It's time for some warnings again.
At the end of my July 6 Options 101 article titled "Price Discovery," I tacked on a paragraph explaining that since fleshing out the article, I had closed the trade being discussed at a loss. In my own words, "the trade had become more directional than not." Trading a directional trade is fine if you're a directional trader and the trade setup makes sense for your abilities and account size. It makes no sense if the trade is meant to be a non-directional trade that benefits from time decay and not price movement. It makes no sense if it furthermore ties up funds and energy that could be devoted to another trade. I elected to take a loss and move on to the next month's trade. The loss was a little over $800, less than my research tells me I'll make on the average profitable trade for my setup. In fact, I have since entered and taken a $2020 profit on the next trade.
Within a few days after that article appeared, I was reading a Bloomberg article with a title that began with the words "Americans Easy Marks." The article detailed programs charging many thousands at a pop. Excited participants are assured that they can quickly and easily change their lives and financial futures by trading options or participating in other get-rich-quick business schemes that involve little risk.
In that same article, former CBOE floor trader Mark Sebastian warned, "While lucrative for brokers, options are risky for amateurs." In another article, Sebastian posited the idea that educators should talk about their losses ("The Education Business," Expiring Monthly) to counter that get-rich-quick-with-no-risk hype. I know an experienced options trader who spends lots of time warning other traders about "risk of ruin," the risk that they can run through their trading accounts by letting losses grow unhealthily large. If you look through the Options 101 and Trader's Corner archives, you'll find some of my archived articles talking about the risk-of-ruin concept, too.
That's why I frequently mention, ad nauseum, that in the spring of 2010, despite believing at the time that I had a workable plan for controlling losses, I lost 14 months worth of profits in a single, two-week period. It's why I wrote last week's article on considerations before sizing up. Although I hadn't yet read Sebastian's article at the time, I was echoing one of his concerns, that traders who see a trade demonstrated with a $10,000 portfolio may not have any idea of the emotional import of employing the same trade on a much larger scale. A $100 unrealized loss is easy for most of us to deal with while we let a trade work. For some of us, a $1,000 loss on the same trade put on with ten times as many contracts may drive us to make unnecessary adjustments. Run that up to a $10,000 unrealized loss on a trade sized up by another factor of ten, and the tension and temptation to over-adjust escalates even more. "Too big to fail" comes into play with options trades as well as financial institutions and countries. We may panic and close out a working trade because we can't stand looking at the unrealized loss. Worse, we may fail to close out a trade that is no longer working because the unrealized loss has grown too large for us to stomach or face.
If you have a pattern of making good profits for a period of time and then, in one month, losing far more money than you make in the typical profitable month, you may be risking ruin. I write about this topic at least once a year, and it's time to do so again. If you have this type of trading pattern and own a Kindle, you might consider buying a little book titled How to Be a Rogue Trader. The book discusses rogue traders at big firms, but you might find many similarities in your own results and risk-taking patterns. You might search online for a risk-of-ruin calculator geared toward options traders and input your trading results into that calculator.
You must certainly graph your trade, even on the rudimentary profit-and-loss charts offered by some trading platforms. Regularly show a trusted fellow trader or spouse the maximum loss you can take in an Armageddon situation as well as your plan for avoiding ruin. Even outside the stories I hear from fellow options traders or our subscribers, I know of two people among friends and acquaintances who ran through their savings trading stocks or options. It happens.
It shouldn't ever happen.
Don't let it happen to you. Here's the honest truth: the markets are going to exert a tuition cost from you at some point or the other. You think your trade is working just as expected, and the market environment changes, teaching you that it wasn't your plan that was working but just that your trade happened to be the right one for that particular time. Just ask all the call buyers from late 1999 and early 2000 what happened to them in March 2000 if they didn't quickly switch to another trade. Or, maybe, like me, despite a plan that had worked for years, you find that that there's a particular market situation that uncovers the hidden danger in that plan.
You can't avoid paying an unexpected tuition. Make it a small one. In my own case, I knew that unrealized losses were mounting but I also knew that I had a plan to keep rolling out of danger and making up that unrealized loss. Never, ever let an unrealized loss grow much larger than the maximum loss you intend to take on the trade because you think you know you can roll the trade out of danger. You might find a can't happen in your lifetime situation that does indeed happen in your lifetime. Your maximum planned loss should never be outsized in comparison to your typical monthly income, and that means that your unrealized losses should never be allowed to be outsized in comparison to your typical monthly gain. Period.
Am I saying that newbies can't learn to trade options profitably by benefiting by the instruction that we and some others offer? No. I am saying to be wary of any program that hypes a get-rich-quick scheme that they swear has almost no risk. Even if the scheme turns out to work just as well as they say it does, there's always the risk of a newbie trying to execute it, and risks must be accepted and understood. We know that if we plan to open a new restaurant business, we assume the costs of buying equipment, leasing or buying a place to cook and serve that food, and other costs and risk losing that investment. We know that if we want to risk less, we start that restaurant business on a smaller scale. Ditto with a new retail store.
In order to make the big gains some programs promise you, you're going to have to take big risks and expect big, in-kind draw downs those times when the trade goes wrong. That's the way it works. If you can't accept that kind of trading pattern--and I can no longer stomach that kind of up and down--then you're going to have to accept a lower percentage gain. There's no way around that. It takes money to hedge against risk, and that money comes out of your profit, just as insurance payments come out of your salary.
Write out your trading plan and discuss it with someone else. Trade small until you understand if your plan and your trade works the way you intend it to work. Size up only gradually and only after you've managed a bad month well, without outsized losses. Know your maximum loss and how it would be hit. Have a trading buddy or a spouse who will call you to order if you're letting a loss get too large or if you're taking on too much risk. If you experience a loss, let enough time go by so that you're not trying to wrest your profit back out of the markets by force, to show the markets who is boss.
There, we've had it, the "I took a big loss and you certainly can, too" article that I feel compelled to write ever so often. Leading into the spring of 2010, I had of course been making money on options trading. You can imagine that wiping out 14 months of profit at one time set back that goal quite a bit, although it happily did not decimate my trading account. Happily, I had heeded some of my own advice and had not sized up into a bigger trade than my account could handle, and I did go to someone trusted and talk about what was happening. When that person advised me to just get out, I did. However, losing those profits even if I did keep my trading account intact did, for a time, damage my confidence in myself, my trade and my plan, and that's had to be slowly rebuilt.