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If you have been a follower of this blog, then you already know that I provide the detailed answers to your questions.

If you read my Rookies Guide to Options, then you know how easy it is to follow my thoughts.

I can help you use options to hedge a portfolio or earn trading profits.

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I’ve poured a ton of energy and love into writing this blog.
But, It’s time to move on. I want to spend time on other aspects of my life.

Thank You

I have many notes of appreciation from readers who felt the passion that I bring to the table when helping others learn to use options. Each one of them is a treasure. Thank you.

I trust that I’ve inspired many of you to take the time to understand how options work before beginning to trade with real money.

I know that I’ve emphasized the importance of risk management when trading or investing. If you learned nothing else from these posts except for that single item, then I have done my job.

Most of all, I appreciate having the opportunity to blog about options. It’s something I thoroughly enjoyed doing for more than three years, and I offer a special thank you for all the encouragement.

Options for Rookies is going into retirement. I’ll still be around at the premium site.

My goal is to earn $2,000 per month (before taxes, commissions, etc.) beginning in January 2012 and to stay at this goal for at least a year before raising my expectations. (This goal is not set in stone and can be changed.) This gives me six more months to learn and practice. During this six months (also not cut in stone):

1. Should trading be limited to strictly paper trading or is there an advantage to trading very small sizes with real money?

2. Should I limit the number of strategies that I am trying to learn?

3. Should I limit myself to the number of trades that I put on each month? For example, one credit spread and one iron condor per month (10 lot paper trades)?

4. I have adopted a stop loss plan of losing no more than the amount of my collected premium. For example if I collected $850.00 (on a 10 lot paper trade) then when the underlying goes against me to the point of $850.00 the trade is closed. Is this a realistic starting point?

Jim,

It’s good to set a goal for yourself. However, let’s be reasonable. First you must prove to the world that you can earn anything. Not everyone makes it as a trader. Had you asked, I would have suggested a smaller goal. Some people would be happy to meet expenses the first year. Note this: Month one you are a novice. Months 11 and 12 you are a more seasoned trader. Still a rookies, but surely more knowledgeable than when you began. That should make a difference in your performance..

Please remember that trading is not a consistent flow of money. There are good, better, and losing months. Sometimes you cannot meet your target. Expect that. Do not allow it to disappoint you. If you make bad trades (ignoring trades that are clearly superior) you are not going to do well. Thus, you may have a monetary goal – but it is far more important to have a learning goal. Making money is not a guarantee that you are skilled and not lucky. And the same goes when losing. It’s important to know whether you were unlucky or making mistakes. This is not always easy to judge.

$2,000/month is a meaningless number. If you have a $20,000 account, you have no chance. None at all. Don’t even try. That’s 10% per month.

If you have a $1MM account, then $2,000/month is not worth the risk. You can do as well at the bank.

Thus, the size of your account matters. Please do not target more than 2% per month and I’d urge you to target 1%. I am talking about now, not for all time.

Some months will offer greater opportunity and others will offer less. That’s the way it is. Sometimes you will like the available trades; at other times you may decide to sit on the sidelines. Winning traders do not force trades. When undecided, trade half (or less) normal size.

1) No. All paper trading is not necessary. It’s okay to trade one-lots with real money. But you cannot make $2,000 per month doing that. The goal should be: make enough to cover commissions and other expenses. It also depends on how much money you have. If it’s $5,000, then you cannot afford the risk – yet. Don’t forget that brokers who have a ‘per ticket’ charge are far costlier when trading those one- and two-lots. Real money is real, with emotions. Paper trading is very helpful, but it often comes with a non-caring attitude. Don’t allow that to happen. Take paper trading seriously.

If it’s less than $20,000, use paper trading until you gain some confidence. That could be a month or two. It does not have to be a long time. Learn to be comfortable making the trades. And MOST IMPORTANTLY. If you trade an iron condor and the options quietly fade into oblivion in a dull market, don’t think you did anything special. Similarly if the market dives 20% the day after you made that same trade, don’t think you did anything wrong. I understand that we are playing for green points (dollars), but for short periods of time, profits and losses may not be the best measurement of how well you are trading and managing risk.

2) Yes, limit the number of strategies, but make it more than one. You cannot discover which feels best unless you read about them and get a feel for how the strategy works. Then they must be traded. I suggest at least 2 and perhaps 3 strategies to test. Not all for real money, and begin with only one. Do not add a 2nd until you believe you are not too busy with the one. Same for adding a 3rd.

However, the key to success is not in finding the right strategy. The strategy lets you into the trading game, but you must manage risk well (and that includes trading proper size) and learn to make quality decisions when trading. In my opinion, the strategy is important. You want it to satisfy your needs. If you love daily action, iron condors are not so good. If you hate to trade, want to play safe, and earn a steady income – consider being an investor not a trader.

Find a strategy that Jim will like – and that you, Jim, can handle. Sure. Practice a few and discard those that are uncomfortable. When you gain more experience and confidence, return to reconsider a previously discarded strategy with your new trading insight.

SUGGESTION: Use different underlying assets so that you can have separate risk graphs for each position.

3) Open a position. If you can follow it comfortably, then add another. Don’t have too much going on at once. I suggest no more than three at one time. You must give yourself time to watch the trade (as often as your plan requires), know your adjustment, exit, and profit points, and not feel hurried. Only then can you add the 2nd and 3rd positions.

4) No. Not even close. If you trade the options ‘income’ strategies (iron condor, credit spread, naked put, covered call, etc), the credit collected has NOTHING to do with how much loss you should be willing to accept.

You pick a position to own. It costs something (ok, you collect a cash credit, but it’s the same idea). The cost should now be ignored because it never matters again – for trade decisions. Never. It does come into play when recording your final P/L in your trade journal, [not everyone agrees with me on this, but I'll defend idea vigorously] but the time to exit the trade is when the position is one you no longer want to hold. The greeks may look too risky. Market conditions may have changed. However you manage risk, how can the premium collected have anything to do with the exit decision? How can that make any difference in deciding whether the position is worth holding or folding? Logic tells you that they are unrelated.

We are not trading stocks. That’s when the stop-loss scenario that you describe makes sense. Not here. Not in the premium selling game. If you decide that losing $850 is the limit for a trade – that’s an intelligent thing to decide. But it does not matter how much cash you collected upfront. Exit when risk is out of line. Exit when you have lost your maximum allotted total, but do not base anything on the entry premium.

Welcome to my world. Enjoy

Learn first. Trade later
• Take the time to understand how options work
• Recognize when positions are equivalent
• Do not ignore ‘the greeks’

Risk management is essential to success

• Think of risk as you examine various strategies
• Size is crucial. Avoid large position than can kill your account when the worst happens
• Adjusting positions is ‘good.’ It cuts risk and gives trader an improved chance to earn money
• Many new traders blow out an account before beginning to think about risk management

It’s your money

• Do not gamble with profits. That cash is your money
• Minimizing losses is the key to success
• Earning money is the easier part. keeping it is more difficult

Don’t open a new trade because it ‘looks ok’

• Verify that potential profit is worth the risk required to earn that profit
• Make a trade plan

Don’t hold short options into expiration

• The last nickel or dime is for someone else to earn
• Near term gamma is explosive
• Short options can result in rapid, large losses
• Avoid having your fate determined by ‘settlement’ prices for European style, cash-settled options

This is the first put spread I have ever done. I’d like to make sure I understand it.
[MDW:This is something to do before you trade, but let's be certain that you understand NOW]

I own the 38 puts. So if the stock falls below 38 I can sell it.
[Yes. But remember that you bought it as protection to limit possible losses. You can sell that option any time before the close of trading on Jul 16, and the stock does not have to be below 38]

This lowers (limits) my potential loss on the spread to $2 per share if the stock plummets.
[The maximum value for that spread is $2. But don't forget to deduct the premium collected when selling the spread: Your potential loss is reduced by that premium]

I sold the 40 puts, so if the stock falls below 40 I am obligated to buy it. It is a bullish trade, so I am believing the stock will be above 40 by the expiration date.
[I know what you mean, but for clarity, it is not 'by' the expiration date that matters. It is 'at expiration,' or the closing price on the 3rd Friday of July. That closing price determines whether the put owner will exercise and force you to honor that obligation.]

If the stock is above 40 at expiration the puts expire worthless and I keep the credit I received (net credit 38 cents per share).
[Yes. That cash is already in your account. And it is yours to keep NO MATTER WHAT HAPPENS. You may decide to spend some cash to repurchase the puts (I know you won't, but theoretically speaking). But that 38 cents is no longer relevant. It is yours forever]

If the stock is between 38 and 40 the 38s will expire worthless and I will be assigned the stock. That is fine, I am getting it at a reduced price and I like the stock; OR CAN I SELL TO CLOSE THE 38s?
[The price reduction is ONLY the 38 cents credit collected earlier. That's not much of a price reduction.

[You may sell the 38s at any time before the market closes on that 3rd Friday, if anyone is willing to pay something to buy them]

[With your emphasis on selling the 38 puts, I believe you are adding a new wrinkle to spread trading - keeping the shares. That's worthy of further discussion - keep reading]

If the stock is below 38 what is best strategy? Since I like the stock I should allow the stock to be assigned to me, and then sell the 38 puts to close (before expiration).
['Best' is not easy to define. In your scenario - keeping the shares, then selling the puts is a very unusual choice because the vast majority of those who trade put spreads have no interest in owning (or selling short) stock. They trade spreads with the intention of earning a profit. There is seldom an interest in owning shares. Thus, the question remains: why did you buy the 38s?]

This reply arrived via e-mail:
This is a bit of a hybrid. Given that I am willing to own stock, doesn’t owning the 38 puts provide some protection? Also, if the stock is below 38 near expiration, the 38 puts have value and I could sell them, thus reducing my cost basis for buying the stock?

[Yes. You are correct. Owning the puts provides protection - for a limited time. But that protection is NOT cheap.

Yes again. Selling those puts lowers the cost basis. However, not buying the puts in the first place lowers your cost basis even more (except when the stock moves well under 38) on those occasions when you do buy the shares via being assigned an exercise notice.

Traders who sell naked puts - don't seek only that short-term trading profit. They are willing to own the shares at a better price (when compared with the stock price at the time the puts were sold) - and almost never buy protection.

You are doing both. You want to own the shares and you prefer to own protection. There is nothing wrong with that. I believe it is always a good idea to limit losses.

However, you are new to options and I want to be certain that you recognize the cost of owning puts as protection. Bottom line: It is expensive. The big question - and perhaps it's something you have not yet considered - is: What are you going to do for protection after July expiration?

Example: If you own 100 shares and buy one 38 put (two month lifetime), paying $1, then the stock price must rise by more than $1 before you earn any profits. If you buy those puts every other month, then the stock must rise by $6 or 15% every year for you to overcome the cost of the put protection. It's not so easy to find stocks that rise 15% per year, and when an investor does that, he/she deserves to make some money, not spend that 15% on insurance.

[This is not the place for details, but if you own stock plus puts, that is equivalent to owning calls - with the same strike and expiry as the puts.] Do you truly want to own calls rather than stock? The answer should (in my opinion) be NO, unless the calls are significantly in the money.

One basic question in preparing a course of study for individuals or groups is deciding which ideas can be taught vs. which can come only with experience.

Students can be helped to understand the greeks, what they represent, and how to make them correspond with the trader’s outlook for the market. In simple terms, all students come to understand that being long delta is likely to bring positive results when the market moves higher. However, there are enough exceptions that the student must be taught when delta (or any other greek) can be overwhelmed by other factors and fail to produce the anticipated profits.

One example occurs whenever news is pending. Option prices tend to be bid higher, so that the after-the-news-is-released collapse of implied volatility can result in the call (or put) owner suffering a loss, despite having correctly predicted in which direction the stock price would move. This is an important aspect of the learning process. However, it is reasonable to expect students to grasp the principle that predicting market direction is not sufficient to generate profits when using options.

Mindset: Moving from stock trading to options

Because getting market direction correct is not good enough, experienced traders often adopt ‘market neutral strategies.’ Instead of predicting the market will move higher or lower, the prediction (or wager) becomes: the market will not move too far in either direction. That is foreign to short-term traders

This represents a big change in mindset for the person who has experience trading stocks. Stock trading is all about direction – bullish or bearish; holding for the long term or short term, betting on daily price swings or 20-second price changes, etc.

Risk/reward ratio is another big change for the trader who is moving from stocks to options. Stock traders always want the trade to have more to gain than to lose. Option traders do not have to accept that limitation. For example, many traders make a living by selling a $5 call or put spread and collecting a $1 premium. The maximum loss is four times the maximum gain, yet this is viable for option traders.

Having the ability to get the options student to recognize that he/she has entered into a new realm is an important qualification for the options educator. It’s truly important to be certain that the student understands that options are different. As trite as that sounds, when that difference is not emphasized early in the education process, some students will be troubled with the idea of ‘risking so much’ to ‘earn so little.’

Risk Management

To help ease the transition of new options traders into our universe, the concept that managing risk (other than by using the stop-loss tool that is so valuable to stock traders) is the essential talent required for success. Timing may add to profits, but it is not as important as it is when trading non-option vehicles. Something as basic as this is mandatory in the training process.

But it involves more than that. I doubt there is an options educator on the planet who does not mention ‘risk management’ in one form or another. However, options are different. Options and option positions have risk that can be quantified (the greeks). When that’s possible, a whole world of risk management becomes available to the trader. We measure those risks and use ‘the greeks’ to describe them.

What’s the big deal? When trading options, knowing how much money is at risk if something specific (price change, IV change, time passes etc) happens – represents the opportunity to reduce and control any specific risk. If the stock trader fears that markets will become deadly dull and trade in a very narrow range, there is not much that can be done. However, the option trader can seek positions with positive theta and/or negative vega. Or, if the trader is a strict believer in owning positive gamma, then sitting on the sidelines becomes the appropriate strategy.

There is such a large advantage to knowing that the greeks can help plan strategies and measure risk, that failure to emphasize their importance makes the whole learning process far less valuable.

Philosophy

Taking a class when the course consists of:

• Explanation of some strategies
• Being told appropriate conditions for using each
• The promise that you can read charts and predict market moves

is just not good enough. The mechanics of using options are important, but not sufficient. Learning the basics, understanding how to apply them, achieving proper (profitable) mindsets – those are important. Those are the ideas that the teacher must pass along to the beginning student. I wonder how many mentors who charge big bucks for an education understand these truths.

A trader buys (or sells if you prefer that terminology) an iron condor, collecting a cash credit of $250. The market moves against the position and the trader decides that he/she is no longer satisfied with the trade. Something must be done. Keeping this discussion simple, let’s say there are two choices.

a) Close the trade, paying $400 per iron condor. Net loss $150 per
b) Adjust the trade

• Define adjustment: Change the position to reduce risk
• Necessary condition: The new position is ‘good.’ The trader wants to own it
• The adjustment is NOT made to avoid taking a loss. It is made to reduce risk

Adjustment cost

When the adjustment requires a cash outlay of $50 to perhaps $200, most traders are willing to protect their remaining assets by making the risk-reducing adjustment.

However, if the adjustment requires paying $300 – $350, there is resistance to the idea.

One of the Gold Members at Options for Rookies Premium made the following comment regarding such an adjustment:

I’m not sure I could spend more on my adjustment than I received; that might be tough.

A significant quantity of traders are predisposed to some ideas (mindsets or mental blocks) because they seem so obvious. The logic behind their reasoning appears to be so impeccable that it ‘s essentially inconceivable that the ‘obvious’ belief can be erroneous.

The quote above represents one such example.

The truth

Without an adjustment, the risk of losing too much money has become unacceptable for this trader.

These are the facts, although not everyone is willing to accept them:

• The iron condor is no longer priced at $250. The current market value is $400
• Making trade decisions based on the $250 price cannot be efficient because it is not a realistic price

Additional facts, based on the trader mindset:

• Trader is willing to spend $400 to exit the trade
• Trader is unwilling to spend $300 to make the trade, even though the new position would be:

• Safer to own, with risk of additional losses significantly reduced
• Less dangerous to own because amount that can be lost has also been reduced
• Good enough to own. That means the trader would be comfortable establishing it as a brand new trade

Bottom Line

Trader is willing to exit, spending $400 because taking losses is sometimes necessary.

Trader prefers not to spend $300 to build a better position that offers a good return in exchange for the risk involved.

Why? Because spending $300 results in a owning a position when the bookkeeping says it can never be profitable (based on the original entry price). The excellent chance of earning money from today into the future is ignored.

When thinking about the cost of adjusting, that decision should be made between the current choices, and has nothing to do with the original price at which the trade was entered. The choice is: exit and pay today’s price; or adjust and pay today’s price. Make the better choice by making the better trade.

That’s the path to success.

I’d like to share an experience that happened to me last night. Penny and I decided to take a friend to dinner for her birthday, and the birthday girl requested that we visit Burt’s Place, located in a nearby suburb.

When calling to find out their business hours, we discovered that to make a reservation, the caller must place an order. That is a solid way to turn over the tables, but it was an unusual requirement to us.

We were told that the only available time was 5:30. Pretty early, but we took the reservation. Then we were told to be there on time because the pizza would be set on the table at precisely 5:30. Wow. Pay for dinner and if you arrive late, you get to eat it cold. This is a business that appears to be so successful that they can, and do, get away with treating their customers harshly.

A genuine Burt's Place pan pizza

Well, not enjoying room temperature pizza, we arrived on time. True to their word, dinner was served at 5:30. The next surprise came when the pizza was set on a nearby table, with a bunch of other pizzas. The waitress gave us each a slice and we were notified that we were not permitted to get up and take another slice. Instead, the waitress had to be summoned to cut and serve.

Most amazing!

Bottom line, decent pizza, but not nearly as good as advertised. It was, however, a unique place to have a meal. I do not think I will exercise my option to return.

Currently, there is no extra charge for Gold Members. That means for the nominal fee of $37 per month you get all the features of Gold Membership, plus the course.

Note: I am still adding content, as it continues to expand. When the course is finished, it will be sold separately. Today, it’s available to Gold Members – at no extra cost. This is the type of course that sells for hundreds of dollars, and some charge thousands for far less quality content.

If you considered trying the Premium Membership, now is the time.

Here is the introduction to the course:

Introduction to Options. Part 00

Short Introduction to the series

Expiring Monthly. June 2011 issued published yesterday.

Table of Contents

Apparently there was a miscommunication. For some of these questions, there were multiple correct answers.

1) True or False:

Trading iron condors is almost free money. Just set it and forget it

False. Set it and forget is likely to result in losses over time. The iron condor strategy can be profitable when positions are well managed because the key to success is being certain that large losses are prevented.

Glad to report that everyone answered correctly

2) You have $50,000 in your trading account. As a speculation, you bought 20 Jul 70 call options. The stock has not performed as you hoped, but it has been moving higher all week and today (expiration Friday) opened for trading @ $69.80. Which of the following are true:

a) You own these options and thus, cannot be assigned an exercise notice. Nothing bad can happen to you.

Not true. If these options finish in the money, your account will be assigned an exercise notice automatically. You will be forced to buy 2,000 shares, or $140,000 worth of stock. Your account is far too small, and a margin call will be issued. You will be forced to sell these shares at the opening Monday, regardless of price.

25% thought this to be true. Owning the options does limit risk, but when it comes to owning them at expiration – danger looms.

b) You must do your best to sell the calls before the market closes for the day – just in case the stock closes above $70 per share

True. If there is no bid and you cannot sell, and if the stock is priced barely above the strike price when the market closes, notify your broker immediately: DO NOT EXERCISE

.
25% chose this. I expected a higher total.

c) It’s a good idea to enter a limit order to sell the options now. Then forget all about them
Not true. See reply to a) above.

13% voted for this choice. It’s seldom a good idea to forget about positions. This automatic exercise rule can result in big problems, even for those who own options.

d) It’s a good idea to enter a limit order to sell the options now. Then lower the asking price later in the day – as often as necessary
True. This is sound policy.

35% recognized that this is a decent choice. It may not be best, but that depends on how much time you have to follow the position during the day.

e) It is a reasonable plan to go for a bonanza by not looking at the stock or option price all day – until well after the market closes. Maybe you’ll get lucky and the stock will close @$72 – or higher.

Not true. Sure, you can go for the bonanza, but you MUST be certain to sell the options before the market closes for trading. You cannot afford to exercise these calls.

I’m pleased to see only one vote for this.

3) Out of the money put options on equities (stocks and indexes) tend to trade with a significantly higher implied volatility than do the out of the money call options. Which of these statemens is true.

a) This has been true since put options were first listed for trading at the CBOE
False. This phenomenon first appeared after the market crash of October 1987.

One vote

b) This observation is known as volatility skew True
50% of the votes

c) This observation is known as option kurtosis Not true
One vote

d) This is unreasonable, and this perplexing pricing will end soon Not true
No votes

e) This is true because huge and sudden declines occur more often than huge and sudden rallies True
The other 50% of the votes

I believe everyone would have voted for both had it been possible.

4) You are very excited about the prospects for a specific stock. You expect it to rise by 40% (from $40 to above $55) within two months, three at the most. You have had this feeling about other stocks in the past, and your track record is so-so. Six times the stock moved lower, but 4 times the stock moved nicely higher (but not as high as you anticipated).

Which of the following represent sound trades? Which trade suits you best? Which is the worst, in your opinion?

a) Buy three-month calls. Strike price $55
Worst possible choice in my opinion. Stock unlikely to move far enough quickly enough

One vote

b) Buy three month calls, strike price $50
Unsound. Almost as bad as a) above.
One vote

c) Buy two-month calls. Strike price $40 Sound choice most of the time. Best for traders who have confidence in their opinions. Three month is a bit safer.
Two votes

c) Sell two month puts; strike price $40 Sound choice, but risky
Two votes

d) Sell three-month, 35/40 put spread Sound choice
34% of the votes

e) Buy front-month 40/45 call spread Not a good choice. Time frame is too short
10% of the votes

f) Buy three month, 40/45 call spread Sound choice
40% of the vote

Best trade had votes spread over the whole map, but d) and f) had the most votes.

Buying three-month 55 calls was voted the worst trade. If you must buy OTM calls, at least buy one that you believe will be in the money eventually.

Thanks for participating