Trade Options with “Fun” Money

10/07/2009 12:01 am EST

Focus: OPTIONS

Kenneth Trester

Editor, Maximum Options

One of the classic statements in the options game is, "Don't play with money you cannot afford to lose." But I'd be willing to wager that many folks hear that caution and let it go in one ear and out the other. It's like telling a teenager that they can't have a party while their parents escape for the weekend. They might conspire to throw an "un-chaperoned" bash that will be the talk of the town!

Leave the impulsiveness to the teenagers and don't be in a rush to start putting options trades on the table willy-nilly just because you can. Remember that buying options—especially calls, which serve as a proxy for owning the stock—requires just as much care and forethought as buying stocks. Just because you're spending less doesn't mean that the investment is any less important.

In fact, if you buy options and the stock doesn't make the expected move by the time the options' expiration date rolls around, the small investment that didn't pay off will suddenly feel like a big deal!

Money you supposedly "can" afford to lose is still money that you value. So, you really should be playing with money that you are willing to light up with a match—money that can be left behind like plastic poker chips on a table if the game doesn't go your way.

Think about it: Gambling establishments make you use chips and tokens when you play games of chance so that you won't value them as highly as good, old-fashioned bills and coins. Therefore, when you're playing with "Monopoly money," you're less afraid to play more chips.

So, to get out of the "Monopoly mindset" when you buy options, you should set aside some fun money every year and kiss it goodbye. View it as though you're establishing a vacation fund. Trading options is an expenditure you want to make, and just like a vacation, it's wise and even necessary to budget it into your schedule every year.

If you treat such money as fun money, you will be able to withstand losing streaks and be willing to continue to take positions until you hit the home runs. To be successful at trading options, you cannot have a faint heart, but instead, you must plow ahead and buy options month after month without quitting, knowing in the end you will show a profit. And the best way you can do this is by using "fun money."

Most investors fail at this endeavor because they are not prepared to stay for the long haul and will quit after taking a few losses. But, like any game you enjoy playing, the more skills you can acquire during the learning curve, the better equipped to win you will be when your turn comes around again.

Options trading is much better than a board game, though, because it gives you an incredible opportunity to win real money—and even big money—when done right. It also lets us win whether we've landed on the right square or a neighboring one—all you need is for the stock to make a move in the right direction, and that's when the game starts to get good! It even lets us get out of the game when we start losing, so we can rotate our capital into another game (rather, another trade) that is more attractive.

These are definitely compelling reasons to trade options—you pick the game, define the rules, and play as much as you want. If you exhaust your fund for the year, it's "game over" for the time being, but at least it was money you were willing to spend anyway.

But once you get on a winning streak—and there's no reason why you shouldn't—there's no telling how profitable the game can be!

By Ken Trester of The Institute of Options Research

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