This Single Rule Will Keep You From Big Losses When Trading Options

Options Trading 101 - The Ultimate Beginners Guide To Options

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by Gavin in Blog
December 20, 2019 0 comments
big losses

Warren Buffet has repeated his two golden rules for investing over and over again:

Rule #1: Don’t lose money.
Rule #2: Never forget rule #1.

This sounds like an impossible task to achieve considering the volatile nature of options and this is perhaps the reason why those who are new to trading options are more inclined to take heavy losses as they think they are just a “part of the process”.

Yes, there’s a learning curve for almost everything you do in life, including trading options, but you don’t necessarily have to enter positions that can either double your money or knock you out the ring if things go south.

The Biggest Mistake Most Amateurs Make When Trading Options

Most people have the wrong perception about options. They commonly see this financial instrument as a bet that follows a random pattern that cannot be predicted.

This view is often followed by all-in strategies that involve buying call or put options based on potential directional price swings they expect to occur, especially during earnings season.

The thing with this type of trade is that they expose you to lose 100% of the money invested.

Let’s say you buy a call option and after earnings are announced the company misses its target and the price of the stock drops.

What happens in that case is that your call option is out of the money and it is now worth zero.

If a significant portion of your portfolio was committed to that transaction such a scenario means that you have lost a lot of money and this will probably lead you to lose any remaining faith you had on trading options as a potentially successful investment strategy.

Here’s the golden rule you should follow to avoid big losses when trading options:

Don’t ever commit a large amount of money on a single trade if a negative result can take you off the game entirely.

By following this rule you’ll understand that none of your trades should expose you to a large loss and this can be achieved in many different ways.

Price Targets & Stop Loss Orders

There are two steps you should take whenever you decide to enter a certain trade to keep your losses limited:

  1. Define price targets at which you will enter and exit the position.
  2. Set a stop-loss order that can be automatically triggered if things don’t work out as expected.

No trade is sure enough to be worthy of a large portion of your portfolio, no matter how certain you may feel about it.

Regardless of the trading strategy you apply, limiting your exposure by setting these parameters will help you achieve steady returns that will reduce the month-by-month volatility of your returns.

Limited gains and losses can help you produce satisfactory returns over the course of an entire year. An average monthly return of 2% – 4% is much more dependable than a 100% monthly return followed by a 70% drop the next month.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now