DOES THE REWARD JUSTIFY THE RISK?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

RISK MANAGEMENT FOR THE NEWER TRADER

BUYING OPTIONS AND PREDICTING MARKET DIRECTION
Newer option traders tend to adopt the strategy of buying calls when they are bullish and puts when they are bearish.
It is very easy to buy some options based on your market savvy. In other words, you -- like the majority of new investors -- probably believe that the trade will be profitable because you believe that the stock price will behave as you predict.
That is based on the belief that you have a talent for stock picking and timing the market.
Despite a ton of data to the contrary (Numerous available data sources illustrate that individual investors perform far worse than the market averages when making buy/sell decisions) most still believe that they are not average investors and have the ability to beat the market.
RISK VS. REWARD
Those beliefs often lead to unwise investment decisions. That brings up the topic: How much money can you afford to risk when making investment decisions based on your ability to know what the future holds?
The more difficult questions are:
·         Can you estimate the probability of earning a profit from a given trade?
·         How does the potential profit compare with the money at risk?
EXAMPLE
The inexperienced option trader may look at a RS 40 stock, decide that the price is heading higher and seeing that the two-month option with a RS45 strike price costs 'only' RS0.15 (that's RS15 per contract), decides to invest RS75 by buying 5 contracts.
ANALYSIS OF THE TRADE
The risk is only RS75, so at first glance this seems to be an acceptable trade. After all, the potential gain is theoretically unlimited and the maximum loss is just RS75.
However, that is not the whole story. This is a stock whose price fluctuations are tiny. Translation: this is a non-volatile stock. In fact, over the past couple of years, the average daily price change is only 5-cents per share. The probability that the price can rally far enough in 45 trading days to turn this investment profitable is less than 1%. In other words, the likelihood of earning any profit from this trade is dismal and the most likely outcome is a 100% loss.

YOUR FIRST OPTION STRATEGY. SHOULD IT BE BUYING OPTIONS?

CATEGORY: FOR THE OPTION NEWBIE

It seems natural to buy options. After all, isn't that why they exist? The answer is no. Options were created to shift risk from the risk avoider to the risk taker. They were not created as a tool for speculators, although speculators play an important role in the options world.
It is important to understand that all investing has a certain resemblance to gambling. However, investors gamble only when they make trades based on too little information or when the trades are based on ‘hoping’ that something specific will come to pass.
I discourage gambling with options and I hope to encourage you to adopt a similar attitude. Nevertheless, it is convenient to use gambling vernacular when discussing certain aspects of trading.
TRADING OPTIONS IS QUITE DIFFERENT than trading stocks. When buying a call option, the investor (or trader) Is making a bet that the underlying asset (usually a stock, but it may also be an ETF (exchange-traded fund), index, currency, commodity etc.
Will move higher or lower before the option expires. Under most circumstances, it is a bad bet.
These are the primary reasons:
DIRECTION. Although most investors/traders believe they have the skill to know when the market will move higher or lower in the future, there is a ton of evidence that says just the opposite. For example, studies show that most individual investors under-perform the market averages, year after year. This is more a result of buying and selling at the wrong time, rather than of owning the wrong stocks. No matter the reason, the average active investor does worse, on average, than those who tend to buy and hold. Much of the poor results can be blamed on buying when everyone’ is bullish (near the market top) and selling when traders dump stocks in a panic (near the bottom).
Another study shows that most investors perform far worse than they believe they do. This seems strange, but perhaps this finding can be blamed on a poor memory. More than likely it is a result of traders remembering good results while tending to forget their worst trades.
If you believe you are a good stock picker and will get the direction right significantly more than half the time, then perhaps you can make money buying options.
However, there is much more to consider. See below.
Keep a written record of every buy/sell decision. This is part of your trade plan. Do not fudge the results because you would only be hurting yourself. If you have a proven (in writing) track record of being able to earn far more than your trading expenses, then buying options may work for you.

OPTIONS FOR BUSY INVESTORS

Both investors and traders can use options.
The generally accepted difference between investors and traders is that investors make portfolio changes far less often and that they have the time and patience to allow their investments to grow. In other words, investors are not interested in instant gratification whereas traders prefer to make a trade, collect a quick (a few minutes to perhaps a couple of weeks) profit and exit the position.
Traders seek stock-market profits by selling as soon as a profit target is met. They never get married to a position. Nor do they have loyalty to the company whose stock they own. They often ignore the nature of the company itself, relying on charts to make buy/sell decisions. Some traders own positions for as little as a few seconds, while others may wait as long as two months for a position to work.
There is also another major difference. Trading is a full-time job because there is a continuous need to monitor positions and to make important decisions. Investing is something that anyone can undertake. Don't misunderstand. It is not a simple process. Instead it requires that an investor finds the time to do the necessary work for making important decisions. Unless you want to pay someone to manage your portfolio by buying mutual funds (a poor choice), ETFs (a good choice) or hiring a financial advisor, the successful individual investor does his/her homework. 
Investors tend to hold positions for years, decades, or even an entire lifetime. As a consequence, they make few investment decisions.
Investor portfolios should be examined on a regular basis (at least yearly) with the goal of unloading stocks that no longer deserve a spot in the portfolio. Alas, that seldom happens and many buy and hold investors believe in holding forever.
Timing is not a big issue because paying a few cents more per share, has little effect on the long-term results.