Mindset to Minimize Options Trading Risk
By Hugh Grossman, DayTradeSpy.com
When I was a kid, my father used to always tell us to keep the screen door closed. We lived in a rural area and it seemed that all the flies would congregate at our house. Whenever someone opened the door, the flies would enter. If you ever enjoyed the experience, flies have a way of relentlessly buzzing around your head at 5 am. Most annoying, the only thing to do was to wake up and swat them. Of course, by that time, it was your sleep that was interrupted, and often made for a miserable day to come.
Knowing how irritated these insects can be, not to mention unsanitary, my dad would go on his nightly ‘fly patrol’. It was amusing to watch him take the vacuum cleaner and suck up these bugs. The kids would have to track them, then my dad would sneak up quietly behind them with the hose and instantly, they were history. Gone. Joined the rest of their buddies along with the dust and other garbage sucked in from the day’s house cleaning. It actually felt good, rather rewarding. Growing up, we kids would also partake in this fly patrol to ensure a good night’s rest.
As we got older, my dad would use his screen door analogy as a metaphor for greater things in life. “Watch your screen door”, he’d say if he saw some distasteful people lingering in our midst. Of course, nobody would enter our lives as an enemy; we would know that and be able to tackle them before they could do harm. Most people who turned out to be enemies would enter as acquaintances or friends, then slowly annoy us to the point they could distract or harm us. Often we would be unaware of what was going on until some damage had already been done, just like the flies.
We extended this protectionism to all facets of our lives. Physically being the obvious but also mentally and spiritually. By creating some kind of a shield around us, we are able to withstand the onslaught of the enemy, so to speak. “Always be aware of your surroundings”, we were told. We are judged by the company we keep and our behavior. Looking back, whenever I got into even the slightest trouble, I can trace it back to ’not closing my screen door’. As with the flies, any grief in my life was likely caused by my carelessness.
My strategy calls for a simple technique that earns me 5% or more per day, trading one outstanding stock, engaged for only about an hour a day. My methodology is not that difficult to learn but does have to be mastered, especially the mental aspect of the game, if you want to succeed. This article will address that psychological quality of trading, a topic that seems so elude most every trading ‘guru’ out there, likely because they do not know how to address it. Yet once understood, your risk will instantly diminish.
My name is Hugh and I am the Head Trader/Trainer for daytradespy.com. Over the years, I made a lot of money and I lost a lot of money, but I always took away a lesson from those losses.
Eventually, I started making some serious money. Then my friends, family and acquaintances saw me bringing home all the toys… exotic vacations, cars, houses, even a new airplane. They couldn’t contain their curiosity and wanted to know what I was doing. Hence we grew to what we are today.
Understand this Business:
Before you embark on your trading career, do understand what this is about. If you treat is as business, it will pay you as such. If you treat it as a hobby, it will treat you in the same manner. Those who give it their serious effort tend to do much better than those tinkering with trades.
Most traders – 90-95% - are out of this business the first year. They simply lose all their money. So the idea is to stay the course, learn all you can and master your one great strategy that works best for you.
This is not a ‘one size fits all’ endeavor. Every trader will have his/her own style, risk tolerances and parameters with which they can work. One fallacy that keeps surfacing is that traders often look to mimic others, thinking they will emulate their mentor’s trades. I can indicate when I will enter a position and you may follow, but we may well exit at different positions. The problem with that is that the follower is not necessarily learning what is being taught, and therefore destined to lose at some point.
As not every trade will be a winner, it is only a matter of time when something goes horribly wrong and the follower gets burned, with or without their leader. It is for that reason that it is imperative that all traders need to understand their trades. Become at one with the market, embrace a viable strategy and make entries and exits second nature, irrespective of your leader. It is incumbent upon all traders to take responsibility for their own trades.
That is not to say you cannot follow someone’s lead; just be cognizant of the inherent risks involved. I have some folks, for example, enter on my morning picks looking to take 8% per trade, simply because my published results support such a risk. Other traders are more comfortable taking 6% but doing it several times a day because they know how the system works, and by taking a lesser profit, they reach their targets sooner and more often. We each have our own styles.
Trading is much like professional sports. You’re only as good as your last game. How we deal with issues, both on and off the game, will impact our trading results. If you are still wound up over an argument with your spouse, it is probably a good idea to stay away from trading. Remain emotionally cool at all times.
I like to trade no more than several times a day. Good or bad, I would be emotionally charged, and thus subconsciously expecting some result from my trades. If I come off a series of great trades, I would anticipate another one, and it is easy to expect the market to deliver. Fact is, the market owes you nothing and can do whatever it wants, setting yourself up for disappointment. Always remain aware of your emotional quotient and stay humble.
Trading is not like any other business. It has no goodwill. Unlike, say a great restaurant that has been around for many years with an outstanding reputation, should the chef have an off night, it does not mean the restaurant is in trouble. Customers would likely dismiss it as an unusual night and return later. That goodwill has value. With trading, there is no such thing. You could be a hero one minute, a zero the next.
As traders, we often look to others for guidance. In particular, traders are attracted to live trading rooms. Here again, be judicious of how it operates. If there are a number of participants, you will likely find that the masses gravitate to the most charismatic personality, irrespective of their trading prowess. I once observed a trading group with perhaps 30 people in it, 29 of which immediately dumped their SPY holdings when one of the moderators suddenly yelled “Sell, Sell, Sell!” The market suddenly tanked. Guess where I was in that fiasco… I was one of the 29 losers. Lost thousands. Yet had I held my own mindset, I could have cleaned up in that move.
The trading business has the ability to change course in a heartbeat. Unlike our institutional counterparts, the retail trader can alter focus should the winds change direction. This is both a blessing and a curse. The unsophisticated day trader may make these changes on a whim, often getting whipsawed out of trades they would otherwise profit handsomely in. Often times, the novice enters a winning trade, riding the profit while increasing the sell point cent by cent. This undoubtedly will reverse, then the trader follows it back down, selling for a loss. It is actually amazing how traders are happy they sell for a loss… “I could have lost more”, they claim. Then the joy turns to sadness when they watch their now dumped trade turn back into a profit, as if it is still their trade. Know that once you leave a trade, it is gone. No longer yours. Never look back.
Conversely, I often hear of traders get angry because they only profited 10%, as they watch their stock climb higher. These are legitimate pangs of anger they feel. My response: never regret taking a profit. You will never go bankrupt by taking gains. Like a city bus, if you miss a trade, there’s another one around the corner. Be happy with your earnings.
Never overtrade. I used to trade 6 to 10 times a day, and did quite well at it, for the most part. Invariably that last trade of the day, where I was so sure of my profits, turned against me. “How could the market do this to me?”, I thought, as if the market owes me an explanation. As it was, I had a decision to make at market close: sell my holdings for a loss or hold overnight. Clearly, I would lose with a last minute sale. An overnight hold would sometimes turn a profit the next morning, leading me to think I did something right and it was ok to function this way, when in fact, I just got lucky. Big difference. Conversely, if the market went against me, I would lose. When I finally recognized that the market moves in overnight with or without me in it, I got smart and decided to stop trading at about noon. If I couldn’t make money in the morning, I likely would not do well in the afternoon.
Two things happened with that revelation: I kept more of my earnings and I also gained back my afternoons to do other things in life. You see, there are two aspects to market success… making money and keeping it.
There are many aspects to the mentality of trading. This article just touches on a few but I want to bring your attention to three key emotions you absolutely must have total control over. Your ‘screen door’ must be completely locked against these mental gremlins at all times if you want to succeed. There is no avoiding it if you are serious about making money on the market.
We need to do everything humanly possible to minimize risk in trading. One bad trade can destroy a person and his family. It is imperative to tackle and hold down these three emotions.
Fear, Greed and Ego
Studies show that fear is the overriding emotion that makes traders sell their positions. You only need to observe any stock chart. Prices gravitate upwards but drop sharply. Money begets money. When demand increases, it attracts more money into the market and prices rise. Similarly, when prices drop and a selloff starts, often with the institutions, traders dump everything like a hot potato. Just watch how prices tank about three times as fast as they rise. Fear is a killer and often times, causes unnecessary sell offs that would otherwise be profitable trades.
It took years to overcome my fears. I even took this exercise outside the trading world, addressing my fears head on. For example, I was always afraid of heights. I would rather endure a root canal than to clean out the eaves troughs on my one story home using a ladder. So how did I combat this crippling weakness? I took flying lessons. Through it all, I endure the terrifying stalls, spins and spiral dives. I experienced forced landings with and without an engine, with and without a runway.
When I got my license, I was given a piece of paper that confirmed my courage, much the same as the wizard awarding the lion a medal in the Wizard of Oz for saving little Dorothy. As a bonus, I also gain a healthy dose of confidence… and intelligence along the way… what a deal that was!
Now when I trade, I see short term, medium and longer term scenarios. When I get compliance on all three levels, I use my intelligence to courageously enter a trade and approach the positon without fear. That guides me to profit.
Fear: conquer it head on.
Greed is a very compelling emotion that can lead to catastrophic results if left untamed. Traders who are normally the most generous, humble and giving people in their everyday lives turn into Jekyll and Hyde personalities when confronted with the stock market. When in a profitable trade, the tendency is to stay in longer and take as much as possible out of the position. Fair enough, except that at some point, the stock peaks and reverses.
Intellectually, all trader know that. Emotionally, it fails to register as the more a trader has, the more he/she wants. To inch up your gains has merit and in a bullish market (assuming you are bullish), why not? Take as much as possible. But you also know that markets can and do reverse quickly and unannounced.
What to do? I am likely the guiltiest with greed. I use several mental tricks to combat this overbearing emotion. First, I hide my account balance, knowing that these numbers are a distraction and can lead to poor judgment. For example, if my account shows $9,950 on a Friday afternoon, I may be tempted to enter one last positon to take $50 and ramp up my balance to $10,000 heading into the weekend. This divergence has cost me thousands as I enter trades for the wrong reason and without any regard to the proven strategy.
Another mind trick is to accept that many smaller, 6%-8% trades are much easier to attain than one 20% or 30% profit. If I cannot be happy with a modest gain… several of them in any given day, then I should rather seek the services of a therapist. Always remember that most people do not even have as much as a retirement savings account set up. Of those that do, most are getting a nominal 5% per year or less. That puts us day traders proudly above the norm.
Understand too that our humility will be well rewarded. In fact, if you only seek a modest 5% per day net profit, you are doubling your money in one month. I have a trading plan spreadsheet that illustrates that using this modest, highly attainable system, one could take $1k into $100k in well under a year.
Greed: remain firm for steady growth and ignore what you ‘could have’ made.
Ego is the final temptation you must keep locked behind your screen door. Accept that no one knows who you are in this game, so any attacks on your account are not personal. You are only an account number with your broker. Accept that you have nothing to prove to anyone. Fellow traders will understand your predicaments; all others do not matter. They have no clue what it is like. Accept that losses are part of trading and that using tight money management techniques will ultimate save your behind, should you fall into a trap. Who you are matters not. There is only one reason to trade: profit.
Whether you earn 5% or 50% in a trade is irrelevant to anyone but yourself. Lose any need to better you last efforts; it’s the slow, steady income that creates long term wealth. I destroy greed by placing concrete sell orders as soon as I make a purchase. If I pick up 8% and the stock rises to a potential gain of 60%, I don’t care… congrats to those who took it higher. I’m good with my fair share of the market.
As a side note, studies show that the best traders are women with no male influence. Single women make the best traders, followed by married women and married men. The worst traders are the single young men, likely on the heels of hit movies like Wall Street and the Wolf of Wall Street.
The market eats those with egos. Park it the night before you start trading.
Discipline and patience are the main characteristics for successful trading. Knowing how to discern which is needed when is key. Even the famed investor, Warren Buffet, said all you need is a 100 IQ for successful trading. Clearly, those who can maintain clarity and calmness are the winners.
My experience is that discipline and patience are like muscles. Use it or lose it. Those who come from a military background appear to be the most disciplined traders. In fact, anyone who needed a strong sense of control to achieve their prior life’s goals make the best traders. Following rules, assessing risk and displaying a sense of will power to ‘pull the trigger’ are traits of a winner.
Like a muscle, it is good to exercise discipline and patience. For example, my fine German built automobile loves to go fast, only superseded by my desire to drive even faster. You can only imagine I have been unable to keep the speed limit since my driver’s test in 1971. I have all the speeding tickets and insurance increases to prove it. However, as a strength and conditioning exercise, I took to the New York Interstate and, in a slow stretch of highway, I pulled into the right lane and held my car at the posted 65 m.p.h. My wife was not amused so I do not do this with her anymore, but often times I will drive the posted speed limit to strengthen my discipline. It started with just one mile, now built up to a 10 mile stretch of highway. Of course, I only do this when there is no interruption of traffic.
Learning to cope on a slower speed of life does become easier over time. You can extend this virtue to other parts of your life, including options trading.
Applying the Screen Door Mentality
I made a point a long time ago to knock out the negatives in my life. Stay positive, stay focused, surrounding myself with only people who exert a positive influence on me.
This is exemplified in my trading.
Using the winning methodology I developed for my own trading, and now teach others, I recently bought the SPY 218 next week’s expiration call options on August 31 for 1.19. The market turned on me. Through careful maneuvering, I bought more at .99, bringing my average buy price to 1.09. From a mental standpoint, most trader would have sold early on with the drop. After all, they were losing, right?
I don’t take losses very well anymore. Through my various inputs, I had every confidence still in the trade. The storm brought SPY down to .63, a whopping 42% drop, but I stuck with it. In fact, I got very excited at that moment, enticed by what was happening in the market. So much so, that I bought a higher risk, this week’s expiration 218 calls for .54, more at .40 to bring my average down to .47. I had every confidence this was to be an outstanding trade. That latter entry was on a Thursday during a Live Trading with the Pros session, shown mostly as a demonstration.
The irony of it all, I spent most Thursday afternoon pacifying our participants in their long positions.
But look what happened on Friday. SPY surged, pulling up all our calls with it.
The accolades poured in, but more importantly, those who stayed the course pulled in stunning profits.
Whether a trader takes a profit or loss has little to do with the actual market. It has everything to do with the mental approach to trading. The market does what it does. It goes up and it goes down. It is how you trade, how you control your emotions that affects your bottom line.
In this trade, I took my gains early on Friday morning.
Front week’s options went from .47 to .72 for a profit of 53%.
Next week’s options went from 1.09 to 1.34 for a profit of 23%.
The following were applied to this trade: discipline, patience, self-control, intelligence, confidence and courage. As well, my proverbial screen door was shut to the naysayers, those well-meaning souls destined to protect me from this momentary loser trade.
Feeling positive on the Friday, heading into the Labor Day holiday weekend, I took on another two positions, this time to the down side.
Again, following my strategy, I bought the SPY 218.50 put options expiring in a few hours for .22, at 10:02 am, selling a mere 7 minutes later for .30, yielding a profit of 36%.
One last trade at 10:48 on the SPY 218 puts for .81, out at .88 topped off the day for an additional 8%.
Total for the day: 120% profit…. and the best part: I was done before 11:30 am, leaving me the rest of the day to enjoy at the beach with my family and friends!
It is understandable how most people cannot fathom how these gains can occur. Instead, the mentality of the masses directs them to complex strategies involving high maintenance spreads, most of which do not approach the potential you can realize by keeping it super simple.
You can only lose if you sell for a loss. If you are losing, you still have opportunities to turn your losses into profits.
Below is the screen shot of the actual positions. Real trades, real people, real money.
The market will do what the market does. You cannot control prices, only your reaction to them.
How you react will determine your profits and losses. Bear in mind that it is other traders you are trading and the winners are those who anticipate what the masses will do.
Once you understand the mind game in trading, how you relate to the stocks and to other traders, it is not that difficult making money in the stock market. The mental approach serves to minimize risk.
Above all, mind your ‘screen door’.
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