Editor's note: Earlier this month options analyst Andy Crowder hosted a live chat to discuss "How to Make a Consistent 15% Every Six Weeks." The response was overwhelming – more than 300 of you tuned in for the hour-long chat, and many of you came equipped with some excellent questions for Andy. While Andy was able to get to many of those questions during the live chat, there were simply so many that he was not able to answer all of them. In today's Daily Profit, Andy addresses some of your most pressing options questions that went unanswered during our webinar.
If you missed the recent live chat, don't worry. You can click here to watch the recorded webinar in its entirety. The next live options chat will be held Thursday, April 5.
Can you quickly explain position sizing and how you apply it in the Options Advantage portfolio?
Great question. Money management, capital preservation, stop-losses, and more importantly, position sizing are the keys to options trading success. Trying to be a hero when a position moves uncomfortably away from you often leads to disaster. All traders have experienced this at some point – sometimes it's unavoidable.
Almost every trading text out there describes, in great detail, the author's great epiphany after a disastrous, account-depleting journey in trading. These one or two failing experiences seem to create that "a-ha" moment where, as a trader, you "get it."
Losses are going to happen. It is what you do to avoid taking large losses that keeps you in it for the long term.
Yet most of those texts never mention the one way to keep those catastrophic trades to a minimum: position sizing.
Options trading seems to create a get-rich-quick mentality that attracts the "speculative gamblers" out there. To me this approach seems short-sighted, unless that is your goal and you are willing to take the risk.
I prefer to take the long-term approach that attempts to beat the market over an extended period of time. Admittedly, I swing for the fences sometimes and place a highly speculative trade, but those are few and far between and I would never allocate a large portion of my portfolio to a trade like that. It is just too risky for my blood after what I have experienced as a trader.
Many investors, especially options investors, have a casual attitude toward the management (risk, money) of their investment portfolios. In the constant race for profits, risk management and money management seem to be secondary. The almighty return, the "we want a lot of return, we do not want any risk, and we need the money by Monday" mentality, seems to override the importance of position sizing.
This is particularly true in the options arena. How many websites have you come across that regularly tout outlandish gains with minimal risk? Such claims aren't very realistic. I'm not saying that the typical options investor can't beat the market by a decent percentage annually. But "shooting for the moon" is not sustainable.
The Gallup organization and UBS recently conducted a survey that found 39% of respondents believed stocks would deliver at least a 15% annual return over the next 10 years. This goes to show how wishful thinking consumes a large portion of the investing public's attitude toward returns. Historically, the notion of such returns is unreasonable.
Position sizing is possibly the most important aspect of any options portfolio and trading system. As an investor you must always be aware of risk management (how much you are comfortable losing per trade) and money management (the size of the position per trade).
So, as far as "how much you should allocate to each strategy", trade, etc., the answers are ambiguous. I can only speak to the strategies I use in the Options Advantage portfolio.
With that said, go ahead and explore varying ways to use position sizing. Try out different scenarios based on the trades we have placed so far this year. Discover which one fits your investment objectives and stick with it. Remember, investing is not a sprint, it is a marathon.
What role does market condition play in your decision to use a credit spread?
Market conditions play a role only if they have reached a short-term overbought or oversold extreme. I try not to guess where the market is headed over the intermediate to long term. It is truly a fool's game. The crystal-ball approach is basically useless to investors. No one knows where the market is headed over the next year. If they say they do, then you might want to reconsider where you get your information from.
What I do know is that 2012, like every year, will present short-term extremes in the market. As always, I will take advantage of these extremes by applying sound, logical options strategies. My approach is mechanical. I patiently wait for short-term extremes, apply the right strategy to fit my assumption on the extreme and then allow time decay or my directional conviction to play out. It is quite simple. My approach is always the same, whether it's 2012 or 2020.
How does volatility affect the credit spread portion of your Options Advantage portfolio?
Volatility is a wonderful thing when trading credit spreads. When I started trading options, the first thing I was taught was to buy low and sell high. This goes for absolutely everything – including volatility – especially if you trade options.
Increased implied volatility means that I can sell options premium for greater prices and in turn allow my chosen position either to make more money or create a larger margin for error just in case my assumption is wrong. This is a huge benefit when trading credit spreads.
Most investors fear volatility. I really don't care one way or the other. I only trade extremes in the market and apply strategies with a high probability of success. In my case, I welcome increased volatility.