balance. Some services consider a $1,000 gain on a $1,000 investment to be a 100% return when the whole account is worth $10,000. SO considers this to be a 10% return — and that is the honest way of doing the calculations.

    –All trades are shared in real time, including entry, exit and adjustments. This is the real deal with no fudging of results.

Members voted SteadyOptions #1 ranked newsletter on Investimonials.

The SO newsletter manages three different strategies:

    –Steady Options trades mostly option volatility, making plays on stocks around company earnings.

    –Anchor Trades manages a fully hedged long ETF investment portfolio.

    –Steady Condors manages few different and unique iron condor strategies on index products.

I understand that people tend to pay maximum attention to performance, but do know that SteadyOptions puts a lot of emphasis on options education. Each trade is discussed before it is executed. SteadyOptions is not a get-rich-quick-without-efforts kind of newsletter. It requires time and effort on the part of subscribers. There is a learning curve to become familiar with the strategies.

All subscriptions include a 10 day free trial. Click here to start your free trial.

Full disclosure: I do receiver a referral fee for new subscribers (please use this link), but this advisory service is run in a manner that appeals to me and my strong belief in a sold options education.

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Repeat: Options are not Stocks.

Hello Mark,

I have a question that is not related exclusively to options, but, given the time decay element built into them, it may be particularly relevant to them.

The question is this: are there any general rules that you use for exiting trades that start to go against you, especially if they are not based on an anticipation of a specific catalyst? For instance, do you tend to liquidate your positions in the event of a general market correction that sends a particular stock lower than the general indexes, in the event of your position losing a given amount of value (say, 50% or 33%), in the event of a clear-cut technical trend being broken, in the event of a combination of these and/or other elements, or with the use of some other methods altogether?
Jakub

Jakub,

1) The problem is that your questions are those of a trader who plays the market and they are not specific to options. That may seem to be a trivial point, but it far from trivial. It is also one reason that so many newer option traders get into trouble.

When using options, you must (my opinion) trade as if you own options and not stock. That requires a different mindset. Bullish stock owners can ignore timing, they do not have to be concerned with volatility, and there is no concern over whether the options are priced fairly (or are too expensive to purchase). None of that matters — unless you own an option position.

Bull Market Symbol

Bull Market Symbol

When trading options, you want to think as an option trader thinks to gain the benefits that come with option ownership.

2) Yes, I have such rules. They are not written in stone, but are general guidelines.

If If you have a “long” position, it must be based on your expectation that the stock price will move higher – even if you do not know what the catalyst will be. I would liquidate that position at ANY TIME that you no longer expect the stock to move higher. Sure it can be when the stock price declines by a certain percentage (perhaps 6 – 10%). Yes, it can be when a technical indicator tells you that the buy signal for the stock market or the individual stock is no longer valid.

However, if you own an option, then there is an additional consideration: Can the stock price change occur quickly enough to generate a gain when you own an option position? You would not look at the percentage decline in the price of your call option because that is not the crucial factor. If you still believe that owning that specific option (and that means you must evaluate the time to expiration and whether the option is ITM or OTM), then you can hold. The only important factor is your outlook for the stock in the time period from now to expiration — and whether that expectation makes it a good idea (or not) to own the option that you own. If it is a bad idea, then get rid of the option. Do not believe that owning “any call option” will generate a profit when the stock price rises. When IV gets crushed, you option may lose value, even in the face of a rally. When time passes, the ATM or OTM option can lose all of its value if the rally comes too late.

Any time you are playing the market, you should have a stop loss. And it can be based on anything that you want. However, in my opinion, it is foolish to buy a wasting asset (call option) when you do not know when the stock price will move higher. It would be better to sell an OTM put spread or by an ITM call spread so that if the stock does not move higher right away, you still earn a profit from your position (the put spread goes to zero when both options remain OTM, or the call spread goes to its maximum value when both option stay ITM).

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Progression Through Option Strategies

Mark,

You mention in your response to Aldo that you would recommend “credit spreads” as a top suggestion for new traders (assuming they are comfortable). Do you have a kind of progression through strategies you would suggest?

I’ve traded covered calls, naked puts and bought calls/puts based on a course (similar situation to Aldo) and I’m looking to expand my trading strategies into spreads.

Thanks,
Patrick

Hello Patrick,

Good question.

I do have a recommended progression. However, it is not because the trader moves from one strategy to something that is “better.” I recommend beginning with covered call writing (CCW) because it involves stock trading and many option newbies have stock-trading experience. That makes it easier to begin using options.

I also recommend writing covered calls because it is a hedged, reduced risk strategy – when compared with stock ownership. One more important point: CCW positions earn profits more often than straight stock ownership, although profits are limited. I want traders to make money with options, and CCW produces far better results than simply buying/selling options (the method taught in the course you took). In fact, I hate the idea of brand-new option traders trying to make money by buying options. There is far more involved than predicting when a stock price will change. One must have a good idea of whether the options are reasonably priced (that requires an, understanding of implied volatility) and which options to buy (avoid OTM options). And the brand new trader knows nothing about any of that.

Option traders should learn about options and not about reading charts.

Next I encourage the sale of naked puts because it is equivalent to CCW. By switching strategies, the trader must learn about equivalent positions. That knowledge is very important to an option trader.

I then encourage traders to understand a collar position (a covered call plus the purchase of a put option) because it demonstrates how options can be used to limit losses. I’d love to get the new trader interested in learning to limit risk from day one, but it is important not to overwhelm a trader with too much new information at one time. Thus, I begin with a risk-reducing (and not a risk-limiting) strategy.

I consider those three strategies to represent the “Three Basic Conservative Option Strategies.”

Next I encourage the use of credit/debit spreads as a method of taking on far less risk.

The call debit spread can be looked at as something similar to a covered call, but instead of owning stock, one buys a call option. This is where the trader learns the difference between buying calls and buying stocks — each combined with the sale of a call option (essentially the ‘covered’ call).

The credit spread is a high-probability, limited profit strategy and is ideal for most traders. Sure there are other strategies that accomplish specific needs, but for the trader who has a small bullish or bearish bias, these plays are far superior to buying options.

Continuing with the discussion of equivalent positions, the trader should next learn why credit and debit spreads are equivalent strategies. To be more specific: Selling a call spread is equivalent to buying a put spread when the strike prices and expiration are identical. That must be mentioned repeatedly, otherwise some people may believe than selling any call spread is equivalent to buying any put spread. Thus, I’m careful to mention that essential requirement as often as necessary to be certain that it is well understood.

Basically that’s it. Once a trader has those strategies in his/her arsenal, more advanced strategies come from combining one or more credit/debit spreads into something that appears to be more complex. The other more advanced concept is understanding implied volatility and the importance it plays in selecting option strategies:

    –Condors, butterflys — vanilla or broken wing varieties; vanilla or iron varieties are just the purchase or sale of one vertical spread and the purchase/sale of another.

    –Then there are strategies that involve volatility more than just price changes. For example, Calendars and diagonals — single and double fall under the volatility umbrella.

NOTE: A vertical spread involves two calls or two puts on the same underlying with the same expiration date. Both credit and debit spreads are vertical spreads.

Bottom line: I do not suggest learning the next strategy is done because it is a “better” strategy. What I urge traders to do is understand something basic and then move on to something that requires a bit more knowledge. We learn strategies to learn more about how options work – and not specifically as a way to make money. Whenever a trader discovers a strategy that suits his/needs and is comfortable to trade, I suggest pausing and getting some good experience using that strategy before moving on.

Patrick, there is one more concept that is crucial (in my opinion): We all want to adopt strategies that have a good probability of meeting our requirements. In other words, strategies that we understand how to use and which make money. However, it is the trader’s ability to maintain discipline and manage risk that is far more important in determining a trader’s success/failure rate. Choosing “a good” strategy for ourselves plays a role, but it is dwarfed by the need to skillfully manage risk.

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Basic Iron Condor Lessons

I just published a few articles containing some basic iron condor lessons at about.com. The lessons are for newer iron condor traders. I plan to add to the series in the coming days.

Regular readers of this blog or my books will not find much in the way of new content because the linked articles are for very inexperienced option traders who want to learn something about trading iron condors.

For readers who are familiar with our typical posts,here is a link to one example of my more advanced thoughts about trading iron condors and managing risk.

Risk Graph for an Iron Condor Position

Condor_strategy

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Spread Trading

Hello Mark, and thank you for your kind help.

I would be grateful if you could answer a few follow-up questions.

1a. I am intrigued by the concept of bull put spreads – thank you for bringing them to my attention. Since you seem to prefer them over bull call spreads, could you briefly explain why? Is it just because in the case of the former time decay works in one’s favor and that profits can be retained even if the stock stays steady, or is there something more to them?

I do not prefer selling put spreads to buying call spreads BECAUSE they are equivalent. It makes no difference which you trade. Each spread has the same time decay. The spreads are essentially identical, even though they appear to be different. When you are ready, take this lesson: Equivalent positions.

Understand that some traders are more comfortable collecting cash when entering into the trade and then they can (when it works) watch the spread value decline towards zero. Others are more comfortable buying spread because they know the cash [paid represents the maximum possible loss and they will never have to pay an money to get out of the position. NOTE: The maximum possible loss when selling the put spread is identical, but some are more comfortable when the cash has been paid upfront. It is all psychological and truly makes no difference.

If you are a new option trader (as your questions suggest), then choose the trade that you want to make. If looking at the trade from the buyer’s perspective makes you more comfortable, then buy the spread. As you gain experience, you will come to recognize that it really does not matter whether you buy a call spread or sell a put spread as long as one thing is true: The options must have the same strike prices and expiration date. That is iron clad. Change anything and the positions are no longer identical.

1b. Would you say that the optimal way of specifying the strike prices of the relevant puts is to make the strike price of the short one correspond to the level we believe the stock can reach and the strike price of the long one to a point somewhat below the nearest major support level?

No. Let’s be honest: Neither you nor I know where the stock price is headed. More importantly, your goal is to make money — it is not to be exactly correct on your predictions.

If a stock is priced at $100, you may want to buy the $100/105 or $100/110 call spread [or SELL the $100/105 or $100/110 put spread]. These should earn a profit when the stock rallies, but will lose money if the stock price does not budge, or when it rallies by ~$1. That’s not good enough for me. I want to make money even when I am not as correct as i expected to be.

Therefore, I’d prefer to buy the $95 calls and sell the $100 calls (or buy the $95 puts and sell the $100 puts). Noe I make money even when the stock does not rally. That’s good – but there must be a downside to making this trade — and there is. If the stock price tumbles, the $95/100 trade will lose more money than the $100/105 trade [If you do not know why, then I recommend starting your option education at the beginning and not try to jump in at this level.] Sure, you want to avoid the larger loss, but if you have any confidence that the stock price will increase, then you ought to have even more confidence that the stock price will not move lower.

Choosing the specific spread to trade is important — but please: it has nothing to do with your predictions unless you have a wonderful track record of successful predictions. One trade risks losing more, but comes with a higher probability of success. The other comes with the chance to earn more money, but with a lower probability of success. Choose whichever spread appeals to you more. You are the mast of your own risk-tolerance universe.

1c. Would you say that it is worthwhile to close out a bull spread (be it call or put) as soon as the predicted upper price level is reached, regardless of how far away one is from expiration?

I think you know the answer. If the stock rallies and reaches your target price, then you clearly do not expect it to move higher. So, why would you want to own a bull spread when you do not expect the stock to move higher? Yes, exit. Expiration has nothing to do with this decision.

I note that you said “upper price level” and not your target price.

If your question is really this: “I buy call spreads. Should I exit as soon as the stock hits the upper strike price?”

Then my answer is: “NO.” If you make a trade and have a profit target for your spread in mind (rather than a price target for the stock), then exit when you earn the profit. It does not matter what the stock price is. You will not want to choose the strike prices such that you expect “the upper level” to be reached. You should pick spreads than you believe will make money. That is the primary goal for a trader. You must remember that if you expect the stock to rise from 75 to 85, do not buy the $80/85 call spread. If the stock rallies, but only gets to 79 or 80, you must own a spread that earns a profit.

1d. Am I right in thinking that the margin requirements for any given bull spread (be it call or put) essentially correspond to the amount of cash one has to put up when assigned, so, for instance, if one sold 2 contracts with the strike price of 40, then the required margin is $8000?

NO. When you buy a spread, there is zero margin. You just pay for the spread. When you sell a credit spread, the margin represents the maximum possible value for the spread, but you can use the cash collected to meet some of that margin requirement. If you sell a naked put option, that is where the Reg T margin requirement is essentially the cash required of assigned an exercise notice. But it is reduced by other considerations, including how far OTM the strike price is.

2. You said “If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options.” Am I right in thinking that what you mean is that you are happy with committing more of your portfolio to option positions provided that they are tied up with non-directional strategies?

Yes. When my positions are much less risky than owning calls, and when they are hedged, I am willing to place more money into option positions. But please note: That is my personal comfort zone and it is NOT a recommendation for anyone else.

3. And, finally, one very different question – are you aware of any free software/website that displays not only unusual options activity, but also shows the list of biggest daily transactions and indicates whether the options involved were bought at the ask or sold at the bid? I know that thinkorswim offers this function, but apparently you need a TDAmeritrade account to use their software, and since I’m not US-based, I don’t think that I can access it.

No, I do not. Nor do I like the idea of using that information. It is 100% useless to you. Yes, 100% useless. So what if you know that someone buys 10,000 calls for a given stock? What does that tell you? It does not tell you whether this is a new position of if the buyer is covering a short position. It does not even tell you whether the trader is making a bullish play because there may be another part of the transaction that you cannot see. For example, if he buys 10,000 ATM calls and sells short 500,000 shares, then he owns a market-neutral position equivalent to owning 500,000 straddles. And if he sells short 1,000,000 shares, then he essentially bought 10,000 puts but to the casual observer it loos as if he bought 10,0000 calls.

One more point, even if you do know whether this big buyer is bullish or bearish, or neutral, what do you know about his track record as a call buyer? Nothing. Acting on this type of information is foolish.

Once again, thank you for your time – I really learn a lot from you and greatly appreciate your expert help.
Best wishes,
Jakub

My pleasure.

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Option Owner’s Perspective

As long time readers know, I prefer selling option premium to owning it. But that is not for everyone. Today I respond to questions from a trader who typically owns options.

Hello Mark,

I would be grateful if you could share your experience and answer a few general questions for me:

1) Do you see any benefits of using long calls rather than bull call spreads if one uses sell limit orders, thus capping one’s upside from the outset anyway?

2) When swing trading with the use of monthly options, would you normally recommend closing one’s positions no later than on Friday preceding the expiration week, or do you sometimes see some merit in holding them into the expiration week?

3) When one does not intend to hold one’s position into earnings but wants to capitalize on the pre-earnings volatility rise, do you – other things being equal – recommend closing one’s positions immediately prior to earnings or a few days earlier? Does your experience suggest that there is some general rule as to when volatility rises the most?

4) What, in your opinion, is the maximum percent of one’s portfolio that can be safely committed to options positions? Is it around 15-20% or more/less?

Thank you in advance for your help.
BK

Hello BK,

1) When comparing the strategies of owning calls (with the potential for unlimited gains) vs. owning call spreads (with a higher win/loss ratio and reduced cost — but with limited gains) in my opinion the most important factor is your expectations for the trade. Obviously if you expect to see a huge price increase in the underlying asset, you will buy calls and not spreads. [Caution: Sometimes the stock moves far less than expected, so please do not buy out-of-the-money calls.] If you anticipate the stock price to increase, but you do not have any idea how far, then you want the lower-cost position as well as the position that is more likely to provide a profit. That means buying the call spread. Remember that the call spread can return a profit even when the stock price is unchanged (assuming you buy an ITM option and sell an ATM or OTM).

To answer your specific question: Yes, there are small advantages to owning calls in the scenario you describe. If you want to exit the trade and take your profit (at your limit price), you may be dissatisfied with how much you can collect when selling the call spread. In other words, you may not be able to exit without accepting less than you think the spread is worth. That is always a risk when trading spreads. It is always easier to sell your single call option when it reaches your target price.

However, I still prefer spreads. I must ask this: How good is your track record? If you are skilled at picking stock direction and if you are skilled at timing the trade, then you have a huge edge over almost everyone else. With that skill-set, you can afford to buy single options. However,it is most likely you don’t have an outstanding record and that translates into trading positions that give you the best chance of earning a profit. That is the call spread. [Side note: You may prefer to sell put spreads instead. If you are not familiar with this concept, you can read about it and decide later. When the strike prices and expiration date are identical, selling put spreads is an equivalent strategy and produces the same profit/loss as buying the call spread.

2) Swing trading is for traders with a specific price target in mind for the underlying stock. Let’s assume that you own calls and want to continue to own calls as expiration nears.Then the true way to look at this problem is: How much does it cost to roll the position out to the next month. In other words, what does it cost to buy the same strike (as you own now) calendar spread? You know that your long option is going to decay rapidly over the final week, unless your stock QUICKLY performs as expected. So most of the time it is better to buy the calendar spread now than it will be to buy it next week. Unless you get the price change needed. I prefer to roll in this situation, knowing that the timing of my expected rally is unknown. The swing trader has a price target but not a time target. Thus, you do not know when the stock will move to your target. That means it provides a better average result — over the longer term — to roll as necessary to minimize the cost of owning options. If you accept that opinion, then Friday, one week prior to expiration is about as long as you should hold the current position.

3) Immediately prior. Although not all stocks act the same, the vast majority of options show a rising volatility on the last day of trading – prior to the news announcement. That is not 100% true, but as a general rule, I would sell options on that last day. HOWEVER: Do not get blinded. If the price increases and you can lock in target profit earlier than that date, take your gains because it does not pay to get greedy.

4) That must vary from trader to trader. If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options. If you are skilled — if you make money via this strategy — and here is a tough one: if you are really a good predictor rather than being a trader who is making money just because it is a bull market — then by all mans, you can afford to invest more than 10%. But understand that bull markets end and if you have little or no experience with buying puts and put spreads, then by definition you will enter hard times if and when this bull market ever comes to an end. Please consider that. I have seen too many traders ride for years with a single strategy, only to lose a ton of money when the market behaved differently.

Good questions.

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How Should a Beginner Approach Option Trading?

The following question seems rather tame, but it addresses a very important issue:

Is there a correct syllabus for new option traders?

Hello Mark,

I’ve just starting to read your Rookie’s Guide book, bought from Amazon. I also read several other options books, while doing my paper trading with OptionXpress with thinkorswim platform.

I also have joined an options course and what they teach are very basic, which is just Buy To Open (Call / Put) and Sell To Close (Call / Put) and pay attention to the candlestick chart for entry point. So making profit from that simple strategy. What do you think of that strategy? They didn’t teach any strategies mentioned on many options books.

Candlestick Charting

Candlestick Charting

But after reading couple of books on options, they all teach the Covered Calls as basic strategy, which from my understanding that one investor has to have real stocks in order to make the options trading. Do I need to buy real stocks? Is that true?

How about if we only open an options account, and didn’t have a real stocks to trade in that Covered Calls strategy? And why I can’t trade the Covered Calls in optionsXpress? Please help me.

Thanks in advance,
Aldo Omar

Paper trading is an excellent idea. It teaches you how to handle your broker’s platform and it gives you experience learning to make critical decisions — entering and exiting positions.

However, this course is a disgrace, in opinion. I do not care how respectable the course giver is, but these lessons are almost guaranteed to see their students go broke when using options. Unless they explain that the course is designed only to teach you something about options and that “buying to open and then selling to close” is NOT a strategy that you ever want to adopt, they are doing you a great disservice. I hope this course is free because it is not worth even that much.

  • First; A trader, and especially a new trader, cannot be expected to know how to use Candlestick charts. It is extremely difficult to “pay attention to” charts and come away with useful information. Think of this way: Candlestick charting is well-known and used my millions of traders around the world. Despite that, the data is clear: The average individual investor does worse than the S&P 500 index. The average mutual fund manager — someone who ears big bucks to pick winning stocks and beat the market averages — cannot beat the averages. Do not get trapped into believing that you can read one or two books on charting and know how to sue the charts. My conclusion is that it is far more difficult to pick entry points than your course teachers suggest.
  • Second; You are learning the simplest of all strategies, and that is a good thing because one should begin with the most basic concepts of options. However, it should have been mentioned as often as possible that buying to open and then selling to close is a death wish. Unless you (A. O.) have a proven track record of predicting which stocks will rise and fall, then you must not — for your financial well being — believe that you can suddenly start trading options and become a successful stock picker. Life does not work that way and using Candlesticks will not turn you into a successful stock picker. The professionals cannot predict stock direction on any consistent basis, and neither can you
  • Third; Even if you work diligently and learn to read the charts successfully, there is more to “buy to open” than simply picking a stock and correctly forecasting the direction of the stock price. Did they teach you that buying out-of-the-money options is not a viable strategy? Did they teach you to pay attention to the implied volatility of the options? In fact, did you learn anything at all about volatility and how crucial it is to an option trader? I assure you of this: If you but out-of-the money options and if you buy them when their prices are relatively high, you will ruin your trading account, even when you get the stock direction right. My advice: If you are going to play the “buy to open” game, at least stick with options that are already several points in the money when you buy them.
  • Fourth; I know that advanced strategies cannot be dumped into the lap of a beginner. Building a sound foundation in option basics comes first. But that is no reason to teach a strategy where the vast majority are guaranteed to fail.
  • Fifth; Yes, covered call writing is a sound basic strategy and yes, it does involve the purchase of stock (in multiples of 100 shares). However, it is still a bullish strategy and the covered call writer can still lose a lot of money if the market takes a dive. Obviously you lack the cash to buy stock. That is okay because there are other ways to use options to generate exactly the same profit/loss profile as writing covered calls. You will get to that in Chapters 13 and 14 in the book that you are reading (The Rookie’s Guide to Options; 2nd edition).
  • Last; The whole idea about using options is to hedge (reduce) risk and still give yourself a good probability of earning a profit on any given trade. Buying options based on Candlestick chart reading is not one of the paths to success. Sure some people can do it, but you don’t want to count on being one of them. Covered call writing is “better” for the new trader – but only when he can afford the downside risk. However, there are other strategies that I would recommend for you. At the top of the list is “credit spreads.” But please have patience. Don’t jump to the chapters on this and related strategies. Go through the lessons at your own pace and if possible, resist the temptation to trade until you feel comfortable.

Aldo,
I hate that course and the sad fact is that this is popular stuff taught by many people.

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