Home   Options     Forex    Learning Tools        Market Trends Option Trading Tips
     
 
 
 

Options Money Management

 
     
 

On this page you will learn important information about options money management. This single factor can make the difference between a successful trader and a gambler! Don't skip this section!

http://tv.ino.com/free/video.html?vidid=livestream-latest
 

 
     
 
 
     
 

     
 
 
     
 
Trading Pro System
 
     
 


Options Money management is is different from money management for trading stocks, and is one of the most important aspects of any type of trading. Neglect this factor and you are effectively blowing a hole in the waterline of your investment ship - you will inevitably sink. It is this single factor that traps most traders, and it is even more critical when trading options, because you can stand to lose 100% of your investment if you have a trade going wrong.



When you trade, the profits are great, but they take care of themselves. We need to make sure that we don't lose money, or that the losses we take are limited and controlled. Take charge of not losing money, and you will find gaining profits that much easier.

I have discussed several trading strategies on this site, and each requires a different management principle. Most stock traders work on the 2% rule, which means that you will risk up to 2% of your capital on a single trade. So, if you have a base capital of $25,000 your maximum risk at one trade will be $500. This does not always mean that you will only buy $500 worth of stock in each trade, but that you will RISK this amount. This rule works for swing trading stocks and for buying calls and puts, but the rules are bit different for when you are selling options.

Here are some examples:

  1. Basic Swing Trade

If you enter a trade with a stock price of $25, you would typically set a 4% stop loss, which you would set at $24. This means that you are risking $1. If your maximum risk is $500, this means that you could buy up to 500 shares of the stock, which is a total trade of $12,500. Looking at it like this, this would mean that you are effectively limited to a maximum of two open trades at any one time (this why buying DITM Options is much more powerful way of swing trading - you get DOUBLE the bang for your buck!).

  1. Selling Credit Spreads

This is much easier to figure out, because your broker requires you set margin for each spread that you sell. The broker that I use requires a margin of $1,000 for each credit spread that I sell, so that if your trade goes badly wrong and you have not set a stop loss (Stupid!), you have enough money to buy the spread back again. So, if you have $5,000, you can sell one spread for five stocks, one five spreads on one stock.

Recommendation: I use an active credit spread trading technique, which means that I will actively buy back spreads that have become almost valueless, and sell another spread. However, I very occasionally need to carry out a spread repair for when a trade comes up against my limit. I therefore leave in cash the equivalent of one spread trade to allow for a buyback prior to selling a further out spread. So, if you have $5,000 you can buy four spreads, and have $1,000 set aside in cash for the occasional repair.

  1. Selling Naked Puts

Again, your broker makes it easy. You will be given a margin requirement for naked put, equal to approximately 12% of the cost of buying the stock at the strike price you have chosen. So, if you sell a put for XYZ at a strike price of $25, you will be expected to have a margin available of $25 x 100 = $2,500 x 12% = $300.

  1. Buying OTM Calls and Puts

Calculating your maximum risk with OTM options is easy. If your maximum risk is 2%, which in this example is $500, then you simply buy a maximum of $500 worth of options. In the event that your option loses 100% of its value, you then only lose 2% of your total capital. So, if XYZ is trading at $24, and you choose to buy a call option for a strike price of $25 for a cost of $1 per option, you can risk buying up to 5 options for a total of $500.

In addition, a very popular and wise strategy is to sell 50% of your trade when your option has gained 100% profit. By doing this, you secure your original investment and just have to sit back and watch your profits explode. So, if you bought calls on a stock for $500, and the value grows to $1,000, then sell half ($500 being your original investment) and watch the other $500 increase for pure profits.

One Warning: When trading OTM Options, NEVER EVER get into the dangerous practice of “doubling up”.  This is when you buy an option, but just after buying it the stock takes a bit of a dive. If your option value decreases to 50% of what you paid, some traders (gamblers?) will buy more of the same option, but at half the price. This reduces the average cost of your trade, so that when or if the stock swings around and bounces up again, your profit figure looks much bigger. BUT you will have doubled your risk. I once subscribed to a newsletter service that autotraded their recommendations. They were in the habit of doubling-up, and every time they did this, I ended up losing money - despite how good the math looked!

  1. Buying DITM Calls and Puts

When buying DITM calls and puts, you are effectively swing trading but at half the price, so you simply calculate your stop loss the same way that you would do for a full priced swing trade. However, if you use the above trade as an example, you will be able to simultaneously enter four open trades, not just two.

 

Whatever rule or tolerance level you set, it is really important that you stick to it rigidly; no matter how much you are tempted to top things up a little. This will eventually and inevitably work against you! Swing trading stocks is fun, and your losses are not terribly huge most of the time. However, the same leverage that works to make you huge profits with options can turn against you and bite you really hard - the only safety net is an absolutely rigid money management system. No emotion, no gambling, no false hopes. That is what will keep you heading for the profits!

 

 

Return from Options Money Management to the Home Page

Move on to see how to calculate Profit and Loss Calculations