Don’t Use a $6,000 Trade to “Practice” Trading Options

The last couple weeks of trading for many newbie investors was quite the learning experience. The market fell from all time highs quickly and then recovered nearly half of that move in a single week. Still, we got a flood of emails from people who were not well positioned for the drop in equity prices and learned the hard way why you can't practice trading options with large, one-sided trades. One unfortunate person placed a single $6,000 trade in a $10,000 account and felt the full wrath of Murphy's Law.

Key Points from Today's Show:

• When the market takes a big dive down, or makes big moves it is easy for people to get drawn into the mania of it all.
• For the most part, people act rationally in these situations... until they don't.
• Emotions play a big role in trading, even when you don't want them to.
• During the extreme highs and extreme lows, it is often hard for traders (or people in general) to act rationally.

Most times when this happens, there are two main bad decisions that traders make:

1) Position size is much too large.

• Traders get really excited about the potential returns, and allocate too much of their portfolio into one trade.
• Then, if the trade goes badly they stand to lose a lot more than if their position size was smaller.

2) Not enough neutral positions.

• Recently, trading neutral has fallen out of favor as the market rallied upwards.
• As a result, not only were people over-allocated during the market fall, but they were over-allocated in the wrong direction.

Trading Framework:

1. Paper-Trade Until You Get the Feel For Things

• Don't practice trading with real money trades until you have a better understanding.
• Rather, start with paper-trading to first get the hang of the market.
• However, don't treat your paper-trading as a real account; use it to practice a lot of different trades, and learn from the mistakes, failures, or successes.
• For example: trade 100 iron condors and by the end you will get a good feeling of where the market is, how an iron condor performs, and how you should adjust them.
• This is a great way to get exposed to a lot of different environments and really study how your trades behave in the market.

2. Start With Really Small, Risk-Defined Positions

• Once you begin making real money trades, start with a very small position that is risk-defined.
• The smallest position that you could possibly create is a $1-wide credit spread, which might have $30 of potential profit and $70 of max risk.
• This allows you to avoid gambling with your money and your allocations.

3. Remember That the Law of Large Numbers is Your Friend

• When you start trading high-probability setups, that does not mean that you will immediately win.
• You start hitting your probability of success level as you start making more and more trades.
• Therefore, more trading is your friend; not your enemy.
• Making more trades helps you smooth out the market noise and it makes market direction become meaningless.
• Market direction is essentially meaningless the more often you trade.

4. Stop Rushing Through Things

• Slow down now so that you can speed up later on.
• Take your time, go through past trades and analyze everything that happened.
• Become a student of the options trading game to truly understand it.
• Slow down, understand the concept, and once you master it then you'll never have to come back and revisit it again.