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Ask the Former Market Maker - November 13, 2018

Follow us on Twitter @Schwab4Traders. This blog updates the last Thursday of the month. The next installment will publish on November 29th

Recall that the last time we talked, I said I would take your questions specific to options trading. Today our question comes from a newer trader, John B. from Tyson’s Corner, VA.  “What is a good amount to trade with?” Today, I will discuss the importance of setting realistic expectations for your trades – for each and every trade. 

What we are really talking about is the importance of entering every single trade with a plan in place: one for a profit and more importantly - one for a loss.  And hopefully you’ll learn more about finding a comfortable amount to start with, as well a comfortable amount to leave with. You hear this stressed over and over, but I can’t emphasize it enough: Have a trade plan. And stick to it.  It’s too easy to become emotionally tied to a security.  

So in order to determine trade amount, Let’s start at the beginning. How much is in your trading account?  I tend to think of my trading account as extra cash, primarily because I don’t have any outstanding debt or any large financial commitments.  I do have a six month reserve set aside for emergencies. Now let’s talk about your trade plan.

The first question you want to ask yourself is – “How much of a loss can I reasonably accept per trade?” Always think about the most you are willing to risk on any trade. It makes it a lot easier down the road, when it comes time to exit a position or positions. Here a few examples of how to start.

Getting into the trade:

Client A’s account: $50,000

               Use 4% per trade or risk $2,000 per trade

               Ex. Buy 10 Calls at $2 or Buy 4 Puts at $5

I know immediately the maximum risk per trade (the amount I am comfortable losing), how many contracts to use, and how many trades I can have working – 25.  Between you and me, I typically only have maybe 5 = working trades at any one time.

Client B’s account: $10,000

               Use 10% per trade or risk $1,000 per trade  --  (Maybe consider 5%)

               Ex. Buy 10 Calls at $1   (Buy 5 Calls at $1)

Now comes the ever elusive “When should I exit?”  Sure everyone wants to believe that they are going to exit for a profit, but have you given it a dollar amount? What if the trade goes the other way? How far does your stock need to go down or up before you get out for a loss? Let’s go to the first example of buying 10 Calls at $2, which means I have at risk $2 x 100 (1 option = 100 shares) x 10 contracts = max loss of $2,000 built into my trade.  Now consider how high your option needs to increase to net a profit.  More importantly, think about when to pull the trigger for that loss. We will use a $2 gain and a $1 loss. Your trade plan might use a $3 dollar gain and a $1 loss, or 1-to-1 ratio. 

Either way, these are set amounts we do not deviate from.  I have seen new traders, including stubborn market makers in the pit, get stuck emotionally in a bad trade.  “Jim, this stock has reached its all-time low; it can’t go down any further.” I am riding this one out or I’m doubling down”. Guess what people? Stock can and does go lower, and when it does – you have now dug yourself into a deep hole.

Don’t get stuck in this predicament. When your trade reaches your exit number (for a profit or a loss), get out of the trade and don’t look back.  A common expression on the trading floor was “Cut your hand off before you lose your arm”. In other words, manage your risk for a minimal loss.  This analogy leads me to why trading is like baseball.

In baseball we are going for singles and doubles. We are not going for that home run. The same is true for trading. We want to have good gains and minimal losses, that’s it.  Remember, striking out is part of the game, so be realistic about losing trades. Now what if the market goes horribly awry?  Do you panic? Do you do nothing? Do you just take a big loss? 

Remember, in baseball you wear a baseball helmet, just in case you get beaned in the head.  The same applies in trading-- you have identified the max amount you are willing to lose per trade. Recall that your maximum loss of $2,000 was established in the very beginning. 

You’ve planned for this eventuality, right?  Let me sum it up for you – If my $2 option goes up  $2 , I will sell it at $4 to close for a good profit, OR if my $2 option goes down $1, I will sell it at $1 to close for a minimal loss.  Worst case scenario – the market tanks and I am out for a $2,000 loss.  For you stock traders,  this analogy can be applied the same way.  Perhaps you set your gains and losses at a certain percentage or amount – a $5,000 gain or a $2,000 loss

I’ll be honest.  I might be a little annoyed if my stock or option ran higher after I closed my position for a smaller profit. The same is true if the stock came back up even though I got out for a minimal loss. But this is a passing thought that lasts about five seconds. In all actuality and maybe because I am a seasoned trader, I could care less when I exit for a profit or a loss. 

It is all part of the game - singles and doubles and striking out. The real frustration is truthfully I when I miss a trade, due to not planning ahead by setting a stock price alert or putting a stock’s earnings date up on my calendar.

Trading should be fun – yes fun. If you keep it black and white by using your set entry and exit amounts, then you take out the emotion when you trade. Have fun playing the game and keep the questions coming.

Next up: “Implied Volatility is Your Best Friend”

Send us your questions here.

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