Tag Archives | trading rules

This Means You

This article recently appeared at (InvestorPlace).

Best Practices

One of the themes that appears repeatedly in trader blogs is a list of best practices. Such lists include trading rules, trader hints, necessary habits for becoming a successful trader, etc. Some lists are intended for beginners. The true benefit of understanding these ideas is to prevent the formation of bad or careless habits. Other lists are targeted to experienced traders and may contain useful ideas for tweaking the way they trade or handle specific situations.

These lists are generally helpful in that they provide good suggestions and much food for thought. One recent example is the ‘Top ten ways new traders lose money’ by John Forman. (The Essentials of Trading). As is the usual situation, each item on the list does not apply to every trader. However, this is an excellent list because it contains some information/advice that applies to YOU.

The Problem

I approve of such lists and the there’s nothing wrong with reading the suggestions of different traders, each of whom may have some idea that truly applies to you, the person reading the suggestions. That’s the good news.

The bad news for people who take the time to read these lists of mistakes is that the individual reader seldom believes that the list is appropriate for his/her circumstances. A common thought may be:

  • I know that
  • Of course. Big deal; that’s obvious
  • Who would make that mistake?
  • etc.

The truth is that too many trader wannabes discard valuable advice. Why does that happen? My belief is that the new trader doesn’t believe the ideas are relevant. They come from too many different places and sometimes the ideas conflict. It’s true that different traders found different paths to winning the game, and therefore have different advice to offer.

But that’s no reason to discard these ideas. Consider each of them and carefully decide its relevance for yourself. On the list above, #2 is: ‘Unreasonable expectations.’ That’s an important item, not to be discarded as obvious. The truth is that it is not obvious. New traders are far more confident of success than more experienced traders because they have not yet moved past the hype that made them interested in learning to trade in the first place.

Let’s face it, brokers want you to believe it’s easy. Come to them for great investment research, and that’s all it takes to make lots of money. Anyone who buys that idea is bound to expect the game to be easy.

Some of the hype-artist educators claim that their courses are designed to allow you to double your money every year, and if you don’t please come back and take their course again at no cost.

Some advisors want to trade your money, and for ‘only’ half of the profits (and none of the risk) they will turn your investment into a pile of cash.

No wonder that new traders have high expectations. That results in trading more size than is prudent, taking more risk than common sense dictates, and holding onto losing trades because they just know that the market will perform in a manner that gives the new trader his/her well-deserved profit. This is the path to ruin, and if those high expectations are not reduced immediately, chances of losing all your money are high.

More experienced traders fail to heed the messages. It’s far easier for them to believe they already know all they have to know to make money. While it may be true that they are earning profits every year, it’s also true that there are ways to improve their results – if they would just take the time to learn what can be accomplished – and then make the effort do learn how to make them happen.

The point of this post is to alert you to a simple fact: When you read a list of suggestions, don’t dismiss them as useless. There is something on that list that you can do to improve your performance as a trader. Of course, if you don’t want to do the work and don’t want to make the effort, that’s a personal decision.

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Establishing Trading Rules: How Much Experience is Needed?


Based on what I learned and thought about over the past few days due to my

  • I would now only buy calls/puts in the front month. The
    odds are more with us [MDW: Us? How did I get involved?]  because of gamma. Is this thinking correct?
  • The
    loss is limited to premium paid, but the upside is huge

  • I would
    never buy otherwise because theta is the enemy

  • I am not sure what I
    would buy though, ATM or 2 levels OTM.


Slightly off-topic: Based on looking at my trades, time decay is not
linear. The more the underlying is at a particular strike, the more the
time decay at that strike.

Is the time decay calculated per day or week
to week?

The time decay graphs given in most literature gloss
over the fact that those decay graphs are concerned with an option which stays
exactly ATM all the time. Why?  The real spot price gyrates?




I get it.  You are an eager student.  You want to trade options right now and make money today.  Every time you see a piece of evidence about a specific strategy, you believe you found the Holy Grail.  I can only tell you that you are making a huge mistake.

You are FAR TOO INEXPERIENCED to make these decisions.

This is learning time.  This is experiment time. 

You cannot make a few trades and reach a permanent-sounding decision such as: 'I would only buy front-month options.'  If you reached this decision, on what is the thought process based?  How many times have you traded 2nd or 3rd month options?  How did the results compare?  Did you make good money by correctly predicting direction, or did something else happen that made the trades profitable.

It is wrong to assume that a profitable trade means you are a genius. 

It is wrong to assume that a losing trade is the result of a mistake.

You must compare the trade with others and discover why the trade was profitable (or not).  The 'why' is how you learn.

NOW is your chance to trade a variety of ideas, analyze the results, keep detailed records, think about the results and make an attempt to get a feel for what works and where to establish risk limits you can handle.

1) No the odds are not with you because of gamma.  The odds are not with you, period.  You have much less time to be right in your prediction.  If it does not happen soon, time decay will eat away at the value of your options.

How can the odds ever be with you when you must predict the direction of the move, the timing of the move, the size of the move?  You must be a very skilled market timer with a PROVEN track record before you can have any expectation of making money when buying options.

I'd hate to see your enthusiasm disappear down a sink hole.  Didn't you try this 'buying options' strategy once before?

2) Yes the Reward to risk ratio is excellent.  But the probability of success is not.

3) I don't understand the 3rd point.  When you buy front-month options, theta is the big enemy.

4) This is your problem in a nutshell.  You want to buy. You think buying and owning positive gamma puts the odds of success on your side.  But you give no consideration to how far the stock must move.  You don't know which options to buy.

It doesn't work that way.  The whole strategy requires knowing which options to buy, or having a method for deciding.  It's not a random selection.  It you cannot estimate the size of the move you should not be buying options.

Buying out of the money options is very much a gamble.  Some players succeed. I have no idea where your talents lie, but if you are excellent (proven track record), you can win this game.  Otherwise, not a chance.  Especially when you buy OTM options.

Off topic:  Time decay is NOT linear.  ATM options have the most time premium and thus, the most rapid time decay.  Time decay of American style options is based on the amount of time remaining until the market closes for trading on expiration Friday. 

The decay can be determined for one week, one day, one second, or any other time period you care to mention.  However, the Greek theta measures the time decay for one day.  Theta tells you how much value the options loses overnight.

Most option analytical tools that measure something specific, such as theta, assume all else is constant.  It MUST be this way.  If you want to know about theta, then if anything is not constant, that item will also affect the option price, and you will NOT be able to tell what part of the option price change is due to theta.  Please tell me that you understand this is true.

One of my basic tenets is that it is very foolish to trade when you don't understand the rules.  Some rules (automatic exercise) can come as quite a surprise to the novice. Other properties of options (how quickly they decay as expiration nears; or the sale of options is not free money) may not be immediately obvious.  But it makes no sense to use tools  when you don't know how to use them.

What's your hurry?  You have the rest of your life to trade. 

Practice in a paper-trading account or trade small size in your real account.  But don't go jumping to conclusions based on one or two trades.


July 2010 Expiring Monthly.  Table of Contents:


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