The Good, the Bad and the Ugly - Part Three
...Continued From Part Two
A Rough Road
Commodity option buying can be a rough road for novices. Many see TV pitches about striking it rich in gold or heating oil options. They then proceed to load up their entire account with far OTM options, only to lose all of their trading capital through premium erosion. The end result is a discouraged options user who blames the options market for his failure.
What these novices don't consider is that, to survive, they must prepare for the inevitable string of losses that accompanies a 10% trading accuracy. They need to survive long enough to be around when that 10% option winner (a.k.a. - a lottery ticket!) hits big. The other 90% will be losers simply from the probability of the trading method used.
In this case, it means dividing our trading capital into at LEAST twenty parts to be able to survive the string of losses that probability will surely bring our way. Successful options trading is about survival and understanding the type of commodity we are trading so that we can adjust the capital risked on each trade. If we are trading at 10% accuracy (option buying) and expecting to make money on the first 3-4 trades, that's simply a matter of arrogance and ignorance.
There are some commodity options traders who will overload themselves with large options positions and then let them erode away, taking a full 100% loss of the total account. They have no plan to exit if the market does not act properly. It goes without saying that this is not a good idea.
Some options traders go so far as to buy a commodity option and use its full value as a stop loss. Thatís acceptable ONLY if you do it with small positions. However, the sad truth is that these "overloaders" frequently cash out when an options premium merely doubles. They call that a big profit and race to grab it, never realizing that they have to fully exploit all winners to maximize this trading strategy. Pure lunacy!
How can a trader be willing to lose their total investment while at the same time be satisfied with only tiny gains? To put it simply, this is a recipe for disaster. The results are predictable - they consistently lose. Their excuse is that their analysis was bad, the commodity markets are unfair or they should have gotten into another trade. You can point the math out to them, but they simply don't understand. No matter what they do, the results will continue to be the same.
Change Your Game Plan
That is, unless they change their money management strategy. The bottom line is this: if your commodity trading method generates an average of 20% (at best) accuracy (as buying far OTM options often does), you have to capture average gains that are four times larger than your average losses. This is simply to break even, without taking into account commissions, bid-offer spreads and slippage! So, if you think that a $2,000 loss is prudent, then you had better be averaging $8,000 gains just to break even. A little food for thought for all you options "overloaders" out there...
At the end of the day, you must sit on your hands and let the profits run when buying options. With a $10,000 account, if you're taking $2,000 profits and $2,000 losses when trading with 20% accuracy, then you will probably be out of the commodity options business in less than ten trades. This may sound like fiction, but trust me, many novice options traders have gone down this road. Learn from their mistakes before it's too late...
Continued in Part Four...
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