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How People Lose Their Shirts in Options Trading

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  • How People Lose Their Shirts in Options Trading

    You must have heard horror stories surrounding options trading before. Stories such as how some people lose their whole account within a few days and even stories of options traders going bankrupt in express time.

    These stories have no doubt cast a shadow over options trading and there are even people who now tout that options trading is as risky as futures trading.

    Well, strange thing is, after more than 15 years of trading options, I have never experienced losing all my money within a few days nor going bankrupt. This led me to wonder why these things happen to some options traders. After some investigation, I conclude that it is not options trading that breaks accounts but specific things some options traders tend to do, especially beginners, that opens the door to such financial disasters. I narrowed these reasons down to two main ones.

    The first of these is that some options traders trade options just like they trade stocks; buying call options with their whole account on that one "hot stock."

    Yes, this is the number reason why most options beginners lose their shirt. Most beginners to options trading do with call options exactly what they do with stocks when they have a "hot tip"; throwing their whole account into that single "hot" trade. Now, this isn't that big a problem in stock trading because if the stock didn't move as expected, the trader could simply continue to hold the position until it does, sometimes for years. However, when you buy call options on stocks that didn't eventually move up as expected, the call options can expire worthless by expiration, taking your WHOLE account with it if you bought those call options with all the money you had! This problem is made even more pronounced by the fact that options have a definite expiration date that goes from a few months to a year for some stocks but never forever. This means that you do not have the luxury of holding on to bad trades forever, hoping they will come back in a few years time.

    Professional options traders like me only enter a single position with money we can afford to lose. If I intend to lose no more than 10% of my account on any one trade, I do not use more than 10% of my account in a single trade. That's right, you NEVER buy a single options position or options contract with all the money you have! Although that would have made sense in stock trading, it is pure suicide and gamble in options trading.

    The other reason is trading credit spreads or naked option writing without using stop loss.

    Many options beginners were taken in by the apparent "free money" phenomena of writing naked options positions unaware that most of these credit strategies have unlimited loss potential.

    For instance, if you wrote call options (shorting call options), you would make a fixed premium in profit if the stock went downwards or sideways. Some "gurus" call this "playing bookmaker". Well, they are right that you are playing bookmaker to gamblers by selling options to them but they forgot to mention the fact that sometimes, gamblers win big too. When you write call options, your position will make an incrementally bigger loss as the stock price rises! It will continue to make bigger and bigger loss as long as the stock continues to rise. This is what is known as an unlimited loss position. This loss is often, or always, much bigger than the premium you received from selling the options. Before you know it, your entire account is wiped out on this one trade because the stock refused to go down as you expected it to.

    Does that mean we should not trade credit spreads or naked writes ever again? Not really. These are excellent options strategies but only if you trade them using a specific and definite stop loss point.

    Yes, most options trading beginners trade such unlimited loss potential credit spreads with stop loss points but most of them give in to emotion when it's time to stop loss and hold their positions beyond their stop loss points in hope that things will turn around, which most often, they never do.

    Professional options traders always trade unlimited loss potential positions with an AUTOMATED stop loss point. That's right, automated stop loss that works without human involvement. This can be in the form of a stop limit, contingent order or trailing stop loss order. As long as you do not have to physically execute the stop loss. Physically executed stop losses are stop losses that rarely gets executed. Remember that.

    Buying options with your whole account and trading unlimited loss potential options positions without stop loss points are the two main reasons most options beginners lose their shirt. Take heed of my advice here and you would go through your initial options trading years in much more safety.


    Article Source: http://EzineArticles.com/3804484
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