Option Investor
Educational Article

Diversification, the key to success!

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By Jim Brown

As I have mentioned before 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 SDLI calls, your financial outlook on trading is best described as a lottery ticket play. Sure, SDLI 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 SDLI 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 seldom 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. 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 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 (July) try going out a little farther. August, September or even January. 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.

Try paper trading longer term options and compare the results with shorter term options on the same stock. There are differences and you need to decide which is best for you. Option trading does not have to resemble gambling. Option investors sleep more soundly than option traders. Because of the stigma attached to options there are just fewer investors than traders. Before you start firing off those emails about a change in my mindset to longer term options let me through in the caveat. I always recommend buying whatever time you need to make yourself comfortable. I just recommend not using it. You can "trade" January options just as frequently as July options. But if you get caught with a gap down on a July position it could be much more financially painful than the same position in a January option. You buy insurance with time but that insurance does not protect you from a falling stock or market. Both will cost you if you fail to sell when the technicals change.

Trade smart, buy time. Just don't use it!

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