Good questions from a rookie options trader

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

999

14 Responses to Good questions from a rookie options trader

  1. Tyler Craig 06/30/2011 at 8:32 AM #

    Very nice Mark. I’ve had to tackle the goal question in the past and feel like you bring up some great points. Focusing on the process is definitely more important than setting expectations on the results particularly when your starting a new strategy. I think I might link back to this one in a future post.

    • Mark D Wolfinger 06/30/2011 at 9:41 AM #

      Thanks Tyler,

      It seems reasonable to me that a the very short term trader should have a monetary goal. He/she is in and out of many trades and the results of the trades are known short;y after making the trade.

      But we trade strategies that require a longer holding period that two minutes. Stuff happens that is outside our control. To me, that combination of a lengthy trade and a dependence on a market to behave as expected (up, down, or nothing) makes each of our results less dependent on trading skills and more dependent on management skills. I believe many would have difficulty agreeing with this conclusion. We keep score in green points, so it seems logical to measure success in those green points. But not to me.

      Regards

      • Dmitry 06/30/2011 at 10:01 AM #

        I would say that in the long term (and with large summs involved) the success of a trader should be measured in green points. Earn too few and it’s not worth the efforts. The reward should be scaled with sophistication: you dont have to be smart to put your money in the bank. Next level – treasuries. Again, no brain power required. So the basic idea is: additional knowledge and skills you obtain should be rewarded accordingly. The harder to understand the instrument traded, the better rewards should be. From this point of view a person earning 2% per year cant be called successful, although he didnt lose money, so he may be a good risk manager.

        • Mark D Wolfinger 06/30/2011 at 11:13 AM #

          Dimitry,

          Yes. Profit/Loss is the ultimate judge, and 2% per year is not successful.

          One reason this discussion is awkward is because the term ‘trader’ – usually refers to people who hold positions for one day or less. I never know which adjective to use when writing about us – ‘options traders’ is the norm. But we are really short-term investors because we ‘invest’ in a position (even if cash is collected, we invest margin) and wait until it matures. We don’t try to take the quick scalp as ‘real’ traders do. We can’t. Bid/ask differentials are too wide in the options world.

          They have to be skilled timers. We have to be good position managers. It’s a different skill set.

          Options are on the ‘difficult’ end of the spectrum when compared with stock trading. From that perspective, more reward is deserved by those who have the skills. Yet, even the passive options investor can come out better with options than with a simple buy and hold strategy. That agrees with your idea that being able to understand options must lead to an earnings boost, or else there is no point in continuing to use the ‘more difficult’ to master investment tool

          • Dimitrios 07/01/2011 at 4:34 AM #

            Mark,

            If 2% is not successful, where (roughly) you put the line, where you say that if you earn below this (X% per year), do not bother trading options. Try another way to invest your money.

            Let’s assume a conservative option trader (trading mainly iron condors), who has been trading for quite some time, who has spent a lot of time studying and learning about options and also spends 4-5 hours per day on options.

            Obviously, we mean this X% as the average of both bad and good times.

            Than you

          • Mark D Wolfinger 07/01/2011 at 11:18 AM #

            Dimitrios,

            The trader should seek a return that suits him/her.

            However, if 2% per YEAR is that number, don’t bother with options. Use a bank.
            If 2% per month is that number – that’s a very different story. That would be an excellent return.

            Good trading

  2. Robert D. 06/30/2011 at 11:36 AM #

    Mark,

    Excellent advice for a beginning trader. It’s so refreshing to see a knowledgeable person setting realistic expectations.

    I do have a specific question for you regarding position management. Are there cases in which you would continue to hold a position that has moved into losing territory? In other words, if time to expiration seems sufficient to see a price reversal in the underlying, might you justify not immediately closing the position? Or do you feel that you shouldn’t hold ANY position that you wouldn’t have opened in its present situation?

    Thanks much,
    Robert

    • Mark D Wolfinger 06/30/2011 at 12:16 PM #

      Robert,

      Your last sentence may describe an ideal, but I never suggested that.

      I would not ADJUST a position to something I am not willing to open. However, we must HOLD positions that are neither good enough to open nor risky enough to consider making any changes. [For purists who are willing to make very frequent adjustments – then the position can be converted to delta neutral every day. That’s not for me]

      If you anticipate a price reversal and (more importantly) if you want to WAGER on that reversal – then sure it’s okay to hold. Just know that you are making a directional play at that point and should make a new bookkeeping entry for directional plays. DO NOT add any additional profits or losses from that position into your records for trading (the initial position). It should be recorded as a directional play from the time when you would close if not opinionated vs. holding because you are.

      Alternatively (and it suits me better), I would handle the original trade as you would handle it sans a market bias. Then, if you want to make a separate directional bet, do so.

      The problem with holding longer: Lets say that the 10-point spread that you sold has reached $5 and you keep holding just becasue you believe in a reversal. Then it moves to $7 and you did not get that reversal. What can happen here is that you reason: I only have $3 left to lose and $7 to gain, so I’ll just hold. That’s the problem. That’s what can happen when you do not get your market reversal. It’s a hidden risk.

      • Dmitry 06/30/2011 at 3:01 PM #

        But doesnt your trading style becomes a “directional bet” after you buy in the cheap leg?

        • Mark D Wolfinger 06/30/2011 at 3:36 PM #

          Dmitry,

          If I am short a call spread that is 20 points OTM and I put spread that is 80 points OTM, I already have a directional bet. By covering those far OTM, very low-delta options, I don’t really change much. It’s equivalent to spending a small sum on insurance against a big market reversal.

          The place where I turn it into a real directional bet occurs when I elect (which is almost all the time) not to sell another put spread to replace the spread just covered. I prefer the extra safety cushion because my goal these days avoiding large losses. I’m happy to accept the available profits and don’t want to take extra risk in an effort to supplement those profits. I’m sure that it is ‘better’ over the longer-term to do as you do: when covering, roll to another credit spread.

          That keeps the trade more neutral. I don’t know how long I will be trading, so at this stage a large loss would be terribly painful and I trade small size and do not re-sell covered spreads. I must believe in safety first. More aggressive traders can afford to take more risk than I do.

  3. Dauddy 07/01/2011 at 7:53 AM #

    Mark,

    I want to say, thank you for guiding me on this business thru this excellent blogs.
    Wish you all the best.

    Dauddy

    • Mark D Wolfinger 07/01/2011 at 11:29 AM #

      Thank you Dauddy

  4. Phil 07/22/2011 at 8:14 PM #

    I have a $25,000 account and I only trade options in this account. I make at least $1 to 2,000 a week using bull put spreads and other vertical spreads techniques. It can be done, but you need to be very careful. I usually trade AAPL, NFLX and other high price, high vol stocks.

    • Mark D Wolfinger 07/24/2011 at 8:36 AM #

      Phil,

      Yes, it can be done. But you cannot be that ‘careful.’ This return comes with enormous risk.
      I strongly recommend that no one else try technique.

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