Managing Options Trading Risk

 
The Good, the Bad and the Ugly of Options Trading– Managing Options Trading Risk

You Can't Win Them All

Proper Money Management

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Friday was not a good day for me. I'm the editor of Cabot Options Trader, and for the first time in nearly two years, my subscribers may be looking at their first total loss on a recommendation.

If you trade options as long as I have, you know that you are going to get the occasional extreme situation: a stock will gap up sharply when you are holding puts, or a stock will gap down while you are holding calls, but it still stings.

In this case, I had recommended the June 36 Call on Autodesk (ADSK) on May 11. The stock was riding the lower rail of an upward sloped trend channel and it was oversold based on the 10-day Relative Strength Index. The RSI measures a stock's recent performance against its past performance. A reading above 70 is considered overbought and a reading below 30 is considered oversold.
 
ADSK Chart
 
The setup had seemed ideal, but the stock gapped sharply lower on Friday after a disappointing earnings announcement Thursday night. The gap lower created a situation where the June 36 Call was virtually worthless, so unless the stock can rally sharply between now and June 15 (the expiration date), subscribers to Cabot Options Trader will suffer their first total loss on a recommendation.

That's the ugly part of options trading.

The bad part of options trading is that if you are buying puts and calls, your winning percentage is likely to be in the neighborhood of 50%, considerably less than a typical long-term stock investing system. I discussed this in an article for Cabot Wealth Advisory last month, Three Factors Determine if You Make Money in the Market. You need to learn about managing options trading risk.

Now let's get to the good part of options trading.

While a 100% loss is something none of us want to deal with, it is inevitable when you trade options for a long time. Autodesk was my 75th Cabot Options Trader recommendation in almost two years. So although I'm disappointed, I can live with one total loss every two years, especially when I look at the seven trades where subscribers made over 100% on the recommendations. There was even one recommendation where subscribers averaged 190%.

The fact that you can lose 100% is the risk of buying short-term options. But 100% is also the maximum you can lose, while your gains are unlimited. The best trade I ever made on an option was in December 1990 when I had calls on a stock and the company got a takeover bid. The calls I bought for $1.75 each were worth $22 each overnight. (Remember when talking about options prices, each option represents 100 shares, so you have to multiply the price of the option times 100, so the $175 options were worth $2,200 each.) That's a 1,157% gain.

The key to surviving a complete loss on a trade is to use proper money management. In the Cabot Guide to Options Trading, there are suggestions for proper money management. I recommend that no more than 20% of your total portfolio be used for trading options, and to manage your trading risk I recommend not putting more than 20% into any one trade.

So if a person's investment portfolio is $50,000, no more than $10,000 should be dedicated to options trading. Out of that $10,000 dedicated to options trading, no more than $2,000 should go into any one trade. So in the case of a total loss, the options account takes a 20% hit and the total portfolio takes only a 4% hit.

Proper money management is important no matter what you are investing in, but it is crucial when using an options buying strategy. You can take a loss like the one we're holding on ADSK, but you live to trade another day, as long as you have learned to control your options trading risk.

Good luck and good investing,

Rick Pendergraft
Editor of Cabot Options Trader

Editor's Note: Forget the naysayers ... 2012 will be one of the MOST PROFITABLE years on record. In fact, we're so sure you'll bank big gains this year that we're giving away the entire Cabot Market Letter buy list FREE with your paid subscription. Click here to learn how you too can win big in the market this year.

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