Option trading can be very lucrative and actually relatively easy to learn when you are interested enough in it. There are some things every option trader should know. Below I have listed the top five most important things every option trader has to do correctly to be successful!
5. Trading Mentality: not letting Emotions influence your trading Decisions
Emotions can be hard to handle when trading. But it is extremely important to control yourself when trading. You should never let your emotions influence your trading decisions. You should try to think and act as rational as possible and always do the most logical thing for your positions. When risking hard-earned money, it can be tough to handle 100% mechanically. To learn more about trading mentality check out my article about trading mentality here.
4. Understanding the Importance of the Portfolio and Diversification
Portfolio diversification is key to success. Especially when you have a bigger portfolio, with multiple positions open at once it is crucial to have a well-balanced and diversified portfolio to be successful. As a high probability option trader, you usually don’t expect the market to move significantly in short periods of time. Therefore, it is best to stay market neutral. This means your portfolio (all your current positions together) should remain as neutral as possible. To do this you should have approximately the same numbers of bearish and bullish positions. To be even more market neutral you could get into beta-weighting. Out of this, you can conclude that the portfolio always is more important than single positions. This means if you have one losing trade, it doesn’t matter so much as long as your overall portfolio still is winning. If you have a big portfolio, you should therefore only add/adjust positions if they won’t affect the total portfolio (e.g. don’t add/adjust positions if they turn your neutral portfolio into a directional portfolio). Another way to diversify your portfolio is by having many uncorrelated positions. Of course, almost every area of the stock market is somehow correlated to another area. But you should try to have positions in as uncorrelated areas as possible. An example of two relatively uncorrelated areas would be social media and oil. The price changes in oil won’t affect social media stocks like Facebook very much. The last way of diversifying your portfolio is by diversifying your assets. You could have options on stocks, ETF’s, indexes. The reason why portfolio diversification is so important is because it is the only way to protect yourself against unexpected events like some crashes, bankruptcies etc… To understand this you have to know that there are two types of risks: Systematic Risk is the unavoidable risk. This risk is completely unavoidable because there always is and will be the risk of some unexpected events happening, which will affect the entire market. This risk will always be there and cannot be mitigated. Unsystematic Risk is the avoidable risk. This risk is a risk only affecting parts of the market like individual stocks. An example for this would be bankruptcies of certain companies. These will affect positions in these companies, but not the entire market. Even though you can’t do anything against systematic risk, you can do something against unsystematic risk. Therefore, you should. This is the reason why portfolio diversification is so important. As you can see on the diagram to the right, the more diversified your portfolio becomes (Number of Stocks), the less unsystematic risk there will be. This kind of portfolio diversification mainly should concern traders with bigger accounts (15’000$+) with multiple (5+) positions on at the same time. People with small accounts and only very few positions at one point can diversify by trading in big indexes (ETF’s) like SPY. These indexes already offer integrated diversification since they are based on many different big stocks. More on market neutral portfolios and beta weighting here.
3. Education (Stock Market Trading Education)
I can’t say this often enough. Education is one of the most important things not only for trading options but for trading in general. It is absolutely stupid to think that you just can start trading successfully without any forms of education beforehand. In times of the internet it is easier than ever to educate yourself, so you don’t have any excuses. If you don’t want to pay for online education, there are plenty of free educational websites (like this one) for every topic your heart desires. It is just like learning a new language. You can’t just go out and speak a foreign language fluently without any education or training. It doesn’t have to be five hours a day, seven days a week but it can’t be nothing at all either. So instead of browsing the internet or watching movies just use an hour of your day to educate yourself for a better future.
2. Staying consistent and doing Things the Right Way
One of the most important lessons is staying consistent. Especially for option trading you really have to stay consistent and have a long-term approach to things. In most cases, you won’t get rich with options in a few days. You have to stay consistent. This doesn’t mean that you consistently have to trade 5 hours every trading day. But you should trade many trades over the course of a few years. If you do this, you will almost guaranteed be successful. The probabilities for succeeding will work themselves out. There is no doubt behind that. But consistency isn’t everything. If you consistently trade the wrong way, you still won’t make any money doing so. You have to consistently trade the correct way. This means you always should order with correct pricing. You always should be on the right side of volatility… You can’t expect to make money when trading the wrong way. So stay consistent and make the correct choices.
1. Option Position Sizing
Possibly the most important thing for trading is your position sizing, especially for option position sizing (because they can expire worthless). Trading with the wrong position size is perhaps the fastest way to blow up your account. For example, let’s say you trade with a 50% position size per trade. This would mean you need two bad trades that go against you to blow up your account completely. That is absolutely ridiculous! The chances of having two consecutive losses are relatively high, even with high probability trading. In fact, if you trade at a probability of 70%, your probability of having two consecutive losses is 9%. This is very low but it is not impossible. I recommend risking between 1 and 10% of your account capital per trade depending on your account size. If you only have a very small account (ca. 1000$) but still want to get into trading, you have to allocate a little more compared to bigger accounts to even make some trades. Therefore, I would say if you have such a small account, it is sometimes okay to have defined risk positions with risk up to 10% of your total account. BUT not more than that! If you have a bigger account (15’000$+), I wouldn’t suggest risking more than 5% for one trade. At a 5% risk-level per trade, you could theoretically lose 20 times in a row before being out of money. The chance to blow up your account (so that all 20 positions go against you) at a 70% probability for each position is 0.000000003486784401 %. This makes it extremely unlikely and practically impossible to blow up your account. I really hope this helps you understand the significance of position sizing.
This Article is part of the Intermediate Option Trading Course. If you are reading the article as a part of the course, you can continue to the next lesson: HERE