Many new option traders believe they are going to beat the markets, climb Mt. Everest, and buy a Mercedes all in their first year of trading the product. OK, maybe not all that, but you get the idea.
I find that most new traders expect outrageously high returns. They have seen the ads for 200 percent returns in two weeks and seem to think that this is reality.
It’s true that a trade I recommended last week did return 200 percent overnight. But realistically that would produce a return of 2 percent to 4 percent in your portfolio. The reason: If all of your money was in a single trade, you could go bust very quickly.
So how much should a new trader expect to make? It depends on various factors, including their sources of information, but in my opinion a new trader should actually expect to lose money in the first year or maybe break even.
Trading is a profession, one that draws the best and the brightest. Ever wonder why there are so many complaints about the “brain drain” in math and sciences? One reason is that all those geniuses are passing up five-figure salaries in research jobs and turning to financial markets to earn millions, or even billions. That is your competition.
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You wouldn’t challenge Tiger Woods to a round of golf, step into the ring with Mike Tyson, or speed skate against Apolo Ohno. But when you put your money in the markets you are stepping up against the likes of George Soros, John Paulson, and Goldman Sachs (NYSE: GS).
Sure, people can get lucky. A trader can make money in the first year, or even their first few years, just by chance. But luck will carry you only so far.
On the Volatility Views radio program, Mark Sebastian recently said he ends up telling most people he works with that they should not be self-directed traders.
So what are new traders to do?
First, set your expectations low. The best hedge fund in the world is arguably Renaissance Technologies, and it has averaged 30 percent returns over the last 20 years. That beats every other fund that I know of, hands down.
Second, trade in small sizes. Each position should be 1 to 4 percent of your portfolio. That way a string of losses won’t wipe you out or put you in a position where you have to win big to get back to even.
Finally, arguably the best thing to do is to use vertical spreads. Many traders use collars on long stock, or just buy calls. But vertical spreads offer a higher probability of success and lower costs than outright calls. And they have the same theoretical profit-and-loss potential as a collar. The rest of your capital can stay in cash. This also means that you have a built-in hedge, so you don’t have to worry about paying for protection above and beyond that.
Too many traders expect to be right on all of their trades, and that leads them to put too much capital into each position. To use a sports metaphor, trading should be thought of more like baseball than any other sport: Striking out will happen often, and consistency is the key to success.
The vast majority of retail traders will lose money, especially in options. You really shouldn’t expect to make money, especially big returns, in the first year. Consider it your tuition, because there is a learning curve — one that is longer for some than it is for others.
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