Successful traders are not emotionally-driven gamblers going all-in when they get a wild hunch. They have a specific trading methodology which they trust and follow on every trade, regardless of the outcome of the most recent trade.
Even following the best system in the world still makes you a gambler if you don’t practice proper risk management. All the effort to find great setups and execute trades flawlessly is wasted if you allow fear or greed to influence or change the amount of your portfolio risked on each trade.
Because markets are random, the results of individual trades cannot be predicted with any sort of accuracy. But the results of many trades can be predicted with great accuracy,unless each trade carries varied risk from other trades.
For example, if one trade represents a portfolio risk 5 times higher than other trades, the outcome of that single trade creates an unpredictable impact on your portfolio, which turns you into a gambler.
Option pricing can experience wild swings over short periods of time. As they are also leveraged, these price swings can have a significant impact on a portfolio’s overall value. Without proper care, an investor may begin to overweight the risk between trades and trade strategies.
A good rule of thumb is to limit the risk of each trade to just 1% – 3% of the overall portfolio. When buying stock, losses are limited through the use of stop orders. When buying options, the trader limits the risk by only spending 1% – 3% of total portfolio value on each trade.
So if a person had $10,000 to trade, the total amount of premium paid would be limited to $100 – $300, and the number of contracts purchased would be limited by the amount risked. Investors who commit to this plan limit impulsive decisions, avoid the unpredictable portfolio impact of varied amounts at risk, and create a system of long-term financial success in options trading.
In general, option buyers should consider risking an amount closer to 1% of their account, while option sellers might consider containing risk to as much as 3% of their account, but no more if possible, in the event of a worst-case scenario loss.
Your success as a trader is not determined by your account size, nor by the amount of time you can devote to trading every day.
What measures your success is how well you follow the rules of your system on every trade and whether or not you keep trading through inevitable losing streaks.
It’s true that you will lose a percentage of your trades. t’s also true that you lose 100% of the trades you don’t take.
Try to think of your efforts as a trader more like a marathon, not a sprint. While many people who decide to trade for themselves feel a great urgency to make up for lost time, try not to put yourself under that kind of pressure.
Your success will ultimately not be measured by a few lucky trades or by how much you have to trade. The real measure of your success is your annual rate of return. A high enough annual rate of return will make up for any lost time or small account size.
Done right, options are a fantastic way to reduce risk, increase profitability, and significantly improve annual ROI.