| Lawrence McMillan is the editor of The Options Strategist newsletter. He is the author of several articles on options and investment trading, including Hedged Options Strategies , a weekly investment newsletter. Mr McMillan currently manages money and trades his own account. Books Options as a Strategic Investment , Prentice Hall, 1993 McMillan on Options , John Wiley, 1996 Axioms for option traders and short- term traders -
Always use a model before trading an option. It's okay to buy an overpriced option, but you must be aware that it is overpriced. Once aware of that fact, act accordingly to limit losses if the option begins to lose its 'pricey-ness'. There are plenty of cheap or free versions of the Black-Scholes model available. Don't trade without access to one of them. -
Don't buy more software than you need. Many traders load up on expensive software that is so difficult to use, they don't even get any benefit from it. Option traders sometimes spend thousands on fancy software and then wind up using only the Black-Scholes model portion of it. Again, as stated in rule 1, there are plenty of cheap or free versions of the Black-Scholes model available. The same thing goes for technical analysis. Fancy systems that over-analyze are not beneficial. Stick to simpler things such as support, resistance, and moving averages - all of which are available for very low cost (even, free) on internet charting services. -
Trade all markets. There are many excellent trading opportunities in futures and indices as well as stocks. Traders who ignore the futures and index markets are missing out on plenty of good trades. -
Use technical analysis to make sure you're going with the trend. No matter whether you're a long-term or a short-term trader , technical analysis can identify the trend. That is, don't buy a stock in a steep downtrend. If you like the stock, wait until it stabilizes somewhat - forms a base or whatever, perhaps rises above a resistance level - and then buy it. Trying to catch a 'falling knife ' is foolhardy and unnecessary. -
Always use a stop. Whether you're a long-term investor or a day-trader, you must use a stop. Not to do so is foolish. The only people who were wiped out when the internet stocks fell by 80% or more were those who didn't use stops. Long term investors often make the crucial mistake of figuring that time will bail them out, and thus they don't use stops. But if you get your cash out of a losing position, it can work better for you in some other stock - rather than sitting around waiting for your 'dead money' to come alive once again. Corollary: once you're stopped out, don't look back. Take a stock off your 'watch screen' once you've been stopped out. You'll only torture yourself if you see it go back up right after you're stopped out, and that might cause you to ignore your stop in the next trade - a potentially fatal error. -
Don't use stop orders with your options. If you're good at selecting stocks, futures, or indices to trade, then use your expertise properly. Use the chart of the underlying as your guide on when to enter and exit the position. So, if you own options, you shouldn't put a stop order in for the option itself, but instead keep an eye on the underlying and use a MENTAL stop for your option - based on where the underlying is trading. -
Take partial profits. If you're fortunate to have a profit in a position, take some of it. Not only does this take some of your risk off the table, but it also allows you to think more clearly about how to handle the position going forward. Once you have booked some profit, you'll be surprised at how you'll be able to let profits run. -
Let the rest of your profits run. The easiest way to do this is to use some simple moving average as a trailing stop. For example, suppose you're long, and the underlying begins to move up. Whether you're long options or stocks, it makes no difference. Use the 20-day moving average, say, as a trailing stop - probably even a closing trailing stop. That is, you stay long unless the underlying closes under its 20-day moving average. Then you can easily let your profits run. As long as the underlying stays above its 20-day moving average, you'll stay long and you can capture some huge moves this way. As a corollary: don't use targets! - they force you to cut your profits short. -
Go against the crowd . Most option traders are wrong at major turning points. Make it your business to find out what they're doing and do the opposite . If they're all bullish, then you should be bearish. If they're all bearish, it's time for you to buy. Option sentiment is quite evident through the put-call ratios. Monitor them and you'll find that you can identify major turning points for the market as whole, and stocks, futures, and indices. -
Most important: only trade in accordance with your philosophy. No matter how good a trading system looks or how successful its inventor has been, it will not work for you if it doesn't fit with your own personal investment philosophy. If it causes you to have sleepless nights, or if you can't take your eyes off the screen, then it's probably too intense for you. Find a strategy that lets you be comfortable when you trade. www.optionstrategist.com | 'In many foreign markets, the dominant mentality is a trading one. Insider trading is permissible and rife, turnover is very high, stories abound, and the locals are mainly interested in running a stock up 25 percent and dumping it. There's no way you can outtrade the locals, so the secret is to become a long-term investor, to adopt a different time scale. Then, their edge washes out over time.' ”Ralph Wanger | |