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Legging into Spreads

I like trading RUT spreads but I’m not sure if its better to place a spread order or just leg in. Does a spread order make more sense with a smaller order? I can see trades occurring at the spread price I want but I fail to get filled.


It is far more practical to enter a spread order. In the vast majority of cases, it is also less risky. The primary reason for that extra safety is that you cannot get trapped by a sudden market move after buying or selling the first leg of the trade.

Very Actively Traded Options

There are exceptions to my recommendation for entering spread orders. If you trade front-month options, especially options that are nearly at the money (CTM or close to the money), then there is a lot of trading volume and a continuous flow of orders. What that means to you is that there is a much improved chance to get a good fill – and quickly.

    The bid/ask spread for a CTM option is $10 bid $10.80 ask.
    When there is a constant order flow, this option will be trading – at least every second, and probably far more often than that – at prices ranging from $10 through $10.80, and probably every 10 cents in between those prices. And this ignores all those trades that occur at penny increments.

    If you enter a sell order @ $10.50 or even $10.60, there is a very good chance that you will get filled when another customer is trying to buy that option and is willing to pay a price near the ask end of the range. Notice that you do not have to depend on a market maker to get filled. You are going to be trading with customers just like you – people who enter orders.

    Once filled, it’s time to enter the order for the other side of your spread. The expectation of getting filled is as before. If it’s a very actively traded option, you have a reasonable chance to get a good price.

    However, there is the huge risk of a sudden change in the air. If you buy a call, RUT may decline a few points in a heartbeat – far too soon to get your other order filled. That’s the risk and it is real.

Less Liquid Options

If you prefer to trade out of the money (OTM) spreads, then you must recognize that there is less order flow, less volume, and less chance of making a successful leg. If you trade options (as I do) that are not only reasonably far out of the money, but are not even front-month options, then the chances for a good leg are dismal. These are low delta options, and even if you get a good leg as far as market direction is concerned (buying a call just before the market moves higher, for example), there will still be difficulty getting a fill on the sell part of the spread. Low delta options don’t move much- and they move even less when implied volatility shrinks – even if by a minute amount.

You do not see trades at your price

To be filled on a spread, your broker’s computer must be able to execute both (or all) legs of the trade simultaneously.When you think that trades are occurring at your price, please understand that they may be off my a few milliseconds – and that’s more than enough to prevent the computer from grabbing both ends of the trade for you. And when you see trades you think should be yours, consider that when one leg is offered at one exchange and the other leg is offered elsewhere, it is more risky for the broker to go after the legs. You must ask your broker what conditions must apply before their trading algorithm allows your order to get filled.

But more than that – what about all the ‘market’ orders? They just get filled. There is no opportunity for that market order to find your spread order, or to be found by that spread order. The system has too many participants and a market order hits the highest published bid (or takes the lowest published offer) and it does it immediately. Those trades are never available to your spread order.

Trade Size

I see one advantage and one disadvantage trading small order size. To get a fill, you must attract a market maker’s interest. Small orders do not accomplish that.

However, when trading with other customers, there is an increased chance to fill the whole order, rather than just part of it when trading two lots instead of 10.

Bottom line: Legging adds extra risk, so if you do make the attempt, be absolutely certain that you will not get stubborn about finishing the spread, even when the price is not as good as you prefer. If you are trying to earn an extra 10 cents per spread, there has to be a correspondingly small ‘loss’ from getting a poor fill. I’ve seen traders lose dollars trying for dimes. It’s not a good practice to take the leg, unless you are a VERY skilled market timer.

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Making the Tough Choices

Seth Godin is an interesting character. He’s involved in many things, but is best known for introducing the concept of permission marketing, in which marketers obtain permission before advancing to the next step – i.e., permission to send e-mail. This is the opposite of ‘interruption marketing’ such as TV commercials)

A recent post caught my attention. Excerpts below.

Very often, we’re challenged to make decisions with too little information. Sometimes, there’s no information–merely noise. The question is: how will you decide?

We talked for an hour [over a difficult pricing decision] and then did the only intelligent thing–we flipped a coin. To be sure we had it right, we double checked and flipped two out of three. The only mistake we made was wasting an hour pontificating and arguing before we flipped.

This is also the way we should settle closely contested elections. We know the error rate for counting ballots is some percentage–say it’s .01%. Whenever the margin is less than the error rate, we should flip. Not waste months and millions in court, we should insist on the flip. Anything else is a waste of time and money.

Or consider the dilemma of the lucky high school student with five colleges to choose from. Once you’ve narrowed it down and all you’re left with is a hunch, once there are no data points to give you a rational way to pick, stop worrying. Stop analyzing. Don’t waste $4,000 and a month of anxiety visiting the schools again.

When there isn’t enough data, when there can’t be enough data, insist on the flip.

By refusing to lie to yourself, by not telling yourself a fable to make the decision easier, you’ll understand quite clearly when you’re winging it.

Once you embrace this idea, it’s a lot easier not to second guess your decisions.

Making the tough choice

Interesting concept

I like this idea. It seems reasonable. When you truly have no legitimate way to make a decision, a coin toss is as good as any other method. I wonder whether any politician would agree to this deal prior to an election.

The point? Is this idea viable in the trading world? I understand that each trader thinks he/she has the edge to make the right decision. But aren’t there going to be situations in which the trader really has no idea which is the better path?

The decision may be very important such as whether to enter the trade or pass. However, it could also be a bit less important, such as deciding whether to give up $0.05 in an attempt to get an order filled.

For anyone who likes this idea for trade decisions, the obvious drawback is becoming dependent on this method for making the difficult choices. I would never suggest it as something to use with any frequency, but if you buy Seth’s premise, then a coin toss is a reasonable method for coming to a decision.

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What you trade matters

Thursday, Apr 28 I will be answering options questions: live via Twitterfeed. 1:30 PM ET. Submit questions to #smartoptions

Traders love to tell people that they can trade anything. That if you have the skills to be a trader, the specific item traded is unimportant. That may be true for some professional traders who are skilled technicians. However, it’s very different for gullible amateurs.

Consider the following (excerpts) by Nathaniel Popper from the Los Angeles Times. It describes how easy it is to find suckers when using hype to trap the unwary.

Foreign currency trading is easy — an easy way to lose money
More and more Americans are dabbling in currency trading and losing in spectacular fashion. Experts say the structure of the currency market makes it hard for amateurs to beat the house.

D.O. began trading foreign currencies after seeing a TV commercial touting it as a way to make extra money…

“The ads made me think, ‘This is easy,'” said the 52 year-old administrator with a Texas, police department.

She used her credit card to fund an account with an online currency broker. Within a few weeks of swapping dollars for yen and euros, she said, her $3,000 of borrowed money was gone.

She made two mistakes: investing on credit and trying to make a buck by predicting changes in currency exchange rates, something best left to professionals, according to personal finance experts. But she has plenty of company.

An estimated 615,000 Americans are dabbling in foreign currency trading, encouraged by advertising from the two biggest U.S. brokers, FXCM Inc. and Gain Capital Holdings Inc., both based in New York.

These customers are losing money in spectacular fashion.

At FXCM, 75% to 77% of customers lost money each quarter last year. At Gain, the number of unprofitable customers hovered between 72% and 79% every quarter last year.

As if those statistics weren’t scary enough, the rules of currency trading allow 50 to 1 leverage.

The losses have triggered recent lawsuits and regulatory scrutiny — but haven’t stopped the swift growth of the industry, which barely existed a decade ago. Gain and FXCM went public on the New York Stock Exchange last December.

Executives with both firms say that they simply provide a conduit for people who want to trade currency, and that customers are given full disclosure of the risk. [MDW: If you believe this, you are as gullible as their customers]

“The majority of people today are not doing well,” said FXCM’s chief executive. “There’s lots of education: ‘Here’s how to do it right.’ … Do most people heed the advice? No, of course not.”

It’s a bit ludicrous to suggest that the novice can ‘Do it right.’ For individual traders, forex represents gambling and speculation, and it’s the strongest reason that I have for recommending options as a trading vehicle.

Options allow the trader to measure risk (using the greeks). They allow the trader to understand reward and loss potential. The vast majority of traders have a basic understanding of how a stock market works. That cannot be said for the currency markets.

I have a (biased) opinion that options afford risk management techniques simply not available with stocks, futures, currencies, bonds…The ability to measure and manage risk represents a huge difference between trading options and other stuff. However, when opitons are used for speculation, those advantages disappear.

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Trading options using market orders


I learned something interesting today when taking a loss on a paper-traded position. It was a debit put spread in which the underlying never quite moved into profitable territory and, it being the eve of expiration, I submitted an order to close the position at market open on expiration Friday. (I don’t have time during the day to adjust my positions.)

There was considerable wiggle room in today’s closing bid/ask spread, and I wondered where I should set my limit order to close. Then I realized that, if I really need to get out of this position tomorrow, I probably don’t have the luxury of setting a limit order! So I decided to submit a market order instead.

This was a situation that I really hadn’t foreseen. Just as a trader shouldn’t feel compelled to hold a profitable position until expiration, he/she should be careful about waiting too long before closing a losing position. It would probably have been worth it to give up hope a day earlier and have more flexibility when exiting the trade. I definitely need to put more thought into my trading plan!



When trading options there are some things that must never be done – unless you truly prefer to lose money. At the top of the list is to never (under no circumstances) enter a market order at the opening of trading. Note: If you have a margin call and your broker enters that market order for you, there is nothing you can do – except to plead for five minutes to make the trade on your own.

A market order at the opening is a plea

“Please take as much money from me as is legally possible. And if it’s a spread order, please do that twice. In fact, if I am selling a credit spread, please make me pay a cash debit to exit. If it’s a debit spread, please, please make me pay more than the maximum value of the spread to get out of this trade. Thank you.”

If you have a job where you cannot take a five minute break – fifteen minutes after the market opens – that is truly a difficult situation. However, it is just one more reason not to carry risky positions.

There is another lesson in this scenario, and your comment makes it clear that you either don’t see it – or don’t agree:

It doesn’t matter whether it’s a winning position or a losing position. Your entry price was long ago and is no longer relevant. You must concentrate on the current price of the spread, market conditions, and risk vs. reward. You should be able to determine whether holding this position is a good or poor idea, and it has nothing to do with its status as a winner/loser. When it’s time to exit, exit.

One more point: Execution prices in paper-trading accounts tend to be removed from reality. It’s still worthwhile to practice the trades and risk management, but profit/loss is not going to be realistic.

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ITM Calls as a Stock Substitute

I found this series of questions to be quite valuable. Here we have a relatively new options trader who finds an excellent method for reducing risk, but who gets caught up in a mistake that makes him question his methods.


I’ve been using DITM options for swing trades, while utilizing the leverage to potentially increase the return of buying stock outright.

Plus much less downside risk, unless you decide to buy extra options with the cash not used to buy stock. To be clear, I’m hoping that you do not decide to buy 10 calls, paying $8 each, Instead of $100 shares at $80/share. That’s a very bad idea. You must determine your correct position size by the number of shares you would have bought, and buy only one call for each of those 100 shares. Careful position sizing is essential to risk management.

I usually pick the first strike showing a 1.00 delta. My question is whether this is actually a good risk to return strategy based on the changing delta.

You adopted an excellent strategy, but your focus seems to be misguided.

100 delta options are too far in the money – unless it’s expiration week. The major benefit of using this trading method (buying calls instead of stocks) is to gain a large amount of downside protection. As you know, a market tumble can be quite costly for stockholders.

If you chose ‘high delta’ options instead of 100 delta options, you would gain that protection at a very modest cost. I urge you to consider the idea of paying a few dimes over parity for a call option that has a 75-85 delta instead of paying closer to parity for that 100 delta option. This is a personal decision and if you refuse to pay that time premium for protection, so be it.


With the stock trading at $76, don’t buy the 65 calls (price = $11.20). Instead, buy the 70 calls (price $6.50). That extra $30 reduces the potential loss. Consider it to be an insurance policy.

Next, I understand neither your reference to changing delta nor “risk to return strategy”.

1) The risk to return is outstanding. You cut the dollars at risk from a gigantic number (when owning stock) to a much smaller number (by owning a call option). Surely you understand that.

2) Changing delta? If you are unfortunate enough to see the stock decline by enough for the option delta to become < 100, that's GOOD for you. You seem to believe it's costing money. All it means is that you would lose LESS money per point of decline that you would lose if owning stock. I have one question for you: If you are a swing trader, why would be holding a long position in this stock when it declines by so much? That is not how swing traders operate. They are quick to cut losses. Remember, until the stock falls enough to cut delta, you lose $100 per point. 'Changing delta' doesn't mean much in your scenario because 100 delta options don't change delta very quickly.

Say I pay $10 for a call with a 1.00 delta, and based on this, expect about a 10% move in option price for a $1 stock move (give or take some). The stocks drops. At this point the option price and delta will also drop,
which could very easily cause the percentage option loss per dollar to go up based on higher volatility.

You are off on several wrong paths here, and that’s the reason for posting this discussion. This is a good learning opportunity for rookie option traders:

a) You should expect the ‘give or take’ to be essentially zero for a 100 delta option

b) You are thinking in percentages, and that is confusing you. As a swing trader, concentrate on what you are doing. You are buying (or selling short) stocks, looking to make a few dollars per share. Using call options changes nothing in your basic plan – except that it reduces risk. Concentrate on dollars and forget those percentages.

c) You do NOT KNOW that the option delta will be less than 100 when the stock declines by one point. You did say these are deep in the money options.

d) If there is a change in implied volatility, you WILL NEVER lose ore than $1 per point in the price of an option when the stock declines. Why? You own the option. You own the vega. You BENEFIT when the implied volatility increases. Thus, any losses would be reduce by that change in volatility. Couple that with your anticipation that the delta becomes less than 100 and you benefit again by losing less than $100 per point decline (in the sock price).

Here’s where you miss the big picture: If the volatility increase is large enough – due to a general market scare – you can MAKE money on the decline when oping calls! Did you know that? Get out your option calculator and see what happens to the value of a call with a 70 strike price when implied volatility goes from 30 to 60 and the stock declines from 75 to 70. Assume options have 30 days before they expire. [Your calls would lose less than $1 in value. If they were longer-term options, they would increase in value]

Should the stock move higher, the volatility may decrease and the delta is maxed out at 1.00. Thus, my option price increases, thereby lowering my percentage gain.

No. Delta may be maxed at 100, but so is the delta of the stock. The long call and the long stock move in tandem. The percentage return is totally unimportant – and in fact, it does snot change. You paid $10, so every one point gain is another 10% return on your investment. Plus, your return is far better than that of the stockholder. I’ll say it again. Forget those percentages.

So I’m wondering if this approach actually causes a disadvantage as the reward potential for say a $2 increase may be lower than the risk potential of a $2 drop because the percentage gain decreases for every dollar going up while increasing for every dollar going down. So I may make 18% on a $2 upside but in exchange for a 30% drop for a $2 drop … again give or take.

No. You illustrated why your idea is good. The bad things you found in the strategy are imaginary. They are contrary to fact. You earn as much on the upside (you may earn a little less if you take my advice to buy options with a small amount of time premium). To compensate, you have an excellent chance to lose less than $1 per one point drop in the stock price.

Sit down. Think about this carefully.

One additional point: These DITM calls don’t do the job for stocks that pay decent dividends because you may have to exercsie for the dividend to prevent losing money.

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Is it Really a Bad Fill?


I heard that it wasn’t a great idea to place long-standing limit orders to close out spreads, as it allows market makers to gauge the market (at your disadvantage) and that conditional orders were better. What are your thoughts on that?


I want the fill. Trying to gain an advantage over the market makers is of no concern (to me). This is especially true when I am bidding 20 cents to exit a short credit spread. All I want to do is exit, lock in the profit and eliminate risk. Nothing else matters.

I hope the market maker takes advantage of my order by selling the spread when I am bidding too much. If I change the order, how much better can I expect to do? Another nickel? For me, it’s ‘no thanks.’ I prefer to exit and find a new trade.

Other traders prefer to earn as much as possible from the current position. Nothing wrong with that. It’s a choice: Hold out to earn a little extra (and it is just a little) here or find a new trade with much better potential profit.

When I enter an order to open a new position, it’s not quite the same. This is when the market maker can take advantage of a poorly priced order.

I prefer to set a limit price, but use no other contingencies. I want my order filled, and if the market moves, making it more attractive to the market makers, then I have a better chance to get filled. To me, that’s a good thing.

Consider a situation in which you enter an order to sell a put spread at a limit price. When the underlying asset moves lower by enough that you expect your spread to sell, what do you do? And what should you do? Leaving that order untouched is surely the best way to get filled. However, with the stock falling and implied volatility increasing (most of the time), it’s easy to feel that you can get, and deserve a better price for the spread.

Thus, the dilemma

If you change the limit price, it’s possible that you will not find anyone to take the other side. This is something that many rookies don’t understand. Your order is not just filled by happenstance. Someone must be willing to trade with your order and take the other side. If you ask too much, no one will buy.

The problem is that the ‘other side’ (probably a market maker) also wants a good fill. When you ask too much and he/she bids too little, there is no trade. I’m pleased when the market is moving to make it more likely my order gets filled.

Deciding on whether to change the order is a psychological problem – with no single best solution.

So I ask? Is it really a bad fill when your order is executed when you may have been able to get another five or ten cents?

Sophisticated traders want to trade only when there is an edge. Who can blame them? If you have no edge, then you don’t a high probability of earning a profit. But if you need an edge – by selling the spread for more than it’s worth, who is going to take the other side of the trade? Traders who demand an edge understand that, and are willing to trade less often. However, they always make ‘good’ (at the time of execution) trades.

I go the other way. I want my position and to get it I recognize that I must give up some edge – at least edge based on the current market prices. The problem is estimating how long to wait patiently before raising the asking price.

Lessons of a Lifetime. My 33 years as an options trader contains some insights, philosophy and lessons I’ve learned. This is not a trading book.

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Trading Plans: Profit vs. Loss

Join Options for Rookies Premium as a free Bronze Member before March 11, 2011 and receive an invitation to a live meeting (one of the premium features).

I’ve stressed the benefits of writing a trade plan for each trade. This seems to be one of those things that is easier to ignore and many question the worth of such plans.

Before entering into any trade – especially a trade with limited profits, it’s important to know just how much can be earned so that it can be compared with the maximum possible loss. Without having an idea of the profit potential, there is no sensible method for deciding whether to make the trade. The thought process may resemble this:

Considering how much I can lose if things don’t work out well, and taking into consideration the probability of losing that much, is the potential profit (and the chances of earning that profit) worth taking the risk?

Let’s take a look at an example – one that I’ve used previously.

The trade: Buy (I know, most people prefer to use the term ‘sell’) a 20-point iron condor and collect a cash credit of $4.00. The underlying asset is a broad based index, such as SPX, NDX, or RUT.

Maximum theoretical gain: $4.00

Maximum theoretical loss: $16.00

We could look at the delta of the short options, or use a probability calculator to give us an idea of how likely it is that the position would finish safely out of the money. We could determine the probability that one of the options would become an ATM option (‘probability of touching’) during its lifetime. In other words, we have some idea of the statistical chances of success/failure.

To determine if you want to own this trade, you should not look at those $4 and $16 numbers, unless you know that you are going to hold this trade all the way through expiration. That would be a terrible idea and is a slap in the face to those of us who believe that risk management is essential to making money when trading.

For traders who do hold, these $4 and $16 numbers are real and the trader achieves one of these result in the vast majority of situations. A small percentage of the time the gain or loss is different, but that requires that the settlement price be within the borders of either the call or put spread. [When the short option is out of the money, then the profit is $4. When the long option is in the money, then the loss is $16. If neither of those situation obtains, then the final settlement price is between the strikes and the 20-point spread is worth anywhere between $0.01 and $19.99.]

Exercise risk management skills

For those of us who know we will neither allow the options to expire worthless nor allow the loss to reach the maximum, we must estimate a maximum profit or loss. Sure we all think of the chances of earning the whole $4, but the risk involved makes it a poor decision – for my comfort zone. I’ve often discouraged readers from seeking every last nickel from a trade.

The point of this post is to alert plan writers to the fact that the theoretical limits are not realistic and you are far better served to enter profit/loss targets that are realistic according to your own guidelines. I would probably use numbers such as $3.50 as the maximum gain and perhaps as high as $8 for the maximum loss. Note: that is a personal trading style, not a recommendation.

In reality, I never seek that maximum gain, while other go after seek every penny. There is no arguing with the fact that leaving money on the table is not the path of the expert trader. However, deciding how much profit is enough, and when the reward no longer justifies taking any risk, is something that comes with experience.

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Trader’s Mindset Series: Oblivious to risks

Here’s one of the most perplexing risk evaluations I ever heard (read) from a seller of naked options:

I was never in any danger. The stock was always higher than the strike price of the puts I am short.

This person was convinced that the only time risk must be considered occurs when short options move into the money. If the options were out of the money, and remained OTM, then the options would expire worthless and the seller would have a tidy profit.

I can’t argue with the 2nd sentence. Options that are OTM once expiration day has come and gone are worthless.

However, that mind-boggling first sentence is believed by more people than common senses would suggest.

Once of the basic truths about investing (even when it would be more truthful to refer to it as gambling) is that some people with little experience believe that it’s easy to make lots of money in a hurry. I don’t know why that’s true, but the fact that skills must be developed over time is a foreign concept to such believers.

Confidence that a current investment will eventually work out is common. Stocks decline and many investors like to add to their positions, increasing their risk in a losing trade. The mindset is that the stock only has to rally so far to reach the break-even point. For example, buy 1,000 shares at $50, then buy 1,000 shares at $40 and the beak-even is ‘only’ 45. Add another 1,000 shares at $30 and the trader’s mindset is that this stock will easily get back to $40, the new break-even price.

There is no consideration for the possibility that this company will soon be out of business. This investing newcomer just knows that his original analysis must be correct. This is the mindset of overconfidence. In a situation such as this, it’s also being oblivious to the real world.

The naked put seller

The put seller described above believes that being short an out of the money option is of no concern, as long as it remains OTM. He just doesn’t get it. The possibility of losing a significant sum is staring him in the face and he truly doesn’t recognize the danger.

I’m not suggesting that this oblivious mindset is common. However, as option traders we must be careful to avoid that mindset. I’m sure that every reader here understands the risk of being short naked options. However, being oblivious to other risks can result in a disaster. How large of a disaster? That depends on just how blind the trader is to the true risk of a position.

The spread seller

As an example, let’s look at a trader’s whose preferred strategy is to sell OTM put spreads, rather than selling naked puts. This is a common strategy for bullish investors.

Let’s assume that one trader correctly decides that selling 10 puts with a strike price of $50 is the proper size for his/her account. Even oblivious traders understand that the maximum loss is $50,000. They also recognize that the chance of losing that amount is almost zero, and that it is difficult to know just how large the maximum loss is. Sure, a stop loss order can establish that limit, but stocks have been known to gap through a stop loss, leaving the trader with a much larger loss than anticipated. The ‘flash crash’ was an extreme example of how bad things can get.

What happens when this trader decides that selling naked puts is no longer the best idea and opts to sell 5-point put spreads. Each spread can lose no more than $500 (less the premium collected). The problem arises if the trader, not understanding risk, decides that selling 100 of these spreads – with a maximum loss of (less than) the same $50,000 – is a trade with essentially the same risk.

When a trader is not paying attention, he/she can become blind when the total money at risk is similar for two different trades. It’s easy to incorrectly believe that risk must be similar. In this example, two positions have vastly different risk.

Position size and probability

The trader whose mindset includes being oblivious to reality, is either unaware of statistics or ignores them. The big factor here is probability. There is a reasonable probability of incurring the maximum possible loss when selling 100 (or any other number) of 5-point credit spreads. Depending on the strike prices and the volatility of the underlying, the chances of losing it all can be near near zero to almost 50%, depending on the strikes chosen. Let’s ignore the ‘near zero’ examples because the premium available when selling such spreads is tiny and no one should be trading those on a regular basis.

However, when the chances are one in five, or even one in 10, you know that such results are going to occur (on average) every five or ten months. It takes some good sized wins to be able to withstand those losses. But the truth is that the trader who is not aware of the difference between the chance of losing $50,000 no more than once in a lifetime vs. losing that amount at least once every year has no chance to find success.

One important aspect of risk management is understanding how likely it is to collect he profit or incur the loss. The size of that profit or loss is not enough to tell the whole story.

Please do not be an oblivious investor. Please understand risk and reward for every trade, as well as for your entire portfolio.

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