I have mentioned before the key to success is never put all your 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 Netflix (NFLX) calls, your financial outlook on trading is best described as a lottery ticket play. Sure, NFLX could gap up another $50 on Monday but gaps go both ways. A $20 call option on Friday can be $2 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 15% of your trading capital in any one stock or 25% in any one sector. Safety is not defined as having 50% of your capital in four different crowd favorites like Alibaba (BABA), GoPro (GPRO), Google (GOOGL) and Tesla (TSLA). I would define that as suicide.

If you spread your risk you increase your chances of reasonable returns over time. Sure Merck (MRK) or Delta (DAL) are probably not going to rise $50 in one week like NFLX but they are not going to drop $50 either. I can hear you now. "But, I made 200% last week!!" Yes but double 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? Zero! 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 (HD) may not be as sexy as Netflix but it can 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. 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 losers list.

Compare the option prices on Netflix to those on Home Depot. It is much easier to blow a hole in your trading account by playing the high risk stocks than investing in stocks that are less volatile. The smaller option prices allow you to diversify your portfolio more. Granted, you are not going to see a $50 move in Home Depot but you will be able to sleep at night.



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 do not 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. If you avoid telling your spouse how much you lost last month it is time for a serious change in goals.

One change in strategy I would suggest is "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 (May) 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 still 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 $5-6 for two to three more months and buy 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 mindset to longer term options let me throw 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 June options. But if you get caught with a gap down on a June 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!

Jim Brown

Send Jim an email