"Must Follow" rules for option traders.
Without rules, your account will be wiped out. Rather quickly. It is especially true
It is true that, if you are correct and lucky you can make 500% gains in a day or even in a few hours. But it is exactly the gains like this that ruins the mindset of an option trader. It may happen once or twice. But sooner or later, one marginally bad trade will wipe out the account.
A lot of option traders think they can quickly multiply the account balance in a few trades. However, a smart and shrewd trader, knowing that options can give huge gains will sit and think about how to take advantage of it wisely instead of going all guns blazing; You need think about how to use the system to his/her advantage and create a decent extra income stream instead of focusing on home runs.
No matter how good the charts are, how good the news is, how good the market is, without a proper trading system ( rules) it is very very difficult to stay long in the world of option trading. So the most important rule is to invest very small in each trade. That is the only way you can take full advantage of the potential gains that option trades can yield.
Below are some of the "must follow" at least according to us, rules that an option trader should follow.
1. Focus only on few symbols ( ideally 3 to 5) and look for potential setups in these symbols for a period of 6 months or until your account balance is doubled. Don't look to trade outside of these two selected symbols. "Symbol Hoping" can lead to loses. What looks like a good trading setup in an other symbol does look good only until you get in that trade. Happens all the time. Think about it this way, by focusing on the same symbols you have better chance of making profits. It may be a little delayed. But how does a few days matter?
2. Look for Liquidity in options. Take a look at Option Volume, Open Interest and the gap between bid and ask. If the difference between Bid and ask is too wide, even if you get your orders filled at mid-point, you would straight away loose 20%.
3. Don't get into strikes that are way out of the money. They are designed to expire worthless. Even if you want to try, try with just a fraction of your account balance.
4. Don't trade weeklies, pick at least 3 weeks to expiry. If the stocks don't go your way, the time decay on weeklies are very high.
5. Don't invest more than 3% in a single trade. ( Combined total after averaging should not be more than 3% of your account balance).
6. Don't be exposed more than 15% of your capital account balance to the market. And more specifically, don't be exposed in one direction. If the market takes goes in the opposite direction, that will have a big impact on your account balance. Let us say your account balance is 10k, and you have 3k worth of calls and remaining 7k in cash. It means you have 30% of your investment in calls, if the market goes in opposite direction, you will loose a significant portion of that 3k investment.
7. Don't revenge trade. That is when you want to recover your losses quickly, so you invest a lot of money in one single trade with the plan of exiting at a few % gain.
8. Have a money management system and position size management system in place. Follow your rules.
9. You are comfortable in complex option strategies, look for debit spreads/credit spreads to reduce your cost basis.
10. Paper trade for some time. Consider yourself ready for trading options only if you can double your money 3 times in a row using your paper trading account starting from scratch every time. Treat trading as just like any other profession that requires skill. Educate yourself. Learn before you invest your hard earned money.
11. Time decay will be very high during the last 4 days before expiry. Plan on exiting your position, or rolling your positions before the time decay starts.
12. Start logging your trades and create a trading journal. Both for your paper trade account and real trade account. This will help you discover your edge.
13. Not all your trades will be winners. Very difficult. So plan or create your trading system considering some trades will not be winners. Instead of focusing on winning every trade, see how you can improve your win/loss ratio. Once you accept that there will be some trades that are not going to go your way, you will have a better system, better rules, better money management to counter the losing trades.
14. Don't have any profit goals, such as daily, monthly or weekly. You will be biased in your trading decisions. Instead trade your process. Trade based on chart and your trading plan. Be happy with whatever the process gives. Having targets, you will be forcing trades out of your plan.
15. Invest small. This is very important for option trading.
16. Have a simple, repeatable exit strategy. And apply the strategy consistently. Don't waver. Doing this, sometimes you may miss out on a big run, that is okay.
17. See if you can place trades in two lots. That is, let us say you planned on investing $500 in a particular option trade. See if you can first buy for $150 and then add to the same position or adjust the position by investing $350 more later on. The 2nd lot or the adjustment lot need not be in the same direction as the initial buy. Basically, you are setting aside some money in case if your first trade does not go as planned. This money will think about how you can adjust the trade.
18. Sometimes it may prove good to accumulate to a losing position and bring your average cost down. But not always. Watch the chart and then take a decision. Nevertheless, your combined planned investement in a trade should not exceed 3 to 5% of your account balance.
19. Always ask yourselves, what are my trading rules? Am I following them? What happend last time when I didn't follow.
20. Don't repeat the same mistake twice. Analyze the root cause, mentally what is causing you the repeat the same mistakes over and over again, and fix the root cause. If you still can't fix them, stop trading. Or try to team up with a friend who can take care of money management while you focus on picking the trade and technical aspect of it.
21. They say, let the winners run. Try to understand what it really means. How do you know when is the peak? Sometimes you may end up giving away all the profits because you waited too long to make that little extra. Adopting the "Let the winners run" approach without having a proper rule may lead to emotional trading. It is certainly a good idea to let the winners run, but have some rules around that and strictly apply the rules.
22. Don't wait to catch the absolute bottom or the absolute top. We never know. No one knows. Simply apply your rules and not worry too much about the chunk you missed.
Please review a few money management strategies posted in www.sleekoptions.com as a sample. You can tweak them to suit your trading style and account balance.
Also review the ProfitCycle Trading System blog