THE OPTIONS COURSE
THE ROAD TO SUCCESSFUL TRADING
Achieving trading success is not easy. In fact, just getting started can be an overwhelming process. The road to wealth can take many paths. To determine your optimal trading approach, start by making an honest assessment of your financial capabilities. Successful traders only use funds that are readily available and can be invested in a sound manner. It is also critical to accurately assess your time constraints to determine the style of trading that suits you best. If you want to trade aggressively, you can do so using various short-term strategies. If you want to take a hands-off approach, you can structure trades to meet that time frame. All of these choices are less difficult to make if you respect the following trading guidelines.
- Gain the knowledge to succeed over the long run.
- Start with acceptable trading capital.
- Establish a systematic approach to the markets.
- Be alert for trading opportunities at all times.
- Develop the fine art of patience.
- Build a strong respect for risk.
- Develop a delta neutral trading approach.
- Reduce your stress level.
Gain the Knowledge to Succeed over the Long Run
You have to have knowledge to succeed. Most new investors and traders enter this field expecting to immediately become successful. However, many have spent tens of thousands of dollars and many years in college learning a specific profession and still do not make much money. To be successful, you need to start your journey on the right path, which will increase your chance of reaching your final destination: financial security. To accomplish this goal, learn as much as you can about low-risk trading techniques and increase your knowledge base systematically. Successful traders have an arsenal of trading tools that allows them to be competitive in the markets. I have used the word arsenal purposely. I believe that as an investor or trader, you need to recognize that each and every day in the marketplace is a battle.
You must be ready to strategically launch an attack using all the resources in your arsenal. Your first weapon—knowledge—will enable you to make fast and accurate decisions regarding the probability of success in a specific investment. Is it incongruous to suggest that trading is war and also that to trade successfully one must reduce one’s level of stress? I believe not. The most composed and well-armed opponents win wars. The same is true for traders. In most cases, winners will be more comfortable (less stressed) regarding their ability to win. Knowledge fosters confidence. If you are well armed, you will be confident as you go off to fight the battle of the markets. Increased confidence leads to lower stress and higher profits.
Start with Acceptable Trading Capital
Many investors start with less than $10,000 in their trading accounts. However, it is important to realize that the less you have in your account, the more cautious you have to be. Perhaps the toughest problem is to establish a sufficient capital base to invest effectively. If you begin investing or trading with very little capital, you will assure yourself of failure. Making money in the markets requires a learning curve, and incurring loss is part of the trading process. When it comes to trading, “you have to pay to play.” You don’t need to be a millionaire, but trading does require a certain amount of capital to get started. In many cases, the brokerage firm you choose will determine how much is required to put you in the game. However, no matter how much you begin with, it is a good idea to start out by trading conservatively. If you invest smartly, you can make very good returns and your financial goals will be realized.
Establish a Systematic Approach to the Markets
The third key to successful moneymaking in the markets is to develop a systematic approach that combines all the weapons in your arsenal to compete effectively in the marketplace. Then, and only then, will you be able to reduce your stress enough to believe in the plan and stick with it. A systematic approach diffuses the inherent madness of the marketplace, allowing you to make insightful trading decisions.
Be Alert for Trading Opportunities at All Times
By opening your receptivity to opportunity, you will be able to find many more promising trades than you thought possible. Where do you find opportunities? Everywhere. When you begin to train yourself to automatically look for trading opportunities in everything you do, you are on your way to being an up-and-coming successful trader.
Develop the Fine Art of Patience
Patience is one of the most difficult aspects of trading and investing and extremely hard to teach. I have to work at applying patience conscientiously each and every day, even after years of trading. As a professional trader and investor, I have the opportunity to sit in front of computers all day long, day after day. This is another double-edged sword. Yes, I have the ability to look for promising trading opportunities because I have lots of information in front of me; however, I also have the opportunity to second-guess great trades due to fluctuations in the market that may be unimportant.
Therefore, I have learned that the best investments are those in which I have thoroughly studied the risk and reward and have developed a time frame for the trade to work. For example, if I place a trade with options six months out, I try to stay with the trade for that period of time. This takes patience. Of course, if I reach my maximum profit level before that time, I take that profit and get out. Do not feel that you are at a disadvantage if you cannot trade and invest full-time. This allows you to avoid the “noise” in the market that occurs each and every trading day. Many of my successful students make more money by not watching the markets too closely.
Build a Strong Respect for Risk
You must respect risk if you are to survive as an investor or a trader. Before you ever place an order with your broker, make sure you calculate the maximum potential risk and reward as well as the breakeven(s) of the trade. This will help you stay in the game so you can achieve your goals. Risk graphs, which are explored in later chapters, are important tools for assessing risk and reward.
Develop a Delta Neutral Trading Approach
Delta neutral trading is composed of strategies in which a trade is created by selecting a calculated ratio of short and long positions that balance out to an overall position delta of zero. The term delta refers to the degree of change in an option’s price in relation to changes in the price of the underlying security. The delta neutral trading approach reduces risk and maximizes the potential return. Effectively applying these strategies in your own personal trading approach generally requires four steps:
- Test your trading systems by paper trading. Paper trading is the process of simulating a trade without actually putting your money on the line. To become a savvy delta neutral options trader, you will need to practice strategies by placing trades on paper rather than with cash. Although it may not feel the same as putting your money on the line, it will help you to develop practical experience that will foster confidence in your abilities. This will come in very handy in the future. Since there is no substitute for personal experience, you should test all ideas and your ability to implement them properly prior to using real money.
- Discuss opening a brokerage account with several brokers. Make sure you have a broker who is knowledgeable and fairly priced. Brokers can be assets or liabilities. Make certain your broker is an asset who will help make you richer, not “broker.” Do not sacrifice service by selecting the broker with the lowest cost. Shop around for the right person or firm to represent your interests. Your broker will play a crucial role in your development as a successful trader. Take your time, and if you are not satisfied, find someone else.
- Open a brokerage account. It’s best to consider a brokerage firm that specializes in stocks, futures, and options. Then you can easily place trades in any market using the same firm. When it comes to trading, flexibility and precision are equally important. Today, some online brokers specialize in options.
- Start small. Any mistakes you make early in your trading career will obviously cost you money. If you start with small trades in the beginning, you will be able to gain the knowledge, experience, and confidence necessary to move on to bigger trades. The bottom line is that a mistake made in a small trade means a smaller loss of capital, which can help keep you in the game.
Reduce Your Stress Level
Successful traders have to find ways to reduce the stress commonly associated with trading. I reconstructed my trading style after experiencing more stress than I had thought I could ever handle. In a typical trading day with the S&P 500 (Standard & Poor’s 500 Index, which represents the 500 largest companies in the United States), I found myself buying close to the high of the day. Immediately the market started to tumble so fast that I was down 100 points even before I got my buy filled (i.e., before my order was executed). I finally was able to regain my composure just enough to pick up the phone in a panic to sell as fast as possible.
By then the market had tumbled almost 200 points. Worst of all, I had purchased too many contracts for the money I had in my account; and, to top it all off, it was my first trade ever in the S&P. That was the point in my trading career that I experienced the panic and stress of losing more than 40 percent of my account in three minutes—more than one month’s pay as an accountant. I did not trade again for more than two months while I tried to figure out whether I could really do this for a living. Luckily, I did start trading again; however, I reduced my trading size to one contract position at a time for more than a year.
Many professional floor traders and off-floor traders have had similar experiences. However, these kinds of stressful events must be overcome and used as lessons that needed to be learned. Simply put, stress produces incomplete knowledge access. Stress, by its nature, causes humans to become tense in not only their physical being but also their mental state. For years, physicians have made the public aware that stress can lead to many illnesses including hardening of the arteries with the possibility of a heart attack or other ailments. Reducing stress can lead to bigger rewards and can be accomplished by building a low-stress trading plan.
To create your own plan, follow this three-point outline:
- Define your risk.
- Develop a flexible investment plan.
- Build your knowledge base systematically.
Define Your Risk As a trader you have the ability to make large profits with the risk of potentially large losses. This is no secret. Unfortunately, that old maxim “cut your losses and let your profits run” is easier said than done. By defining your risk, you are assured that you cannot lose more money than the amount you have established as being the maximum position loss. You will also be able to develop strategies that create the potential for large rewards by predefining your acceptable risk parameters and by applying strategies that combine stocks and options on stocks, or futures and options on futures. Develop a Flexible Investment Plan The second step in reducing risk and stress is to develop an investment plan that is flexible.
Flexibility allows a trader to cultivate a matrix of strategies with which to respond to market movement in any direction. Erratic market movement can change your position dramatically in seconds. Each price move (tick) rearranges everyone’s assumptions about what the market is about to do. This dynamic environment borders on schizophrenia, where the bulls and bears do battle trying to outmaneuver each other. This, in turn, creates profitable opportunities for the knowledgeable investor with a smart and flexible investment plan and creates nightmares for the uninitiated trader without a plan, only a hunch as to where the market appears to be going. Investors and traders have to be entrepreneurial by nature to survive. One of the greatest attributes of entrepreneurs in any industry is the ability to recognize a roadblock and change direction when one is reached. Traders must also exhibit this flexibility if they are to survive in the marketplace.
Build Your Knowledge Base Systematically The third step to creating a successful investment plan is to systematically build a solid base of innovative strategies from which to invest wisely. Most investors start the same way. They read a few books, open a small account, and lose everything very quickly. However, there is one way to differentiate the winners from the losers. Winners persist at learning as much as they can by starting slowly and collecting tools to beat the market consistently. Successful options traders first learn to walk, then to run. Usually traders begin with simplistic strategies such as going long or shorting the market, and using stops to limit losses. Some just listen to their brokers and follow their trading ideas. Once initiated, traders accelerate their learning at the right time to become successful.
Successful traders usually specialize in one area or just a few areas. This specialization allows the trader to develop strategies that consistently work in certain recognizable market conditions. A successful investor realizes that, in all likelihood, these situations will reoccur and the same strategies can be used profitably over and over again. At my almamater, Harvard Business School, the same systematic approach is used. I never realized what the school was attempting to accomplish until after graduation when I had time to apply this approach to the real world—all those case studies on businesses I had no interest in fostered my ability to learn how to think in any environment. This systematic building of knowledge will enable you to quickly get up and running as a successful trader in the marketplace.