What does grilled chicken breast with red onions and spinach in a feta-cheese béchamel have to do with an options spread? When you dine fancy, you pick a place with great food. You choose the best stuff on the menu and most importantly, you pace yourself in honor of all the treats to come.
Investing is also about digestion. And pacing. Have you ever spent days—weeks, even—researching a stock? Analyzing the financial data, the reports, the charts, searching for news, looking for the next Apple or Google before it hits $600 a share? Maybe you’re so convinced you’ve found a winner, so confident it’s a superior opportunity, that you sink a lot of dollars into it. And should the stock price rise, great. But what if it goes south?
So, maybe you can pick winning stocks consistently. Most people can’t. Part of the reason is that efficient markets incorporate any new data into a stock price nearly instantaneously. The other reason is that most stocks are correlated with other stocks in their industry, and with larger indices. So if all stocks are dropping, your stock is probably dropping, too. With most of your money now tied up, there isn’t much you can do if you spot another potential opportunity that might offset the loss of that larger investment. Just like filling up on your first course, you can invest a lot of emotion and lose too much money and time when you make one large investment. During your 5-star meal, it’s small bites and careful slow going. And with investing, it’s trade small, trade small, trade small.
A BIG FORMULA
The idea is that one big trade does not a big trader make. “Big” can simply mean someone who makes money trading. It could be $500 a month or $50,000 a year. But if trying to make a big chunk of profit in one big trade isn’t smart, what is?
One potential path is placing a lot of small trades in liquid products that have a better than 50/50 chance of making money, and using a trading strategy that doesn’t require days or weeks of analysis. The goal is to create enough small profits, and manage them smartly to create a profitable portfolio over time.
Baby steps for potentially big results:
1. Find liquidity
2. Use high-probability strategies
3. Keep it small
4. Manage winners
5. Don’t be afraid to lose
Using our food analogy, let’s start by finding the trading equivalent of a great restaurant. That would be a list of actively traded stocks and options, hopefully with narrow bid/ask spreads. With these, it’s more likely to execute limit orders at a price that keeps slippage at a minimum. The less a stock or option is actively traded, the harder it is to get a good execution price.
Where to find these possible opportunities? Look at the “Penny Increment Options” list on the MarketWatch/Watch tab on TD Ameritrade’s thinkorswim® platform. (See Figure 1.)
Not every stock and index on the list has options with tight bid/ask spreads. But looking at options whose prices trade in 0.01 increments is a good place to start. Doing this gives you an idea of some of the range of stocks whose options you might consider trading.
Use High-Probability Strategies
Now, on to the expensive menu. Just like you can scan a great menu and find just the dishes you love, you want to quickly identify strategies that have a higher probability of making money. Whether your outlook on a stock is bullish, bearish, or neutral, there’s usually a strategy that might be a tastier trade than just buying or shorting the stock. That usually means options strategies like short puts, covered calls, short verticals, and iron condors that have greater than 50% probability of success. You can use the tools on the thinkorswim platform like the Trade page and the Analyze page to explore these approaches. (For more on probability, see “How to find greater than 50/50,” below.)
The probabilities of an option expiring in the money or out of the money are calculated in real time on the Trade page, while the Analyze page lets you calculate the probability that a simple or complex strategy may be profitable at some future point. (Then, to see which strategies may work in which market, check out our Special Feature on spread trading, page 34.)
Keep It Small
Now, how big of a bite should you take so you can make it through the whole meal? This is about position size—i.e., fewer contracts and a strategy with a small capital requirement. When you engage a large number of small-sized trades, each with a probability of profit greater than 50%, over time your portfolio could have a probability of profit that is very close to that of individual trades. No matter how high a single trade’s probability of profit, it could still be a loser. And you don’t want one trade to take you down.
Now that’s not to say you won’t get wiped out with a series of smaller trades as you could with a few larger trades, but smaller potential losses on many trades can keep you at the dinner table longer. Instead of doing 10 contracts each on five trades, for example, do say, two contracts each on 25 trades. And keep the amount of capital used on each trade to a small percentage of your overall account. (Just keep in mind that that many small trades will eat up funds via commissions and fees as well.)
Manage Your Winners
Just like enjoying every bite of a nice dinner, manage your winning trades strategically. Consider taking smaller, more frequent profits when they present themselves, rather than waiting for bigger profits that might not ever come. A very broad target may be taking 50% of the max possible profit if and when it’s available. Of course you have to factor in the additional transaction costs. But by potentially realizing more and smaller profits, you may sometimes reduce the number of times a winning trade turns into a loser.
Don’t Be Afraid to Lose
Finally, if you want to have a fantastic meal, you can’t be afraid to try something new and run the risk you might not like it. The same is true for trading. You can’t be afraid of losses. Every trader has them. Don’t feel bad if a logical trade loses money. It’s part of the experience. If you keep your position size small, two things happen with losing trades. First, the loss is smaller than with a larger trade. Second, you may decide to hold a smaller losing trade longer to see if the stock eventually turns into a winner. Bon Appétit!