Each vehicle has a different level of performance. Some vehicles are fast while others are slower, some require more maintenance, some require constant monitoring, others can be driven everyday with minimal user intervention.

Do You Have A License To Trade That?

To drive a car a license is required, but to trade in the financial markets there is no license required. This leads to millions of people that are trading the markets that have no idea how to control the vehicle that they are using.

Most people will be able to open an account with a brokerage company with little difficulty, and begin trading with out any kind of formal testing or knowledge. This is the equivalent of getting into the drivers seat of a car, and not knowing the difference between the gas petal and the brake pedal.

Driving Fast Cars Without Experience

In the beginning of a trading career many people want to make money really fast, without having to learn how to handle the vehicle they are trading. So they trade penny stocks, and hope and pray that the 80:1 payout will make them money very quickly.

The issue with this approach is it is very similar to giving a 16 year old, with no driving experience driving, a Ferrari 458 Italia. Will it be fast yes, but it will also likely end in a loss of control and an accident. Is it to say that the 16 year old will never be able to drive the Ferrari? Certainly not, it only requires training and experience with the vehicle.

Investing is similar to driving in that it takes practice and education to overcome fear and doubt. Once you have an understanding of how to “Drive” one vehicle, new vehicles will require only minor adjustments for you to become proficient.

2 Types Of Cars You Should Have In The Garage

In general, all investment vehicles can be compared to vehicles. There is a great number of vehicles in the world as there is a great number of investment tools. The two types of vehicles we will focus on are:

• The daily driver (the car we will use to make a living)
• The race car (the car we will use to make a fortune)

Each vehicle requires specific disciplines to be mastered before the vehicle can be fully utilized. If you want to drive a race car, time and money must be spent learning everything about that vehicle. What are the requirement for entry? What are the rules on the race track? Is there specific experience requirements?

Which Vehicle Should You Learn To Drive First?

The Daily Driver is the vehicle that will make you a living. Many traders tend to skip this vehicle because they have a job that makes them a living, they believe the reason they should invest/trade is to make a fortune. Making a fortune is exciting and “when” they find that one hot tip they will be in the money. The issue with this approach is that most people that have a job to make a living, do not have sufficient time or money to learn the vehicle that they want to trade.

My recommendation to most people is to learn how to handle and drive a daily driver. Once the daily driver is creating enough income to financially support a “Race car”, then start learning that new vehicle. With this approach even if the new vehicle is not what you expect, you will still be able to learn another vehicle down the road.

Guest Post by John Pierce

Because of an option’s moneyness, the option can be distinguished in ITM, ATM, OTM. These relationships help determine the intrinsic value which is a key factor in option pricing overall.

Since I continue to see beginners struggle with this concept, I put together these 6 quick examples below to help you figure this moneyness out once and for all. Before you start you also may want to check out our Video Tutorial on Option Moneyness found in the education dashboard.

In-The-Money (ITM)

For a long call option, the option will be ITM if the strike price is below the current value of the stock trading in the market.

For a long put option, the option will be ITM if the strike price is above the current value of the stock trading in the market.

Out-Of-The-Money (OTM)

For a long call option, the option would be OTM if the strike price is above the current value of the stock trading in the market.

For a long put option, the option would be OTM if the strike price is below the current value of the stock trading in the market.

At-The-Money (ATM)

For both long calls and long puts, the option is considered ATM when the strike price and stock price are the same.

Consider this the “tipping point” between an option being OTM and ITM. Generally it is hard to find ATM options that have the exact same strike price as the stock, so anything within a couple points of the closest strike price is considered ATM for options traders.

What About Short Options?

Short option contracts are just the mirror image of the above long contract payoff diagrams. Most of the option moneyness examples we have here would be the reverse for short option contracts. So feel free to bookmark this page and use it as a reference guide in the future.

If you want to learn more about short options, watch these two video tutorials on Short Calls and Short Puts from our video tutorial library. And as always, please add your comments and suggestions below!

Timing is really everything.

Blow-off Top or Pull-Back?

Most traders I talk to are in one of two schools of thought right now. Either you think this is the best shorting opportunity for the next 2 years or you are convinced that we are now in a new bull trend that could take the S&P 500 well above 1,500. It’s pretty much split down the middle honestly.

Whatever camp you are in there are some key stats that are glaring and cannot be brushed under the rug:

1) The VIX closed the week below 20 for the first time since last July.

2) S&P 500 is three standard deviation points above its 20-day moving average.

3) AAII Sentiment is near extreme levels at 47% Bullish compared to 29% Neutral and 23% Bearish.

4) S&P 500 contract short interest has declined nearly 32% – no more short squeeze?

Stick to Your Guns (And Indicators)

Will a top come soon? Maybe (hopefully) but who the heck knows right. I know I have been getting itchy to trade more as I’ve been mostly in cash for nearly a month now. Not that I don’t want to trade, but I think that better risk/reward ratios will come soon and I’d rather have cash on hand to make those trades.

During bull market trend’s like this I find that keeping an eye on the indicators is best. They can and often stay over-bought for weeks but eventually they do break and divergence will be the early warning signals. Look for momentum indicators to drift lower even though the market will continue to move higher.

A key part of a financial education is understanding the basics of risk management with respect to your entire portfolio; specifically how your income capabilities and your risk tolerance level should determine the allocation to options.

The Importance of an Emergency Fund

Before you even think about trading options (or any other investing for that matter) it is essential that you have set aside an adequate emergency fund to prepare yourself for the unexpected events. Although many experts may debate the actual amount of money needed in such a fund, the general consensus is that you should be able to support yourself for three to six months from your emergency fund.

Since an emergency fund is designed to protect yourself in case of an emergency, that cash should be easily accessible in a highly-liquid savings account or money market fund. Check out our post on the top 8 places to park your cash for ideas.

Under no circumstances should you think about investing these funds in options; given the risk management characteristics of emergency funds, this cash should only be placed in accounts that have very little risk attached to them. And never make any excuses as to why you “need” to take money out of it. It shouldn’t be used for a new car purchase or a new iPad.

Finding Cash to Invest in Options

Once your emergency fund is fully funded, you can start to think about the cash that is available to you for options trading. If you have any additional savings that is not a part of your emergency fund, this cash could conceivably be used as part of your allocation towards options trading.

In addition, I would make it a point to include or at least allocate any future income that you earn from your current job to grow your portfolio. Budget out your monthly expenses and include a line item for the “trading fund.” At least that’s why my wife and I do each month.

5 Things to Consider Before Investing

Although such a broad-based education in personal finance could take a lifetime to learn, a few key lessons that I have learned along the way and wanted to share are as follows:

• Always have an adequate emergency fund of at least 3-6 months.
• Do not invest in anything you don’t understand. Hence why we offer free education.
• Diversify your investments among asset classes, strategies, and timelines.
• Never invest money you can’t afford to lose (beginners pay attention here!)
• If you worry about risk management first, the profits will take care of themselves.

Options trading is an inherently risky financial activity that should only be pursued by those people who have developed effective risk management and asset allocation strategies. However, if you are willing to obtain the education and perform the hard work necessary to make money at it, options trading can be a very rewarding and profitable.

How Casino’s Make Money

In very simple and easy to understand terms casinos make money by slightly tilting the odds and chances in their favor. Every game you gamble on in a casino has a built in statistical advantage in favor of the house. That edge can be extremely small (as low as 2% sometimes), but millions of bets with that edge started to add up.

The casino owner’s could care less about any but getting as many people through the doors as possible to gamble. Hence why they offer free drinks, food, great shows and amazing hotels. The more people gamble the more the casino makes.

Casinos know the odds and stick to a very strict risk management plan.

Probabilities and Odds When Trading

It’s fairly easy to find odds data on a particular stock, ETF or index that can transform your trading. By knowing how to analyze historical probabilities you can quickly narrow down your strategy list and choose option strategies that are more likely to make you money over time.

Just like the casino, the concept of trading professionally is knowing up front that you are going to have both winning and losing trades. The key to success is to make sure that the winners outperform the losers on a consistent basis – not just once in a while. Tilt the odds in your favor by making smarter decisions up front and managing risk along the way.

In this video I’ll show you how to find, analyze and choose an options trading strategy using thinkorswim’s desktop platform tools.

Differences Between Weekly & Monthly Options

Before discussing the various trading strategies that can be build with weekly options, it is important to go back and review some of the more important trading terms. Remember that weekly options are different in that they have a much shorter lifespan. Most of these weekly options start trading on Thursday and expire the following Friday. This provides uniformity and also allows traders to easily “roll” weekly options from one expiration to another.

Four Strategies You Can Use

1) An investor can use weeklies as a pure play. Because they do not remain open as long, the may involve somewhat less risk, but it is important to consider liquidity constraints, as many weeklies have smaller markets. The lower risk of a shorter holding period is lost if the instrument is illiquid and the investor cannot trade the position when needed.

2) Offsetting positions can be taken at certain times during the month between weeklies and monthlies. When the options expiration of the monthly contract is nearly identical to the expiration of the weekly option, there may be a price difference that can be captured between the two.

3) You could take a position in the monthly contract and take rolling positions in the weekly contract in the opposite direction. The idea is to establish a consistent hedge against short term market volatility but make sure that you factor in the higher transaction costs for getting in and out of the market more often.

4) The last approach to using weekly options is to use them to supplement income from an underlying position. This is often called a call writing strategy because the investor who owns the underlying instrument writes calls on that position and collects the premium. If the underlying remains static or falls, the investors makes a profit or mitigates losses. If the underlying rises, he or she may miss some of the profit, but the downside protection is used to justify this risk.

What About Trading Daily Options?

Rumors have been floating around the web about the possibility of daily options as the next logical product for traders. We already had monthly options and weekly option popularity is growing fast. Add your comments below and let me know if you would ever trade a daily option that started trading in the morning and expired that same afternoon.

The wording is subtle yet there is a powerful difference between return on capital and return of capital. The first is the return on the money you invest. For example, if you made $8 on $100 of invested money you would have an 8% return on capital. The later is the ability to at least get your $100 back at the end of the day and not lose any money.

Success Is Measured By How Much You Keep

I firmly believe we are entering another very tough and potentially devastating year for stocks. It feels oddly similar to the same market sentiment just before the crash in 2008 – just a new catalyst to trigger the fall (i.e. sovereign debt).

Back at the start of 2009 the best money manager and investors weren’t those who earned the highest return in 2008 but rather those who lost less than everyone else. Being a “smart” investor then meant having money left after the shit hits the fan and the same is going to be true of those investors in the coming years.

Looking back at my trading journal (and this blog’s archives) I know that what was so successful for me trading during 2008 was that I had small positions and a lot of put protection. Moreover, I stayed mostly in cash and waited for the best opportunities to come out before I put money at risk. Living through that time and surviving taught me to focus my attention on return of capital.

From $20/share to Bankrupt In Just 5 Days

Above my computer in my office is a picture of the October 1929 crash newspaper front page. It’s there to constantly remind me of what can happen seemingly overnight. The systematic risk factor that is prevalent in all markets.

Lehman Brothers is also a classic example and still recent enough to remember the pain of a market crash. Keep in mind that it took just 5 days for Lehman to go from a $5 stock and still worth millions of dollars to bankruptcy. And even 9 months before the crash Lehman was a $60 stock. Always remember how quickly things can turn!

Add your thoughts below in the comments section about the top strategy you are going to use to protect your portfolio this year?

Including dividends, the S&P 500 total return index (which is what we track against) returned 2.11% for 2011. Better but still poor performance. Think about it this way; even including dividends you lost money after inflation, which is running at 3.4% trailing 12 months.

Slow & Steady Wins Again!

Each year it amazes me how conservative trading with options out-performs when used with proper risk management. I never had shot for unrealistic returns that cannot be duplicated month after month – and this has been very profitable for me.

This year all 3 Option Alpha portfolios beat the major index by a large margin. Funny how consistently making 1-3% each month really adds up at the end of the year and in my opinion is much safer than blindly putting money into the stock market and praying for returns.

Doing a quick review of the year this week, I have some general comments that I thought might be interesting to share…

1) Notice that you don’t have to trade each month to have amazing performance. Notice that we did NO trading for the Iron Condor portfolio in the 2nd half of the year and yet still made 26%+. Lesson: wait for the right time to trade and don’t force trades into the market.

2) Trading was much more profitable on a monthly basis early in the year. During the 2nd half of the year we scaled back our positions and focused more on risk management and rolling trades to protect against the summer sell-off. Although we sacrificed  some income, I feel the added risk aversion was a big winner for us this year. It’s how I got through the 2008 crash profitable. If it works don’t fix it right?

3) I still believe that we report earnings better than anyone else. We have a model portfolio which includes cash allocations and only report on trades actually filled. More often than not other sites will say they make 40% or more when in fact they just made 40% on 1 small trade and left the rest in cash. This is NOT an accurate description of their returns. They should factor in the amount of money left in cash earning 0%, and thus their returns should be much lower.

How Was 2011 For Your Portfolio?

Add your comments below and share the “ups and downs” of trading in 2011. What worked and what didn’t? What are you going to change in the coming year to make yourself a more profitable trader? Can’t wait to hear from you all!