Option Investor

Covered-Calls 101

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Achieving Long-Term Success

With the major equity averages trading near historic highs, it's a great time to discuss the traits and abilities that make traders successful in the long run.

To be a profitable in the options market, it is important to review proven methods and techniques on a regular basis. There are always new interpretations or processes to be integrated into your current system but maintaining a structured approach to trading is the best way to achieve consistent returns. It is also paramount to have a precise set of rules to govern your actions when positions don't perform as expected. These guidelines must be simple enough to recall and implement while monitoring a complex portfolio during volatile conditions. As well, the rules should apply across a wide range of situations and be designed to compensate for one's weaknesses and inadequacies. To be effective over the long haul, they must be formulated to help you maintain discipline on a general basis and also offer a timely memory aid for difficult situations. Before you make the next trade, consider these well-known maxims:

1. Learn to control losses and your profits will grow.

The science of successful trading is less dependent on making profits, but rather on avoiding losses. The need to restrict draw-downs and prevent losing plays from significantly eroding capital should be a dominant theme in any type of trading. To reduce losses, most traders prefer to use a specific plan with pre-determined exits. Stop-loss orders can be used to remove urgent decision-making from the equation and "trailing" stops can be utilized to follow a position into greater profits while protecting for unexpected reversals. In addition, not only must individual losses be limited, but all positions must be reviewed regularly to ensure that the total portfolio risk is kept to a practical minimum.

2. Know your limits before you open any position!

Just as setting stops on each individual trade is an absolute must, a "maximum allowable loss" must be considered when managing portfolio positions. The rule is simple: Never trade with more money than you can reasonably afford to lose and always maintain adequate cash reserves. When assessing position size and cash or collateral requirements, ensure that funds for active trades are not co-mingled with capital for other functions. It is also very important to set a "loss limit" at the beginning of each month or option expiration period. When this level is reached, trading should be halted for the duration of that period. Of course, if your losses are consistently higher than your gains, stop trading! Step back and take a few days off. When you are ready to try again, evaluate your current trading strategies and review the most recent plays (to learn from your mistakes), then move on. When you begin to make money, put some of the profits in a small reserve account, just in case there are unexpected developments in the future.

3. Know your strategy, its advantages and weaknesses and only use techniques that fit your trading style and portfolio outlook.

You can't make good decisions without knowing the mechanics of a specific technique and the best traders are those who are acutely aware of the shortcomings of their particular approach. Focus on positions whose trading characteristics match your ability and risk-reward attitude. Don't use complex or advanced methods simply because they are intriguing. In addition, if the strategy is not appropriate for your financial condition, it should be avoided, regardless of how attractive it appears. Obviously every strategy has risk. The key is to develop an arsenal of profitable methods, use only those that fit the market outlook, and manage each play for maximum potential.

4. Learn the art of patience; timing is the key to success!

The opening trade is of particular importance. It deserves your best analysis and judgment and it is vital to assess all potential trades well in advance. In the case of stocks, the issue should be one you want to own and the price must be technically favorable with minimal downside risk. Correctly timing the initial purchase requires a thorough knowledge of charting techniques and market trends. The entire process is something a trader must completely understand because a successful exit is by and large the product of a proper entry. Those who are guilty of "over-trading" should assess their past results in this careless practice whenever they are tempted to participate in such activities.

5. Be diligent and after you develop a plan, stick with it!

Success will come when you create a favorable balance between hard work, sound judgment and patience. Too many traders give up after a few losing plays, long before they have time to learn and absorb the various methods required for profitable trading...

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