In investing, absolutely nothing is more important than discipline and careful risk management.
This fact is particularly true when investing using options, because options offer an enormous array of strategies coupled with a huge amount of potential leverage. Essentially, an investor can purchase the right to a large portfolio with a comparatively small capital outlay.
The typical investor doesn’t understand the true concept of leverage. In fact, the average self-directed investor takes on far greater risks than they probably realize. Yes, the rewards can be amplified, but so can the risks.
But we aren’t the average investor.
We understand the importance of thinking in probabilities and how it allows us to define our own risk. We understand the risk associated with each and every investment in our portfolio. Lastly, we follow a few simple guidelines to lay the groundwork necessary to prudently build wealth using options. Here are a few ground rules to follow:
- Always think in probabilities
- View options as an investment, not a trade
- View options from a portfolio perspective
- Allow time to work for you
- Understand how options impact your overall portfolio
Always Think in Probabilities
Do you think about probabilities on each and every investment you make? You should.
Why can’t a financial analyst simply tell me the likelihood that a stock will meet their expected price targets among the many pages of their detailed research reports?
Instead, the actual “pros” in the stock-picking business give you a buy target without providing the probability that the target will actually get hit. That’s amazing to me.
The analysis coming out of Wall Street’s best has nothing to do with the actual likelihood of success! Wall Street analysts are little better than Vegas bookies.
Think about it: A stock goes either up or down, so your probability of success is always 50%. It’s essentially a coin toss.
I’m simply not interested in analyst estimates. And if you want to make money in the markets, I think you’d be best advised to ignore them. That’s because a price target is just a guess, in my opinion. And I’m not interested in guesses.
I want to hear the that the statistical chance of the stock going to $50 is X%, the chance of the stock going to $50 in three months is Y% or a stock moving lower over the course of the next year is Z%.
That’s the type of precise advice I can use… and guess what the options markets provide me with that information.
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