Win with Options by Losing Less

05/17/2011 8:00 am EST

Focus: OPTIONS

The simple fact is that all option strategies sometimes lose, but those who adapt quickly and cut losses will be the traders who earn the lucrative annual profits that are possible with options.

All great options strategies will have losing months. There is no getting around this simple fact, and it is critical to your mindset as a successful options trader that you accept these months as part of the game.

While non-directional options spread strategies are also known as “income options trades” (giving some traders the mistaken idea that the strategies will produce income for the trader each and every month), it is important for the developing trader to understand that it is rare to go through an entire year utilizing a particular strategy without at least one losing month.

In fact, there are certain points in particularly tough trading months where the skilled options trader actually intentionally places a trade into a position that has no chance of ever producing a profit. This is normally done in order to put the trade into the best possible position to minimize the size of a loss in a situation in which there is almost a statistical certainty that a trade will produce some loss anyway.

In other words, there are cases where it is smarter to lock in a small loss than roll the dice on the remote possibility of a small gain at best, contrasted against the distinct possibility of a large loss.

Once a trade is recognized as a probable loser, the skilled options trader can often greatly minimize the size of the loss by restructuring the trade so that the time decay of the short options in the restructured trade allows the loss to be worked down to a very small percentage of committed capital with a minimal risk that a large loss will occur.

The mistake that many developing traders make is that they throw in the towel on a trade which has been adjusted so often that the remainder of the trading cycle does not present any realistic opportunity to turn the trade into a winner.

Unfortunately, that is usually the worst time to end the trade, but traders often fail to recognize that. They think,

“Now it’s hopeless, I have no shot at making money on this trade, I better just shut this down.”

Instead, the correct thought process is: “This trade now has no prospect of turning a profit. Is there a way to position my trade so that there is an excellent chance that I can greatly minimize the loss?” Usually, there is a way to do just that once you have become a little more experienced.

So for example, a trader may find himself in a situation where he is down 8% on a trade which has been adjusted so much that there is only a very small remaining prospect of making even a 2% profit, but a statistically significant possibility of a maximum loss (let’s say 15%, in this case).

Many developing traders will fail to see that there are many viable ways to reduce the loss down to 2%-3% on the trade over time and simultaneously cut the risk of a maximum loss significantly if the trader is willing to restructure the trade so that the best-case scenario is, say, a 1% loss.

Most developing traders have a psychological block against thinking along those lines. “Why should I guarantee myself a loss?” the trader asks. Instead, they will either bail out of the trade completely at the 8% loss level, or worse, they will stay in the trade and try to get lucky by making the improbable 2% gain, all while risking the much-more-probable 15% loss.

It’s far smarter to restructure the trade into a guaranteed small loss as a best-case scenario in exchange for making the maximum loss extremely unlikely, and making a very small loss very likely.

It’s actually really important to recognize when you are in one of those unglamorous situations where your best-case scenario is a minimal loss.

If you are involved in one of those trades and you try to be a hero by hoping to squeeze a tiny and improbable gain out of trade that’s much more likely to end up as a maximum loss, then your chances of making an excellent annual return using that strategy becomes bleak.

If, on the other hand, you handle those months right and keep the losses down to a minimum, you put yourself in an excellent position to make a terrific annual profit.

By Seth Freudberg, option trader, SMBCapital.com

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