Thursday, April 24, 2008
Successful option traders have an 11th commandment...
Risk not thy whole wad.
The concept behind this rule is simple: Don't put too much money into any one trade. But you'd be surprised how strong the temptation is to break this commandment.
Just imagine you've done all the analysis and you've come up with the one option trade that looks like an absolute no-brainer to double or triple in value. Why put just $1,000, $2,000, or even $5,000 into the trade? Why not go "all in," and put your entire savings into the position?
After all, if it's a no-brainer, then why not use it to capture the big score and really pump up your account?
Of course, the no-brainer could turn out to be a loser and wipe out your entire account. Then you're out of the game. That's a temporary condition, though, as you can always get back into the game by taking a second job delivering pizzas or working the night shift behind the glass booth at a gas station.
A more troubling condition is the effect that over-committing to one trade has on your emotions.
Let's face it, people get emotional over money. The more money you have at stake, the more emotional you're likely to get.
And a trader overcome by emotion is like an Opera singer with a sinus infection. Performance is going to suffer.
Traders need to think logically and stick to their discipline. That's tough to do when too much money is at stake. We start watching every tick. We start questioning the logic behind the trade in the first place. And we second-guess every move.
When our emotions are in play, we're more likely to get bluffed out of a position – to exit the trade before it's had time to move in our direction. We're also more likely to hold on to a losing position longer than we should because we just can't stomach taking a loss THAT big... and maybe it'll come back. Of course, it never comes back, and we end up with a horrendous loss.
Every trader I know has gone "all in" once or twice during his or her career. And every trader I know has regretted it.
That's what happens when you break a commandment.
Next week I'll share with you my personal portfolio strategy, and the technique I use for trading my own account.
Best regards and good trading,
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