Let's start by discussing the subject of diversification. How many times have you heard someone say "don't put all your eggs in one basket"? This sounds like good advice, and it certainly is when it comes to trading. But diversification can also reach a point of diminishing returns. While it's true you should spread your risk across multiple trades, having too many active trades going at once can also work against you. For example, the time required to baby-sit your open positions is directly proportional to the number of positions you have. Clearly, this can put too much strain on you and adversely impact your trading psychology. Moreover, if the market should suddenly turn against you, the more open positions you have, the longer it will take you to reduce your risk exposure by liquidating some or all of them in order to raise cash and live to trade another day. Failing to do so would portend a false sense of security on your part, causing you to give back most of your gains quickly. In a nutshell, put your eggs in just a few baskets (i.e., stocks) that you've come to know well, and make sure to never trade on borrowed money (i.e., margin).
Time Frame Selection
Next, let's talk about time frame, as this topic is particularly important to options traders. If all your open positions were short-term trades consisting of weekly options expiring in one or two days, what would happen to them if the market were to suddenly turn against you? They would be rendered practically worthless, and you would likely be wiped out regardless of how many positions you've diversified into. In other words, position diversification wouldn't be of much help in this situation. To prevent such situation from ever occurring, you should stretch out your trading time frame in order to allow your eggs ample time to hatch. Remember, 70 percent of stocks move in the direction of the overall market. Therefore, if the latter were to experience a downfall of 1 or 2 percent on a Thursday or Friday, most stocks would be impacted commensurately. However, the extent of the damage (i.e., premium erosion) imparted on weekly options could be catastrophic. An individual who owns common shares can hold on to his position for as long as necessary until the stock price eventually recovers. On the other hand, an options position in the same stock is doomed unless the 'underlying' (i.e., the stock) stages a miraculous recovery with ample time left until expiration to make up for lost ground (i.e., extrinsic value). In a nutshell, you should design your options trades to withstand the inevitable trials and tribulations of the market by stretching out the expiration dates of your option selections. Look for trade setups on the hourly, daily and weekly time frames. Give them ample time to bear fruit.
General guidelines for option expiration selection:
- For trade setups identified on the hourly chart, select an option that expires in no less than two weeks to one month.
- For trade setups identified on the daily chart, select an option that expires in no less than two to four months.
- For trade setups identified on the weekly chart, select an option that expires in no less than four months to one year.
This shouldn't be rocket science. If you trade common shares of stock, you shouldn't be more than 60 to 70 percent invested at any given time, market conditions permitting. If your account size is $50,000, consider investing $3,000 to $3,500 in up to 10 different trades for a total of $35,000. Say you like $SNDK based on the chart setup, and you decide to spend $3,500 to buy 50 shares at $70/share. If the stock appreciates by 10 percent, your account value will increase by $350 (or 0.7 percent). However, as long as the stock price keeps rising, so will your profit.
The same goes for options trading, even though the profit and loss potential is significantly bigger. That's why you shouldn't be more than 10 to 20 percent invested at any given time, as any unforeseen event could wipe out your investment. Options are leveraged instruments. Therefore the profit potential can be significantly bigger, but so can the potential loss. With an account of $50,000, you would spread $5,000 to $10,000 across five or ten different trades. For example, if $SNDK is trading at $70 on 2/12/2014, and your technical analysis is calling for a move to $80 or above in the next few weeks, you might consider spending $1,000 to $2,000 on the May 75.00 call option that's currently trading at $3.50 (or $350/contract). Say you buy five contracts for a total investment of $1,750. You're effectively giving yourself three months to be proven right. By early April, the stock has already rallied up to $84/share. The $3.50 call is now worth at least $9 or $10 (or $900 to $1,000/contract). You've almost tripled your investment.
On the other hand, if May arrives and the stock is still trading near $70, your options might now be worth 10 percent their original value. In short, options are a two-edged sword.
You should use a trailing stop or stop limit order to make sure the trade is exited profitably if the market or the stock itself should turn against you.
But what if the trade goes against you right from the very start? In this case, use a predetermined stop loss metric of, say, 4 percent, or whatever your risk tolerance allows for. Should the stock depreciate by this amount, exit the trade altogether and wait for a more favorable opportunity. A more elaborate exit strategy would involve the chart itself. For example, if the stock closes below a prior reaction low, you would exit the trade without waiting for the 4% stop loss to be triggered. Other exit strategies may involve candlestick patterns. For example, a gravestone doji, dark cloud cover, or bearish harami candlestick pattern forming in the vicinity of a prior resistance level are all good-enough reasons to exit a trade, winner or loser.
As for when to exit an options trade, the same chart-related guidelines apply here, except it's also possible for your option position to expire worthless even though a) the stock price hasn't depreciated since the time you entered the trade, or b) the stock price has appreciated, but not enough for the option to be in the money (or deep enough in the money) by expiration to exit at break-even, much less realize a profit. How much money would you stand to lose if your option trade were to expire worthless? Assuming only 10 to 20 percent of your account is invested in up to 10 trades, you would stand to lose 1 to 2 percent in any one particular trade. If this risk tolerance is too high, consider using a stop loss metric of, say, 50%. Therefore, should the value of an option erode by 50%, exit the trade, or consider rolling it over to give the trade ample time to work out.
Regardless of what you choose to do, have a plan a stick with it.
With that being said, you should not be discouraged from occasionally taking day trades, as those could be highly rewarding even though daily fluctuations are generally much harder to read than longer-term trends. From experience, the most lucrative day trade opportunities present themselves on expiration Friday when an individual stock or market index has reached an exhaustion level and is finally ready to spring in the opposite direction. On such a Friday, the release of a much-anticipated economic data point is often the catalyst, and a seemingly worthless weekly option (near-zero extrinsic value) could run from, say, a nickel or a dime up to $1.50 or even $5.00. Generally, when news is not really news (i.e., the crowd guessed right well ahead of the actual release), the market might sell off on the good news and rally on the bad news. The important thing is to monitor the price action and identify the chart pattern leading up to the event. Is the most likely outcome already priced in? Does the technical setup favor 'selling the good news', 'buying the bad news', or pressing on in the direction of the underlying trend?
General guidelines for day trading:
Day trading must suit the trader's personality.
Day trading should complement, not conflict with, your risk management, capital preservation, and income generation strategies.
The most lucrative day trade opportunities require very little upfront commitment. Timed perfectly, they can pay outsized rewards.
The most lucrative day trade opportunities present themselves when multiple technical factors align in favor of taking the trade (see example below).
EXAMPLE: the Shark pattern (in blue) on the 10-minute chart of the S&P 500 reached its Potential Reversal Zone on April 4th, 2014 upon releasing the NFP report. This set the stage for a 24-point decline that lasted all day.