This is a transcript from a session Tom Preston at Thinkorswim did a few days ago. When TOS posts this transcript on Chat Archive I will remove this post. Mean while I felt this was soooo good that I post here in advance for anyone that misssed the session.
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Tom Preston: Trading resolutions for 2007
Tom Preston: 1) Don’t try to make back all your losses in one trade
Everyone makes losing trades. Sometimes you get the losers in a row, one after the other, and your account is smaller than when you started. You get frustrated and angry. You decide to take revenge on the market and make all your losses back and then some. So, the next trade you make, you increase the number of contracts or shares because your rage is overpowering your discipline and you’re sure that this trade will be “the one”.
And…you’re probably wrong. The trade turns out to be loser as well and your account is even deeper in the hole. Sure, it might be a winner, but it’s not worth the risk. Don’t let your anger control your trading. Just because you’ve had a string of losers doesn’t necessarily mean your due for a winner.
If you’re in the situation of having nothing but losing trades, a better idea would be to review your trading plan and see if there might be fundamentally wrong with it. Then you can correct it and see if that improves the results.
Tom Preston: 2) Don’t take stupid risk
This goes along with the first resolution. The bottom line is, don’t put your hard-earned money at risk unless you have a good reason to do so. To spin the old trading adage a little differently, if you have a hunch, DON’T bet a bunch. Keep your risk under control.
We suggest that you keep the max risk of any one trade to less than 5% of your trading capital. And keep the total risk of all your open positions to less than 25% or so of your trading capital. That means, if everything goes wrong, you won’t lose everything, and you’ll still have some money left to continue trading.
Also, having some kind of trading plan in place that gives you some consistent criteria for entering and exiting positions will help you put the trades you make based on “gut” feelings or something outside of those criteria in perspective. You can put those trades on, just don’t risk any more on them than you would your “criteria-based” trades, and maybe even less.
Tom Preston: 3) If it looks too good to be true, it is
I can’t stress this enough. I have been saying this since I started thinkorswim, and I find myself saying it again today. Option prices are not wrong. Now, I’m not talking about errors in the quote database. That’s a technical problem. What I mean is that if you see a box spread trading over the difference between the strikes, or a calendar spread trading for a credit, or an adjusted option trading for more than an unadjusted option on the same stock, with the same expiration and strike price, money is NOT lying on the floor just waiting to be picked up. Rather, it means that there is something else impacting those option prices like a dividend or something that you don’t see, but the pros do. The pros are right. It is a fact of the state of option trading that there are no arbitrage opportunities sitting there waiting for the retail traders (you) to take advantage of them.
Tom Preston: 4) Use spreads whenever possible
If you are trading directionally, that is, you are betting on a stock or index going up or down and you want to use options, please consider using verticals. Lately, I’ve been seeing a lot of customers betting on the direction of stocks or indices using simple long calls or puts. Now, I don’t have a problem with directional trading in and of itself. But long single options have sensitivities to time decay and volatility that can make a losing trade out of one that is right on direction. And if you’re buying in the money options, they usually have wide bid/ask spreads and can be less liquid than at the money or out of the money options, so that if you want to/have to exit the trade, you get lousy execution prices.
Verticals are great for when you are less than 100% confident that the stock or index will go in the direction you think it will. If you’re bullish, consider selling an out of the money put vertical. You make money if the index goes up, stays the same, or maybe even drops a little. If you’re bearish, consider selling an out of the money call vertical. Short verticals have positive time decay and less vega sensitivity than outright long options. Yes, their profit potential is less, but so too can be their max loss. If you don’t do too many of them (remember our suggestion of not risking more than 5% on any one trade?) they’re a good way of keeping risk under control.
Tom Preston: 5) Keep learning
Don’t stop trying to learn new things about trading, either by doing research, reading books and articles, coming to classes (try www.optionplanet.com), joining us here on Wednesday afternoons, calling the TOS trade desk with questions, etc, etc.
Everyone is getting smarter and more capable. The tools that we give you for free are more powerful than what I was using when I was trading professionally. You can learn things here no retail trader would have known certainly 20 and maybe even 5 years ago. The difference between the educated retail trader and the professional trader is getting smaller and smaller. That’s both good and bad for you. It’s good that bid/ask spreads are tighter now than they have ever been. You can see live quotes for free. But it also means that the industry is more competitive. Knowing what an iron condor is or how to calculate a roll value isn’t enough. There are hundreds of TOS customers who already know that stuff already. Making money trading is very hard work. You have to be willing to devote the time and energy to try to find an approach to trading that might actually make you money. A successful trading career isn’t built out of luck.
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