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Home // Options Trading // Virtual Options Trading: Earn a Living Trading Options – Video 4

Virtual Options Trading: Earn a Living Trading Options – Video 4

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Hope you guys are trading well here and you’re all paper trading. I hope you have all paper traded beforeyou started actually allocating real money to trades. I have a very special presentation today.

Basically there are four risks to this type of business and I’m going to share all four risks with you today. These risks are something that you really need to keep an eye on as you develop your business. They’re not something that are terribly intuitive, but these are the things I’ve learned while doing this business and by creating these business opportunities.

When creating an investment business,we manage by the numbers. The numbers are everything. Every business understands what their product is. You have to have a very good, firm foundation of understanding what your product is. In this business your product is calls and puts. This is the stuff that we deal with, the product that we deal with. We’re selling options and we are buying options. We are a business that buys and sells.

Anytime you’re in business, you have risks. The four risks that I’m going to talk about todayare concentration of risk, overlapping trades, allocation of capital, and finally over trading or over adjusting positions.

Let’s take the first one, concentration of risk. What I mean by concentration of risk is that you have almost all of yourprofit potential centered around a single strike price. For example, I have currently on the screen our portfolio with the symbol IWM so it’s weighted against the IWM. As you can see, we have a fairly wide range in which the IWM can move and we could still profit from this position. Concentration of risks means that at the 73 strike price you have a very large position at the 73 strike price. I guess size all depends on the capital that you’ve allocated forthis business.

Let’s say $5,000 is a lot of money to you. Well, if you have $4,000 of your money tied up in marginand they’re all centered aroundthe 73 strike price, what you’re doing is you’re concentrating your risk at that point. If prices move way down or they move way up, you’re probably not going to have the same type of profit potential as if you had a wider range in which you could profit from. So that’s concentration of risk.

Concentration of risk means having a lot of contracts or size position for you at a single strike price. That could be if your capital allocation for the businessis $5,000or $20,000, or $50,000, or $100,00, or even $500,000, it doesn’tmatter. If you have a large position that you would consider large at a single strike price you have concentration of risk and that’s very dangerous. Prices can move dramatically against you very quickly and if you have a concentration of risk at a particular strike price, you’re going to get hurt.

The third thing I want to warn you about and the third risk of really this type of business is the allocation ofcapital. Allocation of capital means that you have so much capital available to you even if you had $200,000, you don’t want to spend $200,000 on opening these positions. If you have $20,000, you do not want to use all $20,000 opening these types of positions. If you have $5,000, you do not want to use all $5,000 opening these types of positions.

The reason for that is let’s say a gift store, like any other business, had an opportunity to buy stock to put in their store at a very low cost. This opportunity is only availablefor just a few days because there are other people who are interested in the stock. But you could get it very cheaply, maybe 50 percent cheaper than you can normally buy it, you would need the capital available tomake that purchase as the opportunity became available.

That’s what we need to think about in this business. When our prices start to run up towards our breakeven points in our portfolio,we don’t need to make changes to our business to take advantage of those opportunities because many times a position that runs up against our breakeven pointsis an opportunity to add to our current positions. It’s a smart allocation of capital.

We start our portfolio out on some basic positions but we always make sure that we have capital available, working capital. In any business it’sextremely important that we have the working capital to take advantage as necessary.

The fourth risk that I want to talk about is over trading or over adjusting. If we take a look at a current chart of the Dow Jones Industrial Average, you’ll see that yesterday we had an extremely large run-up in prices. In fact they were up almost $200 yesterday. Today they were up another $115but now they’ve backed down quite a bit. In fact, they backed down to the point where it’sbelow this 208 day moving average which we had kind of determined to be somewhat of aresistance points, as well as the 13,100 level.

Technical analysis is fairly simple. You have support and resistance points. You have support. You have resistance. You have resistance and you have support. That’s pretty much all you need to know as far as technical analysis goes for the type of business that we run. That’s pretty much it.

But prices do tend to fluctuate. Sometimes they go up, sometimes they go sideways, and sometimes they go down. Adjusting positions becomes really an art of knowing when exactly to make those adjustments. You want to try to keep yourprofit picture and your price pretty much centered. And if it goes off maybe you do want to do a little adjustment. You don’t have to do a large adjustment.

So those are the four risks of this business and I think it’s important that you understand those risks. I’ve talked about concentration of risk, allocation of capital, overlapping trades, and over trading orover adjusting but the key point is they’re only necessary because of price risk.

Price risk means that the price is going to move up and down against you. If there was no price risk, you would have absolutely no problem with concentration of risk. You’d have absolutely no problem with overlapping trades because you would not adjust anything. You would have no problem with allocation of capital because you could simply put your positions on at one price and remain there until expiration and you’d have no on risk of over trading or over adjusting.

All four of the risks in this business really have to do with price. Prices will fluctuate sometimes wildly, sometimes moderately, but they always fluctuate. They never stand still. So if it wasn’t for price risk, none of these other four risks would even be a consideration. And those are the four primary risks of this business. All of them are easily managed.

Our DIA position we still have our oneposition on. We didn’t make any adjustments to the DIA. If we take a look at our SPY position, we had to do one adjustment which was there’s really an art and a science. The science is the numbers and the art is knowing when to adjust.

 

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