When trading stocks, the idea is to buy stocks that are going to move higher, or as Will Rogers said: "Don't gamble. Take all your savings and buy some good stock. Hold it till it goes up, then sell it. If it don't go up, don't buy it."
The good news and the bad news about option trading is that it's much more involved than trading stocks.
Option prices don't always move as anticipated because many factors come into play when options are priced. As we recently discussed when talking about measuring risk using the Greeks, one factor that may drive the price of a call option higher (rising stock price) may be offset by other factors, such as the passage of time or a decrease in the option implied volatility. Understanding how options are priced, is essential to trading options successfully. It depends on more than whether the markets are heading higher or lower.
That's the reason risk management is so important when trading options. The idea behind this post is to help rookies understand that strategy selection is not all there is to trading options. It's easy to hear someone rave about the profits he/she earned by writing covered call or owning iron condors – but the truth is that such successes are often followed by significant losses, unless the investor/trader understands how to manage the trade.
Anyone can write a covered call and profit most of the time. Only the person who understands risk management can survive serious market declines. Anyone can own iron condor positions. In fact, it's a strategy that is touted far and wide on the Internet and there are many advisors who will be happy to sell you costly lessons on how to trade iron condors, and even more who will take your cash, and, for a measly 20% of the profits, will trade iron condors for you.
But the investor who understands how to manage risk can trade those positions without paying large sums to others for either trade execution or costly lessons. Managing risk – and by that I mean keeping all losses under control – is the single most important contributor to your long-term success as an option trader.
It's okay to take small losses – in fact, it's inevitable. But eliminating large losses means you will never go broke. When you trade spreads that have a high probability of being profitable, you will win most of the time. Couple those profits with small losses and you achieve success.