Advice for the new options trader

I ‘borrowed’ (and modified) the following question from the EliteTrader Forum.

I have been studying, paper trading, and real trading – using mixed options strategies with mixed results. I mainly sold call & put spreads and did ok – until I got hammered on one trade. I’ve tried weekly & monthly expiration because I was attracted to these trades and their high probability of profit.

I have a $5k account and pay $1.50/contract flat rate commissions. At the moment, I am being lured into iron condors.

I am not dependent on my account but I want to grow it. I prefer strategies that require low monitoring/maintenance, but I am open to suggestions. What strategies should I try to incorporate and why?

Good news for this trader

This rookie trader is seeking advice, has experimented with several trade ideas, has a good attitude (does not expect instant riches), and incurred a loss from which he has learned a lesson. He appears to be patient and is seeking new ideas to consider.

This person has a nice edge: He has a flat rate commission per contract. That allows him to trade small size (yes, even one-lots) without having to be concerned that the ‘per ticket’ charge will consume too much of any profit. This was an intelligent item to negotiate and I strongly recommend this idea for all traders who trade small size. The savings can be significant – if you can get them.

The not so good part of the story

He is being ‘lured’ into a new strategy, but he should only adopt this play if he feels comfortable using it. In truth, it’s merely a combination of the strategies he has already been using – and in my opinion, anyone who understands the risks associated with selling vertical spreads is ready to consider trading iron condors.

The other problem is the size of the trading account. I understand that brokers allow customers to trade with even less capital, but it is a difficult task. It is simply too easy to lose the entire account when it is small.

Advice

As a young person with a job, he is in position to make a deposit into this account every time he receives a paycheck. That’s an outstanding method for increasing wealth over time. However, with this advantage comes the responsibility of carefully managing risk.

Learning to do this well takes time. The best recommendation I have is to be very careful with trade size because that is the simplest and most efficient method for managing risk for any trader. Smaller is better. Less risk and less profit potential is better – especially when the trader is first getting started. There is plenty of time to increase size as experience and confidence grow.

Patience is necessary because some strategies (such as selling credit spreads) may take some time to perform as hoped. [It’s true that selling a put spread can become very profitable quickly when the stock rises, but in a neutral market, iron condors require patience and good risk management.] Experience does not come quickly.

I also offer this advice for our rookie trader:

  • Rapid time decay may look great on paper, but (as you already learned) it comes with explosive negative gamma, making these trades riskier than they appear
  • Longer-term options come with higher premium and more protection against unwanted market moves. They also lose time value more slowly
    • Trading involves trade-offs. Less risk requires accepting a smaller profit target.
    • Your problem is to find the trade-off that feels ‘just’ right.’ Not a simple task – but it gets easier with experience
  • Choosing a good strategy is important. You want to feel that you understand how to use it effectively
  • However, risk management is more important and will have the greatest effect on your overall performance
  • Which strategies?

    The list is long. Options are very versatile and provide many alternatives. If you are comfortable with credit spreads, they make an excellent choice because losses are limited, margin requirement is small – allowing you to diversify, and they are easy to understand.

    Then there is something you may not yet recognize: Selling the put spread is equivalent to the very conservative collar strategy. More than that, selling put spreads is the same as buying call spreads (same stock, strike, and expiration date), and selling call spreads is the same as buying put spreads (same stock, strike, and expiration date).

    That means you are already using a much wider variety of strategies than you realize.

    I believe you are on the right track. Don’t get greedy. Increase position size one contract at a time, and don’t do that too frequently. Keep asking questions and don’t accept all replies as ‘correct.’ Use your own judgment.

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    2 Responses to Advice for the new options trader

    1. Victor 04/05/2011 at 12:49 PM #

      It’s a small world in the options realm. That is my post that you replied to from the ET board and it turns out that I am also an active reader of your blog. Thank you very much for this advice and the reply!

      • Mark D Wolfinger 04/05/2011 at 2:27 PM #

        Victor,

        That is unexpected. I hope the reply was helpful

        Regards.