Featured Trading Article
USING OPTIONS TO LIMIT RISK

Is trading easy or hard? To the outside observer, trading seems easy enough. You merely pick a stock, a futures, or a bond, bet it will go up or down, execute a trade, and see what happens. What’s the big deal? If it were that easy, however, everyone would be doing it and making millions. Unfortunately, it is not that easy, especially in a sideways market or one that fluctuates wildly. In a strong bull market like the ones we saw during the dot-com boom, amateur traders merely opened an online account and watched their account balances balloon. That all changed when the dot-com bubble burst. We’ve seen a taste of “the good old days” earlier this year, but even when the public is interested, and prices go up, trading is not easy. You have to work at it, and it’s not easy, to make profits across a series of trades.

Successful trading is part financial resources, part trading strategy, and part psychology. Suppose that you had a simple trading strategy. You might decide to find markets that temporarily went down on general weak economic news, but by all indications, those markets should increase when clearer heads prevail. You look at all the information, and decide to develop a trading strategy based on “seller’s remorse.” That is, you anticipate that there will be those investors who sold in a panic on weak economic news, and will buy back when they realize that the prices are still good for going long.

But there’s more to it than good trading strategy. You must also decide how much capital you will devote to the strategy. On any one trade you might risk 2-3%, but not all of your picks will go up in the way you had planned. Trading is also part mathematics. Some of your trades will come through, but others will not. You have to decide how many trades you will make, and how much you will risk. And, if you have relatively low financial resources, taking a 20% risk may be hard to handle. You may feel it would be a disaster if your approach did not realize a substantial profit. Psychologically, taking the risk can be anxiety provoking, to say the least. A jumble of thoughts may race through your mind as you execute the trades, and monitor them. As you anxiously await the outcome, you may barely be able to think clearly as your emotions overpower you.

What do you do if you can’t tolerate risk? An obvious solution is to simply take less of a risk. And that’s where options can come in. You may not want to get caught up in overtrading. Instead, it might be better to look for two or three option trades that are the most likely to produce a profit. You do not stand to make as much, but you are not likely to lose as much either. And if you have trouble tolerating risk, the peace of mind you get instead will probably be worth more than the profits you could have made, considering the financial and emotional risks it would require. What are the long-term consequences? On the one hand, it may seem that you will never make huge profits in the markets if you are not willing to take risks. After all, experienced, professional traders put on big trades and it doesn’t bother them. But you must decide if taking such big risks would be in your best interests. And until you are confident that you can make profits in market to market, you might want to sharpen your trading skills before taking big risks.

Don’t downplay the importance of risk management. There are financial and emotional benefits for limiting risks. A hard reality of trading is that there are few foolproof trading strategies. Even the most reliable strategy is bound to fail eventually. Market conditions frequently change, and when they do, your strategies must be changed also. The trouble is that you don’t know when a strategy will fail or when it will not beforehand. Your best defense against the sporadic changes in market conditions is to limit your risk. Limiting risk can be done through options. If you limit your risk, you’ll be able to survive the learning curve, and eventually become one of the select few who earn large profits from trading the markets.

Joe Ross and Trading Educators Inc.

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