We all fear losing money, it's a natural human emotion. I fear losing money just as much as the next person. Today I want to try to walk through a rational and logical sequence of questions that I believe, if followed, will help you uncover the only true risk in the market to your portfolio and, more importantly, how to avoid blowing up your trading account in the process. I'd even dare to say that if you follow the logic sequence from the beginning of this show, you cannot help but come to the same conclusion about trading options, including why the "staying alive" framework all but ensures you'll find success in any market.
- Options trading gets a really bad reputation in the industry and the investing community.
- A lot of people look at options trading as this really evil thing - highly leveraged, rodeo cowboys throwing money back and forth.
- However, when you use a well-defined, conservative system, it becomes much less volatile than trading stocks.
- Q: Do you agree that we cannot make only one single trade, one time, and be successful for life? If you agree, then the next logical question is:
- Q: Do you agree, then, that making only two trades won't work either? If you agree, the next question:
- Q: Do you agree, then, that many trades work better than fewer trades?
- Q: How much sequencing risk do we have?
- Every risk can be pretty much mitigated except for sequencing risk.
- Sequencing risk is the risk that you run into with any system from a series of bad trades.
- It is the risk that you will run into a string of bad trades where you have no control over the outcome.
Here are the four risks we can control that allow us to trade through sequencing risk:
1. Trade Size
- If you are allocating 10% of your portfolio to every trade and allocate a full portfolio of 10% to every ticker, you are effectively giving yourself an opportunity to completely blow up your account with one bad swoop of trades.
- If you randomly pick 10 tickers, allocating 10% to each ticker, and have a really bad sequence of returns, you could end up seeing those 10 trades completely wipe out your account.
- What we suggest at Option Alpha is keeping your trade size under 5%, because if you have a small account, you might have to push that 5% threshold just to get the trade on. But if you've got a large account, you should be at 1-2% for every trade or less.
- If you get a string of 10, 20, or 30 of them in a row, you will definitely feel it, but you will not be knocked out.
- Using options gives us a wonderful opportunity to trade both sides of the market; having bullish, bearish, and neutral positions.
- That way, if the market makes a wild, ridiculous move in one direction, it only affects half the portfolio.
- Having trades on both sides allows you to potentially reduce the impact of a significant sequence of trades that move your positions lower to the downside.
- While balance will not absolutely overcome the move in the market, it will keep you alive to keep trading for another day.
3. Diversity of Tickers
- The idea is that if you understand trade count and understand that you have to be balanced, it makes sense to have a diversity of tickers with uncorrelated risk.
- This means having trades on both sides of the market in a lot of different industries and sectors.
- If you have around 10-15 tickers (on the high end), you'll probably get as much diversification as you need to be successful.
- As you diversify the number of stocks that you are trading, you get less and less of a benefit for each additional ticker.
- In options, because you can choose sectors very easily, you can complete that diversification quickly in 10-15 different tickers.
- There is no set rule on which tickers to choose: select the major markets ETFs (such as IWM, SPY, DIA, and QQQ), including bonds (such as TLT), emerging markets or currencies (such as FXE, FXY, EWW, EFA, EEM, and FXI), currencies, metals or commodities (such as GLD).
- The idea is to try and hit some of the major groups and then fill in the gaps with tickers that are really popular at the moment with high IV, such as XRT, XLY, etc.
4. Trade Count
- There is no magic threshold to cross when it comes to trade count.
- We have no way of knowing what your sequence of trades is going to be.
- Even at 100 trades, you still have some variance.
- It's not until you start getting up to 500-1,000 or even 1,000-2,000 trades that you begin really solidifying your system, your probabilities, and your expected outcomes.
- You could have a series of 20 trades that go against you, but they get averaged out through 1,000 trades.
- The only thing that really breaks the sequence of returns is having a high trade count.
- Traders who stay in the game the longest end up being the most successful.
- Stay alive, never letting one bad movement knock you out!