Options trading get a bad rap. The very word conjures up pictures of some carefree playboy throwing money into any crazy investment - not really caring if they win or lose.
It's not a flattering picture. And that's why conservative investors shy away from anything "speculative" - lest they be called speculators, too.
Well, I'm here to tell you "speculating" isn't a dirty word. You can be a conservative investor and still enjoy that chance at phenomenal profits that speculating can bring.
I learned that lesson from my father, Paul Sarnoff. He was one of the first people to offer an options trading course - introducing novice investors to the concept of Superleverage. But he also had a strong conservative streak. In fact, he was an avid fan of precious metals, advocating that they should be at the core of every solid investment portfolio. He even wrote books on gold and silver investing.
My father proved that even cautious investors can benefit from speculating. But as he always stressed - and as I still stress today - the key to being successful was to have a complete plan of action. You never, ever throw your money around casually...even if it is money you can afford to lose. And you must take steps to make sure you never get in over your head.
Of course, that's easier said than done. That's why my father developed six simple strategies for keeping a level head when speculating. They may sound common sense, but I've spent enough time in the markets to know that common sense isn't that common when money is involved.
So, if you're thinking of dipping your toe into the speculative markets, here are a few proven ideas to keep in mind:
1. Create a sound money-management strategy.
This one flies in the face of the conventional image of a speculator. But believe me, all consistently successful speculators start with a plan. It doesn't have to be anything too involved - just make sure you're clear on your objectives, and set some guidelines for yourself. Figure out your entry and exit strategy for each play, starting with how much to invest, how many open positions you plan to have, how you will monitor positions, what kind of stop-losses you will use to preserve capital, etc.
A sound money management strategy is the most important factor in successful speculation and it allows you to stay in the game.
2. Know your broker and monitor your investment
When choosing a broker make sure to ask as many questions as necessary and that you get the appropriate answers before simply giving over your money. If you are a beginner, find out about the broker's history and references, and speak to them frequently to establish a relationship. Make sure that either your broker or you will be constantly monitoring your investment - today's markets are very volatile and with options trading the price can shoot up 30% or more in just a few hours...so it is necessary that your broker is able to see the option is performing and be able to execute an order in a timely manner, to ensure that your capital is protected.
With so many discount Internet brokers out there, it seems like more and more people aren't doing their homework before opening an account. It's OK to try and go it alone... unless you don't know what you're doing. In that case, it's well worth the time and money to explore more experienced flesh-and-blood brokers.
3. Stick with your exit strategy if a trade goes against you
With a good money-management plan, there should never be any surprises. No matter what price your options trade is at, the action you need to take should be clear.
That doesn't mean you have to be inflexible, however. Just because an option has met your profit target, you don't have to automatically sell. But there has to be a compelling reason to stick with the trade - something more than a feeling that the trade will continue climbing above your target price. (After all, you selected that target price for a reason.) And always use a stop-loss or a trailing stop order to make sure you're ready for any reversal that might pop up.
For a losing trade, however, you need to be a little more harsh. Options are wasting instruments, and their value dies a little each day. Sometimes it's better to stick to your strategy and settle for a loss than it is to wait it out and hope for a miracle. That's money you could be plugging into another play.
4. Always, always, always, ask questions
The Internet age is creating a generation of independent investors. But some are still too proud to admit that there are things they don't know. In the speculation game, what you don't know can't hurt you.
If you've taken my advice about finding a good broker, you've already got a ready source of info to turn to. Dozens of Web sites also offer complete details on options trading. So there's just no excuse for ignorance any more... and losing money because of ignorance makes even less sense.
5. Learn from your mistakes
Find out what works for you. There will be losers along the way - but just make sure you know what you did wrong in previous options trades (e.g. you set a stop loss of 15% and were stopped out too early and the option rebounded to 56% profits). Take every trade as a lesson and use it to improve as you continue trading.
6. Remember that knowledge is power
You can never know too much... strive to learn as much as you can about options and their inner workings, strategies, fundamentals, everything... so that you will be better equipped to profit with options trading.
As I've said in the past, options trading is more accessible than ever before. And the profit potential hasn't diminished a single cent. Going out of your way to learn the myriad of ways they can boost your bottom line is the easiest way to discover what works for you.
Sincerely,
Steve Sarnoff
for The Daily Reckoning Australia
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Comment by James Russell on 4 January 2011:
Can I start trading in options without a broker?