Trading School Beginner Level

Finally individual investors can receive education in the art of selling options.

Lesson 7: How To Limit Your Risk

If you just got here, start at Lesson 1.

In this lesson I will show you how to limit the risk on every option trade you do. I hate losing money. So every trade I out on has limited risk. I know what my maximum loss can be on every trade, and if the trade goes against me, I make adjustments to my position to protect my profit or myself from the maximum loss. Even with a 80% probability of expiring, you will still have 2 out of 10 trades go against you. I do not believe in putting on a trade and not protecting it.

Before I make a trade, I want to know what is the most I can lose, the most I can make, and when I need to adjust my trade to protect myself.

Figuring out the most I can make is easy. It's usually the amount of the credit we receive from selling our options.

Figuring out the most I can lose is easy too. I always limit my losses by buying options at the same time I sell them. Huh?

Let's say I want to sell a call option on IBM with a 50 strike price. For this option I will get 2.00 in credit. To limit my risk I buy an option further out of the money. In this case I can buy the 55 strike price option for a debit of 1.25.

Here's how it works. I sell one option at 2. I buy one 5 points away for 1.25. So my total credit is .75 (2-1.25). That is my max profit. To figure my max loss, I subtract .75 from 5 to get 4.25. (We bought the option 5 points away).

So if IBM stays below 50 we make the max credit. But what if IBM shoots up and goes to 60?

We would have to sell 100 shares of stock at $50. But we bought an option at 55, so we can buy 100 shares at $55. Plus we got .75 for each share so we would only lose $4.25 per share. Even if IBM goes to 300, we still only lose $4.25 a share.

In option terms, this is a called a spread. You sell one, and you buy one to limit your risk. You make less money because you have to spend some of your credit but less money made is a lot better than a whole lot lost.

But what about the adjustment?

Let's look at the Iron Condor trade. A lot of people lose money on these trades because they do them incorrectly. I have even heard option "experts" and newsletter writers advise clients to put on a condor trade and never touch it. If you lose, you lose.

Here is the problem with that thinking.

Let's say we do 10 condor trades, 1 a month for 10 months. Each has a 10% max profit and 80% probability of expiring. When we win, we make 10%, but when we lose we can lose 90%.

Let's look at the trade we discussed earlier on the RUT:

  • Sell 1 NOV 660 Call at $1.98
  • Buy 1 NOV 670 Call at $1.58
  • Sell 1 NOV 380 Put at $4.05
  • Buy 1 NOV 370 Put at $3.50

The total credit we received was 95 cents per option. Our maximum loss was $9.05 per option. So our max return would be 10.5%.

The total margin we have to put up for this trade is $1,000. If we win we will make $95. If we lose the max, we will lose $905.

So let's begin. We trade the RUT in this way for one month, and we win. We also win in the 2nd, 3rd, 4th, 5th, 6th, 7th, and 8th months. Wow, we are hot!

8 months of wins for about $100 each month gives us a total of $800.

But then in month 9, we lose. And we don't adjust so we lose the max. -$900. Now we are in the hole $100. After nine months of work we are negative. That sucks. But wait, we are not done yet. In month 10, we lose again. We lose another $900. Ouch! Now we are down $1,000.

What happened? Even with an 80% probability of success we still lost a boatload of money. In this case 100% of our margin. Let's stay away from these Iron Condors, right?

If you don't know how to adjust, you should stay away from them. Because you will lose your shirt. And if you come across a newsletter or teacher that tells you not to adjust your condors, RUN away from them. Trust me, in the long run you will lose, unless you adjust.

Remember the RUT trade we revisited above. We came out ahead on that trade. But only because we adjusted. If we had not adjusted we would have lost the max amount.

We need to treat our trading as a business. If you were running your own business would it be ok if you could lose your whole year's revenue in one month? Hell no! You want to be positive every month. And if that's not possible then you want to keep your monthly loss to be about the same as the gain of an average month. So if you make 10% in a good month, you don't want to lose much more than 10% in a bad month.

To recap, we limit our max loss by using spreads. And we limit our losses even further by adjusting our trades. This works with all our trade strategies, the condors, butterflies, calendars, credit spreads, covered calls, and all the rest.

In our next lesson I will show you some of the trades we do.

Let's Go to Lesson 8