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Introduction to Options

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Guy Cohen explains the six major prerequisites for options trading and the ten steps to follow to start to build a plan.
This chapter is from the book

Why is it that options are so misconceived as a minefield of danger and risk? How can we make sense of this and look at options as tools to limit our risks, maximize our returns, and SEE WHAT WE’RE DOING at the same time? This is the essence of OptionEasy and this book—how to make seemingly complex things simple.

Options have become remarkably popular, especially in the U.S. Far from being confined solely to the institutions and professional money managers, options trading is now mainstream for “retail” traders from all walks of life. The concept of options is still, however, treated with fear and trepidation in some quarters. When I first embarked upon serious trading, a friend warned me about what I was getting into, but trading can be as safe as you want it to be.

The simple fact is you need to have a trading plan that works. It needs to keep your risk low and your potential for reward high. You need your plan to have structure and simplicity so you can follow it every time. Over the years, my trading plan has become progressively simpler.

To make it as a trader, it helps to develop the following traits—and they can all be developed.

Criteria for Successful Investing

  • Patience
  • Perseverance
  • Knowledge
  • Honesty
  • Pre-planning
  • Discipline

Patience

Making a lot of money in the markets is one of the most exciting experiences you can have in your professional life. I’ve done it in two ways, making thousands of percentage gains each time. The first was probably more luck than judgment. The latter was by using skills that took time to develop. Take time to decide on your strategy (I outline mine in Chapter 11, “Putting It All Together—A Call to Action,” and Chapter 12, “Trading with the OVI”) and nurture your skills. There comes a time when you feel at one with the markets and trade only when the most obvious of opportunities stares you in the face. When you are able to turn down substandard opportunities with a shrug of the shoulder, you’ll know you’ve arrived.

If you’re new to all of this, take your time. Think about it this way: Would you consider yourself able to do brain surgery after just one tutorial? Well, the same applies to trading, and even more so for options trading (although the same principles apply). Give yourself time to learn. By reading this book, you are doing just that, giving yourself a learning opportunity. If you’re already familiar with stocks, this is the next step. And just as you had to get comfortable with trading stocks at first, you also now have to get comfortable with trading options.

Furthermore, when you are comfortable enough to trade, you need to have patience to do the trading itself. We’ve all had the experience of jumping into an investment too early even when we weren’t quite convinced it was the right thing to do. Be patient, take a deep breath if you have to, and stick to your trading plan every time.

Finally, patience also involves selecting a trading strategy where time works in your favor and where your downside is covered. There are plenty of strategies for you to choose from in this book, but you can always elect to keep things simple. Regardless of which one you choose, always wait for the right opportunity to present itself. I stick to a couple of chart patterns to trade, and if they’re not showing up, I don’t need to trade. People who specialize make the most money. So, specialize in terms of what you trade.

Be patient in your attitude to acquiring wealth. The more patient you are in this way, the better off you will be. This doesn’t mean sitting back and doing nothing—that’s apathy, not patience. Give yourself time to learn, gain experience, and then start to apply what you learn consistently so that you begin a process of making money and building wealth.

Consistent with the art of patience is embracing the concept of compounding. If you can make just 1 percent per week, this would mean more than 67 percent in just one year, a record of which any fund manager would be envious. The following table illustrates the power of compounding if you start with just $10,000 in your account:

Weekly return %

Monthly return %

1 year

2 years

3 years

3-year return %

1%

4%

$16,777

$28,146

$47,220

472%

2%

8.24%

$28,003

$78,418

$219,597

2,196%

3%

12.55%

$46,509

$216,307

$1,006,021

10,060%

4%

16.99%

$76,866

$590,836

$4,541,517

45,415%

5%

21.55%

$126,428

$1,598,406

$20,208,201

202,083%

This table is here to remind you about the need to be patient. Allow your returns to accumulate, and let compounding do its work for you.

Perseverance

Keep going. If you believe in something, you have to keep at it until you reach your goal. And once you’ve reached your goal, set another target.

Having embarked on the goal of becoming a successful trader (whether full-time or part-time), you must stick to it in order to get there. Anyone can do it. I’ve seen it time and time again with my students, where sometimes the most unlikely characters become phenomenal traders—even those who don’t think they can. To be practical, give yourself attainable targets to reach in a realistic time frame. So by next week, you’ll be fully familiar with the four main options risk profiles. You may be able to do it tonight. Keep on setting the attainable targets (do make them a slight challenge, though), and in this way you’ll be able to keep up the momentum of learning and gaining experience. You’ll also start to build up your confidence as you go along, reassuring yourself of your ability to understand anything you put your mind to. This book will help you in building your confidence because it’s a practical book and it’s easy to follow and understand. So keep going, and enjoy the process of accumulating.

Knowledge

Having established the need for patience for both acquiring the knowledge and for trading itself, let’s remember that knowledge is attainable now with such ease and speed that it is eminently achievable in a reasonably quick time. Tools exist now to simulate the trading experience, and there are myriad publications and web sites designed to help you build your knowledge database.

The best knowledge comes from experience. It’s all very well to say, “Trade mechanically,” but very few people do. Emotions are part of our beings, so rather than ignore them, it’s more constructive to work around them. That’s what my trading plan is all about—staying safe, but still being able to play for the big wins. Mindset is also key, and that’s covered in Chapter 10, “Trading and Investing Psychology.”

Remember that learning is experience-based. We can all remember the most extreme of our teachers at school, right? You can recall the funniest, the scariest, the smelliest, the prettiest, and the ugliest, but I’ll bet you have a problem remembering anything about the teachers who were somewhere in the middle—those who barely made an experiential impact on you in years of being in the same classroom.

The same applies to trading. A lot of the learning involved in trading is experience-based. In fact, the most pertinent form of learning about trading is experience-based. It’s through the extreme experiences that you find more out about yourself in good times and bad. Most brilliant traders have had terrible experiences but, crucially, have stepped back up to the plate and applied what they learned. Just like me. I made a lot of money very fast, thought I was invincible, and then promptly gave some of it back again. Trust me, I didn’t feel too good about that, but I did learn. And more importantly, I applied the lessons.

So, allow yourself to get your experience, which is what this book and my workshops are all about. Ultimately I’m sure you’ll end up coming back to the simplicity that’s contained in my trading plan.

Honesty

You have to be honest with yourself if you’re to develop into a decent trader or investor. Ultimately, your results determine how good you are. Your decisions are your responsibility, not anyone else’s. Blaming other people never helps. If you pull the trigger, then you’re the one in control. We cover more of this in Chapter 10.

Pre-Planning

You must pre-plan each and every trade. By this, you must know your

  • Maximum risk
  • Maximum reward
  • Breakeven points

You also must plan

  • Your entry point
  • Your exit point whether it’s to...
    • Take profit or
    • Stop losses

With options trading, I tend to base any stop loss on the basis of the underlying stock. The underlying stock is invariably more liquid than its options, so it makes it easier to make your loss-cutting decision based on the price of the stock, future, or whatever the underlying asset is.

The first piece of pre-planning is the choice of the underlying stock itself due to the chart pattern. Then you create the trading plan, which requires...

Discipline—The Key to Success

When you have had the patience to acquire the knowledge and apply the principles previously discussed, it’s imperative not to waste it all. You must be disciplined and apply that discipline rigorously each and every time.

This means that

  • You do your pre-planning every time.
  • You use your (and others’) experience.
  • You do not deviate from your stated sensible plan.

In this way, you take the first steps to become more methodical. Discipline is vital with trading. Without money management, even the most sophisticated of trading systems cannot work.

By sticking rigorously to sensible money-management principles, you ensure that your losses are minimized and your profits are allowed to run.

You’ll also ensure that you will avoid suicidal risk profiles. I’m often horrified at so-called experts teaching option strategies that have terrible risk profile curves. So let’s have a look at a risk profile and why it is so important to your success as an options trader.

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