Yes You Can Trade Stocks and Options Like a Pro

You may believe that professional traders have a huge advantage over the average “homegamer” as Jim Cramer likes to refer to the viewers of his very popular show on CNBC called “Mad Money”. You probably think the pros have a lot of advantages like top notch research and access to high level executives at many listed companies. Well, thanks to the internet, homegamers can now access that same research and thanks to Regulation FD, which mandates fair disclosure of all significant company information in a public forum like an SEC filing or a press release, those cozy one on one meetings are no longer legal although they probably still occur.

One of the professional trader’s advantages is something that you can easily adopt. It is called Money Management or Risk Management. There is nothing exciting or sexy about it, but without it you’re just gambling. I always recommend Vegas for gambling. The casinos there will at least give you a room, a meal and as many drinks as you can handle. Vegas makes it fun to gamble and lose. Wall St. will give you nothing but a quarterly statement reminding you that gambling does not work. Money management is the crucial step of calculating risk before entering every new investment or trade. In this article, I am going to explain how any homegamer can implement a money management system and start trading like a pro.

First, you need to assess your own risk tolerance. Are you willing to swallow large losses (greater than 2{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} of total account size) on any given trade or investment? Maybe you are only comfortable taking a ½ of 1{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} hit on any one idea. These are preferences unique to each investor. The next step is to set up the parameters for the trade. You need to be educated and realistic about expectations both good and bad. Stop price is the parameter you set usually based on analyzing a chart of the stock you’re considering for an investment or trade. The stop price could be a support level, a percent retracement from a recent high or a confirmation of a bearish chart formation. The idea of a stop price is to get you out of a stock before it really goes against you in an unrecoverable way. The target price is another parameter you set and is usually based either on a fundamental analysis of the stock to determine fair value or a technical analysis that uses charts to predict where the stock could ultimately move to before the momentum subsides.
For example, let’s look at a potential investment in Microsoft (Symbol MSFT).
The stock has traded in a $4 range for a year. If you decided to buy MSFT in October 2005 at $25 per share you can realistically frame your trade using the $4 range. You could set your stop price at $24 per share since that has shown to be a good support level during 2005. You could set your target to be $28 per share since that has been the top of the range for MSFT the whole year. Now if you plug in the rest of your parameters, let’s say 1{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} for risk tolerance, $100k for total account size into a Position Size Calculator such as the one available for free at http://broadbandbrew.com/positionsizing_calc.htm you will quickly see that you can safely purchase a maximum of 1000 shares of MSFT and still adhere to your risk management system. The Position Size Calculator is a calculator that uses parameters you set to determine the correct number of shares you should trade for each investment you are considering as well as the risk/reward ratio and total profit potential if your target is met. In the MSFT example the risk/reward is actually pretty good at 3.0 ($3 up and $1 down). The total profit for the trade is $3,000.00 (not including commissions) which is a 12{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} gain. That’s not bad for a homegamer.

The Microsoft example is one case. Now let’s look at another trade, one with very different dynamics. TLT Put Options that expire in 10 trading days. If you decided to buy this option at $0.25 on 11/28 and hold till maturity, it could very well be worth zero or several dollars. It actually was trading at $0.55 just 2 days after your hypothetical purchase. That’s over a 100{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} return in 2 days. You’re a genius or just real lucky. It doesn’t matter as long as you managed the risk.

How does one manage this high level of risk you might ask? Exactly the same way we did for the MSFT example. You could realistically use zero as your stop loss since it’s unlikely you will have a chance to stop out due to the extreme volatility. Using the same 1{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} risk tolerance and $100k account size, the Position Size Calculator comes up with 40 contracts, the maximum number of contracts (options trade in contracts where one contract leverages 100 shares) that you can safely buy and still adhere to your risk management system. If you sold the options at $0.55 you made $1200 (not including commissions) which is a 120{13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} return in two days. Once again, that’s not bad for a homegamer.

I bring up these very different trading examples to make this point. By employing a risk management system, you can trade pretty much anything without fear of depleting your account beyond acceptable levels. Even if you lose, you will survive to trade another day.

I can’t stress enough the importance of risk management. The winning investments always take care of themselves. It’s the losing ones that cause homegamers problems. You just can’t let one losing trade impact your entire account to the point where getting back to even requires unrealistic returns.

It is interesting that most amateur investors and traders focus most of their efforts on investment selection and timing their trades. They spend little or no time on money management. Some always trade a fixed dollar amount while others use a fixed {13624d55b67f4b161de617d2e9d293368a3a357ee2b9d3c0f7245ef1c05927df} stop loss regardless of the varying dynamics of each trade. If you don’t account for the different characteristics of each investment or trade, you are either taking too much risk or not enough. In the long run this will handicap your performance.

There are quite a few different position-sizing strategies that you can use. Some work best with stocks, while others are better suited for derivative trading (options, futures, etc…). All of them are anti-martingale strategies where the size of the position goes up as your account size grows. For a much more in depth discussion of money management systems and position sizing I recommend reading “Trade your way to financial freedom” by Van K. Tharp.

Yes you can trade stocks and options like a pro. You just need to focus on managing risk the way professionals do. You need to use position sizing models like the one employed by this position sizing calculator: http://broadbandbrew.com/positionsizing_calc.htm You need to be consistent in applying your own risk tolerance, and you need to have realistic parameters for each trade or investment you consider.