Disclaimer: None of the following is legal or financial advice in anyway, and respective advice should be sought from an appropriate professional.
If you’re a retail trader, this situation might sound familiar to you. You’ve spent the time doing the analysis, crunching the numbers, making the decision to put your money to work … or maybe you got a hot tip. You know what the next meme stock will be and you’re just waiting for the price action to kick off, before you plough in!
However, you choose to trade, the one thing more important than being able to make money is making sure you don’t lose it. The next trade that you make should not be your last.
Whether they be real or fake, there is no excuse for screenshots such as those that come from wallstreetbets, which show total, utter and complete losses or outrageous wins. For those that choose to gamble, feel free …
But this isn’t about gamblers with too much money … not in 2023!
This is about how the market has been pushing higher, or staying high in spite of economic indicators that still show strength, while the anecdotal evidence shows signs of imminent trouble.
US banks have been downgraded, the US credit rating has been downgraded … the policies and governance have been called out for being poorly run and managed! The cost of living as of September is rising again – the need to exceed remains.
This is about uncertainty!
Every day there’s conflicting information … as a retail trader, what do you do? Sit on the side while the market shifts, or do you take the risk, jump in and ride the waves, whatever they are?
How do you protect your trades? How do you protect your positions? How do you protect your goddamn money?
When it comes to trading options contracts, the good news is that are 4 key ways we can look to protect our trades. Let’s take a look.
Stop Losses & Profit Takers
Perhaps first and foremost when it comes to protecting a trade, as well as protecting your hard-earned equity, is using a stop loss.
As the saying goes, “cut losers quickly, and let winners keep on winning.”
Stop losses do exactly that. Set them for the amount of risk you’re willing to take, and when that level is reached, they will take immediate effect, to close the trade on the spot to prevent you from losing any further.
Stop losses, might take the emotion out of the issue, but they aren’t perfect. Here’s why.
A Stop loss, will look to make the first available trade, so once a stop level is reached … the spread between the bid and ask will be in full force, as well as brokerage, so you can set the stop loss, but you don’t actually know how much you’ll come away with.
Stop Limit orders, allow you to ask for a minimum price to close, but in the case of a sell off, you run the risk of ‘missing-the-market’ where the stop order is placed, but not filled, leading to continued losses!
You can compensate for the spread and brokerage, but that means setting the trigger earlier …
Profit takers on the other hand, take the emotion out of the trade to automatically book profit, making sure you keep your winnings if you can get them.
You can also use a trailing stop, that moves with the price action and takes effect if and when the market turns.
The next thing you can look at is the total cost risk, or the total amount of equity that you use to establish your position or the total amount of money you might lose, which we will cover shortly.
Not every position will need nor even be able to properly make use of a stop loss order. Sometimes the spread between the bid and the ask could be too wide, the trading volume may be too low leading to illiquidity, where missing the market is a real issue.
If you’re ever looking at a situation such as this, total cost risk is not only one way to measure your risk, but also a hard and fast way of figuring out what your worst-case scenario for the trade would be.
If you’re gonna buy 5 contracts at $0.40 each, then your total cost will be $40 per contract … $200.00 + brokerage. Closing anytime while the position still has value, will result in less than the maximum loss.
Unlike buying stock outright, options can be bought or sold in combinations, known as spreads.
These spreads can have significant impacts to a trade. They can decrease or increase the cost of entry, cap or open up unlimited profit, they can allow the trader to trade directionally, up or down, trade sideways movements or even trade for bi-directional volatility.
Most importantly they can build in a hard stop … an absolute ‘Structured’ limit to trade risk.
Unlike trading or investing in whole stock, options contracts cannot be traded during pre or post market hours. And that can make things like stop losses pretty tricky, especially if and when a major report drops that suddenly moves the market … in the wrong direction, like a quarterly earnings report or … Monthly CPI figures!
A spread that limits the total risk, such a credit spread, can not only reduce your credit, but can also limit the amount of money you might be required to hand back if the market turns.
For debit spreads, the risk would be the cost risk!
Hedging your trades.
Perhaps finally, we get to ‘Hedging’ the position.
From a fundamental level, hedging a position involves reducing the risk by adding an offsetting or counter position to one that you have.
Simple right? If you place a trade expecting the market to move one way, then place a counter trade to profit or at least reduce losses; to act as a shock absorber and give you time if the market turns the other way.
Its not quite that simple.
I’m no fund manager, but hedging isn’t a hard and fast rule.
Although I have rules for structuring these; with options, time is a massive factor. You could do something as simple as a strangle … with the added cost! You could counter with a spread … with added cost … see the pattern?
The very act of hedging in itself involves the cost of paying for the alternate position and this on its own complicates the management of the entire trade. Option Values decay … that means, that BOTH trades could go to zero … but we wouldn’t let that happen, would we? Uh-huh … (nod)
Generally, you’d see a price movement in one direction either in favour of one side of the total trade, but the final sting in the tail is as follows.
For one side of the trade to win, it not only has to win, but it has to cover the loss of the other side, and that means that the trade setup itself has to be very asymmetrical and heavily stacked in favour of the prime direction. Hedging is only even worth doing at specific times, or for long time periods.
Related: When and How to start Investing
Even now, the stock market offers one of the most effective and efficient ways of growing your money, and this is even more true for people out there with smaller amounts of it. With inflation now on the move for a second month, the right trade … the small wins could be what makes all the difference.
But you can’t ‘win’ unless you’re actually in the game, and there is a cost of entry! Nothing is risk free, and there is no sure thing.
When it comes to the risks you take and how you manage them, it must be understood, that losses can, do and will happen. Anyone who tells you otherwise is someone you need to steer clear of. First and foremost, if you can’t take the risk … you don’t!
All the same, if you can, and choose to do so, you can’t spend your entire time, with one eye on the markets or your time thinking and worrying. At the very least this can lead to bad decisions.
Protecting your trades is just one part of managing your money as a trader. Making sure you don’t get wiped out is one thing … making sure you can sleep at night is another.