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How To Slay Your Trading Monsters

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October 15, 2014

Monsters under the bed. In the closet. In your vegetables. Scary things were everywhere when we were little. As adults, “trading monsters” can get even weirder. Think about options. When asked if they trade options, the average person offers up a resounding “no” with the usual fears: could lose all my money, don’t have enough money, sounds too complicated.

Maybe those sound like excuses, like why you don’t go to the gym or call your mom. (I don’t know why you don’t work out or call Mom. You know you should but still you don’t.) And overcoming excuses can be tough.

But quiet little monsters in the adult mind are different. Childhood phantoms disappear when you turn on the closet light. They disappear when you’re old enough to know that 500-foot dragons can’t fit under the bed. The same is true of trading monsters. Shine a light on them, and poof—they disappear. The best part? You don’t have to vanquish them alone. Lots of handy tools and financial resources can help get you through the most grueling of battles. So strap on your colander helmet and grab your pillow shield. There are some trading monsters that need defeating!

Monster #1: I’ll Go Broke

I’ll admit it: not having mortgage, rent, food, or retirement money can seem pretty scary. And when some people think of options trading, those fears are first to appear. 

Defeating the “I’ll go broke” monster requires using strategies that have defined risk built into them. What does that mean? Risk is how much you might potentially lose on a trade. Defined risk is knowing exactly how much you could lose no matter what. Some strategies entail potential undefined losses—you don’t know how large the loss might be if the stock or market moves against you. Others, like long or short verticals, carry defined risk. You’ll know your maximum loss if the stock drops to $0, or rises infinitely high.

To see how much you might lose on a trade, use the Add Simulated Trades and Risk Profile of the Analysis page on the thinkorswim® platform. 

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FIGURE 1: SLAY THE I'LL GO BROKE MONSTER.

Defined-risk strategies help limit losses to a specific amount. Here you can see the maximum risk of this short call vertical never increase beyond a stock price above $67.50. For illustrative purposes only.

  1. Click on the Analyze tab, and go to the Add Simulated Trades sub-tab.
  2. Type in a stock symbol, then go to the options chain.
  3. Open up an expiration, right-click on a call option, then Sell, then Vertical, to create a simulated short-call vertical trade.
  4. Go to the Risk Profile sub-tab for a profit-and-loss graph for that strategy. Look at the graphs far-right-hand side where the high stock prices are. (Note the loss on this bearish strategy doesnt exceed a specific amount, no matter how high the stock prices rises. Thats defined risk.)

Even when trading verticals with defined risk, it’s still possible to lose a lot of money. But you can potentially limit your losses by limiting your number of defined-risk trades, so that the loss on all of them combined is potentially only a fraction of your overall account size. In the end, you control how many contracts you trade. So you’re ultimately in charge of how much risk you take. Not your fear. Not your monster. 

Score card: Trader 1, Monsters 0.

Monster #2: I Don't Have Enough Money

We often hear sexy headlines about big investors like Soros or Buffett and think that trading is a billionaire’s game. You might not own a yacht. But you can, for starters, open an account for free and start using the thinkorswim paperMoney® platform to practice “paper trading” to your heart’s content.

As you know, stocks can get pricey. For example, 100 shares of a $30 stock would cost you a hefty $3,000. But remember those defined-risk strategies we employed to slay Monster #1? Contrary to scary rumors, in reality those strategies may not require a substantial investment. You could for instance put up 10 vertical trades in different stocks for a relatively modest amount—typically between 10-20% of the cost of the stock. As well, mini-options on some high-priced stocks that control only 10 shares (versus 100) of the underlying stock at a time, can make for a low-cost alternative. To start, these are two good reasons why option strategies can in fact make sense for new options traders on a learning curve with limited budgets. 

The fine print on risk? Go slow is the answer. You could be an active options trader and put but half of a $2,000 account in play (hard to do with stocks). For example, using $1,000 of your working capital, you could trade a vertical, an iron condor, a calendar, and maybe even a short put in a low-priced stock and easily slay Monster #2. 

Score card: Trader 2, Monsters 0.

Monster #3: I'm Not Smart Enough

OK, there’s a certain amount of jargon that may sound strange and intimidating. We’ve all been there. No one springs from the womb a full-blown options trader. It takes time. Each trade, each expiration, is potentially a new lesson that makes you smarter. And sure, a lot of the formulas that calculate the numbers you see for options—like the “greeks” and probability numbers—can get complex. In theory, you’d need to be pretty good at math to come up with those kinds of formulas. Luckily thinkorswim does the math for you. You don’t need to decipher the formulas to understand what those numbers mean, or more importantly, how to use them.

It’s also easy to get turned around with the names of the various strategies. Straddles and strangles. Condors and calendars. Butterflies and back spreads. But these strategies are more similar than different, and by spending a little time with thinkorswim’s educational resources, all the strategies and lingo will start to make sense. In fact, you can get started today with a live training session right on the platform.

In the upper-right-hand corner, click on Support/Chat to open up the Chat window. Click on either the Seminars tab for archives, or the Chat Rooms tab for live shows like Swim Lessons where you’ll learn how to use the platform, get tips on picking a smart strategy for the current market environment, and more.

Score card: Trader 3, Monsters 0.

So now you know how to beat the three biggest monsters that keep most people from trading options. Just remember, whether its gargoyles or three-headed imps that haunt your dreams and dance on your strategies, it’s the ones in your head that matter most, even if you’re still checking under the bed.