Option Strategies to Limit Losses

Every once in a while I get an email from a prospective member who asks me why I lost money in September 2008. I did have a large loss compared to my prior losses and they want an explanation.   Just like this email from Mike:

First of all, thank you for your free e-mail lessons. In the lessons, you mention that losses can be kept to a minimum….could you explain the circumstances in Sept. 08 that caused you to have losses greater than 20%? Was it the market itself or did you not follow your rules? Thank you very much in advance for your reply.

My reply:

Mike,

In Sept 08, the market tanked very rapidly. We never expect it to drop so far, so fast. I was caught off guard, just like the rest of the investing community. We always have safeguards to protect us from a complete loss, but the stop losses I use are mental, which means I don’t have contingent orders placed in most situations.

I do this because of my service. If I am not at the computer and get filled, I will not know about it and will not be able to tell my members immediately. I send an email to members as soon as I make a trade, any trade, so they can follow along. I don’t think it’s honest to have a trade filled for me and email everyone hours, even days later.

First of all, I want to thank Mike for being so polite. Common decency seems to be a rare thing nowadays.

Selling options

When you sell an option, you have two choices, either sell it naked or sell a spread. A naked option is one that has no protection. If you sell a naked call and the stock goes to the moon, your losses are unlimited; but spreads put a limit to your losses.

Let’s look at an example.

Say you think AAPL, Apple Computer is going up and you want to sell Put options. Selling a Put option will get you a credit and you will profit as long as AAPL is above your strike at expiration.

So AAPL is at 100, and you sell the 90 Put. What happens if AAPL drops and is at 70 at expiration? Since you sold the 90, you lose $20 minus whatever credit you received. That is a large loss, but it could get worse though. Say a report comes out that iPods cause cancer. That would drop the stock a lot lower. Your potential loss on this Put is $90.

But what if we sold a Put spread instead? We sell the 90 Put and Buy the 85 Put. We get less credit than a naked Put because we have to spend some of our credit to buy the 85. But our loss is capped at $5 minus our credit.

So if AAPL drops to 70, our loss is still capped. With a spread, you make less money than with a naked option, but your loss is limited.

Even so, losing $500 per option is not something I enjoy. That would translate into a 100% loss on the trade. That is not something we want to do.

So in all my trades, I know my max loss when I get in. It’s easy to figure out since I only trade spreads. But I never want to take the max loss. We cannot win as option sellers by taking max losses. It would wipe out several months of gains.

Option trading strategies

So here’s how I handle things, I have an idea of the % loss I am willing to take on a trade. If the potential profit on a trade is 15%, the max % loss I would be willing to take is close to 15-20%. Thanks to adjustments and strict trade selection I hardly ever have to use my mental stops.

But sometimes, like in September 2008, the market moves through my mental stops and I lose more than I planned, but a lot less than I could’ve.

To wrap up this post, yes I lost in Sept. It could have been worse, but I make no excuses. Mostly we win, but sometimes we lose. My job is to keep my losses smaller than my wins. If you look at my performance, it was still over 100% in earnings, so I think I did all right that year.

Only Bernie Madoff was able to have consistent winning months with very small losing months. When you have trades that make you a lot of money, (and 10% a month is a lot), you need to be prepared to have months where you can lose 10%. Over the long term, you know you will make it up, because every month is a new cycle, and with an 80% probability of success you will have a lot more winning months than losing ones.

If you would like access to the free course Mike referred to in his email, you can sign up here. It is a 9 lesson course that teaches you how to be profitable no matter which way the market moves.