Welcome to the first in a series of educational articles!
As Phil mentioned on Saturday we will be “embarking on a grand and experimental adventure aimed at writing the best options guide ever!” and in addition our plan is to improve your existing knowledge of options trading and improve your trading skills in the very best way possible – practical examples! We plan on selecting trades that highlight trading strategies each Monday and following them throughout the week. We’re on the cusp of a wave and I suspect with your help it will turn into a tsunami that takes over the options world!
With the agenda set let’s dive into two of the most critical aspects of trading, what I refer to as The Golden Rule & The Cardinal Sin of Investing. It’s worth addressing these issues now because any strategy discussions that follow in future posts should be in context of our two principles.
First let’s understand the Golden Rule of Investing which is “The more uncertain you are about a position, the more you should hedge your position!” There are myriad applications of this rule which I am sure we will address in future articles but first let’s look at an obvious example:
Earnings season: This next week will see earnings announcements from Schering-Plough (SGP), Verizon (VZ), SanDisk (SNDK), Altria (MO), Procter & Gamble (PG) and dozens of others. At earnings our uncertainty about direction of the stock following the movement is at a peak. Even if we can intelligently guess the strength of the report we have no guarantee that the stock will move in the expected direction (just look at Apple [AAPL] as an example of this phenomenon).
If we are entering earnings with directional positions (e.g. long call, long put, stock etc.) it is generally prudent to hedge our positions – unless the trade was initiated as a speculative trade and we can afford to risk the capital! For example, if we are holding a LEAPS call option we might want to hedge with a put option to protect ourselves from potential significant downward movement or if the stock historically does not move in a very volatile manner we could simply look to add some short calls against our existing long calls. Once we combine options in this manner we are forming spread trades and we will cover them in more detail in future articles also.
You will see Phil apply this rule often to protect his current holdings. For example, this last week Phil referred to XOM call options he added to hedge against existing put options. This was designed to mitigate some of the risk from the put options in the event that the stock moved upwards as uncertainty increased prior to President Bush’s comments on energy and the Strategic Petroleum Reserve during his State of the Union address.
The next rule we should be equally cognizant of is The Cardinal Sin of Investing which is to ignore risk management – Don’t every do it!!! Simply put “Don’t ever put all your eggs in one basket” otherwise Murphy’s Law kicks in and no matter how confident you were in the position you might quickly find it moves against your initial expectations!
As Warren Buffett famously quoted “The first rule is don’t lose money” and the second rule is “Don’t forget the first rule!” Why is this so important? Just think about losing 10% of the value of your virtual portfolio. You would need an increase of 11% in the current holdings to get back to breakeven – not so bad. If you see a drop of 20% in the value of your holdings, you will need an increase of 25% to get back to breakeven. And if your account value drops 50% you will require a 100% increase to get back to breakeven!
By spreading our risk amongst many different trades we mitigate our risk of any single position detrimentally impacting our virtual portfolio to a significant degree. History has shown what happens to investors who risk too much on one position (just look at Amaranth as a recent example!). If you are ever tempted just remember the market always offers us another great trade and tomorrow will bring new opportunities.
In future posts we will discuss strategy some more but since these rules are so important we will keep them as our first posting and discuss strategies and hopefully some trades next week.
[For more information on Money Management feel free to check out Section 7, Chapter 16 under the ebook link on the members site!]
I look forward to working with all of you in the year ahead!
Yours truly,
Option Sage
