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9 Lesson Option Course
Lesson 7 - Limiting Your Risk.
In this lesson I will show you
how to limit the risk on every option trade you
do. I hate losing money. So every trade I out
on has limited risk. I know what my maximum loss
can be on every trade, and if the trade goes against
me, I make adjustments to my position to protect
my profit or myself from the maximum loss. Even
with a 80% probability of expiring, you will still
have 2 out of 10 trades go against you. I do not
believe in putting on a trade and not protecting
it.
Before I make a trade, I want to know what is
the most I can lose, the most I can make, and
when I need to adjust my trade to protect myself.
Figuring out the most I can make is easy. It's
usually the amount of the credit we receive from
selling our options.
Figuring out the most I can lose is easy too.
I always limit my losses by buying options at
the same time I sell them. Huh?
Let's say I want to sell a call option on IBM
with a 50 strike price. For this option I will
get 2.00 in credit. To limit my risk I buy an
option further out of the money. In this case
I can buy the 55 strike price option for a debit
of 1.25.
Here's how it works. I sell one option at 2.
I buy one 5 points away for 1.25. So my total
credit is .75 (2-1.25). That is my max profit.
To figure my max loss, I subtract .75 from 5 to
get 4.25. (We bought the option 5 points away).
So if IBM stays below 50 we make the max credit.
But what if IBM shoots up and goes to 60?
We would have to sell 100 shares of stock at
$50. But we bought an option at 55, so we can
buy 100 shares at $55. Plus we got .75 for each
share so we would only lose $4.25 per share. Even
if IBM goes to 300, we still only lose $4.25 a
share.
In option terms, this is a called a spread. You
sell one, and you buy one to limit your risk.
You make less money because you have to spend
some of your credit but less money made is a lot
better than a whole lot lost.
But what about the adjustment?
Let's look at the Iron Condor trade. A lot of
people lose money on these trades because they
do them incorrectly. I have even heard option
"experts" and newsletter writers advise
clients to put on a condor trade and never touch
it. If you lose, you lose.
Here is the problem with that thinking.
Let's say we do 10 condor trades, 1 a month for
10 months. Each has a 10% max profit and 80% probability
of expiring. When we win, we make 10%, but when
we lose we can lose 90%.
Let's look at the trade we discussed earlier
on the RUT:
- Sell 1 NOV 660 Call at $1.98
- Buy 1 NOV 670 Call at $1.58
- Sell 1 NOV 380 Put at $4.05
- Buy 1 NOV 370 Put at $3.50
The total credit we received was 95 cents per
option. Our maximum loss was $9.05 per option.
So our max return would be 10.5%.
The total margin we have to put up for this trade
is $1,000. If we win we will make $95. If we lose
the max, we will lose $905.
So let's begin. We trade the RUT in this way
for one month, and we win. We also win in the
2nd, 3rd, 4th, 5th, 6th, 7th, and 8th months.
Wow, we are hot!
8 months of wins for about
$100 each month gives us a total of $800.
But then in month 9, we lose. And we don't adjust
so we lose the max. -$900. Now we are in the hole
$100. After nine months of work we are negative.
That sucks. But wait, we are not done yet. In
month 10, we lose again. We lose another $900.
Ouch! Now we are down $1,000.
What happened? Even with an 80% probability of
success we still lost a boatload of money. In
this case 100% of our margin. Let's stay away
from these Iron Condors, right?
If you don't know how to adjust, you should
stay away from them. Because you will lose your
shirt. And if you come across a newsletter or
teacher that tells you not to adjust your condors,
RUN away from them. Trust me, in the long run
you will lose, unless you adjust.
Remember the RUT trade we revisited above. We
came out ahead on that trade. But only because
we adjusted. If we had not adjusted we would have
lost the max amount.
We need to treat our trading as a business. If
you were running your own business would it be
ok if you could lose your whole year's revenue
in one month? Hell no! You want to be positive
every month. And if that's not possible then you
want to keep your monthly loss to be about the
same as the gain of an average month. So if you
make 10% in a good month, you don't want to lose
much more than 10% in a bad month.
To recap, we limit our max loss by using spreads.
And we limit our losses even further by adjusting
our trades. This works with all our trade strategies,
the condors, butterflies, calendars, credit spreads,
covered calls, and all the rest.
In our next lesson I will show you some of the
trades we do.
Let's
Go to Lesson 8
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