11 Golden Rules of Trading Options

Personally, I don't like rules. Mostly because I value freedom and flexibility--so when someone says that I have to follow the rules, I naturally push back. Things that confine me or tell me what to do don't fly well with me. But, that only applies to things outside of trading and investing.

I imagine that the 11 "Golden Rules" I'm going to present in this podcast will cause many of you to push back and challenge their usefulness. Mostly because they'll prompt you to trade differently than you have in the past, and being different means being uncomfortable. I'm okay with that, and I welcome the discussion around them. But, don't misinterpret this level of understanding in adoption to also represent flexibility when it comes to these rules. These are "unbreakable" rules for me and should be for you as well.

1. Small Position Size

A small position size means no ticker symbol represents more than 5% of the risk in your account at any given time.
This is simply because we have no idea where any one position will go in any time period.
You don't want to put yourself in a situation where a single position blows up your account.
When your position size is too large, you make irrational decisions.
For more on position sizing, check out: What Everybody Ought to Know About Proper Position Size When Trading.

2. High Trade Count

When you trade a high probability system, you need a lot of occurrences to let the probabilities work out to their expected outcome.
Somewhere around 400-500 trades is where the probabilities really start tightening and converging around the expected outcome.
The longer you stay in the game and the more you get your trade count up, the more consistent you will be over time.

3. Uncorrelated Tickers

In your portfolio, you need uncorrelated tickers-- those that are unlikely to move in the same direction.
You don’t simply need more symbols just for the sake of diversity.
Instead, you need to determine which tickers are uncorrelated to one another. The key is to add uncorrelated exposure to your portfolio.

4. A Balanced Portfolio

When you start trading options, you no longer have to trade in one direction.
Options trading is omnidirectional with multiple payoff paths.
The key is to balance your portfolio directionally through beta weighting. Where would the market need to move for you to make the most money? If you need the market to move higher for you to make the most money, then your portfolio is leaning bullishly. So, you should be careful adding more bullish positions.
You want to move, or trade, in the opposite direction of where the market is moving.

5. Be a Net Options Seller

The key is to be a net options seller more often than you are a net options buyer.
This is how you gain your advantage in the market, by collecting premiums and being patient enough to let the mispricing of implied volatility correct as you move toward expiration.
Options are perfectly priced at the time you enter them for the expectation of where the market is going and how much volatility there will be.
The difference between implied and actual volatility corrects itself as reality plays out over 30 or 45 days.

6. No Stop-Losses

You are better off long-term not using stop-losses than you are using stop-losses.
Generally, what we have seen through backtesting is stop-losses create more losses.
If you place a stop-loss order, there is a very high likelihood that that stop-loss order gets executed.
Stop-loss orders end up negatively impacting performance more often than having no stop-loss.

7. Opportunistic Profit Taking

Determine the best opportunity to take money off the table and have a high win rate coupled with high returns.
When you take profits too early, you have a high win rate but your profitability is reduced in the long-term compared to letting positions go closer to expiration.
In our backtesting, strategies that held positions closer to expiration ended up having some of the highest net profits overall.
However, the longer you hold your trades, the bigger the drawdowns you will go through.
The key is to use the strategy that works best for you as a trader.

8. Ample Cash Reserve

Options contracts incorporate leverage and have higher risk because a single options contract represents 100 shares of underlying stock.
That leverage comes at a cost: if things blow up, you will face a potential ballooning of margin, and you could experience positions that go against you.
As a result, you don't have to invest all of your money to outperform the market with options.
Too much leverage can leave you highly exposed to massive drawdowns, and with too little leverage, you don't see the benefits.
We find that allocating somewhere around 30-50% of your total portfolio to options is where you need to be - and the rest should be in cash.
Cash allows you to be flexible when there are more opportunities on the table and helps you avoid irrational trading decisions.

9. Reduce Commissions and Fees

Broker fees are the cost of doing business, and you should be actively working to reduce that cost of business.
Although fees are never going to break a solid trading strategy that works long-term, that does not mean that you can't work actively to reduce your expenses.
Recent trends downward in brokerage commissions have significantly reduced or eliminated many fees for individual investors. Here are the TD Ameritrade brokerage fees, Interactive Brokers brokerage fees, and TradeStation brokerage fees.
If you have enough emotional stability to manage your own portfolio and stick with it, then you don't need to have a financial advisor.

10. Adjust to Reduce Risk

Often, people get into the mentality that they need to fight back against the market.
As a result, you do things you wouldn't normally do: doubling down on positions, fighting back against trades, chasing a win, etc.
This is the wrong haibt to fall into since it only increases the risk.
Instead, you should only be adjusting to reduce risk--don’t risk more capital when adjusting trades.

11. Non-Emotional Expected Outcomes

In trading, letting emotions control decisions is potentially the number one reason why people fail.
If you let your emotions control your decisions, you will have a tough time weathering the drawdowns.
You should always be looking for a strategy that is going to win in the long-term given enough trades.
As a trader, you should be focusing on getting the things you can control right and let everything else just happen.
Just as an MLB pitcher can only control how the ball comes out of his hand, make sure that the trades are “rolling off your fingers” the right way, and everything else will fall into place.
You have to do what is required to be successful in this business--not just what you feel like doing.

Make informed decisions, not irrational ones. Stay the course, play the expected outcome, and only focus on the decisions you can control.

Option Trader Q&A w/ Alex

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Alex:

I recently rolled my IRA into a new trading account and I'm looking at placing some small, risk-adjusted trades. My account value is about $3,500. What target return percentage should I reasonably expect to achieve over the next year if I'm placing trades at a 70% probability level, using a 2-3% trade size allocation with about 2-3 trades per month?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.