In options trading and investing, as with any business you're in, you want to turn a profit. When things are going great and profits are coming in, the business is thriving. When things take a turn for the worse, your winners come less frequently and your profits become smaller.
That's when things can get really ugly.
But just like in any business - or any part of your life, really - it is how you deal with losses that matters. Your ability to manage your losses is what truly speaks to the profitability of your trading business.
Unfortunately, many investors never learn this... because they don't want you to learn it.
When I say "they," I am talking about anyone who benefits when you lose money. That includes market makers, day traders, the big banks, sophisticated trading firms, or anyone on the other side of your trades.
Today, I'm going to show you the best way to deal with losses.
But to do that, you're going to have to change your whole mindset...
Face facts, traders. Losses WILL happen. There is no 100% winning strategy. The only way to guarantee 100% that you will not take a loss on a trade is to never take a trade.
But you're determined to learn how to trade and do it successfully. And to succeed in trading, you need to learn how to lose appropriately.
I know that sounds counterintuitive - that learning how to lose will help you to win.
So let me explain...
Once you can accept the fact that losses are going to happen in the normal course of trading, it is then important to work out what percentage loss is acceptable to your portfolio.
Of course, I'm talking about risk. It's something we talk about often because it's such an important part of options trading. You can't just go into a trade thinking about your potential gains - you also have to think about your potential losses.
It's part of any successful trading plan.
I've told you this before, but it bears repeating. If you set up a plan where you will risk 50% of your portfolio on your trades and you are willing to risk 100% of that capital on each, two consecutive losses will completely wipe out your trading account. This is not acceptable!
Contrast that wildly irresponsible scenario with one where you decide to only risk 2.5% of your capital per trade. Again, assuming you are willing to accept a 100% loss per trade, it will take 40 consecutive losses to wipe out the account.
If you've been reading Power Profit Trades or following along with Money Calendar Alert, then you know I aim to hit 100% gains on all of my options trades, no matter the strategy. You also know I base the trade cost/risk at no more than 2% of a theoretical $25,000 account, or no more than $500 max risk on each trade.
Of course, your risk profile could be a little different - you might only be comfortable risking 1% on each trade. But as long as you know the risk ahead of time and are comfortable making your trades, you're headed in the right direction.
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Thinking of your trading as a business is important to your success. It allows you to separate yourself as a person from yourself as a trader and can help eliminate emotional decisions from your trade plan.
It is not unwise to treat your trades as your inventory. Just like a store has inventory it needs to bring in and then sell, your option trades constitute your inventory because your aim is to sell each option for more than you paid.
You need to get inventory in and turn it around, preferably selling it at a profit. Consider the inventory that does not close out profitably as "shrink."
Shrink is the term businesses use to describe loss of inventory, and many businesses have a pre-determined shrink amount calculated into their P/L models. It can be attributed to employee theft, shoplifting, administrative error, vendor fraud, damaged goods, or any other factor that contributes to a loss of inventory. Whatever the cause, it's simply a cost of doing business.
So in your options trading business, you have to ask yourself: What is your pre-determined shrink amount? What is the level of loss you're comfortable with as a cost of doing business? Is it 2% per trade? A specific dollar amount? Or are you more comfortable using a stop loss to lower your risk?
Before you begin your trading business, you must determine how much you're willing to lose on each trade and how to handle those losses when they inevitably occur. Now, many of you have already started trading, but it is not too late to incorporate these five simple rules into your overall options trading strategy.
Determine the loss amount per trade your account can bear. Adhere to it with a discipline that allows you to stay the course. That will go a long way to preserving your capital.
Capital preservation is key. The market makers, day traders, and big banks are all counting on you to lose as much money as possible. The better you preserve your capital, the more profitable your trading business will become.
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