OAP 165: Trading Options? Here Are The 11 “Golden Rules” To Follow

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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. In the world of investing, and specifically trading options, you need to live by certain rules. Rules that keep you safe and protected from the unknown of the market.

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 cause you to trade different 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.

Key Points from Today's Show:

1. Small Position Size

  • A small position size means that no ticker symbol represents more than 5% of the risk in your account at any one 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. 

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 together in a market move.
  • Instead of picking diversified tickers, 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.
  • 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 happen as you go through expiration.
  • Options are perfectly priced at the time that you enter them, for the expectation of where the market is going to move and how much volatility there is. 
  • The mispricing only occurs once reality actually plays out over the course of 30 or 45 days. 

6. No Stoplosses

  • You are better off long-term not using stop-losses than you are using stop-losses.
  • Generally what we see is that 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 losing more often than 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, your win rate is really high but reduces your profit in the long-term.
  • Most strategies that are held to expiration end up having some of the higher net profits overall. 
  • However, the longer you hold your trades the bigger the drawdowns they will go through. 
  • The key is to use the strategy that works best for you as a trader.

8. Ample Cash Reserve

  • Options contracts have additional risk because they leverage a single options contract in exchange for 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 face 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 somewhere around 30-50% allocation globally in your whole portfolio 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, but you should be actively working to reduce that cost of business.
  • Although fees are never going to break a great trading strategy that works long-term, that does not mean that you can't work actively to reduce your fees. 
  • You should be contacting your broker and negotiating your fees all the time. 
  • In fact, most of the new brokers coming out are cost-free. 
  • 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 times, 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: double down on positions, fighting back against trades, chasing a win, etc. 
  • This is the wrong mentality to fall into since it only increases the risk.
  • Instead, you should only be adjusting to reduce risk.

11. Non-Emotional Expected Outcomes

  • In trading, this 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.
  • There is no reason for you to trade things that have a negative expected outcome. 
  • As a trader, you should be focusing on getting the things you can control right and let everything else just happen. 
  • 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.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.