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Buyers Option buyers understand the pain that the passage of time inflicts upon them. I’ve always believed that the major goal for all option owners is to sell the option as quickly as feasible. When buying an option, the trader has some objective in mind, and most of the time it’s a change in the price of the underlying stock. Less often it may be based on an expectation of an increase in the option’s implied volatility. If either of those expectations comes to pass quickly, the option owner stands to profit. Once that anticipated event occurs, it makes little sense to hold onto the option. You had an idea, it came true, the market responded. Whether the response was better than you planned (good news), or worse (sad news), the event is over, the market has moved, and there is no reason to own the option. As I said, that’s my belief. Many option traders, especially the inexperienced, are often unsatisfied with the economic result (loss, or profit is too small) and hold, looking for the market to validate the original premise. Because the event is over, holding becomes a wager that the news wasn’t fully digested the first time, but that it surely will be enough to affect the stock price in the immediate future. Clinging to that hope day after day, the position is held, until it eventually expires worthless. If the option is in the money, all time premium erodes, and the option owner may no longer have a profit. Holding into expiration is a difficult thing to do, especially as you watch the value of your option decay. What keeps those holders married to their options is the fact that a decent stock move can change the option’s value by a large amount in a very short time span. Once the option value has shrunk to almost nothing, it pays to hold in the hopes of a miracle. The problem is that these options should have been sold much earlier. Sellers Option sellers are on the other side. The passage of time is most welcome. If the stock doesn’t make an unfavorable move, the option – slowly at first, and then more rapidly – loses its value and the market price moves towards zero (for out of the money options) or parity (The option’s intrinsic value) for options that are in the money. This time the question is not when to salvage as much premium as possible, but rather it’s when to repurchase the short position to lock in the profit and eliminate risk. As the price of the option is decreasing, it seems natural to hold onto the short position, at least for just one more day. And that good idea can result in problems. When holding for that one extra day worked so well yesterday, it’s natural to anticipate that holding for another day is likely to bring a similar result – an increase in profits. When the option is out of the money in the morning, the probability is that it will remain out of the money when the market closes for the day. That makes it an attractive proposition to maintain the short position. When a trader thinks that way, there is seldom any incentive to exit. It seems ‘obvious’ to hold and make more money. Risk is ignored, with the eye trained squarely on the theoretical time decay for the day. We all recognize than an option with a two delta is going to finish in the money one time out of 50, or approximately once every four years. That’s much more frequent than ‘never.’ With so little to gain, why take the chance? It’s important to gauge just how bad it can get, if this position turns on you. The problem for most traders is that they estimate neither the potential loss nor the likelihood of that loss. When the market has been dull and moving quite slowly, it’s even easier to think that way. But just as the option owner gets pretty good gambling odds when holding a soon-to-expire-out-of-the-money option, the trader who is short that same option is taking a big risk (with a high probability of winning) to gain a small amount of money. I’ve been there (Chapter 5) and understand the temptation. But the potential loss does not justify taking that risk. Let somebody else have the last $0.05, $0.10, or even more for those almost, but not quite ‘worthless’ options. Yes, pulling the trigger is difficult, but over the longer term, you will be a happier, less stressed trader. NOTE: I am NOT recommending that you pay cash to repurchase options that are 10% out of the money when it’s two days before expiration. I am referring to placing bids ($0.15 or $0.20) to buy options or option spreads when at least three weeks remain before the options expire. I’ve been able to repurchase spreads @ fifteen cents with as much as seven weeks remaining before expiration. I know that’s a good deal. How much to bid depends on your portfolio. If you have sufficient insurance that a major move will not hurt, there is no incentive to bid more that your comfort zone dictates. I maintain insurance, so fifteen or twenty cents is about all I’ll bid for one month options. But, when I lack insurance, or when a big market move represents a real financial threat, I bid more. My top bid, when risk was present was about one penny per trading day remaining before the options expire – with a $0.35 limit. I did that when markets were more volatile (2008-9). Today, my top bid is $0.25. It’s your money and your comfort zone, but there should be some price – no matter how low – at which it’s a good idea to buy back those ‘cheapies.’ If your commissions are so high that you avoid these trades, you must look into using a less costly broker. Taking extra risk because trading expenses are high does not make sense. Placing a good ‘til cancelled order with your broker is a good 'set it and forget it' routine, but I don't recommend it. You may forget the order has been entered and that can be a problem. If you work full time and cannot watch the position closely, that's a different story and I recommend a ‘good for the week’ order that can be reconsidered each weekend. If you learn to enter an order to purchase those apparently worthless options, ask yourself: Which would make you feel worse i) Not exiting when you know you should, and occasionally losing real money? ii) Exiting and seeing the options expire worthless It’s that psychological factor at play again. If you know taking a specific action could induce feelings that hinder your ability to function efficiently, then for peace of mind, avoid the choice that could result in those feelings. Remember, if you simply learn to ignore what happens after you exit a trade, there is no danger that this will occur. Hold or exit As expiration approaches and you are facing a ‘hold ‘em’ or ‘fold ‘em’ decision, I recommend making the best decision, with everything being taken into consideration. If holding and losing extra money represents an unhappy outcome, but folding, only to see the market ‘behave’ would be so upsetting as to hinder your trading, you would be in the bad position of being forced to take extra risk – just to avoid that ‘devastated’ feeling. Advice: consider making adjustments by reducing position size. By the time it becomes necessary to exit, the position may be small enough that exiting at the market top (or bottom) won’t feel so bad. Obviously it’s best not to be hurt by losing decisions, but the truth is that every trader cannot do that. Trading involves much decision-making. Do the best you can (sure, try to develop skills that allow you to make even better decisions), but learning to live with those decisions is a skill worth developing. This post was presented by Mark Wolfinger and is an extract from his book Lessons of a Lifetime. You can buy the book at Amazon. Mark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. Related articles Trader Mindsets How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash The Art Of Trading Decisions Managing Risk For More Than One Position My Philosophy On Options Education Trade Decisions: Risk Or Profits?
Active investors searching for higher returns hear pundits talk about big easy money from options while promoting shady experts like Karen Supertrader and completely miss the entire point of and primary benefit of options - MANAGING DOWNSIDE RISK. Even hedge-fund managers seem to have forgotten what hedging risk means. When regular-Joe investors begin researching how to trade options they get discouraged by the learning curve, go looking for help and find hype, a lack of individual help, and usually blow up their accounts the first year. There is no magic system to earn steady returns through options. Just the hard work of studying established strategies like calendar spreads, condors and straddles until you can make them your own. Just the discipline of limiting options allocations to 10% of your portfolio and sticking to your strategy. Reality is a harsh mistress—until you submit through disciplined practice. Our trading system produced 117% compounded annual returns over seven years using conservative options trading strategies that avoid big losses against gains won through a steady stream of moderate wins. We post screenshots of our fills to demonstrate that we make all the trades in our own accounts. What's our secret? Some traders like to buy options. Others prefer selling them. This is why the markets exist. Our philosophy is building a balanced options portfolio by combining different options strategies. Unlike some other options "gurus", we never claim that our method is the only way to make money in the stock market. But it works for us and our members, and this is what's important. Here is a post demonstrating member’s wins resulting from understanding the trades and making them their own. Here’s what one of our long term members had to say, “All trades are discussed on the forum, so you don't just blindly follow them, but actually understand the rationale. It is fully diversified with different strategies and not just few credit spreads or iron condors, so your portfolio is not at risk if the markets move big time. At SteadyOptions, all trades are backtested and only trades that performed well in the past are actually executed.” We skip the aggressive marketing tactics used by gurus, preferring to let our results, hype-free honesty and productive community forum attract traders with the discipline to work at becoming a better trader every day. Because that is how you get to live the regular guy dream. Bottom line - we can be of tremendous help to you, but you are going to have to work hard, be focused, and be dedicated to achieve the results you desire. We can only be part of the solution, not the entire solution. We are excited and happy to do our part and we hope you are willing to do the same. I would like to finish with a quote from one of our oldest members: "The last year was a huge learning experience for me as trader/investor. I have realized how much I did NOT know, after a BA and MBA in finance. I remember joining this site, and reading terms like volatility, negative theta, and trying to make sense of them. I think, one of the best moments, is when you(trader) stop blindly following and actually start making some of your own decisions on the trades. Kim always, says: "set your own entry and exit points". I try to do that. But I feel really great, when I make a trade before Kim's alert and happen to be within 2 to 3 cents of his number......" If you are ready to start your journey AND ready to make a long term commitment to be a student of the markets: Start Your Free Trial Related Articles: Why Retail Investors Lose Money In The Stock Market Can you double your account every six months? How to Calculate ROI in Options Trading Performance Reporting: The Myths and The Reality Are You EMOTIONALLY Ready To Lose?
#1: Learn First, Trade Later Our first recommendation to new members: If you are new to options or to our strategies, start with paper trading. Then start with small positions and increase the allocation gradually as you gain more confidence. Even if you have some experience with options, it always takes some time to get used to new strategies. This way you learn how to enter orders, adjust trades, and more importantly learn from your mistakes without losing real money. Many members tell us that they don't like the idea of spending money for the subscription and not having even a potential return on that investment, because they are only paper trading. My response is: When you go to college, are you trying to earn back your tuition fee after one month? No, because you understand that this is an investment into your future. No medical student would expect to even touch a patient during his first years in medical school - yet for some reason, people think it is different in trading. There is a reason for this recommendation. As many members find out the hard way, "learn first trade later" is not just a cliche. Jumping right in, especially if you are a novice trader, usually has an opposite effect. #2: Learn To Win By Learning To Lose Most investors know that in the long term, the stock market produces around 10% annual return. Then why so many select to liquidate their stock holdings after a major drawdown? If you did not panic in 2008 and held your stock portfolio, you would be watching it almost tripling in the next 10 years. Traders are making decisions based on their emotions. It is imperative that you understand how your emotions are shaping your trading decisions, before you become a winner in this game. Big Drawdowns Are Part Of The Game. They are inevitable if you want to achieve good returns. Too many people quitting after a streak of 4-5 losing trades. Losing money is part of the game. Learn how to deal with your losses - and you will become a better trader. If you cannot handle Trading Drawdowns, then my advice to you is simple — quit trading and take up gardening or knitting. #3: Don't Chase Trades Many members tell us that as new members, they had issue getting fills at some of our trades once the trade alert goes out. We preach patience, patience and patience. Let the trade come to you. It is better to miss a trade than to overpay. As Jim Rogers used to say: "I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime.” Trading is a business. As in any business, prices are involved, and our profitability of success will always depend on our ability to get good fills. Every business revolves around this cost equation... If getting good prices was so easy, there wouldn't be any markets/any business... Getting good fills is part of the learning process. Over time when you gain more experience, you will learn how to get better fills. Many of our members started as complete novices and now they get better results in some cases. But those things take time. Which brings me to the next "cliche". #4: Trading is a Journey To become an engineer you have to study 4 years, and probably another 4 years (at least) to become a good one. Why people expect it to be different in trading? The question of what it takes to become a master in any field has been in the epicentre of research for many years. Is it the innate talent what matters or a skill can be mastered with practice. What does it take for professional athletes to become first among others with inborn talents… Some researches would say that you need to spend 10,000 hours to become proficient in any field. Everyone is different, and some traders might need only 1-2 years to become profitable. But we have to accept the fact that trading, as any other highly competitive discipline, takes a lot of hours in front of the screens and practice. #5: Don't Try to "Get Even" It does not matter how good your trading system is - you will not win 100% of the time. It's a fact. At some point, you will have a losing streak. Learning to deal with your losing streaks is a big step forward. After a losing streak, your first impulse might be to overtrade in attempt to recover the losses. HUGE MISTAKE. The market doesn't know that you have lost money. And it doesn't care. If you tell yourself "now I really need some nice winners to cover for the losses", it's a safe path to more losses. What happens is that you get frustrated and angry. You decide to take revenge on the market and make all your losses back and then some. So, the next trade you make, you increase the number of contracts or shares because your rage is overpowering your discipline and you’re sure that this trade will be “the one”. And…you’re probably wrong. The trade turns out to be loser as well and your account is even deeper in the hole. What separates good traders from bad is how you react to your losses. "There's a difference between knowing the path... and walking the path." - Morpheus. To paraphrase Morpheus sentence, "there's a difference between knowing that there will be losers... and actually experiencing them". In a probability game, it is guaranteed that we will eventually experience a string of losses. The right thing to do is continue to execute your trading plan that has worked for you. #6: Patience and Discipline are the Key The real challenges are different nuances of patience and discipline. Patience to wait for just the right set up Discipline to sit on the sidelines and not getting pulled into a trade that does not fully satisfy my requirements Discipline to pull the trigger when the right trade comes along Discipline to remain detached from open positions and properly manage each trade according to trade management guidelines developed over decades of market speculation Patience to allow a position with a substantial profit potential the room and time to bear full fruit The above challenges are very, very real. The markets can force a trader to let his or her guard down. The markets are all about forcing traders to make mistakes. Markets are constantly luring traders with such deceptive messages as: #7: Money Management is Critical Part of trading success boils down to proper money management and not gunning for those high-risk “home-run” type trades that involve too much capital at one time. In the trading environment, we will win and lose. However, we need to be more right than wrong and when right, be big on right. When I was winning I averaged up. But when it started losing, I didn’t cut the losses. As you may know, options swings a lot +/- 30-40% in one day isn’t surprising. Imagine if you are fully invested and if the tide turns opposite to your direction, you can lose 30-40% in one day. My rule is risking a maximum of 5% of overall portfolio per trade/underlying. You may choose yours, but have one in place. Learn to use risk/reward measure before starting a trade. In our model portfolio, we allocate 10% per trade. Since most of our trades risk around 25-30% (there are some exceptions), we basically risk up to 3% of our portfolio in each trade. In some strategies we allocate half position, or 5% of the portfolio per trade. Those are higher risk trades that can potentially lose 50-80%. Conclusion Our long members know that we preach those "cliches" almost on a daily basis. Most people underestimate the role of psychology and emotions in trading. A legendary trading coach Dr. Van K. Tharp discussed the importance of psychology in trading and came to the following conclusion: Many years later, Tharp admitted that he was wrong. Now he thinks that Psychology accounts for 100% in trading success. We can argue about the exact percentage, but there is no doubt that trading psychology plays HUGE role in trading success. I hope this article will help you to overcome some of the psychological pitfalls that every trader goes through. Related articles: Are You EMOTIONALLY Ready To Lose? Are You Ready For The Learning Curve? 10,000 Hours Of Trading Why Retail Investors Lose Money In The Stock Market Probability Vs. Certainty Trap Buy High, Sell Low: Why Investors Fail How To Avoid Emotional Mistakes In Trading Can you double your account every six months? How Position Sizing Impacts Your Returns