Diversification, the key to success!
As I mentioned in my play recap section last Thursday the key to success is never put all you eggs in one basket. If disaster strikes the resulting omelet will not be very tasty.
If your risk capital is only $10,000 and you spend it all on Amazon calls, your financial outlook on trading is best described as a lottery ticket play. Sure, Amazon could gap up Monday another $20 but gaps go both ways. A $10 call option on Friday can be $1 by the time options open for trading on Monday. You know this to be true. It happens every day to somebody. A critical downgrade to the stock or sector before the market opens and your dreams of riches became a nightmare of regret.
How do we dodge this minefield of market disasters waiting to happen?
The first and easiest method is to never invest more than 25% of your trading capital in any one stock or 50% in any one sector. Safety is not defined as having 25% of your capital in four different Internet stocks. I would define that as suicide.
If you spread your risk you increase your chances of reasonable returns over time. Sure Merck or Delta are probably not going to rise $50 in one week like Amazon but they are not going to drop $50 either. I can hear you now. "But, I made 200% last week!!" Yes but triple digit moves only occur in one direction more than once. If you had a triple digit loss how much would that be? After a -100% loss how much capital would you have left? -0- Several big moves upward can be wiped out by only one big move downward.
This is why we try to offer many recommendations across several sectors each week. Sure, Home Depot may not be as sexy as Yahoo but it will put your kids through college safely. Don't get me wrong. I strongly advise a portion of your "risk" capital to be used in high risk plays. Check out the recommendations this week and you will see we have more high risk plays than normal. The time to play "higher risk" stocks is when the market is in rally mode. When money is flowing fast and loose everything goes up. The more exciting the stock the faster the rise. Let the market stop to take a breath and consolidate and those same "exciting" stocks will be the leaders on the down board.
The second way to spread your risk is with longer term plays. I got several emails from astute readers last week asking how I could sleep with so much money riding on December calls with only three days left. First, I did not plan it that way. Second, Murphy's law is alive and well. I had planned to be in and out in a day or two a week earlier. The tech sell off caught me off guard and the rest is history. Murphy's law states that the worst will always happen when you are the most exposed and can least afford the loss. The key here is don't expose yourself to unnecessary risk. If you can't sleep at night because of some play at risk then you should reevaluate your trading strategy. If you snap at your spouse when they ask how your day went then it is time to change your tactics.
Alan Knuckman had a great article in the brokers corner last week about "buying time". While you can't buy an extra Saturday every week you can buy more sanity with every play. Instead of playing the current "front" month (January) try going out a little farther. February, March or even May. The delta is not as great as a front month but the "time premium" will increase rapidly with a strong multiple day move on options farther out. Remember this "longer term" play only insulates you from the intraday drops or an occasional bout of profit taking. It does not protect you from a falling stock or market. You still cannot "buy and forget" but need to monitor closely. Placing stop losses and sticking to them is the best defense against total loss. If you are prepared to spend $4.00 for a current month option then your immediate risk on a sharp move is probably $3.00 on any given day. Why not spend $5-8 for a month or two more time. The $3.00 risk is the same but the options react more slowly giving you more time to react.
Watch for our new "Weekly Education Section" starting January 3rd. We are going to go through the "Basics of Getting Started" over the first few weeks and then move into "Advanced Strategies." This series of articles will be a complete reference guide to trading options.
New on the site this week is the "Monthly Results" link. This Will summarize the results for the past month through each options expiration cycle. The current results are through the December expirations last Friday.
As I mentioned in my market wrap on Friday the outcome of the impeachment vote was almost a sure thing. As you know by now the House did vote to impeach on two of the four articles. This will start in motion a long drawn out battle which will eventually end in some sort of negotiated settlement. I doubt they will throw him out of office with such a short time left. The impact on the market remains to be seen. The light volume next week could be impacted by traders in denial that this would happen reacting to the actual event. I don't believe it will be material. Most investors realized the handwriting was on the wall last Thursday and Friday and the market was still in rally mode. I don't expect next week to be much different. The most likely outcome will be a lightly traded range bound market all week. The bias is still up and any dips after Monday should be considered buying opportunities for the Santa Claus rally after Christmas.
We will continue to publish the newsletter Sunday and Tuesday for the next two weeks but will not publish our regular Thursday update either week. We will continue to update the website with the daily market wrap and any special plays based on market events.