Target Your Wins and Losses
Last month I wrote a column for Cabot Wealth Advisory titled You Have to Treat Options Differently. Afterward, I received an email from a reader who asked how you could make money without winning at least 60-70% of the time. The reader's question got me started on the topic for this article.
There are three factors that determine your level of success as an options investor or a trader: your average win, your average loss and your winning percentage.
You need to know these three factors in order to make an informed decision about a trading style--whether it's stocks or options. Let me give you three scenarios and you'll see what I mean:
This table is based on 10 trades with equal-dollar amounts in each trade. As you can see, it isn't necessary to win all the time, nor is it necessary to have huge wins.
The lesson here is that the relationship between your winning and losing trades, along with your winning percentage, will determine whether or not you make money.
Scenario A would likely be an aggressive options-trading strategy where you're swinging for the fence. It would likely involve front-month, out of the money options. When you swing for the fence, you also strike out more. You could call this the Babe Ruth strategy. Sure Babe Ruth was the greatest home run hitter of his time, but he also set the record for strikeouts in a career and both of his records stood for a long time.
Scenario C would likely be an option writing strategy with a high winning percentage and smaller wins, but bigger losses. A credit spread strategy would likely have higher average losses than average wins, but would also have a high winning percentage.
Scenario B is what I strive for with Cabot Options Trader. Using options that are in the money by a strike or two and using options that are more than a month from expiring, you will have a better chance of a higher winning percentage. With this safer approach you will have a smaller average win than you would have with Scenario A but your average win will be higher than your average loss, unlike Scenario C.
Good luck and good investing,
Editor of Cabot Options Trader
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