You Can’t Make Money Option Trading Until You Master These Things First
To make money option trading it is absolutely vital you understand a few essentials. Firstly, option trading while offering wonderful financial rewards due to the leverage that comes with them, can also be the easiest way to wipe out an entire trading bank. Nevertheless, options in my opinion has huge advantages over other leveraged instruments such as CFDs and futures because unlike the latter, options have limited risk. The maximum you can lose is the amount you invest – less you sell naked options which is never recommended.
This leverage, combined with the limited risk in options, is what makes them so appealing as a trading vehicle. But along with these advantages comes one big setback. All options expire. They are not like shares which you can hold onto until the price recovers. If they are “out-of-the-money” at expiry date, they are worthless. So the length of time until option expiry may be an important piece of your trading strategy.
Work This Out First
Secondly, to make money option trading you MUST have a capital management system in place that you stick to with disciplined resolve. Your financial life depends on it! You MUST accept the fact that not all of your trades will be profitable and need to factor this anticipation into your trading plan. In the end, the raw simplicity of trading success of any kind, is not just about being able to pick the right trades, but above that – it is all about managing the numbers.
These are three essential things you need to decide before you do anything:
1. How much of your entire trading capital will you risk on any one trade?
2. What is the minimum target profit you need to make on every trade?
3. What is the maximum amount you are prepared to lose on any one trade?
Once you have answered these three questions in your mind, from then on, to make money option trading, it is simply about managing the numbers. Let’s explain what we mean with an example.
You have answered the above three questions with the following:
1. I will risk a maximum 10 percent of my trading bank on any one trade.
2. I need to see a setup that will make me a minimum 50 percent profit on any one trade.
3. I will accept a maximum 50 percent loss on any one trade.
Now that you clearly understand your trading parameters, to make money option trading it is simply a matter of realizing how many successful trades compared to losing ones, you need to have in order to realize a profit. Matching this with the position sizing from question one, and you will know what your overall profit should be.
So if you have adopted the above strategy, you need at least half your trades to be successful just to break even. If you can achieve 7 out of 10 successful trades, it means you have a nett three profitable trades at 50 percent each. Apply this to 10 percent of your capital risked and you can work out your overall profit.
So if your trading capital was $10,000 and your risked $1,000 on each trade with a 70 percent success rate, you would realize an overall profit of $2,000 after ten trades. This assumes that you don’t increase the amount you risk after profitable trades or reduce it after losing ones – that the 10 percent of your starting capital is consistent over 10 trades.
After the first 10 trades, you now have $12,000 to continue with, so your investment amount for the next 10 trades will be $1,200. You continue to work your plan – and as long as your success rate is at greater than 50 percent, you make a profit. Don’t let your ego get in the way – this a realistic way to make money option trading.
If you came up with different answers to the three questions, you will need to adjust your stop loss percentage accordingly.
The Next Step
Now that you have first worked out your capital management plan, to make money option trading you then want to combine it with an option trading strategy that will allow you to realize the required profits compared to losses. It may be a simple buying calls and puts approach, or a slightly more advanced option spread trading approach. It could be a more conservative covered calls strategy. If you have educated yourself, it may even involve things like high profit out-of-the-money ratio spreads. You can easily realize 800 or more percent profit on some strategies and if this is your target, then you may be also prepared to realize 100 percent loss (you can’t lose any more than this) on other trades, knowing that, as long as you achieve the required number of succeessful trades combined with correct position sizing, you will profit overall.
The Right Mindset
If you really want to make money option trading . . .
you must adopt the mindset of a businessperson. Anyone going into business without first establishing a business plan is asking to fail. This is how it works in the real world and is no different in option trading. In a ‘conventional’ business, you make some good decisions, others bad. You try different things – some work, others don’t. When they don’t, you cut and run and focus on where the profit is. This is business. It is no different with option trading. Some decisions will profit, others WILL lose and you need to be psychologically ready for this.
The most important part is your business plan.
The next important thing is matching an appropriate strategy with your business plan.
The final ingredient that separates the winners from the losers, is implementing your plan with consistency, persistence, self discipline and commitment to ongoing education and improvement. Follow this advice and you will not just make money option trading – you will have a successful option trading business.