Advice for a New Options Trader

Planning Your Trading Career

Advice for Rookies Traders
Advice for Rookies Traders. Google Images

Good Questions from a Rookie Options Trader

My goal is to earn $2,000 per month (before taxes, commissions, etc.) beginning next January and to maintain this goal for at least one year before raising my expectations. (This goal is not flexible). This timetable allows six more months that I can dedicate to learning and practice. During these six months:

  1. Should my trading be limited to paper trading or is there a reason to trade small size with real money?
  1. Should I limit the number of strategies that I study?
  2. Should I limit the number of trades that I initiate each month?
  3. Is my I stop loss plan reasonable? I would lose no more than the amount of my collected premium. For example, if I collect $850 (on a 10-lot trade) then $850 is the maximum loss I am willing to sustain. I would exit when that happens.

Thanks,
Jim.

Discussion

It’s good to set trading goals -- even before you begin trading. However, goals must be reasonable.

To begin, I suggest a smaller earnings target, but the truth is that your profit target depends on the size of your trading account. If your account contains $20,000, you have almost no chance of earning that $2,000. 10% per month is a huge profit and it requires a great deal of skill -- or very good luck -- to achieve that on a steady basis. I urge you to target no more than 2% per month -- and a more realistic goal is 1%/month.

NOTE: These suggestions are for getting started. If you become quite skilled, then you can raise your target. However, I want you to recognize that a consistent 2% per month provides a wonderful return on your money.

Another factor to consider is that different strategies work differently -- and perform better or worse, depending on stock market conditions (especially volatility).

At times (iron condors, for example) a strategy that does best in a range-bound market can return 20% per month, However, in volatile markets, it is very difficult to prevent taking a loss when trading an iron condor strategy. Your ultimate plan has to be managing risk so that the losing trades do not overwhelm your earnings from profitable trades.

Understand that there will be situations in which you love market conditions and believe that an available trade offers an exceptional chance to earn money. You may be tempted to trade a much larger position size. (Don't do it.) At other times you may decide to trade reduced position size or even sit on the sidelines because the risk seems to high to seek the anticipated profit. Winning traders do not force trades. When conditions are not suitable, wait patiently.

Please remember that trading does not produce a consistent income stream. Do not become discouraged when you miss your target for a month or two. However, if your losses are the result of poor (i.e., inappropriate), you cannot expect to be profitable. If you lack the ability (this is usually a result of poor discipline) to effectively manage risk, you are not going to succeed.

Thus, you may have a monetary goal – but it is far more important to have a learning goal.

It takes some time to develop the necessary skills, and practice is the way to get there. Read, study, and practice with real-money trades on a very small scale. No trader is guaranteed an income. It is mandatory to know the difference between bad luck and exercising poor judgment (i.e., making mistakes). It is not easy for the newer trader to recognize the difference. But if you keep a good trade journal, you can go back and read analyze your decisions at a future time when you have more experience. then you should be able to determine why a trade lost money.

Replies

1) No. Paper trading is not required. It’s okay to trade one-lots with real money. Paper trading can be helpful, but  only when it often comes with a non-caring attitude. Don’t allow that to happen. Take paper trading seriously.

Use paper trading until you gain some confidence in your ability to understand the complete process from deciding which specific options to trade, entering the order, monitoring risk, and eventually exiting the position. 

At first, the goal should be earning enough to cover commissions and other expenses. Later, your earnings target depends on how much money is in your account. If you have $5,000, do not expect to earn $2,000 -- or 40% every month. That is wildly optimistic. If the account value is $20,000, your stated target would be a 10% monthly return. If you do not understand just how much that is, at that rate, your money would double approximately every 7 months. I hope you know that goal is not achievable on a consistent basis.

I hope that you can set your goal at an optimistic 2% per month -- and not any higher. Also, do not expect to meet that goal every month. I truly recommend that your target be established as a percentage return, rather than as a specific dollar return.

MOST IMPORTANTLY. If you trade an iron condor and the options quietly fade into oblivion during a dull market, don’t think you did anything special. Similarly, if the market dives 20% the day after you make that same trade, don’t think you did anything wrong. I understand that we are playing for green points (dollars), but for short periods of time, profits and losses may not be the best measurement of how well you are trading and managing risk.

2) Yes, limit the number of strategies, but do study more than one. You cannot discover which feels best to trade, but if you read about them you may get a feel for how each strategy works. Then trade. I suggest at least 2 and perhaps 3 strategies when in the testing mode. They can be paper traded if you prefer. Do not add a second strategy until you believe that you can handle more than one. Same for adding a 3rd.

The key to success is not in finding the right strategy. The chosen strategy allows you to be comfortable while playing the game, but managing risk well (and that includes trading proper size) and learning to make quality decisions when managing the position are the factors that will ultimately determine your long-term success or failure.

The strategy is important. You want trading to satisfy your psychological needs. If you love daily action, iron condors, covered call writing, and trading call or put spreads should work for you. However, if you hate the tension that comes with frequent decision making, consider being an investor, not a trader.

Practice a few strategies and discard any that are uncomfortable to manage. When you gain more experience and confidence, return to reconsider a previously discarded strategy. With your new trading insight, it may work for you.

SUGGESTION: Use a different underlying asset for each strategy so that you can have separate risk graphs for each position.

3) Open a position. If you can follow it comfortably, then add another. Don’t have too much going on at once. I suggest no more than three at one time. You must give yourself time to watch the trade (as often as your plan requires), know your adjustment, exit, and profit points, and never feel hurried. 

4) No. Not even close, in my opinion. If you trade ‘income’ strategies (iron condor, credit spread, naked put, covered call, etc), the credit collected has NOTHING to do with how much loss you should be willing to accept.

Here is my thought process: Pick a position to own. It costs something (ok, you collect a cash credit, but it’s the same idea). That cost should now be ignored because it never matters again (this is controversial, but I believe it 100%) -- when making trade decisions. The time to exit the trade is when the position is one you no longer want to hold. The Greeks (risk-managing tools) may look too risky or market conditions may have changed. Regardless of which methods you use to manage risk, however you determine whether you are still comfortable owning a position, it seems to me that the premium collected has nothing to do with the exit decision. Either you want to hold longer, or you want to exit (or adjust risk). Period.

When trading stocks, the stop-loss scenario that you describe makes sense. Not here. Not in the premium selling game. If you decide that losing $850 is the limit for a trade – that’s an intelligent thing to decide. But it does not matter how much cash you collected upfront. Exit when risk is out of line. Exit when you have lost your maximum allotted total, but do not base anything on the entry premium. Exit when you cannot sleep at night because the risk is just too high. If necessary exit when the moon is full (I hope you will not do this). But do not exit when you lose a sum that equals the premium collected.

Welcome to my world. I wish you well.