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Options Traders: Three Golden Rules to Avoid Catastrophic Losses

options education options trading risk management Feb 04, 2024
Focused options trader studying charts with three golden rules highlighted

Options trading is akin to a double-edged sword: a potential tool for leverage and diversification, but with it, the peril of magnifying losses.

Over 15 years of interaction with thousands of traders, I’ve witnessed the ebbs and flows of market sentiment and the boom and bust cycles of traders. Though there are many types of traders, something are common amongst all.

So, whether you are a brand new options trader or been trading for sometime especially under a year or two, whether you learnt from OptionPundit or any other options educator, I think every options trader must know and follow these three golden rules.

Dive in to prevent significant trading losses and fortify your portfolio against market volatility following three principles.

Rule #1: Stop Selling Uncovered Options Immediately

Options are not lottery tickets to riches; they are intricate financial instruments demanding a nuanced understanding. Perceptions of credit being equal to income can lead to catastrophic losses especially in stressed situation or in a short squeeze of an underlying asset.

Let me be clear:

Stop selling call or put options, especially uncovered, if you don’t fully grasp them!

Beyond the basics, there are subtle details like the Greeks and the difference between intrinsic and extrinsic value. Margin snowballing is another invisible force that many options seller don't understand and they pursue selling options as if it is a ticket to riches. 

Buying long term options, though less risky, is not different either. But that's a topic for another day. If you don't understand options well, at least consider drawing out profit and loss diagrams for potential trades which can offer a tangible representation of risk and reward.

Take the unfortunate tale of John*, a rookie trader who, enticed by the potential of hefty returns via monthly compounding, sold uncovered calls on Gamestop (GME), in 2021, without understanding the potential for unlimited losses. When the stock surged beyond his wildest expectations, he found himself on the hook for amounts far exceeding his initial investment.

Benjamin Graham, the father of value investing, once wisely stated, "In the short run, the market is a voting machine but in the long run, it is a weighing machine."

The implication for options traders?

If you're making decisions without understanding the underlying mechanisms of options, you're merely voting on a hunch. But with knowledge and understanding, you're better positioned to weigh the true risks and rewards.

Thus, equip yourself with knowledge before casting your vote in the options market.

Rule #2: Know Your Trading Platform Inside Out

Modern trading platforms offer a myriad of tools, analytics, and visuals. With this power, however, comes the responsibility of mastery. Before you let your money dance on the digital stage of stock trading platforms, ensure you know every nook and cranny of that stage.

Most platforms provide tutorials or guided tours—use them. Just an hour spent there can guard against costly errors later.

Imagine Emily, an intermediate trader who had migrated to a new platform. She intended to set a stop loss but inadvertently placed a market order due to unfamiliarity with the new interface. The result? A premature exit from a position she believed in, and substantial losses due to a simple oversight.

As legendary trader Jesse Livermore once said, “There is nothing new in Wall Street. There can't be because speculation is as old as the hills.” While the tools we use may evolve, the necessity of understanding them remains eternal.

Rule #3: Be Cognizant of Earnings Announcements

Earnings season can send ripples or tidal waves for entire stock market, let alone for options traders who are exposed to magnified price movements. 

Always, Always check for earnings announcement dates for your portfolio companies.

Forewarned is forearmed.

And in today’s digital age, setting up automated alerts can ensure you never miss them.

Consider Alex, a seasoned options trader who overlooked the earnings date of a company he had a significant options position in. The stock took a nosedive post a disappointing earnings report, catching Alex off guard. Had he been attentive to the earnings calendar, he might have re-evaluated his position, hedged, or taken some off the table.

In the words of the eminent Peter Lynch, “Know what you own, and know why you own it.” As options traders, it's not just about owning the option, but understanding all external factors that might influence it.

Bottomline

In conclusion, while options trading offers opportunities for significant profits, it also brings with it significant risks. By adhering to these three golden rules, you arm yourself against some of the most common pitfalls in the world of options trading. Remember, the world of options demands patience and continuous learning. By steadfastly observing these tenets, you pave the way for informed decisions and pursuit of enduring success in the ever-volatile market landscape. 

In the relentless ebb and flow of markets, it's the informed and vigilant trader who stands tall against the tides of uncertainty.

Protect your capital, protect your peace of mind, and trade wisely.

Happy Trading,

Manoj Kumar

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