A recent e-mail from one of my members inspired today's blog post. She has been working her tail off both here at TheOptionClub.com, as well as with other courses and programs. She's thinking about giving up on options and trading. I don't blame her.
Just what do you have to do to learn how to actually make money in this trading business?
Well, it is actually as straight forward as any other business or profession. A lot of confusion and distraction exist out there, though. With so many trading websites, courses, programs, etc., it is very easy to spend a great deal of time chasing your tail...not to mention spending a good deal of your money.
I want to break this down for you without talking you into or out of any particular course or program. We can address that at a later time if anyone is interested in my thoughts and opinions on the subject.
Trading is as much of a business as anything else. The trouble for retail traders is that there is very little in the way of barriers to entry, especially today. Just a few thousand bucks and your signature on an account form will have you up and running.
Why is that bad? It's not bad. It's just that because it is so easy to get started most of us forget that we are actually embarking upon a new business that will require from us what any other business would require. We start out thinking of our trading much like one would consider a hobby. It is fun. There is an element of excitement. Then there are those dreams of financial independence, commuting from bed to the spare bedroom by way of the coffee maker as a morning routine.
That is where most retail traders find themselves. It's a fantasy. Light entertainment.
If you fall into that category that is fine. Just keep in mind that what you're doing is more like enjoying yourself in Las Vegas, minus showgirls and the free cocktails. Then there are those who are done having their fun and want to get serious, and that is where our friend finds herself.
STEP ONE - Build The Foundation
Attend our 2-day seminar and learn the secrets to being a successful physician! Discover how to pilot commercial airliners for fun and profit in five easy lessons! Yeah, I'm making fun. But I am also trying to make a point here...
No rationale person would expect to become a competent physician after a two-day seminar or a commercial airline pilot after sitting through a few lessons. Do doctors attend weekend seminars? Sure they do! But that is not the foundation for their careers.
The foundation for your trading business is your education. You need a an understanding of how financial markets work. What markets? Well, if you're going to trade options on stocks you had better develop some understanding of the stock market. Options on futures? Get acquainted with the future markets. Currencies? You should have the picture by now.
Options are derivative products and their value is derived from what goes on with the underlying security and the events that take place in their respective markets. The more you know and understand about those underlying securities and markets, the better.
Most retail traders I encounter have a pretty good understanding of the equity market and their interest lies primarily with trading options on equities. It makes sense. Go with what you know.
The mistake many make is that while they understand the equity market they know little about the options they intend to trade. They have learned about covered calls, married puts, credit spreads, debit spreads, iron condors and butterflies, and all the various exotic strategies.
The trouble is that they have not taken the time to really understand what an option is and how it is valued within the market. This is part of the foundation upon which you will build a trading business. If your business is trading options, then know your product inside and out.
STEP TWO - Develop The Plan
Now that you have given yourself a solid foundation by educating yourself about the details of option valuation it is time to develop a plan. You really know a lot about options now. So what do you intend to do with them?
Remember that trading options is not an end in itself, but merely a means to an end. We trade options to protect and grow capital, generate income, and to speculate in the market. Want to grow capital? Great. Let's sit down and start writing out a plan. Looking to generate a monthly income? Fine. Sit down, come up with a plan to make it happen, and start writing. Just speculating? That's fine but you need to write down a plan, too.
This is your business plan. The act of creating it is just as important as having it. By forcing yourself to do this you force yourself to identify goals, think through how you intend to achieve them, and provide yourself a written framework within which to operate. The plan is there to define and to guide.
STEP THREE - Test And Refine The Plan
This is the trial and error stage. Chances are that the plan you came up with has some weaknesses, so it is best that we identify them and rid ourselves of them before putting a great deal of money at risk. Think of it as flight testing a new aircraft design. Let's make sure this sucker works and fix what needs to be fixed before we put it into production.
My favorite tools for testing are back-testing and live market trading. Hold the horses! I didn't mention paper trading. Don't tell mom, but I hate paper trading and I don't like to do it. It takes a long time and my emotions are completely opposite what I experience when there is money on the line. So, I first back-test a new plan using historical data, selecting different time periods with different market conditions to see how the plan fares in theory. I apply any obvious tweaks, test again, and continue that process until I am content with what I've got. Then it's into the market with it!
Let's not get carried away, though. This is now real money we're talking about and the only experience I've had with this plan of mine is in simulated conditions. Want to know the definition of "simulated conditions?" It means it ain't the real thing. It's fake. So is paper trading. Just ask those fighter pilots who climb into the flight simulators. As realistic as they may be, I bet their exhaust pipes don't pucker in the simulator like when they are executing a real night landing on a real life aircraft carrier. Now they have skin in the game and it's their skin!
Here's a less dramatic analogy. I live with my family on the west coast. When I taught my daughter how to swim I did not walk her out into the Pacific Ocean and point her at Catalina. We started in the kiddie pool. She was a little nervous, but she knew she could stand up at any time and that she would be fine. After she got used to it and had a chance to practice her basic skills we moved into the big pool. The bottom was too deep for her to stand, but I held her and we worked on techniques like floating on her back, swimming to the side, etc. She was building confidence and improving her skills. A couple weeks ago I was on vacation watching her swim lengthwise across the pool, racing her friends. She's still not ready for the Pacific...
You're not ready for the Pacific, either. You have a solid foundation and you've got a plan that has been tested in theory. It's into the kiddie pool with you! Fund an account with $5,000 to $10,000. Less is okay, but not more. Trade the plan with just one or two contracts. Forget about commissions and slippage, we're not trying to get rich here. These are the shallow safe waters. If you get in trouble, close the position and take your $50.00 loss. You're okay. Take a look at what was going wrong, find a way to identify the conditions that gave rise to the problem, and modify your plan to deal with it. After you start feeling comfortable, and if you can at least break-even, consider increasing your size but don't get carried away. Do not go from $10,000 to $100,000. Take gradual, reasonable steps.
There is nothing about trading a large account that makes the process easier. Larger size only complicates matters and magnifies your losses.
STEP FOUR - Trade Your Plan
Now you're in the "Big Kid's Pool" swimming lengthwise across it. Everything seems to be working well, you know how to deal with the trades that are going against you, your losses are limited and your profits are frequent enough and large enough to keep you in the black. Now you're ready to fully implement your trading plan.
Markets change and there will be times when you need to modify your approach. When you do, if the modification is a significant departure from what you had been doing with your trading, consider pulling back on the reigns for awhile so that you can test your revised strategies as outlined above. That written trading plan should be looking pretty worn by now from being repeated revised and referenced. The daily routine should seem just that; routine.
How long does all this take? Some do it in a matter of months. Others require a couple years. A lot depends on where you are now in terms of knowledge and experience, as well as how dedicated you are to moving along the learning curve. The goal is achievable, however. It just takes a clear mind, persistence, and discipline.
If you want to get some help building your own trading business, remember that we're here for you. Come by the Trading Room or visit our free discussion board on Yahoo! Groups.