By: Tom Gentile
on October 13th, 2023
When it come to options trading many option traders haven’t given consideration to how much they are willing to risk and or lose on their trades and this educational piece is here to provide a couple of considerations to help one preserve their capital in the world of options trading.
Today we got our first batch of earnings, and some came from the Financial sector. The securities JP Morgan Chase (NYSE: JPM) which came in at $4.33 vs. expectations of $3.89 and Wells Fargo (NYSE: WFC) reported eps of $1.39 vs. Expectations of $1.25 to name a couple.
Both gapped up on the open, ran higher only to reverse all or almost all of their gains for the day.
Why the Bearish Day in the Markets
Before I give you options traders or thinking about becoming option traders a couple ways to consider handling potential losses, let’s give a bit of insight as to the reversal day for the markets overall.
The University of Michigan’s closely watched ‘survey of consumers’ for October came out with a reading of 63, which was down from 68.1 in the prior month.
Another key part of the report is the measure of inflation expectations. The reported expectations of American’s for overall inflation over the next year jumped to 3.8% in October from 3.2% in the prior month.
Worry? Not Worry?
Some may have taken a bullish options trade on either or both of the financial securities mentioned, saw them bounce higher on the open and then by end of day have a bearish reversal day.
Options traders may be worried about what could happen to their money placed on the options trades.
The consideration I am about to provide are shown to educate everyone on ways to have their trade management established and the amount of money they know is at risk BEFORE they spend a penny on their options.
It also helps one set their option trade up, so they know their maximum risk and even better, know how to set up their position size, (amount of contracts) so they no if the worst thing that happens, losing 100% of their cost in the trade happens, it is only an agreed upon, by them, amount before they even opened the trade.
It is a style of trade management called Cost as Risk.
Cost as Risk
For your consideration
Here is a consideration for option traders on how to manage their options trading Risk / Reward:
There are actually two ways we see one can go about a stop loss.
- Use a percentage stop loss or
- Use one’s Cost as Risk
We teach and use case studies based on a theoretical 25K account in which no more than 2% is at risk on any given trade, meaning no more than $500 risk per trade. Whatever your starting account is will be up to you. The percentage risk per trade, 2% or more, is up to you.
Stop Loss Percentage: If you go with a 50% stop loss rule that means one can set up a trade that costs $1,000 and at a 50% stop one would lose $500 but keep the remaining $500 to live to trade with another day.
Concern is, well let me ask you. How many times have you stopped out at a 50% stop only to see the trade turn around and work? Frustrating, right?
IMPORTANT NOTE: We are advocates of having an alert placed at your percentage stop loss price point rather than placing an ACTUAL stop loss. This way one is alerted their position’s value/risk, without the prospect of an options market maker seeing it on the books and taking it out.
Cost as Risk: how about spend only up to your acceptable max risk or up to $500 on the trade to begin with. You will have less contracts and therefore less profit potential, but you will not have an arbitrary stop loss percentage potentially taking you too soon if you are willing to risk the full $500.
This way the market and your position’s underlying security can bounce around all it wants and unless its value reaches zero you can maintain the trade and stay in it a bit longer, giving it a chance to work out.
It keeps you from having to over-manage it and all its gyrations as well, so less stress in your trading is also a benefit.
Position-Sizing: If you max risk is $500 and the cost of the option is $.50, that would allow one to ‘Open’ two contracts, equaling $500 cost.
Go with the one that suits your personality best.
App: Toms Option Tools
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Stock and options trading has large potential rewards, but also large potential risk.
You must be aware of the risks and be willing to accept them in order to invest in the stock and options market. Do not trade with money you cannot afford to lose.
This is neither an offer to buy/sell/ or recommend a particular stock or option.
Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not been actually executed, the results may have under or overcompensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with hindsight.
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