Q and A. Good Questions From a Beginner

Hi Mark,

I have been told that you should close a position if you have more than 6 or 7 % loss. In my opinion, this percentage is very easy to be written off even in an normal, volatile market, so I would prefer at least a 12-15% loss What is your opinion?

2) Do you agree that you should take your profit quickly? So what do you think should be the minimum profit % for trading option?  Is 20-30% too low, should 50-80% reasonable or over 100% be ideal in option trading ? 

3) I am a beginner and just learned some basic strategies on trading options, mainly buying Calls and Puts. I live in Hong Kong so it is unlikely that I am going to buy any covered call or put or buy the actual stock because it involve quite a considerable amount of funds in US dollars. So I intend to profit by selling the up and down of the call and put premium. Is my strategy too risky? What advice you could give me?

Alex

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Hello Alex,

1) My opinion is that you should NOT allow anyone to tell you what to do.  As you read and learn and collect the opinions of different people, you can decide for yourself which of those opinions make the most sense. What I prefer to do with this blog is to describe how I handle certain situations, but I always explain that these suggestions suit my trading style and that readers should consider my choices and decide if they are appropriate for themselves.

2) When trading options, a 6-7% loss can occur quickly.  When you trade individual options (as I note you plan to do) instead of spreads, then not only a change in the price of the stock, but also a change in the option implied volatility, can easily move the options 10%.

When trading stocks, setting a 6-7% (or some other number) make sense because if the stock moves against you, there's a very good chance that the reason you bought the stock in the first place has changed.  When that's true, it's a good idea to reconsider the trade and perhaps exit.

But, options are different.  I believe you should exit when you realize you were wrong.  When the stock is not moving as anticipated.  When the stock is moving too slowly. etc.  Yes, you should not hold an option until it expires worthless, and it's often difficult to determine an exit point - but I don't think it's good practice to exit an option trade when the loss reaches x%.  Exception:  If you find you can never let go; if you find you are losing 100% too often, then you will need some artificial loss point to protect yourself.

2) Take profit quickly?  If you want to take profits, then do so when you no longer believe the underlying stock is going to continue to perform as you predict.  It's also a reasonable idea to compromise by scale selling, as the price moves higher (sell one or two at a time).

But, in general, my answer is no.  Do not take profits quickly.  More on this below.

3) Here is what I truly believe about buying puts and/or calls.  When you buy options you must be VERY correct:  correct in which direction the stock is going to move; correct on the timing of the move because options have a limited lifetime and they lose money as time passes; correct when deciding how much to pay for your options. That's a great deal of being correct and I don't understand why investors believe they can make money consistently when adopting this strategy.  Yet, make no mistake about it – it's the strategy of choice – at least among option rookies.

Too often a novice option trader buys calls, sees the stock rise, but is bewildered when the calls he/she owns fail to move higher.

My bottom line is that buying options is not a strategy for beginners.  I'll say right now that many people disagree with that idea.  When you buy options, losses are limited – and that's a very good thing.  But, all too often, those novice traders lose 100% of their investment.  it may be a limited loss, but when it happens over and over again, it becomes a very large loss.

So – I ask you this:  Forgetting options for a minute – do you have a proven track record?  Are you satisfied you can tell when a stock is moving higher and or lower?  Have you been able to make money – real or in a paper trading account – by knowing when a stock is going to make its move?

If you lack that record – why do you want to buy options?  I understand that a small investment can occasionally turn into a very large winner when you buy options [by the way, if you take profits quickly and eliminate this possibility, how are you ever going to make any money with options?] and that can offset several losses.  But when buying options, you must anticipate losing money on most of the trades.

4) I do not want to discourage you from learning how to use options, but I'd like to suggest that you hedge your trades by using spreads.  Yes, profits are limited.  But losses are also reduced.  You can buy call spreads when bullish, but if you want a higher probability of success, you can also sell put spreads when bullish – using options that are out of the money.  That gives you the chance to earn a profit from a bullish stance, even when the market declines.

Don't use spreads if it makes you uncomfortable.  Don't use spreads if you don't understand how they work – the comments above are merely descriptive and don't tell you all you want to know before getting started).  Learn first, trade later.

If you prefer to learn from books, I recommend my recent work: The Rookie's Guide to Options.  But you can also find information on how to use call and/or put spreads at the Options Industry Council or the CBOE.

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2 Responses to Q and A. Good Questions From a Beginner

  1. Bill Luby 04/16/2009 at 6:49 PM #

    I must say, Mark, that your thoughtful reader Q&A posts may be the most helpful explanations for rookie traders on the web.
    Someone could certainly learn a lot by curling up with your blog for a few hours. Speaking of which, I finally got around to ordering your book and am looking forward to reading it when it arrives.
    Finally, a blanket thanks for the body of work you have put out in the public domain here.
    Cheers,
    -Bill

  2. Mark Wolfinger 04/16/2009 at 8:06 PM #

    Bill,
    That’s quite a compliment coming from you.
    Thanks. Much appreciated.