Wednesday, 2 March 2016

UNDERSTANDING RISK; THE MANDATORY SKILL

RISK MANAGEMENT
Professional option traders use sophisticated methods because they take great care to minimize risk. We, the individual investor, have it easier. We have simple tools that allow us to measure the risk of investing with options. For example, there is the risk of losing (or earning) money as the days pass. Or the risk/reward possibilities that come when the underlying stock rallies (or falls).
We’ll get into topics related to risk in the days to come, but for today it is enough to understand that options come with built-in risk-measuring tools, collectively referred to as 'the Greeks." No other investment vehicle makes it so easy to measure and mange risk.
New option traders often believe it is difficult to use these tools. The math may be complicated, but using the numbers is a cinch.  Brokers provide the numbers and use the ones that interest us.
Individual investors usually take a little extra risk, seeking larger profits per trade. One of the topics that we'll talk about in detail is how to measure and manage risk.
 Don't get the wrong idea. I mention risk management frequently because all successful traders understand the importance of doing so. The sad truth is that there are always inexperienced traders who don't believe that understanding risk is important, and the vast majority of them wind up with devastated accounts. I want you to succeed, so the warnings come first. You want to begin trading with a winning, risk-conscious, mindset.
Option strategies are not inherently risky -- unless you, the trader, decides to make a high-risk play. Options strategies come with limited and defined risk, and that is beneficial to each trader.
I’ll warn you about such high-risk strategies and do my best to get you to avoid them. However, we are each our own master and we trade as we see fit. Using risk-management tools allows you to understand exactly what can go wrong with each trade -- and that means no unpleasant surprises.
STOCK VS. OPTIONS
People who invest in stocks almost never go broke because stocks seldom lose 50 to 100% of their value  in a single day.
 Stock traders may invest in new and unknown companies, seeking higher rewards. It does not happen often, but those who get in on the ground floor of a giant success story can earn a fortune. That is the attraction (for speculators) of buying low-quality stocks. However, this is not a good way of thinking for the option trader.
Most of the time neither anything spectacular nor terrible happens to such stockholders. Sure, the company may never earn a profit and the investment may never grow, but it is unlikely to become worthless. Unfortunately the same cannot be said for novice option traders because of the special property of options (limited lifetime).
If the option buyer does not see his/her stock price move quickly (and move in the correct direction), the options bought May quickly become worthless. It does not take too many such traders (100% loss of invested capital) to ruin a trading account. Please be aware that there are many other strategies you can adopt, other than buying options.
TODAY’S LESSON:
At no extra charge, options come with excellent risk-management tools (the Greeks). When you learn to respect risk (knowing what can go wrong with every trade) and use those tools, your chances of making money with options increase significantly.
In future discussions, I’ll emphasize trades with limited risk. For today, just know
·         It is very difficult to earn money when your basic strategy is buying options.
·         It is even more risky to sell options, hoping that they will expire worthless.
The most efficient compromise is for traders is to own spreads.

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