BUSINESS - IN THE LIMELIGHT

by Alan Friedman

There is one major mistake that most option novices make that, if corrected, might be the difference between making a profit and a loss in their option trading. Many newcomers to the option market will buy the same number of option contracts with each trade. This a DEADLY mistake.

The proper way to trade is to keep your dollar commitment the same on each trade. Why? Because if you always buy 10 contracts on each trade, a losing position that costs you more money to buy will more than offset a winning position in a lower priced option.

Here is an example. Let’s say you buy 10 contracts everytime you trade. You enter a position in the XYZ September 25 calls at $5
10 CALLS XYZ SEPTEMBER 25 @5=$5,000

At the same time, you buy 10 contracts of the QQQ September 40 calls at $1
10 CALLS QQQ SEPTEMBER 40 CALLS @1=$1,000

Now, let’s say that XYZ drops sharply and the September 25 calls drop by 50%. However, the QQQ calls tripled!!! WOW! You made money, didn’t you?
Sure, the XYZ calls dropped 50%, but you did score a 200% profit on QQQ. You must be ahead of the game, right?

10 CALLS XYZ SEPTEMBER 25 BOUGHT AT $5=$5,000
10 CALLS XYZ SEPTEMBER 25 SOLD AT $2 1/2=$2,500
LOSS =$2,500

10 CALLS QQQ SEPTEMBER 40 BOUGHT AT $1=$1,000
10 CALLS QQQ SEPTEMBER 40 SOLD AT $3=$3,000
PROFIT =$2,000

XYZ TRADE:  -$2,500
QQQ TRADE:  +$2,000
NET RESULTS:  -$500

Whoops! Despite having only a 50% loss on 1 trade, and a 200% profit on the other trade, you ended up with a loss of $500. How can that be? The answer is, because your dollar committment was greater in the losing trade, you ended up a loser.

How can that be corrected? Easy. Invest the same dollar amount on each trade regardless of whether you are buying a $1 or $20 option. Now, let’s revisit our example using this rule.

Instead of buying 10 contracts on each trade, let’s divide the trading capital of $6,000 that we used in the example, and invest $3,000 in each trade!

10 CALLS XYZ SEPTEMBER 25 @3=$3,000
30 CALLS QQQ SEPTEMBER 40 @1=$3,000

Now, if the XYZ calls drop 50% and the QQQ calls triple, the results will be like this:

10 XYZ CALLS BOUGHT AT $3, SOLD AT $1 1/2=
LOSS OF $1,500
30 QQQ CALLS BOUGHT AT $1, SOLD AT $3=
PROFIT OF $6,000

NET PROFIT=$4,500

What a difference! Instead of losing $500, you made a profit of $4,500 EVEN THOUGH THE OPTIONS HAD THE SAME RESULTS! The only difference was that you used proper money management rules and risked the same money on each trade!

When you subscribe to MOMENTUM ON-LINE, you should remember this simple trading philosophy when you buy our option recommendations. Keep the dollar amount that you invest constant, and you will see what a big difference this makes in your trading!

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