This is a reprint of an article I wrote last fall and has been in the top five most requested since then. Since we have so many new readers recently we are reprinting the Options 101 series I did from reader requests. The stocks and charts used in the examples are from December when this article was first written but for example purposes they are still very valid. Take the points discussed in this article and apply them to the picks from this weekend and see if your results improve.
By Jim Brown
Hi Jim, You wrote: "I estimate that a trader who will follow instructions EXACTLY can net $50,000 on a $10,000 account every year without fail. Notice I said follows instructions EXACTLY. "
If you give me your exact instructions I would follow them. I seem to be floundering in the wind with the worst picks, worst entries, and worst exits. I actually do worse now that I think I know something. So what are those Exact instructions?
(sentiments sent by dozens of different readers after an article I wrote last fall)
Now before you read this article, remember I said EXACTLY.
If you have decided that buying options has profit possibilities but you just do not seem to be able to get the right combination of techniques to work in your favor then maybe it is time for the teacher to appear. Many readers find us, take the trial and then just start blindly buying options just like they would stock. This is not the same as stock investing. It is not even close. This is also why the returns are so much greater. Readers that blindly buy call options on faith after reading two or three newsletters have about as much chance of success as a novice bettor walking up to a craps table in Vegas and putting $2,000 down on the pass line. Actually your odds would be better on the craps table.
An educated options trader however should profit from 70% of their trades. It is all a question of timing. Like a surfer facing endless waves or a batter in batting practice, eventually you will get that perfect setup. You may swing at a few extra pitches that were not perfect out of boredom but if you wait long enough that perfect pitch will arrive. A surfer on a calm day may sit on his surfboard for long periods of time waiting on the best wave. The memory of the time and effort he spent just getting to his launch point hundreds of yards off the coast will force him to wait for the right one.
So our task is to prepare ourselves to execute and execute only when the time is right. I know I lost half of the readers with that last sentence. The type "A" personalities would rather throw money at dozens of plays, hoping that the winners made up for the losers, instead of only playing the winners. In reality they need to make more money, more often in order to make up for those losers. This is failure at a fast pace.
It never ceases to amaze me how so many people can read the same play recommendation and get a different answer. People emailed me asking for "exact instructions" because they were losing on almost every play and others are emailing us with success stories on the same plays. If you have not read the Traders Corner articles by Janar you should stop and do that right now. I don't know if it is his marine training or something else but when he reads the newsletter he "reads" the newsletter. He follows the instructions exactly on each play and he is constantly profitable. In his case the key is discipline. He waits for the entry points, EXACTLY. He sells for a profit. He cuts his losses quickly. He is not in the market every day. The data you need to have successful investments is in the newsletter. It is up to me to show you how to use it.
These are the points you need to focus on in order to succeed. I will cover each in detail.
The type of stock YOU decide to play is crucial to your success. A fact we have discovered since we started publishing the newsletter is people with small accounts take the biggest risks. Investors with large accounts tend to be less aggressive and manage risk better. I think the people with only $5,000 are so driven to double or triple their capital that they will play only the high risk - high reward plays. The large account holders are content with 20%-30% per month safely because they don't need the money to make their mortgage payments or Porsche lease. This proves the old axiom "the rich get richer and the poor get poorer" again but on a different scale.
Since the number of emails I received appeared to be from traders that were not having much success I am going to slant this article to traders with less than $10,000 to invest. If you use more than that to trade options this will still give you a basic understanding of the right way to trade.
When selecting a stock/option trade you need to take into account the difference between the bid and ask (spread) on the options. If you can only afford to lose $500 on a trade then a stock like QCOM with a spread of $2.00 is not where you want to be. Yes, options on QCOM can be profitable due to the trading range but the spread is tough to overcome when the trade goes against you. If there is a $2 spread when the stock is moving up, then there is likely a $5 hit when the stock turns sharply down.
I know you have seen it. Take this example:
QCOM $384 DEC-390 call AAF-LX Bid=$16.13 x Ask=$18.13
You buy the call and imediately you are down -$2.00 from the spread alone. If the stock turns down and you know QCOM can drop $5 in mere seconds, the ask may drop to $16 and the Bid to $14 before you can even see it and react. If you have several contracts you can be down -$2,000 in a heartbeat. Don't even take into account stop losses on this stock until you are profitable. The intraday option price swings can be $10 and will knock you out for a loss and then rebound in seconds. This is a stock not to play with a $10,000 account. Does this mean you can't score the big gains? Of course not.
Using the example above only 2 contracts would cost you $3,600 or 1/3 of your trading capital. Using the same capital in a lower risk stock will let you sleep better and you can still make the same returns.
VOD $49 - Jan-50 Call VOD-AJ Bid=$3.25 Ask=$3.38
You can buy longer calls (Jan) and get 10 contracts for less money. ($3,250) Now a $2.00 move in VOD x 10 will net you the same as a $10 move in QCOM x 2 contracts. Now what is the difference in risk? The spread is only $.13 -NOT- $2.00. You can set a stop at -$.50 below the ask and not get thrown out on intraday swings. If you do get stopped out you only lose $500 not 1/3 of your investment. If you buy farther out, April, July, etc, it will cost you more money and lower your margins but you have the implied safety of time working for you. Personally I feel more than two months out is a waste of money because you should never hold an option for two months under any circumstances. If it is flat you should sell it and enter another play. If it goes up over 200% you should sell it and use half of the money to enter a higher strike. You have no risk at the higher strike because you already took your initial investment off the table. If you keep the first position your entire investment is still at risk. Invest smart not greedy.
When VOD was $53 a couple weeks ago the VODAJ option was $6.25. Remember, we are going to buy it at $3.38 while VOD is at $49.00. When it hits $53 again next week the option will again be $6.00. That is a 75% return on your investment in two weeks or less and it is very safe. Why would you want to be reckless?
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. Minimize spreads, maximize contracts to get the same returns safely.
When a duck hunter has a flock of ducks fly overhead he does not just jump up and start firing at the whole flock. He must single out one bird, identify it as to type, lead it according to range and speed and then fire.
The same is true with the 3,000 optionable stocks. You must narrow your universe to a manageable number. Normally ten stocks is all a normal person can follow without missing the moves. The more you follow, the more you miss. The fewer you follow the more you get to know the individual characteristics of each stock. There are people who make a good living only trading AOL. Many others only trade Dell. They may only be in a trade one or two weeks out of the month but when they are in a trade they know exactly what to expect and when to get out.
Pick five stocks you want to trade from the current newsletter plays. Watch them carefully for a week. Chart their support and resistance. See how close you can come to timing their next pull back. Practice, practice, practice.
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. Narrow your targets to only 5-7 choices and study them closely.
If does not make any difference how much money you have to invest. We have found that the more positions you try to manage the smaller your overall returns. To maximize your returns on a $10,000 account you should never play more than three positions at any time. Two positions at $3,500 each is optimal for a $10,000 account. This does not put all your capital at risk. It gives you "breathing room" and lets you sleep at night. Only having two positions will not impact your returns over a years time. If you trade according to the plan you should be out of every position every two to three weeks or less. With two positions every two weeks you have 52 trades per year. If 25% are stopped out for a 25% loss and the other 75% avg a 40% gain using $3,500 as an average position you will have a $43,225 gain at year end.
52 * 25% = 13 losers @ 25% = -$ 875 x 13 = -$11,375
Net profit = $43,225 + $10,000 capital = $50,000
Yes, this is just an example. Yes, the ratio of losers/winners may vary BUT not by much if you follow the plan. Yes, there may be some plays that are flat but there will also be some plays that will rocket for more than the 40%. What if you owned RMBS last Friday? Yes, this is only calculated on 2 open plays of $3500 each at any one time for one year. Yes, you could increase your position size (and risk) or the number of open plays (and amount of risk). Increasing the size of your positions is acceptable within limits. Increasing the number of open positions over three is not acceptable. The more you have at risk, the more likely you will lose it.
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. No more than three positions and preferably only two.
A good entry point is 90% of the trade. Failing to wait for a good entry point causes 90% of the losses. If you did not read my Entry Point article four weeks ago please GO BACK AND READ IT before going forward.
You can pick the best stocks at the wrong time and still lose money.
Repeat after me - Every stock will correct. Nothing goes up in a straight line. I can wait, I can wait, I can wait. You need to remind yourself of this every trading day. The penalty for not waiting is loss of money. If you rush into a position you will have to rush out as well. If you wait for the proper entry point then everything else is easy.
This chart of Nokia shows two great entry points in the last ten days. I you bought on five of the last ten trading days you would have been profitable. If you bought on the other five days you could have been stopped out when the stock corrected.
BEAS gave us a great entry point when it pulled back to support at $80 on Tuesday. The previous entry point on the 12th-16th would also have provided a good profit.
EVERY CHART YOU LOOK AT WILL SHOW YOU PAST POINTS OF ENTRY IT IS YOUR RESPONSIBILITY TO PICK THE NEXT ONE BASED ON THE 3-5-7 DAY RULES. That means every stock cycles every 3-7 days and all you have to do is WAIT for the next cycle.
Do you remember the cartoon with the two vultures sitting high up in a tree and the caption was "To hell with patience, I am going to kill something"? In the markets "If you don't have patience, you will get killed".
If you can't stand to wait then expand your possibles list and look at more stocks. In any ten stocks there should be at least one at an entry point every day.
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. You MUST wait for an entry point before making a play.
I am not going into this very deep since I covered it just recently. The most important thing to remember is to set a loss limit before you enter a trade. The thought process should be something like, "If I buy this for $3.50 then my stop will be $2.50 for a -$500 loss" I can live with that. Once you make the buy then place your stop. Don't change it downward!
Once the play starts moving upward then you can move your stop loss up higher each day as well. When the play finally corrects you will be stopped out for a profit. This is called a trailing stop. If you are using plays like the VOD mentioned above then a -25% stop loss is more than adequate. That is -$850 on a $3380 position. It would take a major event to drop the price that far in one day. On a play like QCOM it can drop that far on one large order.
The most important thing about stop losses is to have one and stick to it. Money management is the only thing between you and a broken account. If you can't force yourself to sell a losing position then you do not need to be trading options. Get a high performing, high tech mutual fund and let them make the decisions for you.
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. You must use stop losses to save capital in case of a bad entry or serious news event.
Be realistic in your expectations about the play. Every play is not going to double in the next two weeks. It may never double. Expectations start with the stock. Using the VOD example and the chart below a reasonable expectation would be for VOD to trade in the $52-53 range in the next week or so. It may have trouble breaking out of that range but a close over $53 could signal a move to a new and higher range. I would not go into the play expecting $60.
My expectation would be to plan on closing the play on any weakness around $53. If it ran up to $53 and then started dropping again I would close and wait for another entry. There is a nice pattern of higher lows shaping up. $42 was the low in Oct, $43 in early Nov, $46 in late Nov. The next pull back could bring it back to $48. I would look to re-enter the play with a bounce off $52-53 around $48-49. The pattern on VOD should be to take a $2-3 profit in the option price and wait for another entry point. If you go into a play with unrealistic expectations you will lose. You will always be waiting for that big bounce that never comes. (read the turkey hunter article at the bottom) If your expectation is to just make $2-3 profit in each play then you will be more successful than the person that is expecting a homerun on every play.
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. You must lower your expectations to something realistic and plan your trades accordingly.
SELLING FOR A PROFIT:
This is one of the most difficult things to do in beginning option trading. The greed factor is running full speed and coupled with the hype factor it is almost a guaranteed failure. Traders do not make 100%-200%-300% profits in option trades on purpose. It does happen but it is an accident. In every major stock move somebody bought at the previous low and then sold at the exact high. This lucky person should buy a lottery ticket. Unless they had insider knowledge AND were psychic to know exactly where the top was going to be then they were just lucky. The other 98% of us have to be content with grabbing a profit out of the middle and then setting up for the next play. More likely than not the trader with the windfall 400% win will put it all back in trying to pick bottoms and tops of the next ten stocks they play. It is like the new slot machine gambler who walks in to the casino and gets $20 in coins. They walk up to a bank of machines and "invest" a few. Suddenly the bells start ringing and they have thousands of coins falling into their tray. Did they have inside knowledge? No. Did they have a special technique? No. Could they do it again if they played every day for a month? No. They were lucky but the casino will get tens of thousands of dollars of advertising for the couple thousand the player won. The promise of big winners lures thousands to the casino ready to reap the same rewards as player X. Did the casino really lose the money? No. Did you know that 94% of the people who win jackpots put the money right back into the machines and go home with less money than they came with? This is the same with huge gains in options.
Once a new trader scores a double or triple they are ruined as traders. Their sights are now set on the stars and they will swing for the fences with every play, no longer content with the already huge 25%-40% monthly returns that normal traders take home routinely.
Fighting the greed factor is hard work. After you have been burned over and over with large gains evaporating before your eyes, you will start to view selling for a profit in a different light. Once you understand the idea of cash flow and compounding you will see that 25% gains every two weeks really does add up to big numbers over a years time.
25% every two weeks is 650% per year with out compounding. That means if you only invested $3500 in every play and only made one play every two weeks and all were successful (this is just an example) you would have almost $25000 in 12 months.
You need to learn to treat option trading like a weekly paycheck and not like a lottery ticket. After all, how many readers do you think won the lottery last week? But almost all of them got a paycheck from somebody!
Recap: To get a 400% return on your investment in one year you need to invest WISELY not recklessly. You must sell for a profit before the profit becomes a loss.
This may seem very basic for many readers but there are many people who still think this is a get rich quick scheme. It is a get rich scheme but just not as quick as most would hope. If it was as easy as some claim then there would be no profit in it. With every investment there are not equal parts of risk and reward. If that was the case then you would be better off throwing darts at the Wall Street Journal options page to decide your next play. Option trading is very profitable to those who will listen, learn and then put into practice what they learned. Option trading is very expensive for traders who think they know it all and don't bother to learn the rules. Which path you take is entirely up to you and nobody but you will ever know. Do you want to trade or do you want to be successful? There is a difference.
The Turkey Story
"I learned that men (or women) win or lose not so much because of economic conditions as because of human psychology".
It dawned on me that my behavior was almost exactly the same as that of an old man I knew in boyhood. He had a turkey trap, a crude contrivance consisting of a big box with the door hinged at the top. This door was kept open by a prop to which was tied a piece of twine leading back a hundred feet or more to the operator; a thin trail of corn scattered along a path lured turkeys to the box. Once inside, they found an even more plentiful supply of corn. When enough turkeys had wandered inside the box, my friend would jerk away the prop and let the door fall shut. Having once shut the door, he couldn't open it again without going up to the box, and this would scare away any turkeys lurking outside.
The time to pull away the prop was when as many turkeys were inside as one could reasonably expect. I remember going out with the old man one day and seeing a dozen turkeys in his box. Then one sauntered out, leaving eleven. 'Gosh, I wish I had pulled the string when all twelve were there,' said the old man. 'I'll wait a minute and maybe the other one will go back.' "But while he waited for the twelfth turkey to return, two more walked out on him. 'I should have been satisfied with eleven,' the trapper said. 'Just as soon as I get one more back, I'll pull the string.' "But three more walked out. Still the man waited. Having once had twelve turkeys, he disliked going home with less than eight. He couldn't give up the idea that some of the original number would return. When finally only one turkey was left in the trap, he said: 'I'll wait until he walks out or another goes in, and then I'll quit.' "The solitary turkey went to join the others, and the man returned empty-handed."
Know anyone like this? This market is high. The purpose of trading is to make money, not get all the turkeys or the highest price. Kelly wrote his book in 1930. Most of it could have been written yesterday. Are we turkey hunters or turkeys?