THEOPTIONTRADER’SMINDSET:

THINKLIKEAWINNER

MARK DWOLFINGER

OPTIONS FOR ROOKIESBOOKS

Copyright2014MarkDWolfinger

AllRightsReserved

IntroductiontoOptions:TheBasics

MarkDWolfinger

PublishedbyOptionsforRookiesBooks

Requests to the publishershould be addressed toMarkD Wolfinger; 1717 DobsonStreet;Evanston,IL60202

This eBook is licensedfor your personalenjoyment and may notbere-soldorgivenawaytootherpeople.Tosharethis book, pleasepurchase an additionalcopy for each recipient.If you are reading this

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Disclaimer: Althoughoptions are designed toreduce risk, the

successful traderunderstands theimportance of properrisk management.Neitherthepublishernorauthorshallbeliableforany loss of profitincurred as aconsequence of the useand application, directlyor indirectly, of anyinformationpresented inthis book. If legal, taxadvice or other expert

assistance is required;seek the services of aprofessional.

FORPENNY

TABLE OFCONTENTSIntroduction

Part I. BackgroundThoughts

Chapter 1. The Nature ofRiskChapter 2. Set Aside yourCurrentMindsetChapter3.TraderMindsets

Chapter4.BraggingRightsChapter 5. Choosing anOptionStrategyPartII.Strategies

Chapter 6. The Iron CondorMindsetChapter 7. Weekly ironCondorsPartIII.TheGreeks

Chapter8.TheGreeks

Chapter9.TimeDecayPart IV.Mindsets that canbeChanged

Chapter 10.What can I earnasaTrader?Chapter 11. Trading toRecoverLossesChapter 12. Being Right vs.MakingMoneyChapter 13. Option TradingandSlippage

Chapter14.HoldingaLosingTradeChapter15.WhentoExitChapter 16. Adjusting. HowMuchShouldIInvest?Chapter 17. MaximumAllowableLossChapter18. TheKiller BlindSpotChapter 19. Rolling for aCreditChapter20.TheTradeor the

Trade Plan. Which is MoreImportant?Chapter21.ATrulyTerribleTradeChapter 22. The UltimateWinningMindsetAfterword

Appendix A. GeneralMindsetAdvice

Appendix B. PsychologicalConsiderations

INTRODUCTION

Becoming a full-time traderhas great appeal for manypeople, not only because ofthe potential tomake a greatdeal of money, but alsobecause it provides a path toindependenceandbeingyourownboss.

Doing the work necessary tofindsuccessislessappealing.

Contrary to popular belief,onecannotdecide tobecomea trader one day and beginearninggoodmoneythenext.It is a business that requiresskill,knowledge,andtimeforaneducation.

This book is designed as aguide to developing a propermindset, or way of thinking,that increases any trader’schance of achieving betterresults. This is not ‘all you

needtosucceed.’Insteaditisa collection of commentarieswith a common theme. Eachis designed to suggest awayof thinking about tradedecisions and finding a good(efficient) method forhandlingthesituation.

To become a winner in theoption-trading game, it isimportant to have a propermindset. This is not aquestionofhavingconfidence

or believing that you can doanythingifyouputinagoodand honest effort. It is moresubtlethanthat.

Do you remember theE*Trade commercials thataired during the technologybubbleofthe1990s?Theadssuggested that opening anaccount is thepath tobuyingyour own island, or theequivalent of winning thelottery. Sure those ads were

humorous, but behind themwas the destructive mindsetthat anyone could becomerich by trading. There is nodoubt that many peopleadopted that mindset byquittingtheirjobstotradefulltime. As long as those newtraders remained bullish andas long as the marketcooperated, there was easymoneytobemade.However,times change and theseinexperienced traders had no

ideahowtoadapt to thenewmarket environment. Whenthebubbleburst,fewadaptedandfewersurvived.Theyhadone idea that worked. Theyfollowed a single (bullish)mindset,andwhen it stoppedworkingtheyweredoomed.

In this book I refer tosituational mindsets that canharm a trader’s performance.None is as dangerous as theone mentioned above.

However, when we adopt atrading methodology basedon ideas that we KNOW (orassume)aretrue;itisdifficulttofindthepathtobecomingawinner. No matter what wedo in our lives, an ever-present risk is thatwedonotknowwhatitisthatwedonotknow. The situation is evenworsewhenwhatwe ‘know’turnsouttobeincorrect.

Ihopetoinstillineachreader

the belief that there is morethan one way to look at anygiven situation and that theobvious is not always thebetter choice. The correctmethod for tackling a tradeproblem is not to seek themajorityopinion,buttothinklogically and adopt a logicalplan.

These thoughts are targetedto, and appropriate for, thenewertrader.However,many

experienced traders developwaysof thinkingandmakingdecisions thatbecomehabits.These can be destructive atworst—and inefficient atbest. All traders below theexpert level should findsomething of value in thisbook—something that has apositive influence on theirtradingresults.

This collection of essayscovers a variety of TOPICS

ontradingoptions.Itcontainsboth fresh material andpreviously-published(updated and expanded) blogposts. Some ideas are notuniversally accepted and arecontroversial. That is whythey are so valuable. Thecommon theme among themis that an option trader canlearntomakemoremoneybythinking differently. Iencouragereaderstoexaminewhytheyactastheydointhe

specificsituationdescribed.

Perhaps you will makechanges to your trademethods.Perhapsyoubelievethatyourcurrentsolutiontoaproblemworksbetterthanthesuggestion. That’s fine aslong as your rationale isbasedonlogicandnotontheassumption that your currentway of thinking has to becorrect. Please pay attentionto the warning: ‘the greatest

risk of all’ in Chapter 1 anddo not discard it by thinkingthatitdoesnotapplytoyou.

Take the lesson in eachchapter as a strongsuggestion. Think about it.Decide whether it applies toyouandwhetheryoucanlivewith it. If it feels so wrongthatyoucannotadoptit,thenyou will have made adecision based on somethingother than grabbing onto the

obvious.

Aswegrowasindividualsweget set in our ways. Wedevelop habits and methodsfor accomplishing certaintasks that feel natural to us.Many of these are simpletasks – as simple as howwebrush our teeth or open anenvelope. These requires solittle thought that weaccomplish these tasksmechanically.

Other habits are not asinnocuous and make adifference in our lives.Somepeople cannot be botheredbalancinga checkbook.Theyassume the bank makes noerrorsandthatthereisalwaysenough money on deposit toavoidbouncingacheck.Thisis a deliberate action ratherthan a habit, but themindsetis that the shortcut issufficient. In this example, it

isnotlikelytoresultinharm.However, it can—onoccasion—turn out to be averycostlymistake.When trading, we developways of thinking that can beclassified as something soobvious that it requires little(orno)thought.Forexample,I cover any short optionposition when there is toolittle reward to justify anyrisk. I enter the 5-cent bids

without much thoughtbecause Iwant to utilize this‘safety play’. How can thatresult in a problemmindset?The risk is that adopting one‘nothoughtrequired’mindsetmay lead a person to adoptother such shortcuts atinappropriatetimes.Mosttradersareunawarethatthey developed suchmindsets.Oneexampleis thetrader’s need to hold onto a

losing tradeuntil itgetsbackto even. Does that soundfamiliar?Formany, this ideais ‘natural.’No otherway ofthinkingfeelspossible.Ihopeto demonstrate that this is amindsetwortheliminating.

This is not indoctrination.Abidebythetruthasyouseeit (and I will do the same).My goal is to make youaware of these issues,allowing readers to think

about ideas that may havebecome habitual. This leadsto better decision-making.Remember that ‘good’decisions do not alwaysproduce the best possibleresult because trading is astatistical game, and part ofthe time odds-on favoritesdisappoint while unlikelyevents come to pass. Whenyou make those gooddecisions consistently, yourchances of becoming a

winningtraderimprove.

Evanston,Illinois;January2013UpdatedJune2014

PARTONE

BackgroundThoughts

CHAPTER1THENATUREOF

RISK

This chapter describes theglue that holds together thethoughtsinthisbook.

Weallknowthatinvestingortrading or gambling—inshort, using money to earnmoney – involves risk. On

rare occasion, there is thepossibility that ourinvestment capital will bestolen. We may fall into thehands of cheats, thieves, orscammers, Madoff (BernieMadoff pleaded guilty tostealing billions frominvestors inaPonzischeme),Wasendorf (Russ Wasendorf,Sr.waschargedwithmakingfalse statements to theCommodity Futures TradingCommission.Beyondthat,he

admitted embezzling morethan $200 million fromclients of his brokerage forfuturestraders)andothersarelurking.

The possibility of goingbroke via trading is muchgreater. Believe this: Theonly satisfactory method forpreventing that fromhappeningistobecertainthatyou never have too muchmoneyatriskatanyonetime.

Let’s turn our attention tomakingmoneybecausethatisthe ultimate goal for traders.Earningmoney as a trader isa skill. Some folks believethat anyone can succeed.Othersbelievethatifyoubuyquality stocks and holdforever,youcannot fail.Thisdiscussion is not aboutcomparing a trader with aninvestor or ‘holding forever’with frequent trading. Thisdiscussion involves what it

takes for you, the reader, toimprove your results whenmaking trade/investmentdecisions.

Before anyone can expect tosucceed, that trader mustdevelop a healthy respect forrisk.Butwekeepscorebytherate at which our bankrollgrows.Thatmeanswefail torecognize the risk we aretaking (if the tradegoesverywrong) because we are

blinded by the size of thepossible gain. Some tradersmaynever reach thepointofunderstanding that being asuccessfulriskmanageristhekeyskillrequiredforsuccess.Many of the ideas offeredhere are designed to givetradersabetterunderstandingofhowtomanagerisk.

If we have, or can develop,the correct personality traits(lack of stubbornness for

one); if we understand thedetailed workings of theproduct we are trading (youwould be amazed by howmanypeoplehavenoclue);ifwe take the time to learnbeforeweplaceourmoneyatrisk (novices tend to be veryeagertobegin);thenwehavean excellent chance tosucceedasatrader.

THE GREATESTRISKOFALLA blog post by R.P.Seawrightdescribestheover-ridingconceptof‘thegreatestrisk of all.’ It is a topic thatfalls under the heading ofbehavioral finance. It isdifficulttogetmostpeopletofully understand the conceptof exactly what is risky. Ialways talk about controlling

positionsizebutthe‘greatestrisk’ is of quite anothervariety. It is difficult torecognize.

The following is an editedand abbreviated version ofthatpost:

“AsIhavetriedcarefully

topointout,riskisdifficult,ifnotimpossible,todefinefully,muchless

quantify.ButonethingweknowforsureisthatriskisriskyTakingtoo

littleriskortoomuchriskisrisky.

“Tothispointinthe

12-partseriesIhaveonlyalludedtothegreatestriskofallIn

theimmortalwordsofPogo(AWaltKelly’s1914comicstripcharacter):“Wehave

mettheenemyandheisus.”This‘biasblindspot’isnot‘only’

true,it’sreallytrue,trueinspades.Itisouroverarchingproblem.

“Weall

tendtosharetheinabilitytorecognizethatwesufferfromthesamecognitivedistortions

andbehavioralbiasesthatplagueotherpeopleifwebelievesomethingtobetrue,

wequitenaturallyassumethosewhodisagreearewrong.Ourbeliefsreflecttheobjective

factsbecausewethinktheyaretrueDuhOurthoughtprocessgoessomethinglike

this:

“I’vethoughtlongandhardaboutitandI’mconvincedI’mright.

Ofcourse,thatlineofthinkingdoesn’tconvinceanybodyelse.Wearenotparticularly

comfortedwhenothersassureusthattheyhavelookedintotheirownheartsand

mindsandconcludedthattheyhavebeenfairandobjective.Butwebelievethat

theyarebiased(andwearenot).

**”existenceofbehavioralminefieldsis

difficultenough.Thatwedon’tthinktheyapplytousisoftenfataltoour

judgment[Emphasismine:MDW]

“Sowhatarethesebiases?

“Confirmationbiasmeanswearenottheimpartialjudgesof information that we liketo think we are. It’s whyFox News and MSNBCviewers tend to see eachother as some version of

stupid, delusional and evil,no matter the situation orcircumstances.

“Optimism bias: we thinkwe’re right far more oftenthan we are. [MDW: This iswhy I always want you tohaveaproventrackrecordofsuccessbeforemakingcertainwagers.]

“Ourself-servingbiaspushesus to see theworld such that

thegoodstuffthathappensisourdoing,whilethebadstuffis always someone else’sfault: We couldn’t haveforeseenthatmarketcrisis.

“Our loss aversion biasmeans that we feel lossesbetween two and two-and-one-half times as strongly asgains. It favors inaction overactionandthestatusquooveranyalternative.

“Theplanningfallacy is ourtendencytounderestimatethetime, cost, and risk of futureactions,andatthesame,timeto overestimate the benefitsthereof. It’swhyweoverrateour own capacities andexaggerate our abilities toshape the future. It’s onereason why every buildingproject tends to have costoverruns.

“Intuitively, we think the

more choices the better. Thesad truth is that too manychoices can lead to decisionparalysis due to informationoverload. It’s whyparticipation in 401(k) plansamong employees decreasesas the number of investablefundsincreases.It’salsowhywesoreadily relyuponrulesof thumb rather than gettingdownanddirtywiththedata.

“Weroutinelyruninherds—

large or small, bullish orbearish. Investmentinstitutions herd even morethan individuals in thatinvestments chosen by oneinstitution predict theinvestment choices of otherinstitutions by a remarkabledegree. It’s why marketbubbles occur—in tulips,baseballcards,internetstocksandrealestate.

“We inherently prefer

narrative to data — often tothe detriment of ourunderstanding. That’s whyridiculousconspiracytheoriesabound, even amongotherwise smart andintelligent people, without abitofgoodevidence.Weareall prone to recency bias,meaning that we tend toextrapolate recent events intothefutureindefinitely.

“Bloomberg surveys market

strategists on a weekly basisand asks for theirrecommended portfolioweightings of stocks, bondsand cash. Even though theyare the supposed “experts,”their collective views are agreat contra-indicator. Thepeak recommended stockweightingcame just after thepeakoftheinternetbubbleinearly 2001 while the lowestrecommended weightingcamejustafterthelowsofthe

financial crisis. That’srecencybias.

“Again,theexistenceofthesebehavioral andcognitive deficiencies isdifficult enough. That wetend to think they’re otherpeople’s problems and notourown—thebiasblind spot—istheicingonthecake.AsI have tried to point outrepeatedly, risk is risky.Because of our behavioral

biases and our tendency tothink they don’t apply to us,the odds are overwhelmingthat we are going tomiss orignoremanyof the risks thatplagueus.

“The greatest risk of all isstaring us in the face whenwe look into the mirror. Atleast,thegreatestriskofallisstaring at YOU when youlookintothemirror.”

That is an excellent piece ofwriting and goes a longwayin explaining a difficult-to-understandconcept.

Itisnoteasytorecognizethatwe have such biases. It iseven more difficult toovercome it. However, thisbook is all about doing justthat. I suggest ways ofthinking about situations(mindsets) that I know arelogical, and thus I naturally

assume that they would behelpfultoanytrader.

I ‘know’ they helpmemakegood trade decisions and arefinancially beneficial. Iencourage readers to givethem serious consideration.I’m sure that the beginningtrader will benefit byadopting many. Even theexperienced trader shouldfind some nuggetsworthy ofconsideration.

Please be careful beforediscarding any of these ideaswithout a second thought. Itcouldbeyourconformationalbias that is tricking you intobelieving that the specificidea is without merit. Ofcourse, it could be my biasthatmakesmebelieve that itis important to share theseideas!

TheWinning

MindsetThoughtProcessofTypicalSuccessful

TraderWe traders do not alwaysreachlogicalconclusions.Webelievewedo, and that’s theproblem because it gives usnoincentivetolookforawayofimprovinghowweconductbusinessorliveourlives.

Beopento theideathateachof us is completely unawarethat we believe some thingsthatarejustnottrue.

CHAPTER2SETASIDEYOUR

CURRENTMINDSET

The idea behind writing thisbook is to offermy ideas onhow you can develop a wayof thinking that is beneficialto your trading career. Theseare not lessons on how to

selectatradeorstrategy.

The purpose is for you todiscover, and then abandon,ideas that harm your tradingresults. This task is moredifficult than it may appear(review Chapter 1 if youbelieve it is easy). Onlybrand-new traders may haveescaped the formationofbadhabits (money-losingmindsets).

HOW I MOVEDBEYOND AFAVORITEMINDSETIspentmorethan20yearsasa market maker at theChicago Board OptionsExchange (CBOE). Duringthat timeIwasarisk taker. Iheld large positions (nakedshort options) for no soundreason.Ialsorefusedtocover

those options when the pricereached its lowest possiblelevel (In those days optionstraded in fractions and thatminimum was 1/16, or$0.0625).

Lookingback,I’msureitwasan egotistical play. I wasdemonstrating to a world ofpeople who did not knoworcare—that I was a bigtrader. Tomake a long storyvery short, big positions

turned into big profits—untilthey didn’t. Big marketmoves leftmeholdingnakedshortsthathadmovedintothemoney.BecauseIwasfoolishenough to own these shortpositions in the first place, Iwasalsotoofoolishtocover.That was a very expensivelesson.Andithappenedmorethan once because it wasdifficult forme to accept thefact that an option that was“obviously” worthless could

turnaroundandbiteme.

Today,Iknowbetter.Idonothold naked short positionsandsuggestthesamestrategytomy readers.Theonly timethatIconsideritreasonabletohold naked short optionsoccurs when selling a nakedput (cash secured) because Iam willing to own shares ofthe underlying asset.However, I recentlyrecognized that naked

options, in small size, areappropriate for experiencedtraders who know how tohandlesuchpositions.Ineverthought I would accept theidea of selling naked optionsbecause I had so muchtrouble with them. I nowunderstandthatitwasnotthenaked short option that wasthe problem. Instead, it wasme— a combination ofselling toomanyoptions andrefusingtoadoptasoundplan

tomanagelosses.

I overcame inferior mindsetsin three specific categories. Inowbelieve:

Size kills. It isimperativeforatradertohave a true picture ofwhat can go wrong andhow bad it can get—nomatter how unlikely.The trader should neverallow—call itbadluckif

youmust—towipeout atradingaccount.[Formermindset: bigger sizeleadstobiggerrewards]Owning positions withlittle togainanda lot tolose is not trading. It isgambling. [Oldmindset:These options are goingto expire worthless.There is nothing toworryaboutandthereisno reason to waste 1/16

bycovering.]Owning short-termpositions with negativegamma (A position inwhich losses accelerateas the market continuesto move in onedirection) is a high-riskplay. The possiblereward must be high tojustify taking risk.[Oldmindset: I’ll coverimmediately if the

market moves againstmy trade – but I knewthat was not the truth. IknewIwasstubbornandlacked discipline withnakedshorts.]

As a retail trader today, Ialways cover short spreadswhentheyreachalowprice.Ialmost never hold a shortpositionintoexpiration.Ipaybetween10%and20%oftheoriginal premium to cover

positionsvoluntarily.Thereisnourgency.Ienter thebidatthefirstopportunity,andwait(unless prudence requirespaying a higher price due toincrease danger). I gladlysacrifice the chance to earnthe remaining premiumbecause I gain the peace ofmindthatcomesfromowningless-risky positions (lessnegativegamma).

WEEKLYSOPTIONSIn 2005, the CBOE listed(Standard & Poor’s 500Index) options that expireeveryweek.Eventually,otherindexeswereadded,followedby the options on mostactively traded stocks. Thelistispublishedeveryweek:

Iwasunwilling to tradeveryshort-termoptionsbecauseofmy past history with being

shortoptionswhentherewereonly a few days remainingbefore the options expired. Inow recognize that I had toset aside that bias to becomemore successful. Workingwith beginner andintermediate traders atOptionsforRookies,requiredme to explain all tradealternatives, and “WeeklysOptions”(TheofficialCBOEtrademarked spelling)generate a lot of investor

interest.

Myphilosophy:Italkaboutatrade, offer my opinion andguidance,andthenencourageyou to reach your ownconclusions on whether mymindset, or an alternative,worksforyou.

Thus, I added weeklyexpiration plays to myrepertoire.Itwasimportanttogatherinformation,gaintrade

experience, and decidewhether I could help tradersearn money with weeklyexpirations.

I overcame a strong mindsetby looking at the biggerpicture.Youcandothesame.

In Chapter 7, we’ll take acloser lookat tradingweeklyironcondors.

TheWinning

Mindset

Luckvs.skill:Atradermusthave confidence in his/herability to make gooddecisions under duress.However,thatconfidencehasto come from more than a‘belief.’ A proven trackrecord of profitable trades isideal.

However, I do recommendthat anyone should allow a

winning streak to convincehim/her that he/she suddenlybecame a superstar. I knowwhengoodresultscomefromgood luck (i.e., a well-behaved market) and whenthe trader made a significantcontribution to his/hersuccess (had thediscipline tomake a risk-reducing tradeand the good judgment toselect the trade that changedthe position from ‘at risk’ to‘worthholding.’

Similarly, I recognizewhenIfail toact ina timelymanneror when I make a poordecision. Example: when Ichoose a trade that givesmean improved probability ofearninganeventualprofit,butwhichwas not very effectiveinreducingrisk.

It is easy to ignore the factthat the sole purpose ofadjusting a trade is to reducerisk.We alsowant to own a

good position post-adjustment, but the planshouldbe to pay attention tomanaging risk first, and toworry about profits second.The losing mindset is toworry about profits first, andbeing less concerned withsolving the problem of toomuchimminentrisk.

I separate the ‘my fault’resultsfrom‘badluck’losses.When we enter a trade that

has an initial probability ofearning a profit 90% of thetime, thatdoesnotmean thatwe can close our eyes andhold the position until itexpires.That90%probabilityof success means that weshould expect to incur a lossapproximately 10% of thetime. It is our job to stay ontop of the trade and reducerisk when necessary. Thetrade may have been 90%when initiated, but it can

easily become a tradewith a50%chanceof successwhenthe underlying stock pricechanges. Most of the time,those newodds are not goodenough for me to want tocontinue to hold onto myposition.

When those inevitable lossesoccuron10%of that typeoftrade, it is not easy torecognizethatitwasanormalresult. Instead, we tend to

countsuchlossesastheresultofbadluck.Afterall,whena90% favorite turns into awinner, surely that is badluck, isn’t it? Losses areinevitable. It is the task of asuccessful trader tominimizethe amountofmoney lost onthesetrades.

Individuality. I never saythat my ideas are best. Isuggest that you consider

each idea from your ownperspective. I anticipate thatthese ideas (call them mytradingphilosophy)willseemlogical to you. If you thinkfor yourself and soundlyrejectone(ormore)ofmypetideas, then I say ‘good foryou.’ If you take the time togive serious consideration totheseways of thinking abouttrading, I’m confident thatyou know your personalsituationbetterthanIdo,and

that you will make the rightdecision.

Iofferideasthatyoumaynothave previously considered.Not ‘how tomakemoneybytrading,’ but how to reasonwell and be well placed tomake good trade decisions,unencumbered by obvious,butflawedthoughts.

Weeklytrades.When I lookat positions that expire

weekly, I know that tradingshort-term credit spreadscomes with high rewardpotential because time decayis rapid. It only takes 2 – 3daysforthoseoptionstolosemuch of their premium. Weearn profitswhen themarketbehaves.

Trading short term creditspreadscomeswithplentyofrisk. Because these optionsare not very far out of the

money, and the premium forselling them is on the smallside, when these optionsbecome ATM and then ITMoptions, losses mount veryquickly.

The best compromisebetweenriskandrewardistotrade weekly iron condors insmall size. It is not smart totake toomuch risk when thechances of something badhappening are so high. Yet,

the rewards are attractive (6to 8% per week is areasonabletarget)thatanyonewho has the time to monitorthe position should thinkabout trading these negative-gamma trades. They are notsuitableforeveryone.

There ismoreonWeeklys inChapter7.

CHAPTER3TRADERMINDSETS

Potential traders are humanand when they undertakeanything new—includingtrading—they come to thetable with certainpreconceived notions orhabits, which I’ll refer to asmindsets. It pays to take

advantage of your educationand experience and applyappropriate lessons to anynew challenge, includingbecoming a successfultrader/investor.

The problem arises whenthose mindsets, developedoveralifetime,areinconflictwith habits that are requiredto succeed in the newendeavor. Bad habits aredifficult to overcome, and

that can make it difficult tosucceedasatrader.NotethatI am not suggesting it isimpossible to learn the newskills,butonlythatoldhabitscangetintheway.

I often write about theimportance of good riskmanagement and moneymanagement. Someone whohas spent years accumulatingcredit card debt, livingbeyond his/her means, or

buying things to impress theneighbors (or spouse/partner)obviouslylacksthedisciplinetobecarefulwhenmanagingmoney. I’m not suggesting atrader must be frugal. Buttrading discipline is not easyfor someone who spendsmoney carelessly and doesnot understand theimportance of avoiding debt—especially at high (creditcard) interest rates. Beingcareful with trading dollars

and getting good value fromyour broker (commissions,fees and good tradeexecutions) contribute tosuccess. The frivolousspender may have a difficulttimerefusingtoinitiateanewtrade because the entry priceisjustnotgoodenough.

On the other hand, it’spossible that the trader whodeveloped a very frugallifestylemaynotbewillingto

invest money where it isneeded (insurance; positionadjustments).Or evenworse,maybeinclinedtoexiteverytrade that is not aninstantaneous winner. It’scertainly not frugal to takeexcessive risk, but aninclination to watch everypenny can get in the way oftrading decisions. Thatmanifestswhentradersrefusetomakeaborderlinetradeforthe sole purpose of saving

cash on commissions. Thattraitmaymakeitdifficultforthe trader to pay $0.05 or$0.10 to exit a position andremove all remaining risk –locking in a profitable trade.Maybethisisonereasonwhyso many who advocate afrugal lifestyle also preferpassiveinvesting.

Unlessyouownaportfolioofveryconservativepositions,itisinevitablethatyouwillfind

yourself in an uncomfortablesituation (more often foraggressive traders) in whichthe risk of losing money isgreater than you prefer. It’sfar better to make decisionsbased on common sense,previously-made trade plans,and the ability to think wellunder pressure than refusingto spend money on riskmanagement.

Individuals who are

accustomedtobeingruledbytheir emotions are not goingto do well under theseconditions.It’struethatthereis recent evidence that wecannot completely ignoreouremotions when makingimportant decisions, butlooking at thebigger picture,wedonotwant fearorgreedto take over the decision-makingprocess.Thus, ifyouhave a mindset that allowsthose important, spur-of-the-

moment, decisions to bemade when emotions are incontrol of your reasoning,that’s deleterious to yourchances of winning thetrading game. Those whorecognize when theiremotionsare takingoverandwho can stillmake decisionswith the less-emotionalportionof theirbrainshaveabigadvantageoverthosewhocannot. No matter howconservativeyoumaywantto

be in your trade selection,there are going to be timeswhen immediate risk hasreached an uncomfortablelevel. Clear thinking is thebestpathwayoutoftrouble.

QUESTIONS TOASKYOURSELFDoyouhavethemindsetthatallows sloppiness in yourdailylife?Canyouovercomeit and become moredisciplinedwhentrading?

Do you think of trading asplaying with Monopolymoney?Istradingagametoyou? Or do you have themindset of a gambler? A

serious trader, understandingthat taking big risk, andlosing, can be ruinous –avoids placing too muchmoneyariskatanyonetime.

Can you develop anunderstanding of where yourcomfort zone lies and theimportance of trading withinthatzone?Thisquestionmaytake some real tradingexperience before you cananswer. NOTE: Experienced

traderswhowant tomove totheexpert levelmust learntoexpand their comfort zones.However, newer traderscannot afford todo thatuntilthey have enough experienceto be 100% certain that theyunderstand why it isreasonable to move beyondtheircomfortzoneboundaries-- for this specific trade -- atthisspecificpointintime.

Mysuggestionissimplytobe

aware of the recommendedcharacteristicsofasuccessfultrader (you can findnumerous opinions online)and be certain that you areawareofanyhabitsthatareinconflict with those desiredtraits.Beingawareisthefirststep towards not allowingthose habits to interfere withyourquest.

RELATEDCOMMENTSThese comments to myoriginal blog post speak forthemselves. I highlighted afewofthekeywords.

“Alotofpeoplewho’dlike

totradeneverevenmakeittothisstageofself-examination.Hopingto

findtheholy-grailofindicatorsorstrategiesthatneverlosemoneyisa

loteasierthantakingthetimetodecidewhichstrategyfitstheindividualAND

tryingtoimprovepersonalriskmanagement.It’shardwork!”

“Importanttoknowyourself

beforeslingingpreciousaccountmoney.It’sbeensaidabouttrading;“youaretrying

toself-destruct—you’vepickedtheperfectmedium.

TheWinningMindset

Learning to trade takes asmucheffort as learningotherskills. I know that the way Iconduct my business andpersonal life provide anindicator of how I willconductmy trading business.And trading is a business,even for the part-timeinvestor.Imaynotbeabletochange who I am, but if Irecognize that certain traitsareharmfulfortrading,thenIwill be aware of those

traits/habits and recognizewhenImustthinkdifferently.

Onefinalpoint:Ifyoudonothave what it takes to be atrader,thewinningmindsetistosaveyourselftheheartacheandbecomeagoodlong-terminvestorinstead.

CHAPTER4BRAGGINGRIGHTS

Dotradersgooutoftheirwayto takeextra risk in anefforttoshowoff?Dotheywanttoboast to buddies, spouses, orteachers?

InhisbookTheMissingRiskPremium, Eric Falkensteinwrites about why thereappears to be a negative risk

premium, defined as asituation in which taking onmore risk results in a lowerreturn. Investors who takemore risk should becompensated, and achievinglowerreturnsformoreriskisa poor result. The problemmay be that the risk takersdon’t recognize that theirreturns are insufficient tocompensateforrisk.

Eric notes that negative risk

premium should be expectedinlotteriesandgambling,butnot in less trivial areas suchas options and stocks. Hesuggests that ‘signaling’ isthe cause. Investors want toshow other people (othertraders, friends, family etc.)how awesome they are bytrading just like a real alpha-generatorwould.

If the mark of an expertinvestor is aggressiveness,

thenanyaspiringexpertmustfollow suit. When expertwannabesaretoldtofocusonlowvolatilitystocksorETFs,they find that advice to bedull and unacceptable. Afterall, that’s not how the ‘bigboys’ trade.Therehavebeenstudiesthatsuggestthedesireto impress others results inthe acceptance of extra risk.That would not be so bad ifthereturnsjustifiedtherisk.

Note this distinction in howpeople defineRiskPremium:Greater Risk must offer thepotential for greater rewardsorelsenoonewouldtakethatextra risk. However, somepeople translate that as:GreaterRiskresultsingreaterrewards.Itdoesnotdothat.Itonlyallowsforthepossibilityoflargerrewards.

Whenwe tradeathomewithour computers, there should

be zero incentive to trademoreoften,or to takeon toomuch risk because no onewillknow.Thereisnopersonaround who could beimpressed by our tradedecisions. And if we takemoreaggressiveaction,againno one will know unless weadvertiseourresults.Sure,weshare our performance withspouses, but probably notwith anyone else. So is‘signaling’ reallyan issue? It

is for those who trade in agroup environment (propshop)orareinvolvedwithaninvestmentcluborwhomeetwith trading buddies on aregularbasis.

For my personal investing, Iprefer not to own indexfunds. Perhaps it is tooboring. Perhaps there is noegosatisfaction.Idon’tknowthe reason. However, beinghonest, I know that indexing

has to be the best possiblechoice for vast majority ofinvestors – especially forthose who lack the time todevelop the skills required toinvest/trade successfully forthemselves.

TheWinningMindset

Beginners should focus onavoidingmistakes.Takeyour

time.Learn.Gainexperience.Trade SMALL positions oruse a paper-trading account.Understand what you aredoing.Makingmoney comeslater and protecting yourassetscomesfirst.

The initial goal for newtraders must be to survive,not thrive. As a trader gainsexperience and hasaccumulatedatrackrecordofmaking money on a

consistentbasis—thatmeansmore than justa fewpositivemonths or winning trades—that is the time when thetradercanconsidermaking asmall increase to positionsize. That is when the tradercan think about practicingmore complex or moreaggressive strategies. Notsooner.

Thewinningmindset is tobeaware of the dangers of

signaling.Ifyoudoenterintoadiscussionwithothersabouttrading, that should be abeneficial experience foreveryone. It’s good to learnfrom others and to sharesuccess/failure stories.However, if you cannot bepart of such a groupwithoutsignaling that you are ‘aplayer,’ it is best to go italone.

PARTTWO

Strategies

CHAPTER5CHOOSINGAN

OPTIONSTRATEGY

It is not the option strategythat makes money; it is thetraderwhounderstandswhenand how to use any givenstrategywhoearnstheprofits.

That first sentence of thischapterisalsotheconcluding

sentence. It is a completemindset all by itself. Pleasebelieve that it is true andhatit applies to you. You aremore important to yourtrading success than thestrategyyouadopt.

Asubstantialpartofknowinghow to use any strategyincludes an understanding ofrisk management techniques.Such techniques vary fromone option strategy to

another.Thereisnoone-size-fits-all method for managingrisk for an option trade.Youmay find a comfortablegeneralconcepttofollow,butthe details of any riskmanagement plan should besuitableforthespecifictrade.

Traders fret over strategyselection, believing that ifthey can only find that‘winning strategy’allwillbewell. The truth is that we

shouldselectastrategybasedon our expectations for thestock market, or at least forthe specific underlying asset.When we have noexpectations, or when weprefer to trade by being‘market-neutral’, then one ofthe ‘income-generatingstrategies’becomessuitable.

Some strategies performbetter than others when

market volatilitychanges. If you want totake a position thatbenefitsfromanincreaseinmarket volatility, youcould: Ownpositionswith

positivevega

Buy calendar ordiagonalspreads

Bullish traders canown ITM callsinstead of stock,benefittingwhenIVincreases.LEAPS (LongTerm EquityAnticiPationSeries)options offer themost positive vega,but generallyrequire payment of

significant timepremium.Trade anappropriate optionstrategy using avolatility indexes,such as VIX orVXX, as theunderlyingasset.

‘Income-generatingstrategies’ benefit fromtime decay and are best

used when the traderanticipates a range-boundmarket or has noopinion on marketmovement. Covered call

writing or the saleof cash-securedputs.Credit spreads ordebit spreads.Reminder: When

thestrikepricesandexpiration areidentical, buying(debit spread) aputspreadisequivalentto selling (creditspread) the callspread. Similarly,buyingacallspreadis equivalent toselling the putspread.Winged spreads:

condor andbutterfly. Alsobroken-wing andironvarieties.Calendar spreadsand diagonals offerboth positive vegaand positive timedecay.

Fordirectionalplays,thestrategy choice dependson how vigorously

bullish/bearishyouwanttobe. AvoidbuyingOTM

options as aspeculative bet.These options arecheap for a reason.Yes, you canmakealotofmoney—butonly if you arecorrect three times.The stock pricechange must be

largeenough,intheright direction, andhappen before theoptions expire.Toomany novices buyOTM options,watch the stockrally (or fall) aspredicted, but findthat their optionsexpireworthless.Owning ITMoptions offers a

good potentialreturn when thestock movesenough toovercome the timepremium.When slightlybullish, Irecommend sellingout-of-the-moneyput spreads. Profitsare limited, but theprobability of

earning a profit ishigh. Sellers of putspreads also earnmoney, even whentheir predictionfails to come true.In other words, ifthe stock priceholds steady ordeclines by a smallamount,thetradeisprofitable.When slightly

bearish, sell OTMcallspreads.Buy OTMcalendars orbutterflys whenthey areinexpensive (IV islow).

VARIATIONS ON ATHEMEWhen the market isunsuitable for your favoritestrategy, that’s when theprepared trader pulls amodified strategy out of his‘Arsenal of Trade Ideas.’Let’s look at iron condors asanexample.

It may feel right to abandoniron condors when volatility

is increasing (negative-vegapositions do not fare wellwhenIVisrising).Ifatraderhasthepatiencetowait,heislikelytoachievebetterresultsafter volatility has peakedandthemarketsarebeginningtosettledown.Activetradersprefernottowaitbecausethatrisingoptionpremiummakesitvery tempting toopennewpositions.

Ifyouprefernottositonthe sidelines whilewaiting, that’s okay.However, do not useyour tried and truestrategywhenyouknowthat it is not currentlyappropriate. Dig intoyour arsenal of tradingstrategies for somethingsuitable.

When markets are volatile,there is another threat: OTM

positionscanmoveITMveryquickly. In such anenvironment,ifwestillpreferto trade iron condors, thewinning trader modifieshis/her approach to tradingironcondors.

One idea is to own ironcondor positions with longerlifetimes. There are twomajorbenefits:Lessnegativegamma (longer-term optionshave less gamma and that

means thatmarketmovesareless painful) and morenegative vega (i.e., longer-termoptionshavemuchmorevega than shorter-termoptions). Make this playwhen you anticipate thatvolatilitywill soonbeon thedecline). Longer-termcondors are well-suited forthose volatile markets. Thistrade (longer-term ironcondors) is especiallysuccessfulwhenthepositions

are not initiated too early.Why? Because rising IV isgoing to put these tradesunderwater and sound riskmanagement may requireexiting the positions with aloss. It issafer toenterwhenyou believe IV has peaked.Avoidthetemptationtojumpin as soon as IV begins toincrease.

When the market is slowly(i.e., without volatility) but

steadily moving in onedirection, that’s time toconsider yet another kind ofiron condor: If you believethe market is trending, thenthereisnoreasontosellbothcall and put spreads. If youare comfortable withmakingdirectional trades, then sellonly call spreads or only putspreads and temporarilyforget about trading ironcondors.

Warning: Adopting one ormore of these modified ironcondor strategies is not besuitable when it pushes atraderoutsidehis/hercomfortzone. The truth is that thelong-termgoal forany traderis to gradually expand theborders of the zone.However,whenconsideringanew or modified strategy isnot the right time tocomplicate your overalltradingphilosophy.

THECHOICEIt’s clear that the importantchoiceshouldbebasedonthetrader’s market bias. Ofcourse, we can get moresophisticated. The income-generating covered call canbe used as a very bullishpositionwhenthecallchosenis out of the money. [Thereare better bullish plays thanthis one]. Or the market-neutral iron condor can be

tradedwithabigmarketbias—basedonhowfaroutofthemoney the call and putsspreads are. [The commonironcondorhasshortoptionsthat have equal delta or areequallyfaroutofthemoney]

Oncethetraderhasselectedastrategy (iron condor, forexample) to suit his/hermarket bias, the big decisionhas been made. Next comesdeciding among the

reasonable alternatives. Thecondor is related to thebutterfly. Consider thesepoints:

The maximum profit isearned when expirationarrives and the stock isequalto(orbetween)thestrike price of the shortoptionsThebutterflyandcondor

(ortheironvarieties)arevery similar. Each canbe traded using onlycalls or only puts. Thecondor has spacebetweentheoptionssoldand the butterfly doesnot.With the iron variety,both calls and puts areused.

EXAMPLE:Butterfly: Buy the100/105call spread and sell the105/110callspread

Buy1XYXJan100callSell2

XYXJan105callsBuy1XYXJan110calls

Iron Butterfly: The

equivalent trade inwhichwesell one put spread and sellonecallspread

Buy1Jan100putSell1Jan105put

Sell1Jan105callBuy1Jan110call

Condor: Very similar to thebutterfly,buttheoptionssold

havedifferent strikes. In thisexample, the spread width isfive points: (95minus 90; or110minus105).

Buy1Jan90call(putforironcondor)

Sell1Jan95call(putforironcondor)

Sell1Jan105

callBuy1Jan110call

Boththeironcondorandbutterfly

prosperwhenmarketsarestable.However,the‘maximumprofitzone’(between$95and$105

intheexample)iswiderthanwiththebutterfly.Infact,themaximumprofit

zoneforthebutterflyisasingletickwide,i.e.,thereisonlyone

price($105.00)wherethetradercanearnthemaximumpossibleprofit.

Thatwide

zoneoffersamuchbetterchanceofearningthemaximumprofit(equaltothe

premiumcollected).Italsomeansthatthecostofentryissignificantlyhigher.Translation:

Usingthesamestrikepriceasthecenterforeitherstrategy,theironcondor

costsmoretoownandthepotentialprofitisless.However,thecondortrader

hasabetterprobabilityifearningsomeprofitfromthetrade.Thuschoosinga

strategydependsonthetrader’sgoal.Aggressivetraderstendtoseeklargerprofits—

andmoreconservativetraderstendtogravitatetowardahighprobabilityofowninga

profitabletrade.Inotherwords

When the call andput spreads are thesame width, theiron butterflygenerates a higherpremium than the

iron condor. As anoffset, the chancesof keeping theentire premium aresmall.The condor costsmore than thebutterfly. As anoffset, the condorhas a widerprofitable pricerange.

As time passes thecondor builds upprofits morequickly than thebutterfly.

Calendar/Butterfly

The ATM calendar orbutterfly spread doesbest when themarket isessentiallyunchangedas

time passes. The truedifference is that thebutterfly is worthlesswhen expiration findsthe underlying assetpricedoutside thewings(the options owned) ofthe butterfly. Thecalendar is seldomworthless. [An optionmust be very deep ITMorveryfarOTMtocarryzerotimepremium.].

More comparisons can bemade, but the concept is theimportant part. You canchoose a strategy that comesclosest to meeting yourmarket expectations.However,yourjobasatraderisjustbeginningwhenyoudothat.

When you open the trade(timing) and choose whichspecific options to buy and

sell (strikes, spread width,expirationdateetc.)andsetaprofit target, you areestablishing a trade plan.These decisions are a vitalpart of any trader’smethodology.Therearemanypossible choices, but how tomake those decisions is wellbeyondthescopeoftheideasdiscussedhere.Theimportanttakeaway is recognizing thatthere is far more to tradingthan picking some options

andenteringanorder.

RISKMANAGEMENTTheabovepreamblebringsusto the major idea thatinvolves the trader mindset.When trading an iron condor(for example), every traderunderstands that two of theeasiest (in terms of figuringout what to do) actions totakewhenreducingriskare:

Closetheposition

Reduce size by closingpartoftheposition.

However,therearealternativeideas for reducing risk. Theideaisto“adjust”thepositionbymakingsomechanges.Werefer to those trades as risk-reducing adjustments, ormoresimply,‘adjustments.’

Itiseasytodevelopafavoritemethodforadjustingrisk.For

newtraders,Irecommendthesimplest method of all:Eliminate the position. Inotherwords,whenyouknowthatthecurrentpositionisnolonger one that you want toown,thenitistimetosimplyexit the trade. When thishappens,youmaybe lockingineitheraprofitorloss.Sure,wearealwayshappiertolockin a profit, however, gettingridofapositionthatislosingmoney and is at risk for

losingevenmoremoney,isasoundthingtodo.

A slightly less aggressiveadjustmentmethodistocloseonlypartoftheposition.Whynot exit the entire trade?Sometimes a positionbecomes too uncomfortabletohold for the simple reasonthattheunderlyingassetpricehas changed and the currentrisk/reward picture is outsideyour comfort zone. At the

same time, you still like theposition (based on youroutlook for the stock price)andwant to continue to ownit. The best choice in thissituation is to hold onlyenough of the original tradethat allows you to becomfortablewiththatpositioninyourportfolio–andtoexittheremainder.

For example, if you traded10-lotsofacallcreditspread

(youbought10fartherout-of-the-money call option, andsold10-lotsofa less-far-out-of-the-moneycalloptionwiththe same expiration date),and the stock rallied, theprobability of losing aconsiderable sum hasincreased. To prevent thatunhappy event fromoccurring, it is prudent tocover(exit)anywherefrom3to 7 of your 10-lot position.Please do not buy back only

the option that you soldearlier.Buysomeofthesamespreadtoreducepositionsizeand also reduce exposure toloss. This position wasinitiated as a credit spreadand should continue to betradedasacreditspread.

Another commonly usedadjustmentstrategyistheroll.This strategy is discussedfurther in Chapter 19. Itinvolves covering the current

position and opening a newspread that is farther out ofthe money. Sometimes weuse the same expirationdate,andsometimesthepositionismoved to a more-distantexpiration date.NOTE: Thisis a strategy for experiencedtraders because it is easy forthe novice to adopt thisstrategy at inappropriatetimes and wind up with aposition that is even moreriskythantheonejustclosed.

Therearemanyotherchoices.To qualify as an adjustment,two conditions must besatisfied:

Thenewposition is lessrisky to own. In otherwords, both imminentrisk (potential loss forthenextdayortwo)andultimate risk(worstcasescenario) must be lessthan it was before

adjusting.

You must like the newposition and want toown it.Do notmake anadjustment that reducesriskwhenthepositionisnotgoodenoughtoown.Youwould be far betteroff exiting the tradeandopening a new positionin a different stock orindex – as long as thenewpositionlooksgood

to you and is one thatyouwanttoown.

Too many beginners roll aposition to get out ofimminenttrouble,onlytofindthat theadjustment tradewasahugemistake.

The successful traderunderstands that optionpositions are not createdequal and the sameadjustment method may not

be appropriate for allpositions. The successfuladjuster reduces risk andalways holds good positions.A ‘one-size-fits-all’ approachto risk management is notefficient.

Risk-managementmethodology cannot remainconstant.

WHEN DOES ASHORT OPTIONBECOME ATHREAT?When should any trader beready to make theadjustment? How do yourecognize when ‘imminent’riskhasbecometoohigh?

Youcoulddecidebasedon:

The number of pointsthat the short options isOTM.

The percentage of theunderlyingprice that theoptionisOTM.

Delta of the option thatwassold.

How much money hasalready been lost andhow that numbercompares with the

maximum acceptableloss(thatnumbershouldbe part of your originaltradeplan).

Oranyfactorthatmakesthe positionuncomfortable for YOUtoown.

Aggressive traders tend tohold onto positions longerthan conservative traders.However, each group may

choose its individual exit oradjustment point based on alosingmindset.

For example, the aggressivetradermaybetoostubborntomake an adjustment when itlocks in a monetary loss.Holding under thesecircumstances is merelywishful thinking and notstrategictrading.

The conservative trader may

become frightened over asmalllossandexitaperfectlysoundposition.

EXAMPLE FORIRON CONDORTRADERSThe aggressive trader maydecide that it isacceptable towait until the short option isonly 10-points out of themoney (for an$800 indexora high-priced stock) or itsdelta isnear40beforetakingdefensiveaction.

The conservative traderwould shudder at thoseparametersandwouldchooseto adjust when delta reached25 (or less) or perhapswhenthe strike was 40-points outofthemoney.

Neither trader is making amistake,aslongasthattradertruly understands therisk/reward situation at alltimes.

A reasonable-sounding, butincorrectmindset is: “Isn’t it‘obvious’ that selling farOTMoptionsisa‘safer‘playthan selling options that areclosertobeingatthemoney’?

Itisnotsafeatall.Itisquiterisky. What fools us is thenotion that we have a veryhigh probability of successwhen selling far out-of-the-money options. Traders whobelieve that this is ‘safe’ fail

to recognizehowawkward itcan get when the trade doesnot work out well. It isdifficulttomakeany‘lockinthe loss’ decision when thatloss is so much larger thanthe original premiumcollected.Ifthetraderdecidestocutriskassoonasthelossequals the original premiumcollected (and this is a fairlycommonadjustmentpointformany), then adjustmentsoccur too frequently and it

becomes a losing strategy.Imagine selling a spread for$0.10andexitingassoonasitcosts $0.20 to exit. This issimplynotviable.

HOW OFTEN TOADJUSTNote that one importantaspectof riskmanagement isdeciding how often anadjustment is necessary. Itcould range from frequent(several times per day) todaily, to ‘as needed for risk’to (I shudder at the thought)never. This is yet another ofthose individual decisions. If

you have difficulty decidinghow often to adjust , restassured that you will get agoodfeelforthisasyougainexperience. All that isrequired is a belief thatholding onto a position andhoping that itworksoutwellisabadchoice.

I suggest beginningconservatively and adjustinginstages.

TheWinningMindset

I manage each strategydifferently. As an example,when my iron condor useshigher-delta, closer-to-the-moneyoptions,Itendtoholdthe short option until it is atthe money because the largeinitial credit reduces the lossfromaworst-casescenario.Inother words, with a higher

possible gain (collected ahigher premium) and asmaller possible loss, theposition remains within mycomfort zone for a longertime.

Holding onto a position thatlong is too dangerous whentheinitialcreditisfarless.Inother words, trading ironcondorswithoptions that arefaroutofthemoneymayfeelsafe, but it is not. The

ultimate risk for suchpositionsismuchgreaterthanthe potential reward. That isnot how we describe a lowrisksituation.

No matter which tradestrategyIchooseasanentry,my overall success dependsonmy skillswhenmanagingrisk.

Options offer superversatility, and I use the

Greeks (Chapter 8) tomeasure risk and tweakpositions.

CHAPTER6THEIRONCONDOR

MINDSET

Among the popular optionstrategies is the iron condor.It is a four-legged spreaddesigned to profit when theunderlyingassettradeswithinarelativelynarrowrange.Forexample, here is a 12-lot

positiononIBM:

Buy12IBMNov170putsSell12IBMNov180puts

Sell12IBMNov220callsBuy12IBMNov230calls

In this sample iron condor,

the trader is short 180 putsand 220 calls. The objectiveisto

Collect cash whenselling the put and callspreads.Pay a smaller amountwhen buying BOTHspreadstoexitthetrade.

When the underlying asset

(IBM in this example) is notpricedbelow$180norabove$220whenexpirationarrives,then all four options expireworthless and the traderkeeps the original cashpremium.That represents theidealresult.

When the underlyingthreatens to move througheither of those strikes ($180or $220), then the traderusually(wisely)makesarisk-

reducing trade. The specificsofmanaging risk are beyondthis discussion, but areworthy of a lengthy book oftheirown.

THEIRONCONDORMINDSETThe position appears to be acombination of two spreads:Short one call spread; shortoneputspread.Andalthoughit isexactlythat, thewinningironcondortraderknowsthattheposition is really a singleposition inwhicheachof thefouroptionsservesapurpose.In otherwords, it should not

bethoughtofasifitweretwoseparatepositions.

THE INEFFICIENTMINDSET

I am short one callspread. If the marketdeclines I will cover(exit)thatspreadtolockinaprofit.I am short one putspread. If the marketrallies I will cover that

spreadtolockinaprofit.When I buy both, Iwillhave successfullycompletedthetrade.

THE EFFICIENTAND WINNINGMINDSET

I own one iron condorposition. To earn aprofit,Imustcoverbothspreads by paying lessthan my original cashcredit. If I cover eitherthe call or put spread,that does not result in a

profit. Repeat: There isno profit when exitingonlyhalftheironcondorposition.

The differenceis subtle, butimportant.It isverytemptingfor thenewer trader to takeanice profit—as he sees it. Ifhe sold the call spread,collecting $120, it seemsobvious that covering thatspread when 50% of the

premium has disappearedresultsinaprofitabletrade.Inother words, by buying thecall spreadat$60, this traderbelieves that he locked in a$60profit.

That is an illusion. There isno profit. The position is aniron condor and not twoseparate spreads. This traderchose to trade thecallspreadand (temporarily) ignore theput spread. This is not a

soundpolicy.Why?

Thecallspreadwassoldas a hedge. It was soldasawaytoreducelossesthat may accrue frombeing short the putspread.Itwasnotsoldtogenerateaprofitbecausethe whole iron condortradeisdesignedtoearnmoney. If youunderstand this idea,

thenyouunderstandhowtotradeironcondors.When the underlyingasset moves lower, theput spread increases invalue and the traderlosesmoney.Inaddition,that put spread becomesmore risky to holdbecause it is less faroutof the money, has ahigher delta, and costsmore to cover. The rate

at which money is lost(if the market continuesto decline) increasesbecause gamma for theput spread becomesmorenegative.When the call spread isno longer part of theposition, it no longerprovides a hedge to(partially) offset lossesfrom the put spread.Thus once the call

spreadhasbeencovered: Losses accrue even

morequicklyasthemarketdeclines.The sum of moneyatriskislarger.There is a higherprobability that thetrade will beabandonedataloss.

NOTE:Thesamesituationobtainswhenthetraderelectstocovertheputspread

inarisingmarket.Thewrongmindsetprovidesatemptationtolockinan

imaginaryprofitontheputspreadandsacrificetheadvantagesofowningahedged

position.

Theironcondortraderwithabetter mindset understandsthat owning the entirepositionandnottwoseparatepositions represents efficienttrade management. The ironcondor trader mustunderstand that a movingmarket is probably going toresultinanoveralllossandisinnohurrytocovereitherthecall or put spread. As the

underlying price movesnearer toonesideof the ironcondor,thatsidelosesmoneymore rapidly than the otherside gains.However, as longas that ‘other side’ is notpriced near zero, it acts as aposition hedge and reducesoverall losses. That is thereason for not rushing tocoverthat‘otherside.’

To understand how thisworks, a casual acquaintance

withtheGreeksisnecessary.

CLOSING HALFTHEIRONCONDORThere is a point at whichthereisnopracticalreasontoremain short one of theindividualspreads.Whenonehalfofthecondorbecomessoinexpensive, there is verylittle left to earn and it nolongerprovidesanyhedge. Itwouldtakeasignificantmove(or some time to pass) for it

to gain another few pennies.Thus, it is best covered.Think of covering as aninsurance policy to protectthe trader against thepossibility that the marketcould suddenly reversedirection and convert thisinexpensive spread into aliability.

Choosing that specific priceto exit is one of thoseindividualdecisionsbasedon

how much cash wasoriginally collected and howmuch time remains beforeexpiration arrives. For me,thepricepointforcoveringa10-point spreadwhen tradingSPXorRUToptionsis15or20 cents (the original saleprice was roughly $1.50). Isuggest that you include this‘buyback’priceaspartofthewrittentradeplan.

Note the very important

difference in the strategy ofcovering half of any ironcondor. We do not rush tocoverwhenthespreadretainsenough premium to act as ahedge when the marketcontinues to move in thesamedirection.Weexitwhenthe premium is so low thatthere is no practical hedgeremaining.

EACH OPTION INTHEIRONCONDORSERVES APURPOSEThe iron condor trader sellsoptions to make money. Wetake market risk (big pricechange) in return for thechance to profit when thoseoptions decay and can becoveredataprofitorallowedtoexpireworthless.

The true risk of trading aniron condor (or a simplecredit spread) can bedescribedasfollows:

Remember: risk is noteliminated until both the callandputspreadsarecovered.

The long options are boughtfor the sole purpose ofproviding insurance thatlimits losses. In the IBMexample, we do not buy the230 calls because we arebullish. Nor do we buy the170 puts because we arebearish.Webuythemonlytoprevent a disaster. If the

marketsurgesthroughoneoftheshortstrikes (220or180)then potential losses areessentially unlimited. Byowningthewings(thefartherout of the money puts andcalls that we bought), themaximumloss is limited to$1,000—less the premiumcollected when initiating thetrade.It isourabilitytolimitlossesthatmakestradingironcondorsareasonablestrategy.

**NOTEInthiscontext,‘coveredataprofit’referstothewholeiron

condor.Itnevermeansbuyingbackonlytheoptionsold.Itisapoor

practicetocovertheshortoptions(seeChapter21)andholdontothelong

options(unlessthoselongoptionsareonlyworth$0.05).TheONLYreasonthatwe

boughtthewingsisbecausetheylimitedourexposuretoalargeloss.They

werenotboughttoearnmoney;theywereboughttolimitlosses.Oncewe

covertheshortoption(soldtogenerateaprofit),this‘protective’optionisno

longerneededandshouldbesold.

TheWinningMindset

The ironcondor isapositionwith 4-legs. It is designed to

be maintained as a positionwith 4 legs. The winningstrategy is to avoid thetemptation to cover only thecall spread or only the putspread.

Imanagethistradeasasingleposition. The only exceptionis to cover one of the twospreadswhen there is far toolittle premium remaining andit no longer acts as a usefulhedge.

IfIturnbullishorbearishandwant to make a directionalplay on the market, I willmakethatasaseparateplay.Iwill notmesswith the ironcondor position. I may exitbecause of my new marketbias, but I will not buy theshort call or the short callspread as a directional play,just because I am suddenlybullish. (More on this inChapter21.)

I believe that trading CTMiron condors (close to themoney) requires a certainway of thinking. It is not forthe trader who cannotcomfortably hold a positionwith an ITM short option. Iunderstand that mindset.There is nothing wrong withit.However, if that describesyou, avoid being in thatsituation. Do not sell creditspreadswhentheshortoptionhas a high delta. Begin your

iron-condor trading careerwith 8- to 10-delta optionsand take your time indeciding how far OTM theshort options should be toallowyoutosleepatnight.

IbelievethatFOTM(delta2-4) (far out of the money)credit spreads and ironcondors offer a return that isfartoosmallfortherisk.Itistrue that these appear to bevery ‘safe’ positions because

they are profitable so often.However there are twoserious arguments againstowningsuchpositions:

Unlikely events (tails ofthe curve) occur moreoften than statisticspredict. Such trades getinto trouble more oftenthat their pitiful rewardsjustify.

It is very difficult tomanage risk when theinitialpremiumissmall.I’m referring tocollecting a credit of 25cents or less for a 10-pointironcondor.Thinkof how difficult itbecomes to pull thetrigger andpay$1.00 toexit.Toexitatthatlevel,you would be locking aloss that covers profitsfor four months. How

about $2.00? That’swheremanytradersloveto open their positions.Wouldyoureallyexitatthat price and lose somuch on a single trade?Dare you let it ridebecause there is no exitprice that feels right? Ifyou believe that gettingout sooner – perhapswhen the premium is$0.40)makessense,youwill discover that you

pay that low price toofrequently, leaving nochancetoearnmoney. One additional

problem: If you doexit one sidebecause it becameuncomfortable tohold, theremaynotbe anyone willingto sell the other(‘winning’) side at

a low price -perhaps10 cents.You may have towait for expirationto exit because(trust me) you willnot feel likepaying10 cents to get outof the trade. Youwill feel compelledtohold, inaneffortto avoid addinganother$0.10tothetotal loss. By not

beingwillingtoaddthat small sum tothe loss, suchtraders fail toconsider thepossibilityof a rareevent in which themarket reversesdirectionandforcesthem to exit theother half of theiron condor (withanotherbigloss).

I recommend that beginnerswith some experience tradeindex iron condorswith one-to three-month expirationsand 8- to 12-delta for theirshort options. However,options with very shortlifetimes have becomepopular tradingvehicles.TherewardsaresotemptingthatImust repeat my warning: Ifyou are not experienced inhandling positions withsignificant negative gamma,

avoid trading the weeklyoptions until you are verycomfortable making risk-managementdecisions.

New traders may feel morecomfortablebybeingshort6-or7-deltaoptions.

I use different risk-management methods whendealing with different typesof iron condors. Short termvs. long term. Ten-delta

optionsvs.25-deltaoptions.

CHAPTER7

WEEKLYIRONCONDORS

I confess. I have a strongpreference for trading ironcondors. I am comfortablewith the risk/reward andbelieve I can manage the

trades well enough to earnmoney on a consistent basis.Some years are excellent(reinforcingmypremise) andothersarenot(reinforcingthetruth:My discipline is good,butnotgoodenough).

I do not recommend ironcondors for everyone. It is agood tool to have in yourarsenal of trades, butfrequency of use has to be apersonal decision. Some

marketconditionscandestroythe iron condor trader. Savethese trades for times whenyou truly have no marketbias, or better yet, for timeswhenyouhaveastrongbeliefthat the markets are headednowhere.

When market conditionssuggest that iron condortrading may involve higherthan usual risk—without anappropriate increase inthe

potential profit—it is a goodidea avoid trading as usual.Recognizing when theseconditions obtain may bedifficultfortherookietrader.As a guideline, if you areespecially nervous aboutentering the trade—and thetrue reason for thatdiscomfort may be unknown—trust your instincts andavoid the trade or open asmall (25 to 50% of yourusualsize)position.

If you do not have anotherstrategy to trade, have thepatience to wait for a goodopportunity and use the timeto learn about or practice analternativestrategy.

RISKMANAGEMENTPositionswith short lifetimesrequire plentyof attention. Ifyou work full time, it ispossible to come home fromwork and discover that aposition has moved near itsmaximum theoretical loss. Ifyou cannot watch positionsfrequently,thetradebecomesmore of a gamble than an

investment. The onlyacceptable defense is to sizethe trade correctly. Thatmeans SMALL size. Forthosewith full-time jobs, theappropriate size for short-termoptionsisprobablyzero.

Time to expiration is short.The options decay rapidlyandaquickprofitispossible.That’sthegoodnews.

However, gamma changes

rapidly.Bottom line:Tradersareinjeopardyofincurringasubstantial loss over a veryshorttimespan.

Trading short-term creditspreads (reminder: an ironcondorisapositionwithtwocredit spreads) is often agamble. The trader wins orloses with little chance tomake adjustments becausechoicesarelimitedwhentimeis so short. [Please: Do not

rolltoanotherexpirationdatewhentradingweeklyoptions,nomatterhow tempting.Theshort-term iron condorrequires different riskmanagement techniques.Extending your exposure foranotherweekor two isNOTthesolution.

THETRADEMy recommendations, andtheir rationale, for tradingweeklyoptions:

Beforemakingthetrade,recognize: This is FULL

TIME trading,despite thefact thatwe are in themarket2-3daysper

week and out 4-5days. The tradermust be able towatch the positionsseveral times eachday.Donotplantoearnevery pennycollected. Exitquicklywhentargetprofit (per yourwritten trade plan)is reached.Holding

anextradayortwoadds considerablerisk.

Minimize theholding period andavoid weekends.This is a risk-reducingcompromise. Youmiss the extra timedecay over theweekend, but you

(more importantly,in my opinion)avoid exposure topossible market-movingevents.

Enter the trade earlyMonday (or possiblyTuesday)morning.Oncethe market settles downfortheday,thepremiumin these short-termoptions begins todisappear. Unless the

market suddenlybecomes more volatile,morning entry gets theday’sbestprices.

Plan to exit no later thanThursday afternoon. [SomeEuropean style index optionssettle(essentiallythesameas‘expire’) Friday morning atthe opening of trading.However, themethodusedtocalculate the final closingprice (settlement price) for

theindexisfardifferent than‘normal’ and can result invery surprising (and costly)results.Formore informationon how these options aresettled,seemyblogpost.]

Check the cost to exitWednesday (or Tuesday)afternoon. On occasion theone-ortwo-dayprofitisgoodenough and sitting on thesidelines until the followingweekkeepsusoutoftrouble.

I prefer to exit late in thetrading day when possible.Once I accepted the risk ofowning the positionovernight,Iprefertoearnthefulldayoftimedecay.

Be flexible.The optionsareseldomfaroutofthemoney(becausetheyaretoo inexpensive to sell).Use your judgment anderronthesideofsafety.

There is a lot ofmoneyto be made, but onlywhen if the trader iscomfortable with therisk, has the skills tomanage risk efficiently,and has the time towatchpositions.The trade plan has aprofit. Take that profitwhenitcomesyourway.YouwillNOTwinevery

week. Establish amaximum acceptableloss because this is notthestrategyforstubborntraders.

Be prepared to adjust byrolling down to lower-delta,farther out-of-the-moneystrike prices. Whennecessary,adjustorexit.

Do not hold throughexpiration. Enter bids to exit

the call spread or put spreadif and when it reaches yourlow price ($0.05, perhaps$0.10).Assumeyoumustpayatleast$0.15toexitanyironcondorasasingletransaction.

When making the trade,collect sufficient premium tocover commissions, the costto exit, and to provide aprofit. Failure to plan aheadmay turn ‘successful’ tradesintotradeswithnoprofit.

Select spreadswith a narrowwidth.Irecommend5-or10-point call/put spreads whentradingindexoptions.

TheWinningMindset

1) The successful optiontrader understands this truth:Options are versatile andflexible investment tools.

Theycanbeusedinavarietyof strategies. That trader isnot married to a singlestrategy.

2)Theironcondortradercanselect from several positiontypes and each is a separatestrategy unto itself. Eachrequires different riskmanagement and exittechniques. Some personalitytraits make it easier for atrader to adopt one style of

tradingasopposedtoanother.

3) Weekly options are quitedifferent from their longer-term cousins. Their valuedisappearsquickly.However,they can become expensiveeven more quickly, andwithoutagiantmarketmove.These short-term optionspresent too much risk formanytraders.

PARTTHREE

TheGreeks

CHAPTER8THEGREEKS

Thisshortchapterisincludedbecause it is very temptingfor newer option traders to‘skip over the Greeks fornow’ with the intention ofpayingattentiontothemlater.That is not a winningmindset.

The Greeks are used tomeasure risk.That isall theydo. Understanding just howmuch can be earned or lostfrom every position in yourportfolio is important.Recognizing what has tohappeninthemarketplaceforyour positions to performwell is mandatory becauseyour positions should reflectyour market expectations.Being aware of the marketactionthatsendsthevalueof

your portfolio into a tailspinis also valuable informationbecause you want to knowwhentotakeactiontoprotectyour assets. When you ownpositionsandthemarketdoessomethingsurprising,itisnotwisetosittightand“seewhathappens.” When a traderknows what to expect interms of gains or loss, thattrader is well placed to lockinprofitsorminimizelosses.

The Greeks is not acomplicated topic.Ofcourse,youcanundertakeacomplexand detailed study of theGreeks.However, there isnoreasonforthenewertradertoget bogged down at thispoint. There are benefits togaining a deeperunderstanding, but pleasedon’t skip a basicintroductiontotheGreeks.

RISKMEASUREMENTWhen markets move, or failto move, option traders earnor losemoney. I thinkweallunderstand that. However, ifyou know just how muchmoney you may make (orlose) when the market doescertain things, then you willhave much more confidencethat you know whether the

positions in your account arewithinyourcomfortzone.Forexample, a trader wants tohave answers to these verybasicquestions:

If the underlying stockmoves up or down bytwopointsover thenextweek, how much doesthat change the value ofmyposition?

If I own call options,howmuch money can Ihope to earn if theunderlying asset moveshigher by 3% over thenexttwoweeks?

Can I afford toown10-lots of this position?Would that be placingtoomuchatrisk?

IfIopenacreditspread,howquicklywillImake(or lose) money if thestockmoves in the right(orwrong)direction?

This is not complex. Nomathematicalcalculationsarerequired, other than additionand subtraction. Calculatorsdo all the work and supply

the numbers. Your job is tointerpretthenumbers.

It is worthwhile to gain anunderstanding how theGreekswork.

TheWinningMindset

If Iwant to have any chanceof managing risk effectively,thenImustspendalittletime

reading about the basicGreeks.Those include: delta,gamma,theta,andvega.

CHAPTER9TIMEDECAY(THETA)

FORTHEOPTIONSELLERWarning:Time decay can bea wonderful thing for theoptionseller. In fact, it is thedriving force behind the so-called ‘income-generating’strategies. The trader holds a

position,waits,andthenexitswith a nice profit.When theposition is market-neutral,andwhenthemarketbehaves,all gains can be attributed tothemagicoftimedecay.

Positions with thatpositive time decay aresubject to losing moneywhen the underlyingassetdoesnotbehaveasanticipated.Theselosses

are directly related tonegative gamma [theGreek thatmeasures therate at which deltachanges. Negativegamma makes theposition longer (morebullish) as the marketfalls and shorter (morebearish) as the marketrallies]. For our waitingperiod to proveprofitable,itisnecessaryfor the market to

‘behave.’ Translation:The market must notstray too near to thestrike price(s) of theoptionsthatweresold.

For positions where theshortoptionshaveonlyasingle strike price(calendar, butterfly,credit spread), theunderlying must remain

near, or move towardsthat strike price formaximum profit. Thereis leeway, but lossesoccur when theunderlyingmoves to farfromthatstrike.

For positions with twosuch short strikes(condor, for example),the underlying mustremain between thosestrike prices (preferably

not near either) for thewaiting period to besuccessful.

FORTHEOPTIONBUYERThe opposite is true for theoption owner. When owningan option, the trader has thepotential toscoreabigprofit—if the underlying assetmakes the anticipated move.However,optionsarewastingassets and lose value eachday.Fortheoptionowner,the

passageof time is anegativefactor and once the option isbought, the desired pricemovementmust occur beforethe option expires, and thesooner the better. Note thatthe underlying does not havetomove toanyspecificpricewhen your plan is to sell theoptionwell before expiration(recommended).

Too many option ownersmake the mistake of buyingoptions and holding all theway to the end, therebysacrificing every penny paidfortimepremium.

RISKMANAGEMENTAnd that’s the problem.Waiting for options to decay

is ‘easy,’ but can be a riskyproposition.Intherealworld,things are not simple. Theunderlying stock or indexmayapproachthestrikepriceof your short option(s). Thatcanbea frighteningsituation—especially for the rookietrader who is experiencingthis for the first time. Thenatural—and appropriate—reaction is to relieve the fearby reducing or eliminatingrisk.

Being willing to takethat defensive action isan essential part ofmanaging risk for thesepositive-theta (timedecay is on your side),negative-gamma trades.When things go well,traders who holdpositive theta positionscanmake a good living.However when markets

become volatile orunidirectional,lossescanaccumulate quickly. Tosurvive, the trader mustbecome a skilled riskmanager.

It’s a fine line betweengettingout of a positionthat has become tooriskytoownandholdingontothetradeforalittlelonger, looking for amarketreversal.

Thebiggestdifficultyforthe rookie trader is toavoid adopting thismindset: “The marketcannot move any morein this direction. Lookhow far it has comealready. I know there isa reversal coming verysoon.” That thoughtrepresents a financialdeathwish.

Believe me, it is an easy

mindset to develop. Wealways prefer to believe thatwemadegoodtradedecisionsand thatour tradeswillworkout well in the end. That isconfirmation bias. Andperhaps these will becomeprofitablewhenallissaidanddone. However, the risk ofsubstantial loss has becomehigh; too high for thedisciplined and successfultrader to take the risk ofwaiting. He knows that

something bad may happenand that the happy endingmay never be seen. Forexample, it isnotuncommonfor a stock rally to ‘squeezetheshorts’—onlytofallbackto earth. That happens. Butwhy take the risk? Why putyourself in position to take abigloss?

Thepropermindsetis:“Idon’t know whether the

market ismovinghigheror lower from here. Ihave a bias, but I justcannotaffordtotakethatchance.I’mgoingtogetoutofmyriskytradeandtake the loss. I willsurvive to trade (andprosper) in the future. IfI want to place a wageron my current marketbias, I can find a farbetter way to make thatplay than holding onto

my current (money-losing and risky)position.”

During a discussing onposition management,one trader offered thefollowing: “Theta ishowItrackmyprogressforanytrade.”

I get it. We watch thevalue of our accountgrowsteadily.Wewatch

the price of the shortoptions move towardzero (or the price of thespread we own increasein value). It is so easyfor new traders tobelieve that theydiscovered the HolyGrailoftrading.

Thateuphoriacangoonfora long

time.Pleaseremember:

There is no freemoney.All trades involve risk.A winning streak canendsuddenly.

Theta is the trader’sREWARD for anotherday passing with norelevant consequences.Translation:Theta is the

reward for taking riskand owning thewinningside.

Yes, you can watch theprofits accrue day afterday. There will beperiods when the tradeplan (hold and wait)works perfectly. That isnot as beneficial as itseems because it may

bring unrealistic (anddangerous) expectations,suchas falselybelievingthat trading creditspreads is far tooconservative and thatthere is so muchmoneyto be made by sellingnakedoptions.Whenthetrader does not buyfather OTM option tocomplete the creditspread, the net premiumcollected is significantly

larger. That increasesprofit potential. Thedifficultyis thatriskhasgrown enormously—because losses are nowessentially unlimited.Someone who has notlived through a violentmarket can go bankruptinaheartbeat.Thatless-experienced trader oftenbrushes aside allwarnings because thosevolatile markets

represent something hehasneverseen.

As you watch the dayspass and profitsaccumulate, it is easy tolosesightofthefactthatrisk (defined as theamount of money thatcan be lost from yourcurrent position) hasincreased. The factor

that changed as timepassed is that theprobability of incurringthatlossisnowsmaller.

It only takes ONE badday to kill the profitsfromweeksofcollectingtheta.Translation,asyoucontinue to wait, a twostandarddeviationmove(expected about onceevery 20 trading days)could turn your winners

intolosers.

When a trader watchesan account grow everyday,hebecomesblindtorisk. Trust me. I havebeen in your shoes andwatched positive thetagrowmyaccount.ThenIwatchedastheta’sGreekcounterpart (gamma)withdrew all the profits,and more, from thatsameaccount.

Warning: Recognize thedanger of beingmesmerized by profits.Riskisnotdiminishedastime passes. Theprobabilityof losinghasdecreased,butthatisnotthe same thing. Thechance of losing doesnot reach zero untilexpiration has passed orthe position has beenclosed.

Please be aware of risk.Do not growoverconfident. Timedecayisyourfriend,butit is not your savior.Owning positive thetapositions can be a veryprofitable strategy. Thewarning is to be certainthat you never fail torecognizejusthowmuchmoney can be lost fromanytrade.

TheWinningMindset

“Iknowmyriskatalltimes.Imanage positions to earnmoney,butmore importantlyto maintain risk that is wellwithin my ability to absorbanypotentialloss.”

TakeoffofPeteSeeger’ssongadaptedfromEcclesiastes:

Toeverything(turn,turnturn)there is aseason(turn,turn,turn)A time tosellpremiumand atime nottosellit

A time tosell thetaand atime toowngammaA time tocollectdailydecay,and atime toavoidit.

To repeat: A proper mindsetinvolves accepting that youdo not know whether themarket is moving higher orlower.Youmayhave a bias,but cannot afford to riskholding onto high-riskpositions. You will the riskyposition, take the loss, andsurvivetotrade(andprosper)again. Ifyouwant toplaceamarket wager on your bias,findafarlessriskytrade.

PARTFOUR

MindsetsthatcanbeChanged

CHAPTER10

WHATCANIEARNASATRADER?

Over the years the singlequestionthatIamaskedmostoften is: “How much can Iexpect to earn when usingoptions?”

I understand the thoughtprocess behind the question,butitalwaysdisturbsme.It’sthe wrong question to ask. Iwould have much moreconfidence that the newtrader is on the right track ifone of these questions wereaskedinstead:

HowmuchtimeshouldIplan to devote to myoptionseducationbefore

I can anticipate earninganymoney?

How much cash do Ineed before opening anoption-tradingaccount?

Do most new optiontraders find success? Ordotheytendtogiveup?

I’ve never traded stocksor anything else. Willthat make it difficult tolearntotradeoptions?

Is itworthwhile to learnto trade options orshould I pay aprofessional trader totradeforme?

These questions demonstratethat thepersonwhowants tobecome an option traderrecognizes that this is not agimmie, and that some timeand effort must be expendedbeforerewardscanbeearned.The commonly asked

question: ‘How much can Iearn?’ suggests that theperson asking ‘knows’success is easy, and that theonly thing holding him backfrom joining the game iswondering whether it’sworthwhile.

I seldom, if ever, receive aquestion along these lines:‘What does it take tosucceed?’It’salwayssimilarto: ‘I’m going to succeed.

HowmuchcanImake?’

A READER’SLETTERBelow is one sample letterfromJo:

HiMark,

Isitpossible

foranordinarypersontogenerateincomefromtradingoptionsiftheyareable

tosustainthemselvesforafewmonthswithoutajob,whilelearningtheropes?

Howmuchcanonehopetoearnthroughtradingoptionsontheconservativeside,

andhowlongdoesittaketobecomeanexpertonaverage?

Is

itnecessarytopurchasespecialsoftwareforoptionstrading(technicalindicatorsandsuch)?

Thankyou,

Jo

These are thoughtful andoptimisticquestions.

Isitpossible?

Yes.Itcanbedone.Youcangenerate income. Apparentlyyou are seeking to earn aliving by trading instead of

looking for employment.Please be aware of oneimportant point: There is agreat deal of pressure on theinvestor/trader when moneyis ‘needed’ for livingexpenses. Learning to traderequires time to study,practice and grow into thebusiness.Thataddedpressureoften leads to poor tradedecisions. I’m sure youunderstand. And that’s whyyou plan to have ‘a few

months’ cash in reserve.That’s an excellentbeginning. I’d prefer to seeyou have enough cash setasideforsixmonths.

The good news is that yourecognize that profits do notbegin from day one. The notsogoodnews is that you areasking whether it’sreasonabletolearnenoughtomake a living—during thosefewmonths.Thefirstanswer

is that every student has adifferent ability to learn andsome just have a betteraptitude for options and canwork more quickly thanothers. So yes, it is possibleto produce earnings withinthat time slot. But noteveryone can move asquickly. And of course, noteveryone can do it nomatterhow much time and efforttheyspendonaneducation.

One reason for that is thegeneral cautiousness ofpeople. It’s a good idea tobegin trading with a smallnumber of dollars at risk. Infactmany startwith apaper-trading account and continuewith that for many months.You would not have thatluxury because you wouldhave to get in some usefulpractice, and then trade withsmall money. After thatcomes gradually increasing

position size and taking onmore risk.Whymust you dothat? Because you are notlooking for supplementalincome; you want to earn aliving, or earn enough tomake a significantcontribution to your monthlyneeds. Thus, your earningsgoalcannotbetoomodest.

YesJo,youcandoit.Ifyouhavethepatience.If

you take the time tolearnandarenot rushedinto trading. Ifyouhaveorcandeveloptheskills.And if you havesufficient capital to giveyourself a realisticchance.

Achieving success as aninvestor can be veryrewarding over theyears. It is easier toaccomplish when you

have the comfort of afull-time job and theincome that it provides.Trading full timerequires a differentmindset.

Therefore, you need at least$3,000 per month (for verymodest/frugalliving)ormuchmore if you are anythingother than a new collegegraduate who can livecheaply while developing

tradingskills.

Itisnotthat$3,000or$5,000or $10,000 per month is notanachievablegoal.However,it is not the total dollars thatyouwanttoearnthatmatters.Thereallyimportantquestionishow much money can youdeposit into your tradingaccount? When usingoptions, we tend to ownpositions for much longerthanoneday,andthatmeans

we must meet marginrequirements. In turn, thatmeans we must have somecapital before we can ownpositions.Marginisadeposit,requiredbytheSECandyourbroker to own certainpositions. Think of it ascollateral that protects yourbrokersfromlosingmoney.

If you open an account with$20,000, I hope youunderstand that it is almost

impossibletogenerate$5,000per month. That would be areturn of 25% in onemonth.Yes, you may do that wellduring your trading career,butonlyoccasionally.Infact,unlessyouarewillingtotakeon a lot more risk than isadvisable, you should notexpect to earn even 5% permonth. Do notmisunderstand. Five percentper month is a huge return.Earn that return everymonth

for twoyears andyouwouldconvert $1,000 to $3,225.Wouldn’tweall liketotripleournetwortheverycoupleofyears?

It takes money to makemoney,andthatisoneoftheobstacles that is usuallyunrecognized upfront. Evenwhen a trader has access tofunds,itisverylikelythatthemoney would have to beprotectedagainstlossandthat

means the trader would usemore conservative strategieswithsmallerpotentialprofits.

The answer to yourquestion is that you canmake a lot of money.However,youmusthavea good-sized accountbalance to do that. I tellnew traders that it is areasonable GOAL toshoot for 20% per year.

Please read the wordscarefully. That is perYEAR. It is also aGOAL. It is a goodtarget.However, do notbelievethat it isaneasytargettoachieve.Donotbelievethatyoucanearnthat much on aconsistent basis. Thebottomlineisthatifyouhave an account worth$100,000, itmay not beanywherenearenoughto

generate sufficientincome to meet yourneeds. I would considerearning $15,000 on that$100,000 to be a goodyear for most traders,most years. Yes, youwill do better duringsome years. However,youwillalmostcertainlyfail to earn that 15%return much (if notmost)ofthetime.

BottomLine:Ifyouadoptstrategiesthatrequire a holdingperiod (and thatincludes thecommon strategiesthat I recommend:condors,butterflies,calendar spreads,credit spreads ordebit spreads) even$100,000 is notanywhere nearenough money for

you or me, or anytrader to expect toearnaliving.

If you trade high riskstrategies, you have achance to earn a largereturn on yourinvestment (10+% permonth), but that comeswith a very highprobability of goingbroke. Yes, not just aloss, but a complete

blowing up of a tradingaccount. High rewardsare usually the result ofaccepting high risk.Please recognize thesubtledifference:

The more conservativetradermayseek‘only2-3%’permonth.That’savery good return, but itprovides only $2,000 to

$3,000 permonth on anaccount valued at$100,000. Mostprofessional traderscannot earn that much.BrettSteenbarger(Psychologist,tradingcoach,traderandblogger) once told methatthebestprofessionaltraders earn ‘in the low(emphasis on low)double digits’ per year.That assessment sounds

righttome.

Going by the above opinionand based on my experiencewith newer traders, earning1% per month is a realistictarget.

Thus, this is the mostimportant question fordeciding when you can getstarted: How much cash doyou have for trading? Mostpeople assume they should

target earning a specificnumberofdollars,ratherthana specific return on theirinvestment.

Alsoconsiderthis:Whenyoubegin with a small sum, theriskofruin,ortheprobabilityofgoingbroke, isvery large.When you have extra cash,youcanwithstandastringofsmall losses and still stay inthegame.

Also:Whenyouhaveasmallaccount, if you haveoutstanding success anddouble the account value inone year, the total dollarsearned is small. It does takemoneytomakemoney.

If you have $10,000 and doanexcellent jobandearn2%every month, that’s a grandtotalof$200/month.Thatwillnot take you very far. Iassume you would want to

earnaminimumof10to20xthat amount. That isunrealistic.There is achancethat you could have a nicewinningstreakandquadrupleyour money in a year or so.But the most likely outcomeof seeking such huge returnsis thelossofallyourcapital.The two major requirementsfor getting started are havinga sufficient bankroll and asufficienteducation.

THE EXPERTTRADERExperts are few and farbetween—assuming that by‘expert’ you are referring tosomeone who knows how tomake money and thenactuallymakesitandkeepsit.The expert has a deeperunderstanding than othertraders. With that definition,few are experts. The good

news is that there is no needfor you to become an experttrader.Yourgoal is toearnaliving. If you achieve thatgoal, then your own talentswill tell you whether youshould seek to become anexpert.

Trading is a game in whichyou are continually learning.And that’s importantbecausemarketschangeovertimeandif you never change or

develop new ideas, you willnot remain a successfultrader.

Onaverageittakesforevertobecomeanexpert trader.Thevast majority never get thatfar. Don’t let that upset you.No professional basketballplayer has to be as good asMichael Jordan was. Goodplayers can achieve successand win championships andearnahugeliving.

You do not have to becomeanexperttrader.Being‘good’is good enough. Yourobjectiveistoearnenoughtomeet your needs. If youunderstand the basics, if yougraspthestrategiesandknowwhen to apply a couple ofthem, if you have thediscipline,andifyouhavethebankroll, then you can doverywell.

It is true that Iwould expect

the expert to earn more thanthe ‘good’ trader. But thebottom line for futureearningsstilldependsonhowmuch money you have fortrading and how much riskyou want to take. Beingconservative and preservingyour capital is a splendididea.Justbeawarethatbeingprudent does limit yourearnings potential. I supportthe conservative approach. Idon’t believe we should risk

our bankrolls to make moremoney.Optiontradingcanbeboring.Well, boring is good.Boringisprofitable.

To succeed, you mustunderstand what you aretrading,andthatmeanstakingtime to learn option basics.You should have no troubleunderstandingthatoptionsaredifferent (better) from othertrading vehicles. For onething, options come with

built-in risk-managementtools:TheGreeks.

If you are brand new totrading,thereisevenmoretolearn, including basic thingssuchashowtoenteranorder,how to use your broker’stradingplatform,thedifferentorder types (market, limit,stop etc.). Someone withstock trading experience isalready familiar with thoseitems.Thatmayappeartobe

an advantage because it cutsyour learning time.However,ifyouarejustbeginning,youhavenobadhabitstounlearn,andthat’sagoodthing.

DISCIPLINEYou did not ask, but inadditiontohowoptionswork,thetradermustpossess(orbeable to develop) certainpersonality traits. Jo, if youare willing to learn howoptions work, and if youbelieve you can demonstratethe traits listed below, thenyoumayverywellbeabletosucceed.Noteveryonecandoit.

Anyone can trade. Anyonecanenter thearenaandplacean order. But to have achanceofmakingmoneyonaconsistent basis, the tradermusthave:

Discipline.The ability to recognizerisk. That meansknowing how muchmoney is at stake for

every position andunderstanding theprobability of losingmoney.Patience to learn beforetrading.Patiencetopracticewhatyou have learned,usually in a paper-tradingaccount.

The ability to controlharmful emotions. Fearleads to panic, whichresults in terribledecision making. Greedhas traders taking toomuch risk for too littlereward. Prideencourages traders torefuse to take a lossand/or get out of a badtrade.

The ability to recognizethat a few successfultrades does not makeyouastartrader.An understanding thattraders cannot earnmoneyeverymonth.The ability to recognizethat a 90% chance ofwinning means there isa veryreal10%chance

oflosing.Acceptance.Believethatyouwillnotmakemuchmoney when yourbankrollissmall.An understanding thatstock markets live in astatistical realm.Translation:luckplaysarole in yourperformance. However,

the skilled riskmanagerprotects the portfoliowhen the unlikely eventunfolds.

TECHNICALINDICATORSI never use technicalindicators. I know that sometraders are very skilled indoing so. But they did notlearn overnight, and anyonewhotellsyouit’seasytoreadchartsandmakemoneyfromthe signals is not telling thetruth.

I use no trading software,

other than risk managementsoftware supplied by mybroker. If you prefer to usesoftware for the purposestatedinyourletter,Ioffernoobjection.

I suggest getting started byreading and attending freeseminars offered by theoption exchanges or yourbroker.Itmaybeeasierifyoutakeacourse.However,thesetendtobeveryexpensiveand

you never know whether thementor/teacher isqualified tohelpYOUlearn.

Plan to spend some time inthe education mode,especially if you set a fewmonths as the time limit.There’snotimetowasteonceyouquityourjob.Iwishyougoodtrading.

TheWinning

Mindset

I will not rush into trading.Myeducationcomesfirst.

I will not attempt to tradeoptions with a tiny bankroll.$10,000shouldbeenoughforthe casual trader. Yes, I cangetbywith less,but the taskismoredifficult.IfIexpecttoearn a living, I need at least$200,000.

I do not anticipate successwith little effort. Tradingrequires knowledge and skillandIwillacquireknowledgeand practice to develop theskills.

I want to earn money.However, I know that Ishould think of my earningsin terms of a percentagereturn onmy bankroll, and Iwill not target a specificnumberofdollars.

CHAPTER11TRADINGTO

RECOVERLOSSES

Goodquestion.Ifbuying500calls(yes,itisonly$7,500)isfairly bullish, how many doyou buy when extremelybullish? (That is a rhetoricalquestion.)

I see no problem in buyingthinly traded options underappropriate circumstances.When thin options are at- orin-the-money,theytendtobe

more liquid – because theybecome a stock substitute(i.e., you can hedge theposition at any time bytradingstock.)

However, buying OTMoptions—already a largegamble—becomes an evenbigger problem when youdecide to sell. The onlybuyersarethemarketmakers,andthereisnoguaranteethatany of them will make a

decent bid. They know theopen interest, and theyrecognize that when oneindividualholdsall,oralmostall,ofthatopeninterest,theyhave you at their mercy.Why?Becausenooneelseisinterested in buying thesecalls. I note that the strikeprice is $22.50 and that thestock is $13.30. This stockmay have stalled in its rally,butdidyoureallybelievethatbuyingoptionsthataresofar

outof themoneywouldeverbe profitable? Why not buyanequaldollar’sworthofthecallstruckat$15,ifyouwereverybullish?

Atother times, it couldworkto your advantage to ownthinlytradedoptions,butthatonly occurs when the peoplewho sold the options areanxious to get those shortsout of their accounts. Youmaybecometheonlysellerof

theseoptionsandbuyersmustcometoyou.Butthatisarareevent. However, the marketmakersareprobablytheoneswho sold these thinly-tradedoptions.Thatmeansthattheyhave you over a barrel andthatyouhavenowhereelsetogotosellyourcalls.

If these callswere ITM, thatwould be a different story.You would be able to shortstock (up to 50,000 shares)

against thecalls, lockinginaprofit (when the stock isabove $22.65; strike pricepluspremiumpaid).

Thus,tradingthethinoptionswas not dumb (in myopinion).Buttakingabig(forthatstockanditsdailyoptionvolume)positioninoutofthemoneyoptionswasthepartofthe trade thatmakes it bad. Iunderstand that you werebullish, but what was the

stockpricewhenyouboughtthe calls? Right now theseoptions are hopelessly out ofthemoney.Youwerelookingforabigmoveinaveryshorttime.Believing that this typeof move is possible is whatresults in traders buyingoptionswithan inappropriatestrikeprice.

HERE IS MYPHILOSOPHYWhen you earn money, thedollars spend the same,regardless of which stockproducesthoseprofits.DonotfeelcompelledtoearnmoneyfromXXXX.Translation:Donotdoanything foolish inanattempt to recover the loss.Accept that this is a losingtrade and chalk it up as a

lessonlearned.

SOME THOUGHTSON YOURSITUATIONI know you want to sell putoptions to collect enoughcash to partially offset theloss from buying the calls.However, there are two bigproblemswiththatidea.

First, it is too late. Time isvery short (one week toexpiration),andit isnoteasyto collect any reasonablepremiumbysellingOTMputoptions. If you sell puts thatareonlyoutof themoneybyasmallamount,you facebigdownside risk. Such riskshouldonly(ifever)betakenwhen you are confident thatthe stock will move higher.You have no such opinionand selling puts would be a

bigmistake.

Second, the stock must rallyby more than 60% to movethe calls into the money.These calls provide zerohedge (because they arealreadyessentiallyworthless),so any puts sold would beessentially naked short.Selling thoseputsplacesyouin jeopardy of suffering agiganticloss.

Youmay be able to sell Sep2212.5puts.TheyareOTM,butthemostyougetforthoseis$0.05–andyoumaynotbeable to get that much whenselling. Collecting five centsper option represents toomuch downside risk for thereward. We both know thatthese puts are very likely toexpireworthless,butIbelieveyoucanfindbetterplays(inadifferent stock), withappropriate risk/reward

potential. This is not a goodchoice.

SellingtheSep20putswouldbe better – but there is littlechance of collecting fivecents – and to be honest – Istill do not like the idea ofriskingyourmoneyforsuchasmallreward.

I see your choice as comingdowntotwo:

Enter an order to sellyour long calls at 5cents. There is littlechance that anyone willbuythem.Hold and hope for amiracle.I’mnotafanofdepending on hope. Butthis trade represents alost cause. Take the$7,500 loss and moveon.

Youcanconsidermovingthisplay beyond the Sep 22expiration date. But please –do not make this trade aspride recovery.Do notmakeit to ‘get back’ some of theloss.Do itONLYifyoustillwant to maintain a bullishposition and if this trade isappropriateforyou.

OTHERPOSSIBILITIES:

SellOct 10 puts at 15 cents.DONOT sell 500.DONOTtry to ‘get even.’ Do thisONLY in an attempt to earnSOME money from apositionthatyouareeager toown.Thesaleof50putsmaybe too many because youcould find yourself owning5,000shares.Sizedependsonyour comfort with the tradeand whether you are willing

tobeshortputs.Thinkofthedownsideriskwhenchoosingpositionsize.

Sell (becarefulwithpositionsize)Oct12.5putsat40to50cents. Do not think in termsofcollecting$7,500.Thinkinterms of how much can belost if the stock falls out ofbed. With the bid for thisoption so low (25 cents) andthe bid/ask so wide, we donot know how much the

marketmakers arewilling topay to buy these options.Demand a higher price thanthe bid. These thin optionscan trade very strangelybecause you never know thetruebidorask.

Maybe you can sell the Oct10/12.5 put spread. Spreadsare a problem when optionsarethinlytraded.Youhavetoanticipate being forced to

hold to expiration.Youwanta GOOD price to make thistrade, knowing that lack ofliquidity will becomeimportantifyoueverwanttoadjust or exit the trade. Isuggest 30 to 35 cents. Sure,you can accept 25 cents, butatsomepricetheriskwillnotjustify the potential gain.Again, that is something foryoutodecide.Itdoesdependon just how bullish youchoosetoremain.Warning:It

is easy to sell too manyspreads when losses arelimited. [The loss may belimited, but the chances oflosing the maximum are farfrom zero. It is common tobecome frozen and unable toact when a trader has apositionthat is larger thanhecan handle and troublelooms.]

Bottom Line: If your ‘short-term bullish outlook’ has

expired,thendonottradethisstockatthistime.

TheWinningMindset

I never force the sale ofoptions.Inevermakea tradejust to ‘do something. ’ Inever make a trade out ofboredom. If there is no tradethatsuitsmyneeds–andmy

need is to open a positionwith numbers that I like:maximum loss vs. potentialprofit, combined with theprobability that my shortoptions will not ‘get intotrouble.’

Translation: The shortsremain far enoughout of themoney so that I remaincomfortable owning theposition. There are nospecific numbers associated

with getting into troublebecause each individualtradermustdefinethebordersof his own comfort zone. Iknow there will be plenty ofopportunities in the future. Itmay be tempting to ‘make afew extra dollars’ by sellingfar OTM options and watchthem expire worthless, butrisk is too large for the tinyreward, despite a highprobabilityforsuccess.

When bored, I take a breakand walk away from themarketforawhile.To DL: I must reemphasizethatsellingnakedoptionscanresult in a large loss. Youmust have an acceptablereturn inexchange for takingthatrisk.Idonotrecommendselling naked options. Theonly exception: It isacceptable to write cash-secured puts when the trader

wantstoaccumulatesharesata price below the currentmarket.

Sellingoptionsandcollecting$0.05 or $0.10 apiece is alosing game over the longer-term. Please remember this:You spent $7,500 on calls.Whensellingputs,youwouldsell so few that the dollarsearnedwouldbarelydentthatloss.Don’tdoit.

Important mindset: When Ilose money, I never believethat the specific stock orindex ‘owes’ me anythingand I avoid the trap ofseeking revenge. Myobjectiveasatraderistoearnmoney. The net liquidationvalueofmyaccountdoesnotknow the source of profits.Nor does it know whichtrades resulted in losses. Alldollars earned spend thesame. I let the losses go and

seek a better trade – whenI’mready.‘Hope’isnotastrategy.Tradinglimitedlossstrategiesrequires recognition that thepossibility of incurring themaximumlossisreal.I enjoy the reduced risk oftradinglimitedlossstrategies,such as: credit spreads, debitspreads, iron condors,

butterflys, calendars,diagonals etc. I’ve learned toavoid a blind spot that trapsmany rookie traders:A trademay have a limited loss, buttraders must not own aposition that is too large.Losingthemaximumpossibleamount is something that isgoing tohappenonoccasion,nomatterhowcarefulyouareinmanagingrisk.

EXAMPLE:You are willing to buy$15,000worth(200shares@$75)of stockandunderstandthat it is possible, but veryunlikely to lose that$15,000.Losingevenhalf thatamountisveryunlikely.

When you sell an October70/75 put spread, collecting$150,itispossibletolosethemaximum ($350 per spread).

Do not make the mistake ofselling20spreadswhenyouralternativeistobuyonly200shares.The20-lotscanresultin a $7,000 loss (20 * 350)and that is farmore likely tohappen than seeing the stockpricegetcutinhalf.

Trade size is important. Ifyou want to buy 200 shares,then trade two of these putspreads. Do not trade largersize.Thatisatraptoavoid.

***THIS MINDSETALSO APPLIESWHEN EXITING ATRADEIfyesterdaywouldhavebeen(lookingback)agoodtimetoexit because some of mygains have gone away today,Iacceptthatfact.Yesterday I elected to holdthe position and target an

even larger gain for reasonsthat were appropriateyesterday.Todaythesituationhas changed and if I believethatitisagoodtimetoexit,Iexit.Idonotdwellonthefactthat yesterday would havebeen better. Imust dealwiththesituationasitexiststoday.Ithasbeendemonstratedthatpeople believe that losingmoney feels far worse thanmissing an opportunity to

earn the sameamount. It justhurts more once the moneybelongedtoyou.

CHAPTER12BEINGRIGHTVS.MAKINGMONEY

The successful trader doesnot assume that once aprofitableapproachtotradinghas been discovered, allhe/shehastodoisimplementthat strategy and practice

sound risk management.Times change, marketconditions change, thetrader’s financial obligationschange, etc. Each of these(and other) factors plays arole in deciding how wetrade. It’s important to beaware of the bigger picturewhen deciding whichstrategiestoadopt.

It’s obvious, but when youmarry, raise children, buy a

house,plantopayforcollegeor retirement—your financialneeds change. You probablydon’t want to continuetrading as you did earlier.More responsibility suggestsa less aggressive behavior.Beingawareofthisispartofthe mindset required forsuccess. Know where youstand in planning for yourfinancial future. Thatwill goa long way toward helpingyou decide how to choose

tradestrategies,positionsize,how aggressively to managerisketc.

This simple, not-repeated-often-enough truth, from ablog post by The CrosshairsTraderwas the driving forcefor putting these ideas intowords:

It isnoteasyfor traderswithan incorrectmindset to focusonmakingmoney.Thereisalot of ego satisfaction thatcomes with having made asolidandaccurateprediction.

However,ifyourgoalis(asitshould be) to grow youraccount while taking anacceptable level of risk, thenit is more important torecognize when you arewrongsotradescanbeclosedand larger losses avoided. Itis more important to makemoneythantoberightonanyspecific percentage of yourtrades.

Ifyouacceptthatastrue,then

be certain you are makingtrade decisions based on anappropriate mindset. As anexample, I recentlyrecognizedthatanewwayoflooking at one specificsituationwouldbebeneficial,even though it represented acomplete change. I have notdiscarded that mindset. Itremains near the top of mytrading beliefs. However,other factors came into playwhich made me recognize

that even the most cherishedbeliefscanbeputontheshelftemporarily – for the rightreasons. And who knows?Temporary may becomepermanent.

FIRST A LITTLEBACKGROUND ONMY MINDSETCHANGE.DuringmycareerasaCBOEmarket maker, I stubbornly

refused to cover shortpositions when they reachedtheminimumtradingpriceof1/16 ($0.0625). I wanted toearn those last few penniesand always allowed theseshort options to expireworthless. The more successthat I had, the more itappeared to represent freemoney.Tomakealongstoryshort, I earned lotsofmoneyvia this strategy. However,when the market moved

against those shorts, andwhen the move was suddenand violent, the losses werespectacular and easily wipedoutallpreviousprofits.

After repeating that debacle(morethanonce),Ifinallygotit: Cover those cheap shortpositions and let someoneelse have the last fewpennies. What a differencethathasmade!That iswhy Ipreachtheideathatgivingup

the last nickel or twoon anytrade is a worthwhile riskmanagement technique foroptiontraders.

It is easy to extend my eye-openingrevelation.Ifitisnotright to hold short optionsthrough expiration, it is rightto exit all high risk positionsas expiration nears. Thus, Imoved away from tradingshorter-termoptions.Inthosedays,one-monthoptionswere

the shortest duration. Whenoptions with a weeklyexpirationwereintroduced,itwaseasytoavoidthemonthesimple premise that they hadtoo much negative gammaandthatitwouldbebetterformy personal comfort zone toavoidsuchoptions.

Note: Weekly options arevery popular and areappropriate for traders whorecognize the risk/reward

potential–andwhowill takedefensive action whennecessary.

That worked for me.However, as an optionseducator, it is not right tosubject readers to thatpersonal bias. Thus, I beganto look into trading shorter-term options so that I couldhold serious discussions onwhich strategies to adoptwhentradingweeklyoptions.

Iamstillgunshyofnegativegamma. Istill issuewarningsabout how much potentialrisk there is when tradingshort-term options, but thetruthisthatIalsowriteaboutthe attractive rewardpossibilities.

So, I’ve made the mindsetchange.Itusedtobe:Donotsell options when they comewith significant negativegamma.

Now I think this way: Becautious when trading short-termoptions.Theycomewithhighnegativegammaandthatmakes theminappropriate forsome traders. However, therapidtimedecaymakesthemattractivetoadifferentgroupof traders. Evenwithweeklyoptions,donotholdpositionstoexpiration.Coverallshortsat an appropriate low price.Do not trade the weeklyoptions as a habit. Make a

decision–each time—as towhether current conditionsmake the trade appropriate.Some market conditions(volatileor trendingmarkets)are unfavorable for premiumsellers.

Thebasisforthismindset

Both buyers and sellersare subject to highgamma and high theta.That is just too much

risk for my personaltradingstyle.

When a position haslarge gamma, the valueofanypositionissubjectto a big and suddenchange. As a result, thetrader could earn (ifhe/she has positivegamma) or lose(negative gamma) a lotof money very quickly.[Positive gamma is the

rate at which yourpositiongetslongeronarally (equivalent tobuying more shares) orgets shorter (equivalentto selling shares) ondeclines. If you are notfamiliarwiththeGreeks,please take the time todoalittlereadingonthetopic. For now, theimportant thing to knowis quite basic: Greeksallowtraders tomeasure

risk. When risk is toohigh, we can makeappropriate risk-reducing tradeadjustments.]

Theta describes howmuch the value of anoption changes as oneday passes. We earn(positive theta) or lose(negative theta)significant money whenwe have a position that

is near expiration andthe price of theunderlying does notundergothatbigchange.

Either way—long or short—these options were not forme. Iprefer less risk.Endofstory. I had a closedmind(set).However, I cannotallowmypersonalbiastogetin the way of providing asolid education for allreaders. So I set it aside and

began experimenting withweeklyironcondortrades.We must understand theadvantagesanddisadvantagesof tradingshort-termoptions.Only then can any tradermake a solid decision abouttrading, or avoiding, them.My results were mixed.Profitswereearnedearly,butthen it became a losingproposition when therelatively small premium

proved to be insufficient topay for needed adjustments.Near-term options are fordisciplined traders who havethe will power to do whattheyknowiscorrect.

THE NEED TO BERIGHTHere’s the exaggeratedrationale for avoidingcovering cheap short-termoptions. Please understandthat this is the thoughtprocess of a trader who isunlikelytofindsuccess:

“Icouldhavepaid5cents toexitthistradeandlockinmyprofit,but refused todoso. I

know this option will expireworthless.

I could have paid 10 centsjust a few hours later. It stilldoesnotmatterbecausethesewillsoonbeworthless.

The next morning it wouldhave cost 40 cents to get outofthetrade,andtherewasnoway that I would pay thatmuch.Plus,thereisnoreasonwhyIshould.Iknowitisnot

possibleforthestocktomovethatfarthatquickly.

Today, it’s $1.00 per optionto exit. In otherwords, I amworseoffby$95peroption.Idon’twanttomakethattrade.However, maybe I can getlucky.These options are stilltwo points out of the money($100 stock price), so I amnotyetinREALtrouble.Yes,I admit that I now see thepossibility that I was wrong,

butI’mnotgoingtopay$100peroption.”

This situation is the verydefinition of real trouble. Ifthe stock moves a few morepoints, it could easily costthattrader$400peroptiontoexit. Even a 10-lot wouldresult in a$4,000cost,whenthetradercouldhavecoveredthe whole position for $50.Thisistruetrouble,andwhenthe trader denies that it is a

problem because ‘the optionisstilloutofthemoney,’thenthis trader is not thinkinglogically. This trader is notmanaging risk. This trader isblindtobigtroubleandisnotlikely to survive over thelongerterm.

AVOIDINGTROUBLEOne way to stay out oftrouble and avoid thesituation described above isto cover (buy) your shortoptions positions (spreads orsingleoptions)whenthepriceis attractive (i.e.,inexpensive). Do not hold toexpiration. Do not seek thelast nickel or dime from the

trade.Takeyourgain,andgetout of a potential (even ifunlikely) large loss. That isthewinningmindset.

Adopting that way ofthinking convinced me thattrading all near-term optionsis a risk notworth taking.Aclosed mind kept me out oftrouble.

Whenwehaveamarketbias—bullish,bearish,orneutral,

we WANT to be right. Theobvious reason is that wemakemoneywhenthemarketdoes as we anticipate. Andthat’s a doubly good feeling.Wenotonlyhavetheprofits,but we also have the egogratification that comes withbeing‘sosmart.’

However, when the marketdoes not behave as youexpect (and you know thatwill happen), it ismandatory

not to take it as a personalinsult.The‘market’isnotoutto get you.What the marketcan (and does) do is trap thestubborn (undisciplined)trader.When you arewrong,that shouldbe the endof thestory.Exit the trade; take theloss; live to play again andreconsideryourbias.Itsoundssoeasy.However,itis difficult for many tradersbecause it is contrary to

humannature.Ifwerefusetoacceptthelossaspunishmentfromanangrymarket, and ifwe recognize that statisticalcalculations represent thetruth (if our inputs areaccurate), thenwe know thatthe market will not do asexpected all the time. Weknow that a 99% probabilitymeans thatyoucanexpect tolose one time out of every100trades.

Traders know that theycannot earn a profit fromevery trade. They knowlosing trades are inevitable.Yet, each individual losingtradebecomes itsownbattle:Good risk management(common sense) vs. theneedto be right (stubbornness). Itmay even be recognized thatthetraderdoesnothaveatrue‘need’ to be right this time,but he strives for it anyway.This is not the mindset of a

successful trader. In fact,exitingthetrade,cuttingrisk,acceptingreality(thistradeisa loser), is being right. It isnot being right about earlierexpectations, but it is beingrightnow(whenitisfarmoreimportant).Itisokaytoadmitbeing wrong about anexpectation.

Our true need is to makemoneyover time.Traders donot have towin all the time.

Traders must know when totakelosses.

Our true need is to preventthe large losseswhichhinderour ability to continue as atrader.Manytraderslosetheirentiretradingaccounts,neverto return to the game. Thewinning mindset is to beaware of that possibility andto trade accordingly. Thatmeans we must tradeappropriate position size and

consider how bad things cangetforeachtrade.

Our true need is to practicedisciplined,butnotrigid,riskmanagement.

ADAPTINGTOTHECURRENTMARKET

The current (mid to late-2012) market (generallyrising over the past 12months)makesitdifficultfor

traditional, market-neutral,iron condor traders. To stayahead of the game and haveany chance to make money,the trader would have tomakesomechange tohis/hernormalmethods.

Consider the trader whoadjustsinstagesandplanstocover 20% of the short callspread when the marketreachesaspecificpricelevel.To accommodate a bullish

bias, the trade plan couldencompass the idea ofinitiating the trade with aStageIadjustmentalready inplace:

EXAMPLEAssume the usual (ironcondor) position is short ten15-delta put spreads and ten15-deltacallspreads.

Instead, the new trade couldbe:Short tenputspreadsandonlyeightcallspreads.

ThisisequivalenttomakingaStageIadjustment (buybacktwo call spreads) at the time

thetradeisinitiated.

Another idea is to sell callspreads with a smaller deltathan the put spreads. Thatdelivers less premium, but itis similar to a position inwhich the call spread hasbeen covered and rolled-down to another call spreadthat is farther out of themoney.

TheWinningMindset

Forget about being right.Forget about bragging rights.Makemoneyandtakecareofyourselfandyourfamily.

Idonotbelieveinrigidrulesthatgoverntrading.However,therearesituationsforwhichadhering to a rule makessense. For me, covering

inexpensiveshortpositionsisonesuchrule.

Knowing the answers to thefollowing questions helpsdefineyourcomfortzoneandthus, develops correct andprofitabletradinghabits.

Do you really want totake the risk associatedwith earning the lastcouple of nickels on atrade?

Can you handleincreasing negativegamma that comes withvery short-termpositions?

Can you sleep at nightwhen your short optionshave become ATMoptions?

Do you know exactlyhow much cash can belost if something

unexpectedhappens?

Haveyouchosenatradestrategy that suits yourneeds? Or are youcopyingsomeoneelse?

Do you know yourself?Are you aggressive orconservative?Greedy ordo you have areasonable profit target?Seeking a fortune orsatisfied to use options

to augment yourincome?

Do you recognize thetruth? Options are notfor everyone and if youtruly don’t understandwhat you are trying toaccomplish with yourtrades, that’s okay.There are investingalternatives.

Do you trade with a

confirmation bias, or anopenmind?

MOREADVICE

Don’t be stubborn. Ifyou missed an earlieropportunity,donotmissanother opportunity. It’sokayifthetradeisnotasgoodrightnowasitwasearlier. You live in thepresent and must tradeaccordingly.

Concentrate on

developing a tradingstyle, but there is nourgency for the newertrader. This includesselecting strategies thatyou understand and feelcomfortable trading. Iprefer iron condors, butthere is no good reasonfor any reader to do thesame. There are severalgood ‘income-generating’ strategiesthat rely on positive

thetatomakemoney.

When learning all aboutoptions,pleasetakeyourtime. I know there is aneagerness to get to thenext chapter, the nextlesson, the next book orblog post. Absorb theinformationatyourownspeed. Learn the basicsbefore moving ahead.Havepatience.

CHAPTER13OPTIONTRADINGANDSLIPPAGE

Onenegativeaspectofoptiontrading is that we frequentlyencounter wide bid/askspreads.Thereareexceptions,but we have to anticipateseeingwidemarketswhenwe

want to place a trade. Thatdoes not suggest it isalwaysdifficulttogetordersfilledata decent price, but it doesmakeitdifficulttogetagoodestimate the pricewhere youcan easily get your orderfilled.

For example:You see acredit spread with amarket of $1.00bid and$1.60ask.There is littlechance of selling the

spread and collecting$1.45 or $1.50 (unlessthe price of theunderlying assetchanges). To achievethat price, there wouldhave to be a buy orderfor the spread that youare selling; the orderwould almost certainlyhave tooriginate fromaretail trader; and youroffer would have to bethe lowest available

price at the same timethatthecustomer’sorderis still active (not yetfilled). That’s quite alongshot.

For the most part, wehave to trade withmarket makers.However, if the optionsthat we prefer to tradeare very actively traded,itisquitepossible(don’texpect it tohappenvery

often) thatonecustomermay bid for the optionwe want to sell whileanother is offering theoption we want to buy.When that happens, ourbroker’s computershould be able to spotthe bid and offer andalmost instantaneouslytradewithbothorderstocompleteyour tradeatafavorable price. That’sthe theory. In practice it

would require that bothorders be presentsimultaneously and thatneither order is goodenough to get filledimmediately by themarketmakers,and thatthere is no other order(similar to yours) thatcould grab those twooption orders beforeyour broker’s computercan act. That is anotherlongshot.

Thepoint is that tradingisnotcheap.Every timewe enter an order wemust expect someslippage (getting ordersfilled at a price that isworse than themidpoint). Ifweassumethat the middle price—between thebidandask— is a fair price, thenalmost every trade isgoing to be worse thanthat fair price. Because

that happens,we cannotafford to trade toofrequently. NOTE: Donot refuse to make atrade just to avoidslippage, but do avoidmakingfrivoloustrades.

When we use income-generatingstrategies,weearn money throughpositive theta (timedecay). We overcomethat slippage by holding

onto our trades. It isimportant to recognizeapotential mindset error:We are not entitled totime decay profits.When we hold anyposition,themarketmaynot behave. We maywait for theta to comeour way, but we couldlose far more moneythan theta provides.Waiting to collect thetacomeswithrisk.

We cannot ignore that riskand must apply our riskmanagementskillsasneeded.Weholdpositionswhen theyare working, risk is withinourcomfortzone,andthereisnoothercompellingreasontoadjust or exit the position.Thatishowthetaiscollected—by taking risk. It is notsomethingthatjustdropsintoourbankaccount.

TECHNICALANALYSISWhen using technicalanalysis to make entry andexit decisions, the tradinggame is all about timing.Non-optiontradersmayexitatrade within seconds orminutes, earning a fewpennies per share per trade.Overcoming slippageprevents(orextremelylimits)

the probability of being ableto grab a quick profit whentradingoptions.

With the type of strategies(“income-generating”) that Imost often recommend, wetake into considerationspecial items that are of nointerest to the short-termequitytrader:

Is the implied volatilityhigh or low? In either

situation, we plan tohold the position untilIV reverts to the mean.The equity trader wantsthe stock price tochange, and optionpremiumlevelsareofnoimportance.

Has the market beenvolatileorcalmovertherecentpast?Thesuccessof your strategy maydepend on the stock

market remainingvolatile or calm. Theequity trader looks onlyfor the predicted pricechange.

Is the market trendinghigherorlower?Traderswhofollowatrend,holdpositions, allowingwhatever time isrequired for the trend towork.

Isanymajornewseventoverhangingthemarket?That often affects theimplied volatility of theoptions and you mayprefer to exit prior tothatnewsrelease.

Do you have too muchdelta, gamma, theta orvega risk? Risk ismeasuredbytheGreeks.When any specific riskfactoristoohighforthe

personalcomfortzoneofthe trader, it is prudentto reduce or eliminatethatrisk

TheWinningMindset

When a trader anticipates adecent-sized market moveover thevery short-term,andwants to make a bet on the

direction of that move, thebestplayistoownanin-the-money put or call option,with the premium as low aspossible(minimizinglossesifthe option becomesworthless).Thereisnoreasontobuyorsellaspreadwithitsembeddedslippage.

NOTEWhenyoumake

thisplaybecausenewsispending,expectoptionpricestobehigh.When‘everyone’

knowsthatnewsiscoming,optionsareindemand(lotsofbuyers,fewersellers),

andpricesmovehigher.Whenitisknownthatapricegap(eitherhigher

orlower)ismorelikelythanusual,optionsbecomeattractiveforthespeculator—

despitethehigher-than-normalpremium.Becautiouswhenmakingabullishorbearish

play(buying/sellingsingleoptions)undertheseconditions.Spreadsarealmostalwaysabettervalue

(becausespreadscomewithlessvegathansingleoptions)forthebuyerandprovide

atonofextrasafety(bylimitinglosses)fortheseller.

Never delay a neededadjustmentorexitbecauseof

tradingcosts.Slippageispartofthecostofdoingbusiness.This does not mean thewinning trader pays the askprice or sells the bid price.Traders always try to gettrades executed at decentprices, but know in advancethat some slippage occurswhentrading.

Be aware of tradingcosts. That includescommissions,

exercise/assignmentfees, or anything elsethatyourbroker chargeswhenfillinganorder.Avoid trading when theprofit potential (aftercommissions) is toosmall.NEVER worry abouttrading expenses whenthe position is outsideyour comfort zone.Risk

managementcomesfirst.Use common sense orunderstand the positionGreeks to get a handleon what can go wrongwiththeposition.

CHAPTER14HOLDINGA

LOSINGTRADE

“DearMark,

“How can the $155Salesforce (CRM) call bepricedat$4,andthe$160calltradeat$2.50–whichmakesthebreakevenpriceforoption

buyers $159 and $162.50respectively? The stock isonly $147 and there are twodays left before the optionsexpire!

“Thisisaveryjuicypremiumon OTM options when thestock has little chance toreachthestrikeprice.Whyisthe implied volatility so high(it is 157)? Am I missingsomething?

“By the way, the regular 3rdFriday Aug options havealready expired and mybroker is still showing someAugustoptionsthatexpireonAug24(thefourthFriday).”

THEREPLYThese Aug 24 options are“Weeklys” options and thereis nothing weird about theexpiration date. The trulyunusualthingisthatyouwant

to make a trade using thoseoptions despite the fact thatthere is some factor aboutthem that confuses you. Theexchanges list options thatexpire at one-week intervalsforsomeofthemostactivelytraded stocks and indexes.ThatisthesituationforCRMoptions.

Itisdifficulttoestablishrulesthat always apply to tradingsituations. There are almost

always exceptions for everyrule. However, this rule ismandatory:

Please be 100% certain thatyou know these options arenot something special anddifferent.

It is so true that we don’tknowwhatitisthatwedon’tknow. This time there isnothing to fear because the

option exchanges have beenlisting Weeklys options forsome time and they arestandardizedoptions in everysense except for that unusual(to you) expiration date. I’msurprised that you wereunaware of their existence—especially when you want tomakeatrade.

It is also important torecognizewhen something istoogoodtobetrue.Thereare

toomany situations inwhichthe unaware trader can getinto trouble. And newspendingisoneofthem.

EARNINGS NEWS. AquickGoogle search tellsmethat quarterly earnings forSalesforcewillbe announcedafter the close of trading onThursday, one day beforethese Aug 24 options stoptrading. The very highimplied volatility tells you

there is something strangegoing on. It is not a smartmove to trade those optionswhen you do not understandthe reason for the highpremium. That is why Isearched for the earningsdate. You could have donethe same.Once you discoverthe truth, itbecomespossibleto make a good decisionabout buying or selling theseoptions.

I note (from othercorrespondence) that you dohave a source for earningsdates,butyoumustknowthatthe accuracy of such lists isnot guaranteed. I hope youunderstand that options donot carry such high premiumunlesssomethingspecialisintheworks.Noonepays such‘absurd-looking’ prices foroptions without a validreason. Similarly, no oneshould sell these options

without understanding whythe premium seems to be fartoohigh. Ifyoudonotknowwhat that something specialis, then it is far better not totrade.

Ihopeyoudidnot justsellabunchofthesepuppies.

Thefollow-upmessage

“HiMark,

“I failed to exercise duediligence, my broker’splatform did not display theearnings date in the columnwhere itwas supposed tobe,and I did not double checkelsewhere. Iwill do that duediligencefromnowon.

“Selling a bunch of thesepuppies is way out of myleague. Thatwould beWAYover-leveraging.Ididsellone165callat$1.40yesterday. I

was thinking that it is somekindoferrorandIwanted toget in on the action small—puregreedandnoplanonmypart—I curse myself now asthiswasimprudent.

“Andoneday later (it is stillprior to the newsannouncement) I don’twantto take a $15 loss and I canjustify to myself the plan tohold to expiration by thisreasoning: stock already had

anicerunupinpasttendayson earnings expectations.Dividend per share isnegativebecausetheyarestillacquiring and building theirempire. So, some smartmoney that is alreadyinvested, may unload now.And most important—I stillhavea$17.50cushioninthestock price before I startlosingmoney.”

MYREPLYBe careful. Not wanting totake a loss is a dangerousmindset: You already lostmoney. It may only be $15,but right now your trade isunderwater. Sure, there is avery good chance that youwill earn a profit if youcontinue to hold, but adecision is required: Do youwant to take the risk thatcomes with seeking the

potentialprofit?Icannothelpyoumakethisdecision.Yourposition size is good, so noloss is likely to really hurt,butadecisionisstillrequired.You should not make thisdecision on whether or notyour trade is currentlyprofitable.

Your reasoning is a perfectexampleofconfirmationbias.Youwanttoberight.Youdonot want to admit making a

mistake, so you justify thesaleofthecalloption.

You are allowed to remainshort and you are allowed tohold the position. I stronglyurge you to do that only forthe right (reasonable,realistic) reasons. In myopinion, none of yourrationale is reasonable. Theworstreasonofallisrefusingto accept a $15 loss. If thattiny sum gets in the way of

good decision-making, howcan you expect to managerisk for any position thatfacesagood-sizedloss?

If you had no position andwere first looking at theseoptions (now that you knowabout earnings news) wouldyou feel the same? Is yourrationale truly that of anunbiased person? Far toooftenwe‘talkourbook.’Thatphrase means that we say,

and make ourselves believe,that we have an unbiasedreasonforourbeliefswheninreality, those beliefs are100% dependent on ourposition.Wewant to believewe made a good trade. Wewanttobelievethatwemadea smart trade. Ifwe lose,wearegoingtochalkituptobadluck. “Talking your book” isnotaviablemindset.

Youhaveaverygoodchance

toearnaprofit.Theproblemis that there is no goodestimate of your exposure.We have no idea how highthisstockmayriseduringonedayofeuphoria.

If earningsaredisappointing,oronlyslightlybullish,whenthe stock next trades (Fridaymorning, after the news isout) the stock will not movenear $165 and you will beabletocoverat$0.05orwait

for the end of the day. Iwould buy those options.Onoccasion, the marketreconsiders its originalinterpretation of the earningsnews because the ensuingconference call offersunexpectedfutureguidance.

Thepointhereisthatyoucangain no more than the $145premium collected, but yourpotential loss is far larger. Isit an acceptable risk? For

most traders it is acceptableto hold onto a one-lot—ifthey allow themselves to sellnaked call options.Now thatyou understand what isinvolved when being shortone call—and believe mewhen I tell you I understand— perhaps you would notmakethetradeknowingwhatyou know now. However,youhaveadifferentproblem.You cannot bring yourself toaccept a small loss as the

priceoflearninganimportantlesson.That isan impossiblemindsetoverthelongerterm.

Do remember that the stockmay run another 30 pointsafter the Friday-morningopening. Be aware of whatyouaredoing.

Yourprimarygoalasatraderis to make money—fromtoday into thefuture.Stayingshort this call option is one

waytodothat,butbecertainthat is the position that youwanttoown.

Do not think in terms of: ‘Istillhave17pointsofsafety,’or ‘I sold this option and Icannot cover.’ Those 17points (and more) candisappearattheopening.Thatis only an 11% move. It isunlikely, but not impossible.The important lesson aboutearningsnewsandpricegaps

is this: The option is notpriced to accommodate atypical bullish rally. It ispriced for the fact that someportionofthetime,theoptionis going to be so far ITMwhenthestockopens,thattheaveragevalueoftheoptionis$145.

MORE FROM THEMESSAGE“Should I be afraid to let it

expire if CRM opens farbelowstrikeprice?”

Yes. If you win this time,plan to cover at $0.05because the stock price maychangeduring theconferencecall.

The true decision is whetherto hold thorough theannouncement. You shouldnottakethisriskjustbecauseyousoldthecall.Youshould

take the risk only if it isjustified. So now that youknowtheplusesandminuses,you must decide whether toholdorcover.

“Igotoutwitha smallprofitwhen stock dipped earlier. Ichosenot towait throughtheearningsnews.”

All’s well that ends well. Ilike your final decision toexit. However, please

(please):

The best part of this is thatyou learned a couple ofBIGlessons and it cost nothing.Traders are not always sofortunate.

TheWinningMindset

I only trade markets that I

understand. I will not tradespecific options if the priceseems to be FARout of lineunless I discover the reasonfor that out-of-line price.Why? Because trading thoseoptions assumes thateveryone participating in themarket is being foolish. Thatisnotpossible.

I will only trade an optionwhen I know the details,including ex-dividend and

earnings release dates. [Oneexample: The spot VIX isNOTtheunderlyingassetforVIX options. The underlyingassetisaVIXfuturescontractwith an expiration date thatdiffers from that of the VIXoptions.]

If I do not know why anoption can be purchasedunder parity (for less thanitsintrinsic value) I will notmake the trade. Options are

never available underparity(European options maybe under parity in certainsituations because theycannot be exercise beforeexpiration)andthereforethereissomethingabouttheoptionpremium that I do notunderstand. After mergers,spin-offs, large specialdividends, the deliverablemaybeotherthan100sharesof underlying stock. It mayinclude cash, bonds, stock in

another company etc. [The“deliverable” is the packagethat a call owner buys (or aput owner sells) when anoptionisexercised.]

There is no such thing as afree lunch. There is no freemoney.Thesemaybeclichés,but they are true on WallStreet.

CHAPTER15WHENTOEXIT

Onebigpartofmyjobasanoptions educator is to helptraders develop a healthymindset about trading. Thisreasonable-sounding notefrom a reader illustrates asubtlepoint.

“Mark,“I hold two iron condorpositionsandtheprofitsofarisverymodestbecause Ihadto adjust each of the tradeswhenthemarketrallied.Iamhopingtobuildupthosegainsby waiting until Friday ormaybe Monday to close. IrealizeIamatriskandcouldlose even this modest gain,especially as the positionshave a growing negative

gamma.“But, isn’t this the trade offwealwaysface?Iamwillingto risk holding a littlelonger.”REPLYLet’s first discuss yourcurrent positions. Then wewill lookat theproblemas achoicebetweentwomindsets.Yes, this is a commonproblem:Dowetakewhatwe

haveorcontinuetohold?Ironcondor(andsimilar)positionscome with positive theta(time decay) so we areprogrammed to preferholding to exiting. However,we do not get that theta fornothing. Nor do we want todo the “obvious” withoutmaking the rational decisionthat the “obvious” representsthebestcourseofaction.Wealwaysaccept the riskof

seeing the underlying assetmakeasubstantialmove.Youmay believe that yourdiscipline is top-notch andthatyouwillbequick toexitonce such amove starts, buteven the most disciplinedtradersmaybeawayfromthecomputer screen for a shorttimeormayget stubborn fora few minutes. Even worse,sometimesthemarketsgapatthe opening leaving you notime to act before losses

becomesignificant.Thus, the constant decision:hold‘emorfold‘em.Inyourexample,thereisnoreasontoget out right now, when themarket is so calm. Once themarket opens and youescaped the risk of anopening gap, it is reasonableto plan on holding for theremainder of that one daybefore deciding what to donext. Just recognize that

holding overnight presentsanothergaprisk.I know you want thatweekend time decay, but bignews events can occur overthe weekend. Also considerthe fact that market makersare sophisticated folks andthey do not want to load upwith weekend time decayeither. Thus, option pricesoftendeclineonFriday.Lookat it as a weekend discount.

Thus,exitingFridayisnotaspainful as it seems becauseyou sacrifice less time decaythan you may expect. Youshould compareFriday/Mondaypricechangesto see how this works foryour specific underlyingasset.You probably know all thatand understand youralternatives. However, I’mraising these important

questions:

Why does the fact thatyour gains are modestaffect your decision?You know that if thetrades had been bigwinners you wouldavoid all additional riskand accept those juicyprofits.Why is it so difficult toaccept modest profits?

You made a risk-reducing adjustment toeach position. That stepprobablyreducedoverallprofitpotential. Isn’t themodest profit goodenough under thecircumstances? Aren’tyoupleased tohaveanyprofit after goingthrougharoughperiod?You seem to beconcerned about the

chances of seeing these‘modest’ gainsdisappear. I may bemisinterpreting yourfeelings,butitsoundstome as if you are nolonger within yourcomfort zone and thatyou refuse to exitbecauseyoubelieveyou‘deserve’more.

Whyisitdifficulttoseethatyoualreadyearnedanice profit and a bigpayoff? By adjustinginsteadofexitingearlier,you were able to movean underwater trade tothe profitable category.That’s a nice recovery

from where you were.Yet that does not seemtomatter.Do you knowwhyyouthinkthatway?It seems ‘natural’doesn’t it? The keyquestion to ask everyday is: Do you want toown this position rightnow?

Regarding the mindsetalternativesIn my opinion, it does not

matter whether you have acurrent profit or loss. It doesnot matter whether the tradeisabigorsmallwinner.Youownapositionrightthismoment.Doyoulikeit?Doesit fit your investing/tradingobjectives?Doyoustillwantto own it? Nothing elsematters. I do recognize howdifficult it is to live by thatidea. We all want to holdtrades until they become

profitable. There is nothingwrong with that concept, aslong as the position isworthholding.These positions are eithercomfortable to hold or theyare not. Look at the currentpremium you would have topaytoexit.Wouldyoupreferto own the specific positionwe are discussing today—atthat price? Or would youprefertoexitbecausetherisk

and reward combination isjust not good enough towarrantholding?Isn’tthatallthatmatters?

Whyshouldtheoriginalpriceofthetrade(andyourcurrentprofit level) make adifference in how you feel?You had a loss, salvaged thetrade, andnowhave aprofit.Isn’t thatgood?Doyouneedbetter?The past is history and you

own this trade rightnowandhave to make the hold/exitdecision. That decisionshould not be difficult tomake. And if you cannotmakeit;ifthereistruedoubt;then exit half and hold half.NOTE:When exiting in thisscenario, there is noemergency.You do not haveto pay the ask price nor sellthe bid. Enter a reasonablelimit price that has a goodchancetobefilled.

Right now, with theunderlying in its sweet spot(no shot option is beingthreatened) and expirationrapidly approaching, sometraders would love to holdthis trade. I prefer to find alow-cost exit. But it is yourdecisionthatcounts.Make a new plan. Youmustmanagerisk,andmayhavetoabandon the trade underduress. However, you have

moreflexibilitywhenyouareon the winning side simplybecause more options areavailabletoyou.Suggestions:Plantoscaleoutofthetrade,afewlotsatatime.Pickyourprofit targets and exit whenthey are achieved.Donot bestubborn. If the risk/rewardpicture changes, so must theplan.I do not like hard and fastrules. I prefer that a trader

learn to think for himselfunder stressful conditions.Right now, there is no stress(!) and that’s wonderful.Sometradesare like thatandwehave to count on them tomake our biggest profits ofthe year. It would beunfortunate to take a losshere, but it remains apossibility.The bottom line is that youare willing to hold a little

longer. This time, I concurwith that decision. Sitting atthe sweet spot does make adifference. However, I muststress the idea that avoidingan exit because the profit istoo small is not a long-termviablewaytotrade.You will face a similardecision every day—forevery position that you trade— (if not every hour), untilyoufinallyexit.

TheWinningMindset

Iknowitisnoteasyforeverytrader to accept this way ofthinking. However, I firmlybelieve it distinguishesbetween the gambler and theperson who wants to runtrading as a profitablebusiness.

I cannot base a hold/exitdecision on my profitabilityforthetrade.Eachpositionisworth holding (or folding)based solely on where itstands at the time a decisionmustbemade.Thisissimilarto the hold/adjust decision.TherightmindsetistoignoreP/L and recognize that thecurrentpositioniseithergoodenough to own now, or it isnot.

If current risk isunsatisfactory (either toolargeor tooimminent); if thecurrent remaining reward istoo small, if I feeluncomfortable with positiondelta, gamma, vega, or theta;if I am torn between mychoices, then it is time toclose the trade and removeriskandanxietyfrommylife.IfIhaveaniceprofit,that’sabonus. But it does not affectmydecision. If Ihavea loss,

that’snotasnice,but itdoesnotaffectmydecision.Mygoalasatraderistomakemoney. That means tradingfor profits and holdingpositions that have goodpotential.My goal is to exit unworthypositions because thosepositions are likely to resultin losses. Another subtlety:The position may have beenworthyofyourtradingdollars

when it was initiated, but ifthings change and theposition has shifted to thedark side (may the force bewith you), it is time to getout.

ANOTHERVANTAGEPOINTYouknowwhataprofit is.Itis exiting a tradewhen thereismore cash inyour accountthan when you made the

trade.You know a loss when yousee one: Your account hasless money in it than whenyouinitiatedthetrade.I have an underwater tradeand choose to make anadjustment (rather than exit).Thatrisk-reducingadjustmenttrade turns a $400 loss to a$50loss.Tome,thatisareal$350gain tomyportfolio.Adifferent tradermaycorrectly

call ita lossandnotaprofit,but it is a big recovery fromthe point at which the tradercouldhavedecidedtoexit.Infact, it is such a goodrecovery that I would bepleased with the result.Wouldn’t any trader? Ifinstead of that $50 loss, itwere a $50 profit, wouldn’tthat still be a good result?Sure the latter is better, butneither should be adisappointment.

Pleasedonotbelievethattheprofit is insufficient becauseit failed to meet pre-tradeexpectations. This trade didnot work as planned. Anadjustment was necessary.Youmanaged the tradewell,earned a good recovery, andyetyouhaveaneedtowritealargerprofitnumberintoyourtrade diary. My advice is totake the good result and exitthehigh-riskposition.

If you continue to hold, onlytwo things can happen. Thefirst is that your profits willincreaseandyoucandoabitbetter than where you standtoday. The other is that theprofits begin to fade and thefinal result depends onwhenyoupullthetrigger.Isn’tthatgambling?This is a business, not agambling casino. Imust owngood inventory. I am not

married to this trade justbecause I expected a betterresult.

CHAPTER16

ADJUSTING:HOWMUCHSHOULDI

INVEST?

Atraderbuys(orsells ifyouprefer that terminology) aniron condor, collecting $250credit. The market movesagainst the position and thetrader decides that he is no

longer satisfied with hisholdings.For thepurposesofthis discussion, let’s assumethat one of the short optionsis not far enough out of themoney for this trader’spersonal comfort zone.Somethingmust bedone.Hecan adjust, reduce positionsize,orexit.

Keeping this discussion verybasic allows us to focus onone specific point: Is there a

limit on how much cash atrader should invest in thisposition when making anadjustment? The goal is totransform this ironcondor sothat it becomes good enoughtohold.

Let’s assume that the traderfaces two (and only two)choices:

Pay $400 to close thetrade, losing $150 per

ironcondor.

Pay $300 to roll downthe threatened spread toa more comfortable setof strike prices, usingoptions with the sameexpiration.

Let’s make the followingassumptions

This adjustment trade issomething the trader

wantstodo.Itisnottheresult of forcing anadjustment for the solepurpose of ‘refusing toacceptaloss.’

Theadjustedironcondorisapositionthetraderispleasedtoown.

Potential gain from thispoint in time is goodenough to justify anyrisk associated with

owningtheposition.

The trader’s comfortzone is no longerviolated.

The loss ($150) is lessthan the maximumallowable loss, asdescribed in the tradeplan. (Establishing amaximum lossencouragesdiscipline.)

Considering alternative

adjustment trades is notpartofthisdiscussion.

Thelosingmindsets:

“Irefusetotakethelosswhen there is even aremote chance to turnthis trade into awinner,and therefore I will notexit”

“I refuse to adjust any

trade when the bestpossible result (afteradjusting) is a smallloss.”

Whenadjustingthe$250ironcondor, most traders arewillingtospendupto$150orperhaps $200 to ‘fix’ theposition. That allows for thepossibility of coming outaheadwhenthesmokeclears.

There is another group of

traderswhowouldmake thistrade–evenwhen they dislikethenewly-adjustedposition.

Why would anyone do that?It’s done in an effort to ekeout a profit from the trade,despite the fact that the newposition is not worthy ofbeing in the portfolio. It’sdone because the traderpostpones an unhappyending. In other words, nolosshasbeenbookedyet,and

the trader believes thatwhenthe trade remains open thereis a chance to exit with aprofit.

It’s true. Such a chanceexists. But it is far better togiveupthisbadtradeandtryto earn money from anappropriatefreshtrade.

In other words, theadjustmentwasmadeonly toavoid locking in a loss. The

trader knows his chances ofsuccess are poor because healready dislikes the newlyadjusted position.Nevertheless, avoiding thelocked-in loss (for themoment) is the mindset thathauntshim.Ihopethereisnodoubt that this is a losingmindset. Some positionswilllose money and they cannotbesalvaged.

Inmy opinion, abandoning a

bad trade and substituting anew trade that meets thetrader’sneedsshouldproducebetter results, on average.Traders are not well servedwith a mindset that makesthem unwilling to let go oftheirlosingtrades.

There is a different scenarioto consider: The situationchanges when an adjustmentcosts more than the initialcredit. When the adjustment

would cost $300, this groupoftradersrefusestomaketheadjustment because the bestpossible result for the post-adjustment trade–assumingthe best possible result–is alossof$50.Our trader isnotgoing to own a trade forwhichthereisnowaytoearna profit. For this trader,adjusting when the cost ismore than the initial credit isoutofthequestion.Heexits.

This is a common way ofthinking. The logic feelsimpeccable.Afterall,atradercannot earnmoneywhen thetradecannotpossiblebeclosefor a profit. Surely (says theincorrect mindset), it has tobebettertoexitrightnow.

This represents the loser’sargument. If you come awayfromthisbookunderstandingwhy this is not the winner’smindset,thenIknowyouwill

beamoresuccessfultrader.

The better mindset: “I amnotwillingtoexitwhenthereisanadjustmentthatgivesmeaposition that Iwant toownand which comes with anexcellent opportunity torecoverpartoftheloss.”

Let’s look at the trader’ssituation from a differentperspective. Ignore profitsand losses for amoment and

consider:

The iron condor is nolonger priced at $250.Thecurrentmarketvalueis$400.

When making tradedecisions today, it isnotefficient to dwell on atrade opportunity that isnolongerpossible.Lookat thenumbers nowanddecideonthebestaction

totakenow.

Alsoconsiderthis:Thetraderis willing to spend $400 toexitthetrade,butisunwillingto spend $300 to adjust thetrade,eventhough

The newpositionwouldbe good enough to ownasabrandnewtrade.

The new position islikely to earn money

from today until theposition is closed.Translation: The finalloss is likely to be lessthan the current $150loss.

Yet, the trader prefersaccept the loss, ratherthan adjust. This cannotbeasensibledecision.

There is no disputing thatsometradesshouldbeclosed.

However, basing theadjust/exit decisionexclusively on how much itcoststoadjustthetradeisnotasoundpractice.

That mindset is verycommon.Iencouragereadersto accept the followingargumentinstead:

It is better to own a goodposition when it is availableat a good price, rather than

refuse to own it because itwas built from a previous,losing trade. If you wouldopen a new position that isidentical to the position thatyou refuse to ownbecause itistheresultofanadjustment,thensomethingisnotmakingsense. The position has thesame chance to earn moneyfrom today into the future–regardless of howorwhen itwasborn.

Your records may tell youthatitcanneverbeprofitable(based on the original entryprice) to own a specificposition, but that does notmean you must reject theadjustmenttrade.Ifyouallowrecordkeeping to affect yourtrade decisions; I suggestfindinganalternativemethodfor keeping your traderecords.

Donot ignoreanopportunity

toearnmoneyfromapositionthatmeetsallyourcriteriaforagoodtrade.Thisistheheartoftheargument:

TheWinningMindset

DoIwanttoownmycurrentopen position now? Do Ibelieve I can earn moneyfrom this position? Is thereanyreasontoavoidthetrade?

OristhereabettertradethatI

canmakerightnow?Inotherwords,shouldIquitthistradeand invest my moneyelsewhere?Isthatothertrademore attractive? Do I haveenough capital to own bothtrades?Isthataviableidea?

The winning mindset allowsthe trader to consider thosequestions. It does not requireclosingapositionbecausetheoriginal trade generated acash credit that is no longer

relevant. We own a positionright now and must decidewhether to exit the trade ormake a risk-reducingadjustment that requires acashinvestment.

Buying good positions at afavorablepricewithadecentrisk/reward ratio–isn’t thathowweselectourtrades?

Ifthetradeisgoodenoughtoownitdoesnotmatter that it

is an adjusted trade with alocked-in loss. It is farbetterto earn money (and we onlydo that in the future) from agoodpositionthantogiveupon a trade because of somebookkeepingconsideration.Atrader’s job is to grow theaccount value by owningpositionswithacceptableriskandrewardpossibilities.

Whenthinkingaboutthecostof adjusting, that decision

mustbemadeamongcurrentchoices, and has nothing todo with the original tradeprice. The choice is: exit attoday’s price; or adjust attoday’sprice.Makethebetterchoice.

That’s the path to success.However, it does requireadopting a mindset that maybedifficulttoaccept.

CHAPTER17

MAXIMUMALLOWABLELOSSLet’s continue the discussionfromthepreviouschapter,butfrom a different perspective.It is time to think about onesituation that occurs(hopefully, not too often) fortraders. When the winningtraderinitiatesanewtrade,he

writes a tradeplan as part ofthe process. The specificportionof theplanthat is thefocus of our attention issettingamaximumallowablelossforthegiventrade.

Definition: During thelifetimeofatrade,ifthetotalloss reaches a specific level,the disciplined trader closesthe position and accepts thatloss. This serves twopurposes. First, it gets the

trader out of anuncomfortable position.There is a big psychologicalbenefit when doing thatbecause the trader can nowforget about the risky trade,the mounting losses, andanythingelsethatbothersourtrader when working tomanageaposition that is notgoingwell.

Second,itpreventsapendingdisaster. The trader who

procrastinatesor iswilling tokeepthepositionopen‘justalittle longer’ may discoverthathesoonreachesthepointwhere he tells himself: thereis‘nowayI’mgoingtotakealoss that this large.’ If youdon’tbelievethatthisthoughtcanoccurtoyou,pleasethinkagain.Thesamemindset thatencouragesa trader toholdapositionuntil it ‘getsback tobreak-even’(Chapter11)isatworkhere.Itissotemptingto

believethat thingscannotgetmuch worse (or at least notgetmuchworseveryquickly)andthat there isstill timeforthe trader to show disciplineand take defensive action. Itis a fact that some tradersholdshortcreditspreadsuntilthey achieve the worstpossible result (spreadreaches its maximum value).The same is true for ironcondor, butterfly, diagonaland calendar spread traders.

Some lack the discipline totake the action promised inthetradeplan.

Ifyoueveralloweda5-pointcredit spread to reach that$500 maximum value (i.e.,bothoptionsareinthemoneyat expiration), then youunderstand how it neverseemed to be an appropriatetime to exit.Once the spreadreachesacertainpoint,manytraders just close their eyes

and hope for the best. Forexample, no one would pay$490 to exit because themaximum additional loss isonly anther $10 and becauseit is still possible for thespreadtolosevalue,allowingthe trader to get out with amuchsmallerloss.

But, if youwould never exitby paying $490, how aboutpaying $480 or $470?Doesn’t it seem right tohold

once the position is that farunderwater? It has to seemreasonabletoriskanother$20or$30forthesmallchancetorecoverupto$470or$480ifyou get an unexpected luckybreak.

Thisreasoningcangoonandon.When thathappens, thereis never a point atwhich thetrader I willing to accept thelarge loss and get out of theposition. For that reason, it

pays toestablishamaximumpossible loss and that meansgetting no later than whenthatlossisachieved.

The whole point of thisdiscussionistoavoidholdingontoanytradeuntilitreachesa price at which you decidethat “there is no point inexitingnow.”

WRITING THE

TRADEPLANLet’s be honest, writing atradeplanoftenseemstobeawasteoftimebecausetradersbelieve they will actappropriately—if andwhenatrade decision becomesnecessary. However, writingthe plan makes decisionseasier to make. In otherwords, pulling the trigger onan adjustment (or otheraction) is much less difficult

when the decision wasmadein advance, under non-stressful conditions. Thoseadvancedecisionsinclude:

Establishing a targetprofit to be certain thetrade is worthwhile andtohelpthetradertakeontoo much risk by beinggreedy.

Establishingamaximumallowable loss for this

trade.

Deciding at what point(price for theunderlyingasset, delta of shortoptions, time toexpiration) you want tomake an adjustmentbecause at that pointyourriskparameterswillbe out of line with theboundaries of yourcomfort zone and thataction to reduce risk is

needednow.

We all know that takinglosses is a necessarycondition for traders. We allprefer not to take thoselosses. However, refusing totake a loss is a dangerousmindset. There is no goodreason for owning a positionwhen:

You no longer like the

position, for any of anumberofreasons.

The trade has becometooriskytohold.

The trader’s maximumloss for the trade hasbeenreached

TRUESTORYAs described in the previouschapter,itmaybedifficultforsome traders to invest morethan a predetermined suminto a position adjustment.I’ve received severalcomments/questions on thistopicfromreaders.Wheneveran adjustment costs morethan the maximum possibleprofitfromtheoriginal trade,itiseasytoabandonthetrade

—rather than make a solidinvestment that truly makesthepositionworthowning.

Important clarification: Thediscussion below assumesthat the adjustment is goodand that it is necessary. Itassumes that the adjustmentis not made for the solepurpose of avoiding an exitthat locks ina loss.This is avery important point. Manytraders adjust just to stay in

the position. Do not dependon good luck to protect theassets in your tradingaccount.

There is nothing wrong withexiting when you areuncomfortable with a trade.Thus, the decision to exit isalways acceptable. If youprefer never to adjust aposition, that isacceptable.Itmaynotbethebestlong-termmethodology, but if it feels

righttoyou,thendoit.Beingcomfortable with tradedecisions is one way for thetradertoavoidstress.

When you have a choicebetween two reasonablealternatives it’s important tomake the trade that leavesyou satisfied. We may nottalk about psychologicalsituations very often.However, it is alwaysadvisable toavoid trades that

leave you emotionallyunsatisfied. Here is onesimpleexample.Ifthechoiceis between buying in a shortoption vs. waiting until itexpiresworthless,Iamhappytobuythatcheapoption.SoIdoit,evenwhentheoptionishopelessly far out of themoney. Feeling good aboutmy trades is important. Justremember that the final,adjustedpositionmustbeonethatyouwanttoown.

Iftheaboveconditionsabovearenot satisfied, then choosethe exit. Why did our traderchoose to exit the originaltrade (Chapter 16), paying$400 instead of making agood adjustment and paying$300? Answer: Because of alosing mindset. It is notuncommon for traders toabide by certain ‘rules’ withno idea of the rationalebehind those rules.Note thatclosing the position was not

wrong. It was just the lessappropriate choice for mosttraders.Rememberthatifthispersondidnotwant toadjust—for whatever reason—thatisacceptable.

Assuming that anyadjustment is made forappropriate risk-managementreasons,thenthetruedecisionis based on looking at yourchoices right now, andignoringyourinitialtrade:

Do you prefer to investmorecashat thecurrentprice becauserisk/reward and profitpotentiallookgood?

Do you prefer to investthe necessary cash –rightnow–togetoutoftheposition(exit)?

Youcannotdoboth.[Ok,youcanexithalf thepositionand

keeptheotherhalf.However,this discussion involves howto think about deciding whatto do, so let’s keep it a‘choice between alternatives’decision. Choose betweenexitingoradjusting.]

TheWinningMindset

The original premium shouldplaynoroleintheadjust/exit

decision—If you are adisciplined trader (with atrackrecordtoproveit),thenyou can be flexible—for thecorrectreasons—onceatradereaches the maximumallowable loss. It is not agood idea tobelieve thatyouare disciplined. Demandproof(trackrecord).

You have a position—attoday’sprice.Nothingcanbedone to change that. You

must exit, adjust, or do theunthinkable (take more riskthanyouraccount, tradeplanand psychological health canhandle.

Do not foolishly throw goodmoney after bad trying tosalvage junk. But do not beafraid tomakean investmentthatgivesyouagoodchancetoearnmoneygoingforward.

This logic can be applied to

anyposition—evenwhenyoualready lost as much as youare willing to lose for anygiven trade. If you trulyunderstand and believe thatthe arguments made in this,and the previous, chapterrepresent the best way tohandlethissituation, thenthe‘max loss’ rule does notapply.YoushouldNOTholdthepositionasitexists,butttis acceptable to fix the trade—ifandwhenyoureachthat

‘max loss’ level. Howeveryou must be honest withyourself. The ‘fix’ has to bereal. It has to severely cutimminent risk. It has toproduce a position youhonestlywanttoown.

Thereasonthatthe‘maxloss’ruleservesagoodpurpose isthat it prevents traders fromallowing losses to hurt atradingaccount.Ifyoudonothave the discipline to handle

the very difficult decision ofcutting losses at some pre-determined point—thenplease adopt and always usethat ‘max loss’ rule. It is inplace to protect a traderagainst making anunreasonable decision underself-imposed duress. If andwhen you reach themaximumallowableloss,youwill be under a lot of stressand may not be prepared tomake the best decision

without a trade plan tofollow.

CHAPTER18

THEKILLERBLINDSPOT

From my perspective, themost important aspect ofteaching risk management tonewer traders is helping

people see the big picturebecause being aware of justhow much money is on theline is not something thatcomesnaturally.Itissomucheasier to make a trade, feelgood about it, and then payfar less attention thannecessary aswewait for ourdeservedprofitstoappear.

Traditional investors buystock or mutual funds andseldom (only after a huge

decline), ifever,worryaboutlosses or give anyconsideration to limiting riskorlearninghowtohedgetheirholdings.

As individuals, we each see‘risk’ differently. That’s onereasonwhythereismorethana single definition of riskwhenthetopicismoney:

Thesumthatcanbelost.

Theprobabilityoflosingmoney.

Theprobabilityoflosingit all (blowing up atradingaccount).

The risk of taking toolittleriskandasaresult,limitingprofits.

The risk of not playingon a level playing field;i.e., being at acompetitive

disadvantage. In today’smarket, with computeralgorithms providing somuch of the tradingvolume,Ihavenodoubtthat we individualinvestors are at acompetitivedisadvantage.

Theriskofnotknowingwhat it is that we don’tknow.Thingsthatappeartobeobviousmaynotbe

true. My favoriteexample: VIX optionsdo not use the CBOEVIX index as theunderlying asset.Instead, VIX futurescontracts represent theunderlying.

TALK ABOUT NOTSEEING THE BIGPICTURE! The following

statement is one of the mostperplexing risk evaluations Iever heard from a traderwhosemainstrategyissellingnaked(unhedged)options.

Discussing the result of ashort strangle trade on avolatile stock, he made thefollowing statement after thenaked short put position wasclosed:

“I was never in any danger.

The stockwas always higherthan the put strike price andtheoptionswerenever in themoney.”

While he was holing thisposition, the options movedfrom far OTM to almostATM and increased in valuefrom$0.80tomorethan$20.That represented a loss ofmore than $1,900 per optioncontract—andhethoughtthathewasneverintrouble.

This gambler was convincedthat theonly timeriskhad tobeconsideredwaswhenshortoptions had already movedinto the money. In hismindset, when the optionswere out of the money, andremained OTM, then theoptions would expireworthless and the sellerwouldhaveatidyprofit.

Ican’targuewithpartof thesentiment.Ifthoseoptions(as

eventually happened) nevermoved ITM, then the personwho sold them wouldeventually get to keep theoriginal premium as 100%profit.WeallknowthatOTMbecome worthless onceexpiration day has come andgone.

However, thatmind-bogglingfirst sentence that describesany out-of-the-money optionas nothing to be concerned

about leavesme in a state ofshock. Sure, we can try toconvince ourselves that anOTM option is not going tomove ITM, but the very factthatwewouldneversellsuchoptions as our initial tradeought t be enough to tell usthat we do not truly want tobe short anOTMoption thatcarriesa$20premium.

Unfortunately,thismindsetisnot unique. A number of

option sellers believe theiroriginalpremise—thatsellingthis put will prove to beprofitable—that they fail torecognize danger when theysee it.Yes, this traderwas inbig trouble. The $1,900 peroptionwasn’teven themajorproblem.Thistraderfailedtorecognize the possibility thatthis stock, after making asignificant move, couldcontinuetomoveinthesamedirection. There was no

reason to believe that thismovewascomingtoanend.

Gamblers who do notrecognizejusthowbadthingscanget tend tosell toomanyoptions. They are convincedthat selling far OTM optionsis the path to earning easymoney. And the truth is thatthe strategyworks quitewellwhengreed isabsentand thetrader knowswhen it is timetoabandonatradeandaccept

theloss.

Another problem: It Iimpossible to hold all tradestoexpiration,hopingforgoodresults because lowprobability does not meanzeroprobability,andthose5-delta options canmove ITM.And theywill,approximatelyonetimeinevery20trades.

Thepersonquotedabovehaslittleexperience.“Iwasnever

in trouble” tells the story.When he was short thoseoptions priced at $20 each(that is $2,000 cash peroption),hehadenoughassetsin his account to cover themarginrequirement.Hadthatextra cash not been there, hewould have been forced tobuy those options to exit thetrade.

This time, the trader wasblind to risk and came out

unscathed. His mindset tellsme that he will not survivelong because he will temptthe fates until he suffers aloss that wipes out hisaccount.

There is no doubt that ourtrader got lucky this timebecause the stock pricesteadied and remained abovetheput’sstrikeprice.

His blind spot ismuchmore

difficult to understand. If thestockcouldmakeabig-sizedmove to place his short putalmost ATM, why couldn’tthatdeclinecontinue,movingthe option price from $20 to$40?Ihavenoanswertothatquestion. However, that thisblind spot can exist amonginexperienced traders is oneofthereasonswhyIbelieveitis crucial to any trader’ssuccess that he learns aboutrisk management very early

in his trading career. As Dr.Brett Steenbarger(notedpsychologist, trading coach,author, and blogger, hecontributedatonofimportantwritings in the area of‘psychology of trading.’)said:

Selling 100 (equivalent to10,000 shares of stock) ofthese cheap, far-out-of-the-money puts probably seemedverysafewhen the tradewasmade.However, at theworstpoint, the loss would be

almost $200,000, or morethan enough to decimate theaccountsoftheunwary.

Oneof thebasic truthsaboutinvesting (even when itwould be more truthful torefertoitasgambling)isthatsome people with littleexperience believe that it’seasytomakelotsofmoneyina hurry. I don’t know whythat’s true, but the fact thatskillsmustbedevelopedover

time is a foreign concept tosuch traders. Trading, as aprofession, gets little respect.Noonewould try to becomea doctor or lawyer withoutany training, but some traderwannabes do not have thatlimitation.

Confidence that a currentinvestment will eventuallyworkoutisacommonfeeling(confirmation bias). Stocksdecline and many investors

like to add to their positions,increasing risk in a losingtrade.Themindset is that thestock does not have to rallytoo far to reach the break-evenpoint.Forexample,buy1,000sharesat$50,thenbuy1,000 shares at $40 and thebreak-evenis‘only’$45.Addanother 1,000 shares at $30and the trader’s mindset isthat this stockwill easily getback to $40, the new break-evenprice.

There is no consideration forthe possibility that thiscompanywill soon be out ofbusiness. This investingnewcomerjustknowsthathisoriginal analysis must becorrect. That overconfidencehurtsmanyatrader.

THE NAKED PUTSELLERThe put seller describedabove believes that beingshort an out-of-the-moneyoption is of no concern, aslong as it remains OTM. Hejustdoesn’tgetit.Hefailstounderstand that he hasalready lost a ton of moneyand that the possibility oflosing a far more significant

sumisstaringhiminthefaceand he truly doesn’trecognizethedanger.

I’m not suggesting that thisobliviousmindsetiscommon,but it is not rare. As optiontraderswemustbecareful toavoid that mindset. I’m surethat most reader understandsthe risk of being short nakedoptions, but too often thatunderstanding comes fromsuffering the consequences.

Whydoesittakeabiglosstoconvince some people of thepossibilities?

Being oblivious to risk canwill result in adisaster.Howlarge of a disaster? Thatdependsonjusthowblindthetraderistothetrueriskofanyposition. It isok to take risk,butknowthatriskanddonotexceedyourpersonallimit.

THESPREADSELLER

Asanexample,let’slookatatrader whose preferredstrategy is to sell OTM putspreads, rather than sellingnakedputs.Thisisacommonstrategy for bullish investors(andonethatIrecommend).

Let’s assume that one tradercorrectly decides that selling10putswitha strikepriceof$50 is the proper size for

his/her account. Evenoblivious traders understandthat the maximum loss is$50,000.Theyalsorecognizethat thechanceof losing thatamount is almost zero, andthatitisdifficulttoknowjusthow large the realisticmaximumlossis.Sure,astoploss order can establish thatlimit for a trader, but stockshave been known to gapthrough limits, leaving thetrader with a larger-than-

anticipated loss. The ‘flashcrash’ (May 6, 2010: TheDJIA plunged about 1,000points (9%), and recoveredthoselosses—allwithinafewminutes.)Thedeclinewasnotsteady and many stocksgapped to incredibly lowprices (pennies per share),before moving higher.) Thisis a rare extreme example ofhow bad things can get in ahurry. NOTE: Some of themost outrageous of these

trades were “busted” by thepowersthatbe.

What happens when thistrader decides that sellingnaked puts is no longer thebest idea and opts to sell 5-pointput(sellthe$50/$55putspread) spreads as a ‘safer’strategy? Each spread canlosenomore than$500 (lessthe premium collected). Theproblem arises if the trader,not understanding risk,

decides that selling 100 ofthese spreads—with amaximum loss of less than$50,000—is a trade withessentially the same risk asselling 10 naked puts. Thatwouldbeabigmistake.

The probability of incurringthe maximum loss (or anyloss)mustbeconsidered. It’seasy to incorrectly believethat risk for these two tradesmust be similar when the

maximum loss is the same.These two positions havevastlydifferentriskprofiles.

To lose $50,000, the nakedput seller would have to seethe stock priced at zero. Forthe 100-lot spread seller, the$50,000lossoccurswhenthestock is below $50 whenexpiration arrives. That is afartoocommonsituationandthe correct position sizeremains 10 contracts. If you

would consider selling 10 ofthe naked puts, then sell 10put spreads instead.Sure thistrade offers less possiblereward, but the possible lossis reducedfrom“gigantic” toa reasonable $5,000 (lesspremium collected whensellingthespreads).

POSITION SIZE ANDPROBABILITY

The trader whose mindsetincludes being oblivious toreality, tends to ignorestatistics as well. The bigfactor when comparing thenaked put with the short putspreadisprobability.

There is a reasonable chanceof incurring the maximumpossible loss ($50k) when

selling 100 five-point creditspreads. Depending on thestrikepricesandthevolatilityoftheunderlying,thechancesof losing the maximum canbe near zero to almost 50%.When selling tennakedputs,the chances of losing thatsame$50karefarless.That’sthe big blind spot: Selling abunchof limited-loss spreadswill, on occasion, result in amaximum loss when thetrader gets unlucky or

carelesswhenmanagingrisk.

When the chances areone infive, or even one in 10 thatthe trader will suffer themaximum possible loss(when both options expire inthe money), you know thatsuch results are going tooccur (on average) onceevery five or ten times. Ittakes some good-sized winsto overcome those giantlosses. The trader who sees

selling ten naked puts and100 put spreads as ‘similar’has no chance to win theoptions-tradinggame.

One important aspect of riskmanagementisunderstandingthe likelihood of collectingthe target profit or incurringthemaximumacceptableloss.Thesizeof thatprofitor lossdoesnottellthewholestory.

Pleasedonotbeanoblivious

investor. Understand howmuch is at risk (and thechancesoflosingthatsum)aswell as the target profit foreach position in yourportfolio.Pus,beawareofthesame elements for the entireportfolio.

TheWinningMindset

As a rookie trader, Iunderstand that selling nakedoptionscanleadtosubstantiallosses and is best avoided.After I gain the experienceand confidence that comeswith being a successfultrader,andafterIprovethatIknowhowtolimitlosses,itispermissible to sell nakedoption in appropriate (small)size.Ialwaysknowmymaximum

lossforanytrade.However,Icannotmeasurerisksolelybythenumberofdollarsthatcanbe lostandIalwaysconsiderboth the maximum loss andthe chances of incurring thatloss when choosing positionsize.

CHAPTER19ROLLINGFORA

CREDIT

When seeking information,all too often traders ask thewrong questions, such as:‘How much money can Iexpect to earn when tradingoptions?’(See Chapter 10.)That is a question with no

answer.Manyvariablesaffectatrader’searningpower,suchas the trader’s experience,bankroll, aggressiveness,willingness towork,personaldisciplineetc.

This chapter is concernedwith a common practice thatrepresents a similar anddangerousmindset.Thatwayof thinking can besummarized with the phrase:“always collect cash when

makinganadjustment.”

There is a subset of optiontraders who try to avoidpaying cash for anything.They make trades such thatall opening trades andadjustments involve no out-of-pocketcash.Iftheycannotfind agood adjustment for acashcredit,thentheycreateatradethatprovidesthatcredit.For example, they may electto sell extra spreads, i.e., sell

more spreads than theybought when covering theoriginal short spread) or sellspreads that generate arelatively high premium,despite the fact that thesespreads violate the trader’scomfortzone.Inotherwords,generating that cash credittrumps all otherconsiderations. That is not asustainablestrategy.

The general strategy is to

allow all options and optionspreads to expire worthless,but on occasion theymaybewillingtopayasmallsumtoexitaprofitabletrade.

The problem with adoptingthis trade-for-a-cash-creditphilosophy is that tradersoftenfindthemselvesowninganewlyadjustedpositionthatis already outside theircomfort zone. They wouldneverownthispositionifnot

‘required’ to do so by theirtrading rule. Demanding thatall trades produce a cashcredit severely limitsadjustmentchoices.

The trader with a winningmindset recognizes that riskmanagement trumpseverything else and that it isfar better to exit a badposition than to turn it intoyetanotherbadposition.

MANAGING THETRADECredit spreads begin with acash credit. If all goes welland time passes, the optionslose value and mayeventually reach a pointwhere the trader iswilling tocover.However,payingafewnickelstoeliminateallriskisnot a popular among choicethe ‘always collect cash’

crowd.

Thinkaboutwhatcanhappenwhen the market goesagainst theposition.The rateat which losses accumulateincreases(duetothenegativegammaofsuchpositions)andthe risk of a big lossincreases. The firstadjustment may result in adecent position. However,whenthemarketcontinuestorise (or fall), the second

adjustment is almost alwaysgoing to requirecovering thecurrent position and sellingspreadsthatarefartheroutofthe money. To compensatefor the reduced premium,additional spreads are sold.This is very similar to theMartindale strategy in whicha player keeps doubling hisbet until he finally wins. Ofcourse, sometimes the stringof losses is largeenough thatthe player goes bankrupt. In

theoptionsworld,itdoesnottaketoomanydoublesbeforethe trader has exceeded hismarginlimit.

Traders with a rationalmindset, such as: “Thisposition requires anadjustment because mycurrent risk is toohigh and Imustavoidalargeloss”haveno trouble making goodtrades that reduce risk.Mostof the time, these trades

involvespendingcash.

TheonlyadviceIcangivetoyouis tostatemyfirmbeliefthat trading for a cash creditalways feels good, but itshould not become theoverriding decision-makingfactor.Topreventfallingintothat career-dooming mindset,I suggest the followingthought patterns whenadjustingaposition:

Reducesize;buybackaportionoftheposition.

Buy single options togain delta and positivegamma.

Buy debit spreads forlimited protection. Butdo not buy spreads thatare farther out of themoney than the shortoptionbeingprotected

Buy…Inotherwords,be

willingtopaysomecastwhen adjusting.Adjustments with risk-reducing, positivegammaarenotfree.

MINDSETAnadjustmentiseasytofindwhen no attention is paid torisk. A trader may enjoyselling extra spreads tocollect extra premium

because it affords anopportunity to make evenmore money. The fact thatoverall risk has increased isignored. The dollar signs areallthathesees.

If this overly optimisticthought process seemsunbelievable, just know thatsome tradersbelieve thatanyoption sold will expireworthless.Andifitdoesn’t,asimple roll will solve the

problem. This mindset is acombination of too muchconfidence coupled withconfirmation bias. Theimportant takeaway is:Whenrisk increases after anadjustment is made, thatadjustmentdidnotdoitsjob.

SELLING PUT SPREADSAS A BULLISHADJUSTMENTConsider this high risk

adjustment trade: When themarket rallies, an ‘obvious’adjustment choice is to sellput spreads. That deliverssome positive delta alongwith extra cash, but it comeswith more negative gammaand provides no significanthelpwhentherallycontinues.Even worse, downside riskhas been added. Selling newput spreads without coveringthe original put spreads (theiron condor position is short

both put and call spreads) isnotinmyplaybook.Prudencedictatespayingsomeprice toget those puppies off thestreet, but the intrepid cash-collecting trader does notthink thatway. In fact, inhismind those options havealready expired worthless. Ihope it is clear that isdangerousthinking.Itmaybevery unlikely but somethinghorrendous can happen, andwith it can come an

unbelievable stock-marketdecline.Thereisnoreasontotakesuchriskwhenpayingasmallpricecaneliminatethatrisk.

WHATABOUTROLLING?Rolling is a good risk-reducing technique, but isoften used inappropriately.Rollingisatermdescribingatrade in which the currentposition is eliminated

(covered)andanewpositionissoldasareplacement.

I prefer to roll down (thatmeans choosing a new,fartherOTM,spreadwiththesameexpirationasthespreadbeing covered)—withoutselling extra spreads. Thatalways costs cash. For the‘always collect cash’ trader,rollingdownrequiresthesaleof extra spreads to preventpayingcashforthetrade.The

(incorrect) justification formaking that trade is: ‘theseoptions are too far OTM tobecomeaproblem.’

Increasing position size isappropriatewhenthepositionbeing fixedwas less than thetrader’s maximum AND theextraspreadscanbesoldatagood price AND the newtrade is something theunbiasedtraderwantstoown.It does not work when used

as the standard adjustmenttrade that ignores otherfactors.

Rolling works when youconvertthe‘atrisk’spreadtoa good position with lessimmediate risk and noincrease in overall risk. It isnot always possible to find asuitable trade. When thathappens, it is better to exitand accept the loss.You canalways open a brand-new

position that is suitable forcurrentmarketconditions.

Whenthenewtraderesultsina position that is far fromneutral and requires animmediate adjustment, it isnot a suitable trade. Beginanew with a good-to-ownposition.

ROLLING DOWNANDOUTTraders often roll down andout(fartherOTMandamoredistant expiration date) withthebeliefthattheycanfindaway to protect assets bymakingalmostany trade thatpostpones expiration, as longas it does not cost cash. Thetruth is these trades succeedoftenenough toconvince the

trader that this should be thepreferred adjustment trade.Andthatsetsthetrap.Choiceis limited. Increasing thenumber of spreads soldbecomes the only alternativewhen the trader must collectcash.

EXAMPLE: Rollingdown and out. It is July 1.INDX is 1030. Impliedvolatilityisrelativelyhighfor

INDX options. If it werelower, the traderwould haveto sell additional spreads toavoidpayingcashtoadjust.

1. Trade: Sell 10 INDXAug 1100/1110 callspreads.

2. INDX rallies. Roll theposition to 12 Sep1120/1130spreads.

3. INDEX rally continues.

It is Jul 15. Roll theposition to 15 Oct1140/1150spreads.

4. INDX soars to 1125. Itis Jul 20. For thistrader’s comfort zone,theshortstrikeshouldbe1200orhigher.Forevenmoney, the trader cansell 25 Oct 1200/1210spreads and cover 15Oct1140/1150spreads.

Tradesizehasincreasedfrom10 to 25 contracts; marginincreased from $10,000 to$25,000;thepositionremainsat risk; and it is still three-months before expiration.This trader has lost moneyand is in trouble. Imagine ifanotherrollisrequired!Thereis no reason to get into thiskind of trouble. By payingcash, the trader would nothave increased position size.Bypayingcashatradercould

have really reduced riskinstead of just believing thatriskwasreduced.True,profitpotential would be less. Butthatisnothingcomparedwithwhat this trader has done tohisoverallrisk.

Note: When you move yourshort options farther OTM,you probably ‘feel’ safer.And you are safer from theperspective that it is lesslikely that additional money

will be lost or that anotheradjustment will be required.However, a reducedprobabilityoflosingmoneyisnot good enough when thesum at risk has increased bysomuch. You never want toallow for the possibility ofblowing up your tradingaccount with a singleposition.

From the perspective of‘moneyat risk’ (that’show I

suggest risk be measured),position size has increasedandriskhasincreased.

If you take the stance thatthere was no need to sellextra spreads because thetrader could have rolled lessfarOTM,youarecorrect.Butthat offers another unhappychoice. This trader is trulytrapped with poor choices(when unwilling to spendcash): Too much size or a

positionwheretheoptionsarenot far enough out of themoney.

The trader with the winningmindset is never caught inthistrap

THE IMPORTANT POINTFORTHISCHAPTER

Asimplerolldownisn’tgoodenough for some traders andtheyprefer thedownandouttrade because it can often bemadeatacredit.However:

The rolled-out positioncomes with additionaltime to expiration andmany traders prefer totradeshort-termoptions

Despite a trader’sconfidence that themarketcannotmoveanyhigher (or lower), it canand itwill. These extra-largepositionsarenotas‘safe’astheyfeel.

NOTE:Thesepositions‘feel’so safe because the traderbelieves that thepositioncanbe rolled again (and again)whenever it becomesnecessary.Thetraderbelieves

that cash can be collectedrepeatedly until the tradefinally ends with all optionsexpiringworthless.Thisisanillusion because each rollcomes with additional risk,suggestingtheinevitabilityofblowing up the tradingaccount.

Isuggestavoidingrollingoutuntil you have worthwhileexperience adjusting optionspreads using other methods

(and even then I do notrecommendthedownandoutroll).

Therisk-increasingdownandoutrolltradeviolatestheveryfirst rule of successful riskmanagement: Avoidincreasing position sizebecause it increases potentialloss. Repeating the impropermindset: “The short optionsare father OTM, and theindex cannot rise forever. If

the new trade gets intotrouble,I’lljustrolldownandoutagain.”

This is a perpetual processuntil the options finallyexpire worthless, or thetrader’s account expiresworthless.

Rollingforacashcreditoftenmakes the trader falselybelieve that no loss has beentaken and that there is still a

good chance to collect theentire(original)premiumasaprofit—but it’s an erroneousbelief. The truth is that theloss has already been lockedin. The trader now owns anewpositionthatnotonlyhasadditionalrisk,butitisalsoaposition that may not beacceptableasanewposition.This is essentially the sameproblemwe discussed earlier(Chapter 11, trading torecoverlosses).

EXITGetting rid of a bad positionisarelativelyeasychoiceformost traders—once thedecision to ‘do something’has been made. Take theprofitwhenithitsyourtargetandmoveontoanothertrade.To the cash-is-king trader,buying in cheap options is awasteofmoneyandthetraderbelieves that options were

made to expire worthless—another misconception anddangerousbelief.

If the mindset described fitsyou, please think aboutmodifying the way you planto manage risk inuncomfortablescenarios.It isnot necessary to collect cashfromeverytrade.

TheWinning

Mindset

I adjust only when the after-adjustment position is goodenough toown,atacost thatis worth paying. There mustbe a reasonable expectationofearningaprofitfromtodayinto the future, with anacceptablelevelofrisk.

I never force an adjustment.If I believe that closing theposition and taking a loss

represents a good choiceunder the circumstances, I’llexitwithnosecondthoughts.It is difficult to find a goodadjustment every time that aposition becomesuncomfortabletohold.

There is nothing inherentlywrong with collecting cashwhen adjusting a position.However,Iamcarefultoturnthepositionintoonewithlessimminent risk and less

ultimate risk. The cost toadjust is not my primaryconcern.

It is a simple concept: Imanage a portfolio so that itcontains good positions. I donot micromanage. If I owngood positions and makegood risk-managementdecisions, I will come out awinnerintheend.

It is tempting to roll a losing

trade into a more distantexpiration. It feels as if thelosshasbeenpostponedwithan improved chance to comeoutawinner.Itisanillusion.

If I roll down (sameexpiration), I consider thenew position as the originaltrade for bookkeepingpurposes,withanadjustment.

Whenaposition ismoved tothenextmonth,Iconsiderthe

first trade closed and I nowownabrandnewposition.

Imust answer yes to this: Isthis the position I want toown now? If ‘no’ then I donotadjust.

Idonotgettrappedintoabadnewtrade.Idonotrollouttoa later expiration. I exit andfindsomethingnew.Iplantomake money going forward,and I own positions that are

well suited for that purpose.If Imust accept a loss togetout of a poor position, so beit.

CHAPTER20

THETRADEORTHETRADEPLAN:WHICHISMOREIMPORTANT?

Two divergent paths areavailable for traders. Welearn tomakegooddecisions

that lead to profitable trades,orwedon’t.Myobjective inwriting this book is to helptraders understand how tomake those good tradedecisions.

Anyone can buy or selloptions. However knowingwhat you are doing andhaving a viable plan lead tosuccess. Traders cannotafford to take shortcuts.Trading is not an easygame.

Take the time to learn,practice,andunderstandwhatyouaredoing.

Thosewhoarenotcutoutforthe multitude of decisionsrequired of traders may turnout to be very successfulinvestors. The maindifferencebetweenthetwoisthe frequency of trading andthe holding period. There isalsoamindsetdifference.

Thetradermustknow:

Howmuchcashisatriskforeveryposition?What must happen forposition risk to increasebeyond his comfortzone?The steps a trader cantaketoalleviatethatrisk.

When is the appropriatetimetotakethosesteps?

When preparing to open anewposition,Iencourageyoutowriteagameplan. Iknowit may seem unnecessary.And perhaps it is for sometrades. However, by writingthe plan and keeping a tradediary that includes yourthoughts–before,during,andafter exiting – a trade, youwill have an excellent

collection of data.Periodically reviewing thenumbers and your thoughtscan only make you a bettertrader. Looking back, youwill discover thoughts thatwereclearlymistakes.Notsomucherrors,butdecisionthatyou made as a less-experienced trader.Thesearemistakes that you will notmakeagain.

Theless-experiencedtraderis

not yet aware of whichdecisions belong in the plan.No problem. As you gainexperience it becomes clearwhich itemsdeserve to be inthe plan. Begin withestimating the target profitand maximum acceptableloss. Includesomecommentsabouttherationalebehindthetrade. If you do not knowwhy it makes sense to makethistradenow,thenperhapsitwouldbebetternottodoso.

After a few trades, the traderhasamuchbetterfeelforthereasons behind setting up atradeandestablishingtargets.Todevelopgoodhabitsandawinning mindset, beginmaking a written trade planwith the very first trade.Theplan will probably be short,with a profit target somethoughts on how much youare willing to lose. But the

next plan will contain moreinformation because youwillrealize that you have moreideastoputinwriting.Theseplans soon become valuable.As stated above, the truevalue comes from lookingback on your trade diary (oryoumay prefer to refer to itas your trade journal) andanalyzingyourdecisions.

If you believe (as I do) thathavinga tradeplan isagood

idea, the question becomes:which ismore important; theplanorthetrade?Ifwedon’twant to ‘put the cart beforethe horse,’ then we have toknow which the horse is.Translation: Isourpriority todevelop the plan and thenmake trades that rigidlyfollow that plan? Or do wetrade aswe deem best at thetimethatdecisionsaremade-- and use the results todevelop a plan for future

trades?Thismayseemtrivial.However the winning traderunderstands the role of theplan.Youtrulyhaveachoice:The tradeplan isgospelor itismerelyastrongsuggestionformanagingtheposition.

Thelengthydiscussionbelowillustrates one trader’sthought process on a singlestrategy and how hedeveloped a trade plan. Mycomments are included in

blue.

Note: For some readers thisdiscussion will be toodetailed. My reason forincluding this chapter is toillustrate how smalldifferences(oromissions)canmakeabigdifference inhowa trader handles a position.That inturnhasasignificantimpactonresults.

BASEDONADISCUSSION

IN THE OPTIONS FORROOKIES FORUM (nowclosed)

“Mark,

“I am revisiting the idea ofbuying a double calendar.[Two simultaneous calendarspreads on the sameunderlying asset (sameexpiration). Typically onestrike is above, and onebelow, the underlying price.]

Earlier, my challenge was innot knowing when to take aprofit on the winning side(i.e., on the calendar spreadthat is showing a profit, andignoringtheotherside).NowIhaveadifferentthought.

“Inmypapertradingaccount,Iopenedthefollowingdoublecalendar with RUT@ $840:Totaldebit$12.70

Buy

RUTNov/Dec795putspreadBuyRUTNov/Dec880callspread

“When the market runs

toward either the call or putstrike,Iwillexitthatcalendarat a profit. [Calendar spreadswidenastheunderlyingpricemoves nearer to the strikeprice.] If implied volatilityincreases (a commonoccurrence on stock-marketdeclines) perhaps bothcalendars will increase invalue. If that happens, I willexit thedoublecalendarwithaprofit.Ifnot,Iwillproceedwiththefollowingplan....”

[MDW] Iseeproblems.

Do youhave anyreasonformakingthistrade?Thegeneral

reasonforowning adoublecalendaris anexpectationthatimpliedvolatility(IV) willrise. Thispositionis long a

lot ofvega [theGreekthatmeasuresthesensitivityof anoption’sprice to achange inIV].

We

previouslydiscussed(Chapter6) ironcondors,agreeingthat thetrade is asinglepositionand thatthere isno(except

fordiscussionpurposes)‘profitableside’ andno‘losingside’.Thatmindsetalsoapplies tothedoublecalendar

becausethedoublecalendaris onepositionand theobjectiveis to exitthe wholepositionwith aprofit.

1. Yourplan callsforsellingonecalendarspread‘ata profit.’That isnotenoughinformation.Howmuchprofit?

What areyourcriteriafordecidingwhen toexit?Dollarsearned?Whenstrike isonly XpointsOTM?

Wouldyou sellall atonce orscale outbyclosingthepositionafewspreadsat onetime?

With no

specifics,do youplanmakerandomdecisionson whento exit‘oneside’of theposition?That isnot aplan; that

is tradingbymarketfeel. Thisis thewrongstrategyfor thattradingstyle. Ifyou planto makebullishandbearish

trades attimes thatyou deemto beappropriate,then youdo notwant aspreadthat is sorich invega. Youwant totrade

delta [theGreekthatmeasuresthechange inan optionprice asthe priceof theunderlyingassetchanges],not a

positionwhoseprofitpotentialis sodependentonvega.

Mybottomlinethought:Wouldyou exit

eitherside if thepricewere lessthan the$12.70paid forthe wholeDC(doublecalendar)?If yes,how doyou plan

to collectenoughadditionalcash toearn anoverallprofit?Marketsdo notreversedirectionjustbecauseyou want

them todoso.

2. Goingfarther:Why areyoulookingatthispositionas if itwere twoseparatetrades?

Thecorrectmindsetistoconsiderany tradeas asingleposition.It may bepracticaltomanagerisk as if

youownedtwoseparatepositionswhen riskforhalfofapositionthreatensto turninto alargeloss), butyou

shouldnot havea tradeplan thatcalls formanagingone sideatatime.

Let’s lookat risk asthemarketmoves

lower.

a)Youknowthatamarketrallywillkillthevalueof

thecallcalendar(becauseitbecomesfartherOTM),andthatisanexcellentreason

forsellingsome(orall).Thatdecisionisallaboutmanagingrisk.Iknow

thatyouwouldprobablyrefusetosellthecallcalendar(asanadjustment)on

adeclinebecause(fromtheperspectiveofyourmindset)itwouldbelockingin

alossonthecallhalfofthedoublecalendar.

b)Whenthe

marketdoesdeclineandtheunderlyingassetistradingnearthestrikepriceof

thecalendarspread,andespeciallywhensometimehaspassed,thatputspreadwill

betradingatahighprice(true,‘high’isarelativeterm,butat

somepriceitwillbecomeverystressfultocontinuetohold).Ifthatspread

were,forexample$15to$20holdingbecomesahighriskproposition.Iftime

passesandRUTholdssteadyormovesevenclosertothestrikeprice,the

calendarspreadwouldgainvalue,andthatwouldbeexcellent.However,ifIVdeclines

(whenthemarketisnolongerfalling)ortheRUTmakesasuddenrally,

thecalendarspreadwilllosevalue.AndifRUTralliesfarenough,allof

yourprofitswoulddisappear.[Anytimetheputspreadcanbesoldformorethan

youroriginal$12.70debit,thetradewouldbeprofitable.]Whenwouldyousell?What

istheplan?Doyouhaveatargetprofit,orwillyoudecideto

sellwhen‘youfelllikeselling?’

Whenlookingatthe DCfrom ariskperspective,do you

knowwhetherthe putspreadwill gainvalue(decliningmarket)fasterthan thecallspreadlosesvalue? As

I read it,your planis to picka time tosell theputspreadand thenhope toconvertthe callspreadinto aprofit

source(more onthatlater).

The callcalendarlost a lotof valuewhen themarketdeclined,and I seethat you

discusswhat todo aboutthatbelow.

3. Trading the doublecalendarismorecomplicatedthanwaiting toexitoneside.You never mention positiondelta. Is delta managementsomething that you plan toignore because you prefer toconcentrate on only the

calendarspreads?

“The plan then is to buy (toclose) the short option in thecall calendar (i.e., the Nov880C), and then sell theDec870C to complete a Dec870/880Ccreditspread.

“At this point, the onlyconcern may be: how muchcan I collect by selling the870C? Iwouldbe selling the

870C for not a whole lot. Iamawareofthis.Butthefactis this 870/880C spreadwould be pretty FOTM bythattime.”

Iseemoreproblems.

a)RUTmovedmuchlowerand

noadjustmentsweremade.Youarewaitingtoselltheputspreadatsome

unspecifiedpriceortime.Asmentioned,withnoadjustments,thisisariskyplay

becausethecallspreadcouldhavelostalmostallofitsvalue.True,the

passageoftimemaybegoodfortheputspread,butunlessRUTdeclines

further,youmayneverbeabletoearnaprofit.

Unlessthedouble

calendarisearningmoneyasthemarketmovesinonedirection,itisnot

atradethatworkswithyourplan.Dataisneeded.IsuggestcollectingP/L

dataasRUTchangespriceandastimepasses.

Youdonotwant

toadoptthisstrategybecauseyoureadaboutitsomewhere.Remember,thisisnot

atypicalstrategythattradersusetoplayrisingandfallingmarkets.Thisposition

isallaboutvolatility.

Totradeanystrategy,youmustknowhowit

makes/losesmoney.Thatistheonlywaytolearnhowtomanagethetrade

(i.e.,howtodeviseatradeplan).Rightnowyoudon’thaveaviable

plan.Whenpaper-trading,collectdataandusethatdata.Youmayconcludethat

thisisapoorstrategyforeverydayuse.

b)Oncethatputspread

isclosedyouplantoconverttheremainingcalendarspreadintoafarOTM

callspread.Asyoumentioned,holdingthatspreadisunlikelytogeneratemuchprofit,

anditisloadedwithrisk.

c)Yourplanistocovercredit

spreadswhentheytradeatlowprices(becausethereissolittletogain

bybeingshortsuchspreads)whentradingironcondors.Whydoyouwantto

taketheoppositeviewnow?Itisfarlessriskytosellthelong

call(therebyclosingthecalendarspread)thantoconvertintoaspreadthatcould

hauntyoulater.Andthatisespeciallytruewhentheprofitpotentialisso

small.

“Alternatively, maybe I canmove closer to the moneywhen I initially establish thedouble calendar. This is toaddress the problem ofcollecting too little premiumwhen opening the new shortstrike(Dec870C).”

Warning:Thisis

thecruxoftheproblem.

Youadoptedastrategy.Youselectedatrade.

Arationalassumptionisthatyouchosethepositionyouwantedtoown.Now

youareconsideringadifferenttrade.Notbecauseyouprefertoownthatposition,

butbecauseitwouldbeeasiertomanagetheleastimportantportionofthe

trade–namelywhattodowiththelow-pricedcallspreadafteryou

soldtheputspread(atahighenoughpricetogenerateaprofit).That

isnotefficient.

Let’sslowdownandconsiderwhatyouaretryingto

accomplishasatrader.

Make money by takingappropriaterisk.

Adopt an appropriateoptionstrategy.

Plan the trade setup:Choose specific optionstotrade.Decidewhether

cost of trade makessense. Know both profittarget and ultimate risk.Writeviabletradeplan.

Question:Whichmindsetgives youthe betteropportunityto earnprofits ona

consistentbasis?

a)IlovethisplanandIselectedmytradebased

onwhichpositionworksbestwiththatplan.

b)Ilikethistrade

andcandevelopatradeplanthatletsmemanagethepositionefficiently.

c)Iwillconsiderboththetradesetupandthetradeplan.Theidea

istofindagoodcompromisethatallowsforadecentprofitwithas

littleriskaspossible.

d)Iwillchoosewhichoptionstotradeso

thatIcanmakealess-costlyadjustment.ItdoesnotmatterwhetherI

feelcomfortablewiththeoriginalpositionbecausetheadjustmentprocesswillbeeasier.

I don’thaveresearchtosupporteither a)or b).However,mosttradersmake atrade thatsuits theirneeds(and

marketoutlook)and thenmake aplan tomanagerisk.Choice b)feelsrightto me. Ifyou mustemphasizethe plan,then

adopt c)andallowthespecifictradeselectionto beimportantin yourlife.

You areconsideringdeveloping

the planfirst (tobecertainit isviable),and thenfinding asuitabletrade.This feelsbackwards.Especiallywhen youare so

concernedwithmanagingthe verylow-pricedposition(theresidualcallcalendarspread)that canbeheldor

soldwithouthavingmuchinfluenceover theeventualprofitabilityof thedoublecalendartrade. Torepeat:This risk-

managementdecisionhas littleeffect ontheoverallprofitabilityof thetrade,andthereforeis notveryimportant.

Yourgoalwith theresidualpositionis to becertainthat itNEVERcausespain.Hold,close, oradjust,you do

not wanta low-probabilitychancethat thefuturewill bringasignificantloss whenthere isnot muchto beearned.

Thechoicesrequireverydifferentmindsets.Mosttraders(and Iagree)believethat riskmanagementis

importantandcannot beignored.However,the tradechosenhas to beone thatoffers thebestchanceforearning a

sufficientreward,consideringthe riskinvolved.Riskmanagementcomesinto playinselectingtradesize,target

exits, andwhenrisk-reducingaction isneeded.Riskmanagementis not thedrivingforcebehindwriting atrade

plan.Thereforechoice d)iscompletelyinappropriate.

It is anexcellentidea topracticethe DC,with thegoal

being tolearnwhetherthisstrategycanproduceprofits,andespeciallywhen toadopt thisstrategy.In the

schemeofthings,what youdecide todo withthat low-value callspread isunimportant—as longas it doesnotbecome asource of

additionalrisk.Handlingthat putspread(inyourexample)is criticaltosuccess. Isee noreason touseoptions

withdifferentstrikepriceswhen youalreadychose theoptionsthat youprefer totrade.

WHY THE DOUBLECALENDAR?

The onecrucialfactorthat ismissingfrom thiswholediscussionis” Whythedouble

calendar?Whatattractsyou tothisstrategy?I do notknowwhythisstrategyappealsto youbecauseyou have

noplantomakemoneybased onthespecialpropertiesof theDC.Whathas tohappen togeneratethatprofit?

You donotmentionvega, themostimportantfactor inthistrade.Youanticipatethemarketwill moveto the

strikeprice ofthecalendarspread,but thereis noestimateof howmuch youbelievethewinningcalendar

will beworth.

Here isthe keypoint: Ifthe planincludedacalculationandstatedsomethingalong

theselines,then Icould seea path toprofitability:

“IfRUTmovestothe$800to

$805levelthreeweeksafterthetradeisopened,andifIVincreasesby

5%,Icalculatethatthetheoreticalvalueoftheputcalendarwouldbe$13.50.

IfIcanunloadatthattime,I’llhaveaprofitforthetrade

(Ipaidonly$12.70).Ialsoshowthatthecallcalendarwouldbeworth

$0.75.Icouldholdthatpartofthepositionasaninexpensivebullishgamble,

butIwillnot.Ineedthat$0.75becauseitrepresentsabigportion

oftheprofit.”

“IfRUTrequiredfourweekstoreach$805and

ifIVincreasesby10%,thecalendarswouldbeworth$14.60and$0.80.That’s

whyIlikethistrade.”

Withnostatementofwhereprofitswillcome

from,Idonotknowhowyouwillmakemoney.WiththeICwe

knowwemakemoneywhentimepassesandthemarketsarenotmovingmuch.

Wehaveprofittargets.Here,youmadeatradewithonlyageneralidea

toselloneside‘ataprofit.’Isuggestthatyoufigureouthow

thistrademakesmoneybeforetakingtheriskofowningit.

Dependingso

heavilyonthisplanassumesthatasaleofonecalendarspreadwilloccur

‘ataprofit’.Whatifitdoesn’t?Whatiftimepassesandlossesincrease?

Doyouhaveanexitplanoranadjustmentplan?

Ibelievethat

thetradershoulddependongoodtradeselectiontoleadtoprofitsandthat

thetradeplanisbestusedtoestablishideasforwhentoadjustor

exitthetrade.Therisk-managementplanisnotthesourceofprofits;it

isthemethodweusetoprotectourassets.

Iadmirewhatyou

aredoing.Youwanttodeterminewhetherthedoublecalendarcanwork.However,I

believetheemphasismustbeondiscoveringtheprofitsource.

BACKTOBASICSThisreturnsusto themostbasicpoints:Whywouldyou tradethedoublecalendar?

Whatmarketconditions?What isthe profittargetand doestheunderlyinghave tomovetowardsoneofthestrikes to

makemoney?What isthe resultif theshortsexpireworthless,RUT isunchanged,and IV is5%lower?

Whenyouanswerthosequestions,the next(mandatory)questionbecomes:Do youwant totradecloser-to-the-money

options,or didyouchooseappropriatestrikes inthe firstplace?

Myopinion isalongtraditionallines: Do

not selecta specifictrade forthe solereasonthat it iseasier tomanage ifsomethingspecifichappens.

Irecommend

enteringinto agoodtrade andthencreatingrisk-reducing,profit-collecting,ideas tosuit thetrade.The trade

is thedog. Donot allowthe tail(tradeplan) towag thedog. Thetrade ismoreimportant.

“What do you think ofmanaging a double calendarthisway?”

Notmuch.You haveno profittarget.You havea vagueidea thatyou willsell one

halfofthepositionat someundefinedprice andwill turnthe otherhalf intoa high-risk, low-rewardposition.Ido notlike the

managementplan.

Toproceed,plan tofindanswers:

What market conditionsleadtoprofits?

Must the underlyingasset move near one of

the strikes to earnprofits?

What has to happen foryou to believe that thetrade has gone badly?Howmuchwouldbelostbythattime?

Isithelpfultoneutralizepositiondelta?

Is vega the key toprofits? Does anythingelsematter?

Thedoublecalendarisdependentonimpliedvolatilityand thusit isdifficultto know

its valueat anypoint inthefuture.That isthe truerisk ofowning adoublecalendartrade,and youhave not

addressedthat riskfactor.

You aresearchingfor amanagementschemethatworks fora doublecalendarposition.

It is FARmoreimportantto knowwhy youwant toown theposition,when it’sappropriateto initiatethistrade,and howto choose

thestrikes.Do youexpect IVto rise?Do yousee anaberrationbetweenthevolatilitylevels ofthe Novand Dec

options?Is thatwhereyouredgelies?

Yourplanhas toinclude arationaleformakingthe trade(such as:

I amselling aput creditspreadbecause Iamslightlybullish;or I amtradingan ironcondorbecause Ibelieve

themarket isgoingnowhere).Why doyou wantto ownthedoublecalendar?Theanswershouldnot be:

Because Ifound aneat waytomanagerisk forthatstrategy.

Once youknowwhyyou wantthatposition

—andthatincludeswhy youexpect itto beprofitable—thenextstep isdevisingaplan tocapturetheprofits.

If youmanagethedoublecalendaras asingleposition,the goalis not totake aprofit onone side.The goal

is to payattentionto thewholeposition.

TheWinningMindset

The Trade Plan is animportant part of anysuccessful trader’s modusoperandi.Someplansinclude

every conceivable detailwhile others are very shortand include only thehighlights.

The trader with the winningmindset writes a plan thatmeets his/her needs. Don’tspendtimeonintricatedetailsbefore knowing that thestrategy can be adopted (andtradedprofitably).

If you fear indecision under

stress,includemoredetailsintheplanbecause ithelpsyoutrade. The plan is for yourbenefitandnooneelse’s.

Practice trading is beneficialwhendevelopinganewidea:newstrategy,newadjustmentstyle,etc.Writea tradeplan;makeandmanage the trades;exit and takes notes on theimportant features of thetrade. Repeat. Makemodifications. Then decide:

Give it a test drivewith realmoney or discard the idea.Thisstakestime.Bepatient.

The trade represents reality.Makea tradewhenyouhaveconfidence in it. For sometraders, that confidencecomes from timing theentry.For others the trade is basedon a belief that the strategy,all by itself, provides awinning edge. Some tradersbelieve their management

skillscanturnano-edgetradeintoawinningtrade.

The winning mindset is tofind a way of trading that isboth comfortable andprofitable.

CHAPTER21ATRULY

TERRIBLETRADE

There is one recurringsituationthatoffersthetraderwith a losing mindset anexcellent opportunity to losemoney. This situation is alltoo common as traders takeadvantage (disadvantage?) of

thatopportunity.

There is no logical reasonwhy anyone should get thiswrong,butithappens.

THESCENARIOA Trader made a directionalplayandsoldacallspreadonastockorindex.Timepassesand the trader changes hismind.Heisnolongerbearish.In fact, he is bullish anddecidestobuysomecalls.

Currentposition:

Let’s consider a fewalternatives (there are many

othersfromwhichtochoose):

1. BuyNovcalls1. Possible strike

prices: 70, 75. 80,85

2. BuyDeccalls1. Possible strike

prices: 70, 75, 80,85

When the trader has a losingmindset, he chooses to buy

Nov 80 calls/ Why? For thesimple reason that he isalready short those Nov 80calls and decides (with littlethought)thatmustbethebestoption to buy. In truth, it istheconvenient option tobuy,butitisaverypoorchoiceforthebullishtrader.

Look what happens. BycoveringtheNov80calls,henowhasalongposition:Nov85calls.Hewouldneverbuy

those calls when making abullish play because they arewaytoofaroutofthemoney.Yet, once he covers theNov80shortcalls,thatiswhatheowns and he is most likelygoing to incur a loss on hisbullish play.Do youwant tocorrectly be bullish and losemoney when the stock pricerises?Ihopenot.

The trader with the winningmindset considers these

alternatives:

1. Which option do Iwanttoown?

2. What should I do withthecallspreadthatIsoldearlier?

Notice that the primarydecision is based on openinga new, bullish trade.Emphasis is on owning theposition that the trader

believes gives him the bestchancetoprofitNOW.Thereisnotemptationtomorphtheexisting position intosomethingmorebullish.

Once the bullish trade hasbeen decided (I recommendthe Nov 70 calls in thisexample), the trader makesthe purchase and then goesabout the business ofdecidingwhat to dowith theremainingbearish spread.He

will probably cover it, butperhapshewouldkeepitasahedge against the newlypurchasedcalls.Whateverthedecision, it is well reasonedandnotrandom.

IfhehaddecidedthatbuyingtheNov80callswasthebestmove,therewouldstillbenoreason tomaintainownershipoftheNov85calls.Themostlikely scenario would be toexit the call spread and buy

extraNov80calls.

TheWinningMindset

If Iwant to owncall options(or put options) as adirectionalplay,IwillchoosethebestoptiontobuywhenImake the trade. My decisionwill not be influenced byexistingpositions.

As a separate decision, Idecide how to handle anyexisting positions. But thekey point is that this is aseparate trade and a separatedecision. I will not own aninferior position just becauseitisconvenient.

It would be extremelyunlikely to discover that theoption I prefer to own nowhappenstobeanoptionthatIamcurrentlyshort.Iwillbuy

onlytheoptionsthatIbelievewillworkbestformycurrentmarket outlook. It is foolishto buy an option for the solereason that I had sold itearlier.

CHAPTER22

THEULTIMATEWINNINGMINDSETEach trader has a reason forgetting into the game. Theobvious and probablyuniversal reason is to makemoremoney.We allwant toenjoy a better lifestyle andavoid the pangs that beingshort money can bring. The

sad truth is that the averageworkingpersoncannotaffordtodomuchintoday’sworld.

My guess is that none of uswill ever have what isconsidered to be ‘enough’money. There is justsomething about beingwealthy that seems to bringontheneedformorewealth.

That aside, the trader islooking for additionalmoney

and is takingappropriate risktoachievethatobjective.ThepointthatIamtryingtomakehere is that there should besome reasonable limit.Why?As long as it is necessary totake risk, there is always thepossibility of incurring a bighit. Ifyouhaveenough,whytakethatrisk?

So I leave you with myultimateadviceforawinningmindset. Most of us will

never have a chance to putthis into practice, but I nowrecognize that at one point(actuallytwodifferentpoints)I had all the money I wouldever need. One reason forfeeling thatway is that I amnot a big spender, and don’tneed luxurious items, and Ido not squander money.However,failingtorecognizehow well-placed I was, Icontinued to play the gamewith more risk (and greed)

thannecessary.

I offer this advice to traderswiththehopethatyoufindanopportunity to put it to gooduse:

AFTERWORD

We know that any activitythatenhancesourlivescanbeenjoyable. That is why wehave hobbies. The mostfortunateamongushavejobsthatweenjoyanddonothaveto depend on finding otheractivities to make our livesmorecomplete.

Tradingcanbefun.However,

it is not the same as other‘fun’hobbies.Youmayenjoyplayingpokerorgoingtotherace track. As long as youhavetherightperspectiveandkeepwagerssmallenoughsothat neither winning norlosing provides anyextraordinary pain orpleasure, then such activitiesqualifyashobbies.

Investing is more seriousbecause it comes with long-

term goals that includeproviding for our financialsecurity. Ihopenoone looksat long-term investing as ahobby.

Trading is an even moreserious undertaking. If wekeep it simple and define‘investing’ as seekingmoneyover the longer term and‘trading’ as looking forshorter-term profits, then wemustrecognizethat thegame

we play is serious. It can beplayed for small money.However, traders who makemoney seldom continue totrade small position size.There is the human naturetemptationtotradebiggerandbigger size as earningsincrease. That’s fine to apoint. However, never losesight of howmuchmoney isatriskateverymomentalongthe way. Understand thatwinning streaks do end.

Recognize that a string ofprofitabletradesisverylikelytheresultofafortunatesetofcircumstancesandnotaresultof you suddenly becominginvincible.Treat yourmoneywithrespect,especiallywhenoverconfidence blinds you totheriskoflosing.

When we enjoy an activityand that activity is profitable(theprofitsdonothavetobemoney)itisnaturaltoexpand

that activity.Do trade biggersize as you gain experience.However, tradenomore thanreasonable size. You don’thear this phrase very often,yetitistrue:“Sizekills.”

If you want to be successfulwhen trading, and morespecifically when tradingoptions, I hope you will payattention to the subtleties,suggestions, and insightsoffered in The Trader’s

Mindset.

From my perspective as anexperienced trader who istrying to pass along some ofthemanylessonsI’velearnedover the years, I am not somuch trying to tell you howto behave as much as I amsuggesting that certain waysof thinking—mindsets—canget in the way of findingsuccess.Pleaserecognizethatit may be very helpful to

modifytheirhabitsorwayofthinking to produce thewinner’s mindset. Towardsthat end, I offer the contentsof this book and my bestwishes.

APPENDIXAGENERAL

MINDSETADVICE

I am not alone in writingabout how important atrader’s mindset is to hissuccess. The following ideasfocusonthebigpicture.Dr. Brett Steenbarger warnsinvestors to lose a mindset

that suggests that eachindividual trade is a battlethatmustbe won. He uses abaseballplayer’schallengetoillustratehowa tradershouldapproach trading. He urgestraders not to becomeemotionally attached to theresults of each individualtrade,but instead to focusonthelonger-termobjective:

"Fora

successfultrader,atradeislikeasinglepitchtoahitter.Itis

onepartofoneatbat,whichispartofoneinning,whichis

partofonegame.Thegoalistowinthegame,notto"win"

oneachpitch…

“Fortheactivetrader,therearemanytradesina

dayandtherearefivedaysinaweek.Aslongasyoudon't

losetoomuchinatrade,youcanturnthedayaround.Aslong

asyoukeepdailylossesreasonable,youhaveachanceforagreenweek.

Andaslongasaweekdoesn'tdigyouintoadeephole,you

canstillbeprofitableonthemonth.

“Thegoalistohavea

successfulseason:thatviewmakesiteasiertoshrugoffthepitchesthatget

awayfromyouandfocusonwhatistrulyimportant."

Donot take toomuch riskatany one time—either when

the trade ismade,orafteranadverse move in the market.Your goal is to have aprofitable trading/investingcareer.

***Assetallocationandportfoliorebalancing are commonlyusedtechniquesformanagingrisk when investing.However, that requiresinvestors to overcome the

greed/fear mindset. DavidSwensen, chief investmentofficer at Yale University(They have a LOT ofinvestmentmoneytomanage)believesthat

“Dramaticbearmarketssignaltheneedfor

significantpurchasesoflosers,whileextraordinarybullmarketscallforsubstantialsalesofwinners.

Whenmarketsmakeradicalmoves,investorsdemonstrateeitherthecourageorthecowardiceof

theirconvictions.”

It is difficult for the averageinvestortobattleeuphoriabyselling his holdings as themarketsaresurging.Itisalsoquite a challenge for anyoneto maintain that re-balancingmindset and control decisionmaking by buying aseveryoneelse ispanickingasthemarkettumbles.For true believers in asset

allocation, unemotionaltrading is a necessity. Mostinvestors have the wrongmindset and get excessivelybullish when markets aretopping and bearish whentheyarebottoming.The‘buythe top’ mindset must beeliminated to do the jobproperly.

***John Forman, writing TheEssentials of Trading blog

offers a comment to acommonquestion:

APPENDIXBPSYCHOLOGICALCONSIDERATIONS

I’ve presented ideas that Ibelievecanbeadoptedeasilyby traders. Assuming youaccept my premise thatmoneyearned isyourmoneyand not ‘house money,’ it isnot difficult to change how

you utilize that money. Thisis a question of logic: Eitheryouagreewiththepremiseoryou do not. Either you treatthosewinnings as if they arethefruitsofyourlabororyoudon’t. Either you considerprofitstobetheequivalentofyour salary check, or youdon’t.

However, it is not always assimple as agreeing with anidea and changing the way

youbehave.Ifyouacceptthepremise that conformationbias and overconfidence gotogetherandmake itdifficultfor a trader to recognize thetruth in some situations, it isnot easy to change yourmindsetandbehavior.

Psychologyplaysa role. It isnoteasyforanyonetoacceptthe fact that we have beendoing something inefficientlyor incorrectly for years

(decades?). We have beliefsthat we put into practice.Some examples: We knowthat smoking and drinkingsugared soft drinks, are badfor our health, but noteveryone can (or wants to)changehabits.

Youmaybeconvincedthatitis necessary to rebalance aportfoliobysellingintoabullmarket, but the fear ofmissing out on future profits

is real. The lifetime plan isforgotten. People hold ontotheir investments and watchthosegainsfadeaway(asthemarket falls once again),never taking any action.Some people want theircigarettesandCoca-Cola,andthefreedomtomakechoices.But wouldn’t you prefer tomakewinningchoices?

Losing habits can beovercome with work. You

can change losing mindsetsthat take your cash. It takesbelieving the ideas areworthwhile. That’s the easypart.Youcanacceptorrejectanyidea.Thedifficultpart istaking action. Accepting thatthere is a better way to dothings and that you arewilling to make the effort isnot too difficult. Making thechangesisthedifficultpart.

Idon’tknowwhatittakesfor

amarket re-balancer tomakethe first sale as prices rise. Idon’t know what has tohappen for that same persontocontinuetosell—andresistthe temptation to change hismind and repurchase allstocksthatweresoldintotherally. But I do know that ittakes an effort to recognizethe correctness of the overallstrategy and maintain thewillingness to accepttemporary discomfort for

long-termsuccess.

MISSINGOUT

Fearofmissingout.Thisisasignificant psychologicalfactor for a trader. It isexactly the reason why it isdifficultfortheassetallocatortosellasothersbuy.Itisalsothe reason that traders staywithpositionstoolong.

They hold losing trades forfear of missing out if andwhen the market reverses.

Theycannot tolerate the ideaof seeing that this specificposition would have becomea winner—if they had onlyheld.

Theyholdwinning trades forfear of missing even largerprofits. The psychologicalfear of missing out oftenoverwhelms the need forprudence and riskmanagement. This is onereason why a trade plan has

toincludeaprofittarget.Thattargetgives the traderasolidpieceofadvicefromsomeonehe trusts (it was his ownadvice when the trade wasinitiated),making it easier toexitthetradewhenthattargetisachieved.

The proper mindset is tounderstand that trading is abusiness. When yourcustomer pays your askingprice, you sell the inventory

and find a wholesaler whohas more inventory to sell.Don’t fear missing out. Youarenotinbusinesstogamble.

Thedirectoppositeoffearofmissing out is the fear oftakingaloss.

TAKINGALOSS

We know that losing tradesare in our future. We knowthat allowing losses to run isthe biggest obstacle to oursuccessasatrader.Andifyoudon’tknowthis,givetheideamore consideration. Profitsaregreat,butthebigthreattoatradingcareerisblowingupanaccount.Thatcomes fromfailuretorecognizerisk.

Formany traders,pulling thetriggertoexitorrefinancetheposition (paying cash toimprove or adjust theposition) is recognizing thatthe trader was ‘wrong.’ It isaccepting the fact thatwhateveritisthatencouragedyou to open the trade in thefirst place has not come topass.

Oncethepositioniscorrectedto reduceoreliminate risk, it

willbeimpossibletomeettheinitial trade objective. Atrader has to accept thisreality.

It’s not personal. Statisticstell the story. We know thatthe 80% probability trade isgoing to be profitable trade80% of the time, but only ifour risk manager personaallowsustoholdthepositionuntilitexpires.

Do not worry about whatmight have been. Once youexitaposition,acceptthefactthat you made the bestdecisionthatyoucouldatthetimethatadecisionhadtobemade.Losingmoneyonsomepercentage of your trades ispart of every trader’s gameplan.

NOTE:Addingontoalosingtrade (doubling down, dollarcostaveraging)isthesameas

holdingalosingtrade,hopingforareversal.Ifatradeisnotgoing well, do not blindlyhold.Donotblindlyaddtoit.Re-evaluate and decidewhetheraddingtoitisagoodidea.Sure,itcouldbeagoodidea. However, the losingmindset is that the originaltrade premise is still good(because you never makemistakes) and thus, has tobeevenbetternow thatyoucanaddtoitatabetterprice.

Avoid that losingmindset. Itis a trap.Do not getmarriedto any position. Only ownpositions that are good rightnow. Unload positions thatare not worth owning in thecurrent market. It is okay totake a loss. In fact, it shouldmake the trader feel goodbecauseheknowsthathecanoperate a successful businessandmakedifficultdecisions.

The list of psychologicalexamples is lengthy. If youdevelop the winningmindsetyou will discover othersituationsthatcanbehandledmoreeffectively.

OTHER BOOKS BYMARK DWOLFINGER

MYBOOKS:

TheRookiesGuidetoOptions,2ndEdition(2013)

Createyourown

HedgeFund(2005)

TheShortBookonOptions(2002)

MYEBOOKS:

IntroductiontoOptions:TheBasics(2014)

WritingNakedPuts(2014)

The

ShortBookonOptions(2002,2014)

LessonsofaLifetime:My33years

asanOptionTrader(2010)

THE BEST OPTIONSTRATEGIESSERIES

IntroductiontoOptions:TheBasics(2014).

BookONE.(Volume0)

WritingNakedPuts(2014)

ABOUT THEAUTHOR

Mark Wolfinger has been inthe options business since1977. He began as a marketmakeron the tradingfloorofthe Chicago Board OptionsExchange. He also workedfor trading companies as anoff-floor trader, trainer ofnewly hired traders, and risk

manager. He now serves asan educator of publicinvestors, showing themhowthey can intelligently andconservatively use stockoptions.

BorninBrooklyn,NewYorkin 1942, he currently residesinEvanston, Illinoiswith hislife partner Penny. Hereceived a BS degree fromBrooklynCollege and a PhDfrom Northwestern

University(Chemistry).

His blog:http://blog.mdwoptions.com

He writes on options forabout.com:http://options.about.com

MarkDWolfinger