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What is The Best Approach To Option Trading If You Only Have $5000?

Posted by Pete Stolcers on April 16, 2008

Option Trading Question

Money management with low balances. I read a lot about managing accounts by limiting the percentage of your balance you risk on any individual trade. However, if a person wants to get into trading, but has a limited amount of capital they are willing to risk, say $2000 - $4000, it seems that one has to risk a substantial percentage to make any gains when all the fees are added in. If you were to only risk 20% or less on any one trade, you would have to almost double your money a large percentage of your trades and trade short term OTM options. It seems that risking a larger percentage on a longer term deep ITM trades on quality companies would be safer. How would you approach trading if your account balance was less that $5000?

Option Trading Answer

Your statements would have been correct five years ago when minimum commission charges for stock options were much higher. Now, there are at least three or four firms that I know of that offer commissions as low as one dollar per contract with no minimum.

When minimum commission charges were $30, you had to take larger positions because your profits would be eaten up by your transaction fees. For instance, if you sold a five point OTM put credit spread for $1, your commission costs would be $60 (2 x $30). A one contract spread position would net you a $40 profit ($100 - $60) if it expired worthless. If it did not and you had to buy the spread back, your commissions ($120) would exceed your potential profit ($100) and you could only lose money on the option trrade.

This same spread could actually return a nice profit of $98 ($100 less commissions 2 x $1) with a $1, no minimum online option broker. Consequently, you are not locked in to any one strategy and you can spread your capital across many trades.

With regards to the best option trading strategy, $5000 is not much capital to start with. Assuming that you have read books on option trading and technical analysis, I suggest starting with out of the money bullish put spreads or bearish call spreads. If you think a stock is going to rally from $50 to $55, consider selling the $45 puts and buying the $40 puts. The stock can pullback 10% to $45 and you will still make money. Evaluate your forecast and adjust your timing based on how well you did. Place a stop to buy in the option spread at the short strike price. By playing on the frindges, you are increasing your probablity of success and you are building a positive experience. If you consistently nail the direction and the timing, consider buying options.

When you buy options, scale into postiions and buy lots of time premium. You will never pick the perfect entry point and scaling in/out will keep you in control. You will also be able to average your cost. Again, a discount online option broker is key. By buying lots of time, you will be able to watch the behavior of the stock and hone your timing skills.

Timing and risk management are the most difficult skills to develop. Options are a wasting asset and they move quickly. Start slow, build gradually and spread you capital over as many trades as possible. As your option trading skills develop, you can construct option strategies that mirror you opinion on the direction, magnitude and duration of the move.

Option Trading Comments

  • On 04/23, Donna Lepley said:

    When do you bail out? Say you purchase front month calls a week before the current month’s expiration. You’re in top-rated global companies with relative strength of 99 and upside guidance for the next quarter or year. The market draws them down early in the trade, but you still have nearly a month before expiration. Is there a specific point in time during the contracts you would consider exiting the trade if it did not become profitable? Or do your ride it to the end as long as you’re not at a significant loss?

  • On 04/30, Jason said:

    Donna,

    I think it all has to do with the rules that you have set before entering the trade. IMO, A stop loss, a profit stop and a time stop should all be set before you enter the trade. I can’t remember where I read it, but the analogy goes something like this..."You wouldn’t enter a burning building without first knowing where the exits were, would you?”

    One good rule of thumb I try to live by is once there is 30 days or less to expiration, I get out of the position. Time decay accelerates within those last 30 days and even if there are marginal gains in the price of the stock, Theta is going to kill any gains you would have on the option.

    Just my 2 cents…

  • On 05/01, Pete Stolcers said:

    To Jason’s point, know when you are right and wrong. Outline what you expect the stock to do. When it stops behaving (bullish trade: rally with the market and hold gains during market declines), get out. As long as the price action is constructive, stick with it. If the stock is not doing anything, consider stopping out. When you entered the trade you expected it to move.

    You have to be much more careful when trading front month options. Your timing has to be perfect because you will be fighting time decay.

  • On 09/24, tony said:

    Discovered this blog by accident and has been a God send, all my questions answered! However I do have a question for you, could you recommend a low cost discount broker. please.

  • On 12/04, option trading said:

    Same as Tony, could you recommend a low cost broker too please. You can email me. Thanks.

  • On 12/23, team building said:

    This system is fantastic! I started using it two weeks ago, and I already made 50% on my first trade! I really want to thank you for sharing this amazing system with me.

  • On 12/30, Pete Stolcers said:

    I’m glad to hear of your early success. The OneOption Scanner is the cornerstone to all of my research.

  • On 08/26, edward said:

    Great site.I was just wondering, why buy debit spreads, why not buy the call or put and save on commission especially if you are planning on selling them for a credit--double commission.

  • On 08/27, Pete Stolcers said:

    Debit spreads are a way to reduce your risk/reward profile. You defray the cost of your long option by selling one that is farther out. If you are wrong, the spread position will lose less money. If you are right, you will still make a nice return.

    When the market is range bound, I favor spreads. When the market is trending, I favor buying options.

  • On 04/28, William Stout said:

    How do I learn how to obtain technical indicators such as Bollinger bands, RSI, etc. and actually practice using them on my computer?

  • On 05/02, Pete Stolcers said:

    Get a good book on technical analysis (Martin Pring) and use a free resource like Yahoo charts.

  • On 05/27, Matt said:

    To everyone looking for a good discount broker I am with OPTIONSHOUSE. They have everything I need to trade options well & have very low rates.

    People often wonder how much you need to begin trading options. I started with $150. When you know how to trade well you don’t need alot of your own capital. Take the money from the stock market on your wins. Learn to trade with very few losses if any. DO NOT LEAVE YOURSELF OPEN TO TOO MUCH EXPOSURE!!! Get in & get out. Don’t hope & pray that your loss will turn into a gain. Using $5000 or $50000 won’t matter if you are not able to see setups, profit from them with either calls or puts & get out with some profit. Most of your gains will be 30% or less with an occasional 75-100% or more trade. There are plenty of stocks to make you some great money. I love trading the SPY weekley options, LVS weeklies, BIDU & POT. They make me money all the time because they consistantly move well & the options are very inexpensive & provide a high delta & multiplicity (or the ability to buy many options with your available capital).

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