Philosophy of Options Trading. Part III. The Importance of Strategy Selection

Part IPart II.

My area
of expertise is speaking to option rookies and helping them get started by developing
winning habits.  Too many beginners adopt strategies suited for speculators, not investors, and as a result, lose money before they take the time to learn about options.  They are out of the game before they have a chance to understand how options work.  That's avoidable.

The Rookie's Guide to Options contains my philosophy on option trading, based on more than 30 years
experience.  There are many concepts about trading options that are easily shared.  For example, you can be shown how to think about the process of choosing strike prices for a specific strategy.  When each of many alternatives is discussed, and the pros and cons of each is described, you can develop a sense of what goes into the decision.  It still takes practice, but at least the rookie starts with a good idea of how to make a decision and there's little chance the choice will be made randomly.  That's how beginners can learn from the experience of others. 

But other ideas are far more subtle and are not only difficult to explain, but the reader or listener (seminar) may find certain ideas to be unrealistic – or at least against what is perceived to be 'common knowledge.'  These concepts require discussion so the rookie can consider the rationale offered by the author, and then make a reasonable decision as to its viability.  These concepts are absent from most educational offerings.  Costly seminars prefer to get clients attention with ideas on 'how to make money' and ignore concepts such as risk management.


A Subtle Concept

Here's the bottom line:  Although selecting one or two options strategies is important because you must feel comfortable trading and have confidence that your strategy can produce profits, your long-term results are going to rely more upon your ability to manage risk than upon which strategy you use.

Opinions such as these are not
typically offered by option educators.  Many traders don’t
recognize the importance of risk management until it's too late.  By the time they understand that preventing losses is the name of the game, their trading account has been wiped out.

Options
were designed to reduce risk.  It's unfortunate that far too many rookies begin
using options as tools for speculating in the stock market.  And it's not only beginners.  There's something appealing about using options as a mini-lottery ticket that escapes me.  The odds of success are against the investor, but an occasional win keeps them playing.  Just like the lure of a slot machine.  Lose a lot, win some back and continue, until broke.  Option trading should not be done that way.


Options
have specific risks that can be measured.
 
Think about that.  When you buy
stock, your risk is simply that the stock can move lower, resulting is a monetary
loss.  But when you own a position that
consists of options instead of shares, the risks can be identified, quantified, and eliminated.
  That's the subtle beauty of trading with options.  When you adopt a specific strategy and make some trades to implement that strategy, what you have really done is make an investment whose risks can be managed.  When you own stocks the only way to manage risk is to sell some shares.

By understanding the risks,
you have the ability to keep them under control.
It
may feel ‘more risky’ to have a position with specified risk factors – but the
truth is that those factors can be reduced by taking appropriate
actions – and that makes option trading superior.  

Which risk factors of an option position am I talking about:  Time decay (theta), exposure to a change in the market volatility (vega), being too long or too short (delta, or share equivalence).  If you are familiar with ‘the
Greeks
’ then these risk factors are already known to you.

Most traders consider choosing a
specific option strategy as the key to their profitability.  They speak of iron condors or selling naked puts as if those words could manufacture money all by themselves.  Only the more experienced trader understands that preventing losses and managing risk is more important.  Most reasonable strategies can produce good results – but market conditions must be appropriate.  No one is going to suggest that selling naked puts works in a strong bear market, but if managed well, it can be a winning strategy for investors who like the idea of accumulating stocks.  I don't use it myself any longer, but at one time it represented a good portion of my investments.

Traders argue the merits of their favorite strategy.  Strategy
selection is important because it allows you to trade options successfully.  You
understand how the strategy is supposed to work.  You know what has to happen for your position
to make or lose money.  When you adopt
limited risk/limited reward methods (as I recommend) and are satisfied with the potential
profits and you know the potential risk, you are in control.  But, the choice of strategy is less important
than your ability to manage risk.  If you lose too much at one time, it's going to hurt your long range results.  Be careful and don't allow losses to overwhelm profits.

Your job, as risk manager for your portfolio, is to prevent those
maximum losses from occurring.


Bottom
line: Choose a trading strategy that makes you comfortable, but manage risk carefully.  Choose the ‘best’
strategy is not your objective.  The strategy does not make
money.  The strategy is merely your
method of playing the game.  The strategy
tells you which options to buy and sell, but risk management tells you how many
to buy and sell, when to buy and sell them, when to take your profits and exit
the trade, and most importantly, how and when to manage risk to be certain you don’t incur large losses.

to be continued

360

2 Responses to Philosophy of Options Trading. Part III. The Importance of Strategy Selection

  1. TR 06/20/2009 at 10:03 AM #

    Hi Mark
    I just wanted to thank you for consistently and repeatedly talking about the importance of risk management.
    A few days ago I made my first proactive risk management step. I had a total of 12 open contracts of Aug IC’s (various strikes as I was purchasing 2 lots about every week) and I decided to limit my risk by buying one July Call and one July Put option that was just inside my closest short strikes. This move cost me $390 (or 25% of my anticipated profits), but the effect it had on my risk curve was wonderful. I actually FELT GOOD about REDUCING my target profits by 25%, because my risk was reduced.
    Anyway, it may end up being unnecessary insurance, but I am fairly confident I made a good decision for my comfort zone. Thanks again for your consistent reminders on this – you are getting through to me.
    Let me know if you have any comments or suggestions.
    Rdgs
    TR

  2. Mark Wolfinger 06/20/2009 at 11:31 AM #

    Insurance is unnecessary most of the time. But when you need it, you NEED it.
    Risk management is near and dear to me. Although the need for it was mentioned to me many time when I first got inot this business (1977), I just thought it did not apply to me.
    And even after I lost it all the first time, no lessons were learned and I lost it all again. But fortunately I got it before it was too late – and that’s why I impart so much importance to the fact that the number one rule is: Don’t go broke.
    Thus is a lesson easiest to learn from a bad experience, but I prefer to help others avoid that experience.