(07/01/11) The Truth: Trading Options for Income

I recently received an e-mail from an option trader asking about the realities of trading options for income. They were good questions I have heard many traders ask in the past, so I thought I’d share my answers with MoneyShow.com readers:

First, the questions:

“My goal is to earn $2,000 per month (before taxes, commissions, etc.) beginning in January 2012 and to stay at this goal for at least a year before raising my expectations. (This goal is not set in stone and can be changed.) This gives me six more months to learn and practice. During this six months (also not cut in stone):

Should trading be limited to strictly paper trading or is there an advantage to trading very small sizes with real money?

Should I limit the number of strategies that I am trying to learn?

Should I limit myself to the number of trades that I put on each month? For example, one credit spread and one iron condor per month (10 lot paper trades)?

I have adopted a stop loss plan of losing no more than the amount of my collected premium. For example, if I collected $850.00 (on a 10 lot paper trade) then when the underlying goes against me to the point of $850.00 the trade is closed. Is this a realistic starting point? Thanks, Jim”

Jim,

It’s good to set a goal for yourself. However, let’s be reasonable. First you must prove to the world that you can earn anything. Not everyone makes it as a trader.

Had you asked, I would have suggested a smaller goal. Some people would be happy to meet expenses the first year. Note this: Month one, you are a novice. Months 11 and 12, you are a more seasoned trader. Still a rookie, but surely more knowledgeable than when you began. That should make a difference in your performance.

Please remember that trading is not a consistent flow of money. There are good, better, and losing months. Sometimes you cannot meet your target. Expect that. Do not allow it to disappoint you.

If you make bad trades (ignoring trades that are clearly superior) you are not going to do well. Thus, you may have a monetary goal–but it is far more important to have a learning goal. Making money is not a guarantee that you are skilled and not just lucky.

And the same goes when losing. It’s important to know whether you were unlucky or making mistakes. This is not always easy to judge.

$2,000/month is a meaningless number. If you have a $20,000 account, you have no chance. None at all. Don’t even try. That’s 10% per month.

If you have a $1M account, then $2,000/month is not worth the risk. You can do as well at the bank.

Thus, the size of your account matters. Please do not target more than 2% per month and I’d urge you to target 1%. I am talking about now, not for all time.

Some months will offer greater opportunity and others will offer less. That’s the way it is. Sometimes you will like the available trades; at other times you may decide to sit on the sidelines. Winning traders do not force trades. When undecided, trade half (or less) normal size.

NEXT: Answers to the Four Questions

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Here are my answers to each of your questions:

No. All paper trading is not necessary. It’s okay to trade one-lots with real money. But you cannot make $2,000 per month doing that. The goal should be: make enough to cover commissions and other expenses.

It also depends on how much money you have. If it’s $5,000, then you cannot afford the risk–yet. Don’t forget that brokers who have a “per ticket” charge are far costlier when trading those one- and two-lots. Real money is real, with emotions. Paper trading is very helpful, but it often comes with a non-caring attitude. Don’t allow that to happen. Take paper trading seriously.

If it’s less than $20,000, use paper trading until you gain some confidence. That could be a month or two. It does not have to be a long time. Learn to be comfortable making the trades. And MOST IMPORTANTLY, if you trade an iron condor and the options quietly fade into oblivion in a dull market, don’t think you did anything special. Similarly if the market dives 20% the day after you made that same trade don’t think you did anything wrong. I understand that we are playing for green points (dollars), but for short periods of time, profits and losses may not be the best measurement of how well you are trading and managing risk.
Yes, limit the number of strategies, but make it more than one. You cannot discover which feels best unless you read about them and get a feel for how the strategy works. Then they must be traded. I suggest at least two and perhaps three strategies to test. Not all for real money, and begin with only one. Do not add a second until you believe you are not too busy with the one. Use the same method for adding a third.

However, the key to success is not in finding the right strategy. The strategy lets you into the trading game, but you must manage risk well (and that includes trading proper size) and learn to make quality decisions when trading. In my opinion, the strategy is important. You want it to satisfy your needs. If you love daily action, iron condors are not so good. If you hate to trade, want to play safe, and earn a steady income–consider being an investor not a trader.

Find a strategy that you, Jim, will like–and that you can handle. Sure. Practice a few and discard those that are uncomfortable. When you gain more experience and confidence, return to reconsider a previously discarded strategy with your new trading insight.

SUGGESTION: Use different underlying assets so that you can have separate risk graphs for each position.
Open a position. If you can follow it comfortably, then add another. Don’t have too much going on at once. I suggest no more than three at one time. You must give yourself time to watch the trade (as often as your plan requires), know your adjustment, exit, and profit points, and not feel hurried. Only then can you add the 2nd and 3rd positions.
No. Not even close. If you trade the options “income” strategies (iron condor, credit spread, naked put, covered call, etc), the credit collected has NOTHING to do with how much loss you should be willing to accept.

You pick a position to own. It costs something (ok, you collect a cash credit, but it’s the same idea). The cost should now be ignored because it never matters again–for trade decisions. Never. It does come into play when recording your final P/L in your trade journal, (not everyone agrees with me on this, but I'll defend this idea vigorously) but the time to exit the trade is when the position is one you no longer want to hold. The Greeks may look too risky. Market conditions may have changed. However you manage risk, how can the premium collected have anything to do with the exit decision? How can that make any difference in deciding whether the position is worth holding or folding? Logic tells you that they are unrelated.

We are not trading stocks. That’s when the stop-loss scenario that you describe makes sense. Not here. Not in the premium selling game. If you decide that losing $850 is the limit for a trade–that’s an intelligent thing to decide. But it does not matter how much cash you collected upfront. Exit when risk is out of line. Exit when you have lost your maximum allotted total, but do not base anything on the entry premium.