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Commodity Futures and Options Trading- Money Management, Risk and Trading Logic, PART 3
Possibly the most important aspect to succeed in trading is survival. This is number one. Without surviving the bad times we are gone, without hope. Money management and risk may seem like boring subjects, but read on to see how exciting they can be once you learn the specific reasons and logic behind their use. You may never trade the same way again!
Buying commodity options can be difficult for newbies. Some see a TV argument about how to strike it rich in gold or oil. They load up their entire account by buying out-of-the-money options, lose all their trading capital through premium erosion, and then curse the market. They do not consider to survive, they must prepare for the inevitable series of losses when trading with 10% accuracy. We have to survive long enough to be around when the 10% option winner hits the big time. The other 90% will be losers simply because of the probability of the method used.
In this case, it means dividing our trading capital into at least twenty parts in order to survive the series of losses that probability will surely bring us, over time. It’s about survival and knowing what kind of commodity trade we’re doing so we can adjust the money at risk on each trade. If we trade with 10% accuracy (buying options) and expect to make money on the first 3-4 trades, it’s pure arrogance.
Then there are some commodity options traders who overload themselves by buying large options positions and are willing to let them erode, with a total loss of 100% of the total account. They don’t plan to exit if the market doesn’t act right. It’s not a good idea. However, some buy a commodity option and use its total loss as a stop loss in itself. This is only acceptable if you are doing it with small positions. But the sad thing is that when these guys get only double the price of the option, they call it a big profit and take it. Pure madness!
How can you be willing to lose your entire investment and at the same time make tiny profits while still trading with 10-20% accuracy? The results are predictable. They lose constantly. Their excuse is that the analysis is bad, or the commodity markets are poor, or they should have entered another trade. You can tell them the math, but they don’t understand. No matter what they do, the result will remain the same unless changes are made in how money is managed. By the way, one definition of insanity is doing the same thing over and over again while expecting different results. ( smile )
The bottom line is that if your commodity trading method averages 20% (at best) accuracy by design, as buying out-of-the-money options often does, you better watch the your average winnings four times larger than your average losses. And that’s just for savings not counting commissions, bid spreads, and breakdown! This means that if you think a $2,000 loss is prudent, you’d better average $8,000 in gains to break even. Just to break even!
You have to sit on your hands and let the profits run when you buy options. This is long term where things even out over time. In the short term, you may trade better or worse, but over time, probability will put you where you spend the most time. With a $10,000 account, if you make $2,000 in profits and $2,000 in losses trading with 20% accuracy, you will probably be out of the commodity options business in less than ten trades. This may sound like fiction, but believe me, many new traders do exactly this, thinking that they will win in the end.
Part Four of Five Parts – Next!
There is a substantial risk of loss in futures and options trading and it may not be suitable for all types of investors. Only venture capital should be used.
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