Option Investor
Trader's Corner


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Last week I read a letter to an editor in a well-known trading publication. That letter gave me the shivers. In that letter, a reader indicated his intention to begin trading options the next month. He wanted recommendations for options-trading software, analysis and alerts.

It's not that easy. Perhaps this trader indicated an intended time frame for beginning to trade options because he's been spending a number of months paper trading options or back-testing strategies through the programs offered by several trading platforms. He feels that his period of study will be completed in about a month. On OptionInvestor's Futures Monitor, Jane Fox often updates readers on the results of the back-tests she runs on her trading parameters. She uses those back-tests to hone her entry and exit parameters and check for the times when those trades are most and least profitable. Recently, she noted that the changes over a period of time in the profitability of trades taken during a certain time period on a certain instrument. She works hard, and her effort shows. She's put in the time and effort needed to decide whether her system works for her. Maybe the magazine's reader has done the same thing.

Anyone thinking about trading options needs to put in time studying and testing skills first, but back-testing isn't the only method available or needed. An online search including some combination of the words "options," "simulated trading" and "demo trading" will call up many companies offering free 30-day trials to those wanting to try their skills at trading options. If considering a trial of a simulated or demo trading site, finding one that offers real-time simulations will help recreate the drama of trying to make a decision about entries and exits when markets are moving. New traders need that drama because they need to know how they'll react to it.

Paper-trading options in real-time can also offer some insights into how options decay. They provide an assessment of how much movement in the underlying is required in what time frame in order to profit.

It's still not that easy. That's not all it takes. With time and experience comes the knowledge that a trader buying an option on the OEX can probably split the bid/ask spread about 30/70, with the trader paying 70 percent on entry and getting 30 percent on exit, but that traders are probably just going to have to pony up all or most of the bid/ask spread if they're buying an option on the XAU. Even then, it may take a while before someone gets around to noticing that you've put in an order for an options trade on the XAU. Not knowing the differences in the way certain instruments trade can result in the unhappy circumstance of having gotten into an options play with your great entry when markets were quiet, and then either chasing options prices lower or putting in a market order and hoping for the best when an economic release sends the price of your options crashing.

Even if you decide to stick with liquid, heavily traded instruments such as the OEX's, it's still not that easy. As much as any back-testing method or simulated trading platform attempts to recreate the real-deal trade, it cannot recreate the heart-thumping reaction when a position goes against you and goes against you quickly. Competitive traders can recreate some of that tension because they can't stand to lose even on a simulated trading system--that would include this writer--but that's still not the real deal when it comes to handling emotions while trading. If back-testing, trading a demo platform or paper-trading, no harm is done when, moments before the FOMC announces its latest rate-hike decision, a child screams after busting a lip, a boss steps to your door with a new project or a dog that just got a bee sting on the nose goes tearing through the house. Those kinds of things can and do happen in real-life trading, and traders must be able to handle them and still maintain their trading accounts.

So what's the point? Should newbies just give up the idea of trading options at all? Should they hand over their trading decisions to professionals? In a back-handed way, all these paragraphs seem to argue in favor of new traders placing money in the hands of those who sell that software, not argue against that policy.

It's still not that easy. If any software or alert could provide all the help traders needed to be profitable, all the traders in the world would have gravitated to that same source. Some traders are Type A enough that they don't want to trade anyone else's system--that again would include this writer--but guaranteed profits would attract most of them, too. If a system or software solution could do it, we traders could all just program our trades, and then either mountain bike, kayak or do lunch, whatever the preference.

Even a profitable alert system or source doesn't work for all. Traders need to know enough to evaluate those alerts or software and their appropriateness for trading styles. Some systems might prove appropriate only for those traders with large enough accounts to allow them significant margin. This would include some positions established with credit spreads, for example. Some might prove appropriate only for aggressive traders; some only for conservative. Traders whose personalities best fit short, aggressive trades may find that they lose money on strategies intended to play out over weeks. Many a trader has traded a straddle or strangle into an unprofitable play when it might have been profitable when left alone. Boredom sometimes leads the aggressive trader to take any play offered, even if the writer or service offering the trade notifies subscribers that the play is high risk and without a strong risk/reward parameter.

The converse can happen, too. Fear can lead conservative traders to take profit too soon if they've latched onto a play on a momentum stock. A scared trader taking profits too soon can fail to build enough cushion to make up for the inevitable losing plays.

Trading options can be profitable. Some options tactics provide traders with enough leverage to trade with relatively small accounts. They allow directional traders to enter both bearish and bullish plays. Through various combinations, they can protect profits on long or short stock positions or benefit the trader who believes that prices will stay in a predetermined range.

Trading options can also deplete a trading account. They're wasting instruments. Traders can be right on direction and right on the eventual target but just a little wrong on the timing--as little as a few hours wrong, if we're talking about the difference between the close on an option expiration day and the open the next trading day--and the profitable play turns into a losing one. OptionInvestor's Jim Brown has always advocated the "teach a person to fish" philosophy, and that philosophy proves important whether traders are going to trade their own signals, another trader's or a software system's alerts.

So, how does one learn to fish? Reading, studying, back-testing, trading a simulated account or paper trading, and then going one step further. That simulated or paper trading should include at least one and maybe more option expiration weeks, at least one FOMC meeting or other market-turning economic or earnings release. Then and only then, it might be time to fund an account with a small amount of money that one EXPECTS to lose. Trading a small account will almost guarantee that there won't be enough funds to weather the inevitable draw-downs that occur when several plays in a row go wrong, as absolutely will happen, but it also limits how much money newbies can lose. It avoids trading through the children's college fund.

Trading a small account promotes familiarity with the mechanics of placing a trade and protecting it with stops or setting profit limits. Many a trade has gone sour when a new trader is too clumsy placing orders to exit when the profit target is hit and prices reverse. Perhaps while trading that small account, new traders will find that a particular broker's setup doesn't work for them.

While trading that small account, newbies should keep a trading journal that notes all the particulars of each trade, including the emotional ones. Examining emotions at the time of entries and exits are necessary to those who want to discover their trading styles. Those notations will reveal whether traders prefer to ring a trade with stops and walk away, not watching the moment-by-moment action, or if traders need to see every zig and zag of the trade if it unfolds.

Only when newbies know what kinds of options trades are workable, which fit their trading styles, and the mechanics of placing the trades and stops should they consider trading someone else's alerts or relying on software. I hope that's work that the letter writer did before asking for those recommendations, but I still get the shivers when I think perhaps it's not.

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