When looking through the archives for an old article I'd written, I discovered that the site has archived articles going all the way back to 1998. An early article was titled "Top Ten Rules for Option Trading."
Back then, options were still quote in eighths. For the newbies among option traders, that might mean you'd call your broker and say you wanted to buy a specific option for 5 and 3/8's. How much easier life is for options traders now that decimalization has been completed and we don't have to hunt down our broker by phone, hoping he's not tied up with a client!
Nevertheless the guidelines set forth in that 1998 article still hold relevance. I thought it might be time to update a few of the precepts from that article, although I won't be able to cover all ten rules in a single article. Whoever the original author of that staff article might have been, that writer employed a tighter prose style than I do.
The original article first cautioned that traders should not sink all their money into a single trade, and that the number of open trades be restricted to three to five. Both suggestions still prove relevant. In my own case, I divide my trading accounts into thirds. One third of the money is left as cash, available for adjustments to my open positions or as a not-at-risk amount just in case of a black Swan type event that might wipe out my other trades. I don't anticipate any such event happening, but this cash would be my start-up money if it did. Leaving a third of my trading accounts in cash has also allowed me flexibility in the type of adjustments I consider when a trade is going wrong. If I want to adjust a butterfly by adding another butterfly when prices reach my particular adjustment point, I have the capital to do so.
What about the other two-thirds of the account? One third is reserved for current-month trades, and one-third for next-month trades. In other words, I might want to put on a RUT DEC iron condor while my RUT NOV/DEC double calendar is still working. There might be a slight overlap in time, and I need to have money in reserve to do that.
Day traders likely never have overlapping trades, but they should still refrain from investing a hefty percentage of the account's value in a single trade. That's particularly true if a trading account is a small one. Risk of ruin--the risk of running through an entire account--rises with small accounts. No matter how good the trader or the trader's methodology, a time comes along when a number of trades in a row are losing trades.
Even if a day trader's win/loss ratio is 7/3, that doesn't mean the trader will experience 7 winning trades in a row, providing a hefty cash balance for the 3 losing trades that are coming before the next string of 7 winning trades. That's not how statistics and probability work. It's just as possible that the day trader will experience a period when 6 losing trades are stacked together in a row, with the win/loss ratio balancing out again only after a hefty number of trades. A number of losing trades in a row is going to result in a drawdown on the account's balance, and that rebalancing can never occur if those drawdowns wiped out the account. Therefore, keeping losses small remains an important precept for all traders and an even more important one for traders with small accounts. It's easier to keep losses small in proportion to account size if the original trade was also small in proportion to the account size.
The original article counseled that a trader with a $2,000 account should put $1,000 into two plays, and one with a $5,000 account should divide that account into three plays, etc., but I would be even more conservative. While it's difficult to divide a $2,000 account into thirds, it's possible to divide it into halves and leave half as a cash cushion, trading with the other half. Impossible, you say? $1,000 is too small an amount to trade? It's not. As of October 9, 2009, a 2-contract IWM NOV/DEC calendar would have required an investment of approximately $231 plus commissions, and calendars sometimes return something in the neighborhood of 15-25 percent of the initial investment. Depending on where the wings were placed, an MNX iron butterfly might have brought in anywhere from $420-573 in credit minus commissions and resulted in about $100 in buying-power effect or margin withheld. A long call or put on a favorite equity might have made up the rest of the amount allotted for that month's expenditures. The calendar and long call or put would have benefited from an expansion in volatility, while the butterfly would have been somewhat hurt by a rise in volatility. The calendar and butterfly would have benefited if the price stayed within certain ranges, while the long call or put would have benefited from a bigger change in prices, as long as the direction chosen was the right one. Not only were risks kept small dollar wise, but they were spread out among vehicles and strategies.
Readers have probably noticed that I chose the cheaply priced but highly liquid MNX and IWM for two of those strategies. I'm not recommending these specific trades, but I did deliberately choose these when discussing the risk of ruin for traders with small accounts. Trading the big indices requires more capital.
Not investing too much in any one trade also involves another precept that's particularly important for traders with small accounts: keeping commission costs as small as possible. I trade in decent size or at least what feels like decent size for these market conditions and this time in my life. When I trade iron condors, I split the iron condors among at least three vehicles and I trade 25-30 contracts on each of those three. If I were trading smaller contracts, especially on indices such as the MNX and IWM, however, with my brokerage I'd quickly run up against a daunting reality. My brokerage charges a minimum fee that's prohibitively expensive if I were trading a one-lot MNX iron butterfly or a 2-contract IWM calendar. The commissions would eat up all or most of the profit I made. That would result in lower gains and bigger losses, and that's ruinous for small accounts. My brokerage's fee structure works for me because I don't typically trade in one- and two-lot trades. In addition, lifestyle issues make it necessary that I have a broker who can personally step in and manage my trades according to my instructions if I should get called away due to a family member's health issues. For the purpose of experimenting with smaller lots when I'm trading unfamiliar vehicles or strategies, I have a small cash account at another brokerage that doesn't charge those minimal fees.
Traders with small accounts must search out the cheapest commissions they can find. While great execution and entries may be the best thing for ensuring success as an option traders, too-expensive commissions for the size of the trading account can be an undertow that it's difficult to fight against.
That 1998 article also discussed the maximum number of trades that a trader should keep open at any one time. I could not agree more with the injunction to keep trades down to a maximum of five at a time. For most of us, it's difficult to focus on more than a few trades at a time. Hopefully, if trades are diversified across vehicles and strategies, they won't all need attention at the same time, but I can guarantee you that one of the biggest problems I faced in October, 2008 was the mechanics of placing all the orders that needed to be placed that day as fast as my fingers could type. Despite having a full allotment of iron condors, trades that aren't particularly friendly in such an environment, I was pleased that I was able to keep my losses as small as I did, but my losses would have been smaller if I could just have entered orders faster than I was able to do in that fast-market environment. If I'd had more trades on more vehicles, the losses might have been bigger. When this last summer presented a number of health challenges to members of my family and extended family, scattered attention made it difficult to pay attention to my three live trades, much less the paper trades I was experimenting with, so I let those paper trades go without adjustments at times. What if those had been live trades? Could I have paid adequate attention to three live trades amounting to 75 contracts plus the three or four other trades, if they'd been live, too?
I next wanted to skip ahead to number three on that original list "Top Ten" list. That rule warned, "Never play deep OUT OF THE MONEY call options." Those options are cheap, but there's a reason they are, the article warned. That reason is delta: the amount they're expected to move with a one-point move in the underlying. If you buy an option with a delta of 0.07 (or 7, on some platforms), a 5-point move in the underlying would change the option's price by only $35.00 (0.07 x 5 x 100 multiplier)! That may not be enough to pay for slippage, commissions and fees for buying and selling the option.
Although the original article mentioned "call" options only, this relates to puts, too, of course, when they're chosen for a directional trade. Conversely, it's those deep OTM options that we iron condor traders love to sell. We love to sell them for the same reason that the original article's writer cautioned against buying them. Statistically, they're unlikely to be profitable at expiration and, barring a strong move prior to expiration, they're unlikely to move much in response to a move in the underlying.
Although this guideline from the original article illustrated the propensity for most option traders to be directional traders, and, often, directional traders engaging in bullish trades, changes have been afoot since that time. We now put in our orders in decimal form rather than eighths and we likely place the orders ourselves rather than conveying them to a broker we've called. Even I do that, although I have access to a broker who is familiar with my trading style. We may engage in a number of different trading strategies and directional trades may now compose a minority rather than a majority of our trades. However, that original article's rules still apply when warning against investing too high a proportion of an account's value in a single trade or opening too many trades at once.