How to Avoid Catastrophic Option Trading Losses

Online broker TradeKing has posted their top 10 option trading mistakes beginning option traders make.

The purpose of this article isn't to critique the TradeKing list but rather to take a step back and look at the bigger picture.

Obviously no trader wants to lose money, but the larger issue here is how to avoid the really big option trading losses, the catastrophic losses.

In my view, there are basically three categories of catastrophic risk in the stock market:

A truly catastrophic, civilization-ending macro event like nuclear war, collision with a giant asteroid, massive zombie outbreak, or an alien invasion and conquest
Investments in structurally vulnerable businesses
Self-inflicted and structurally disadvantaged trades

For the purpose of this article, I'm going to focus on that last one.

If you're more investor than trader, you can check out this article to learn more about using - and expanding - Ben Graham's Margin of Safety concept to protect your investment capital.

Self Inflicted Option Trading Catastrophic Risk

The TradeKing list, on the whole, includes some good advice, but their article doesn't make a distinction that I think is important and often overlooked - minimizing risk vs. avoiding it altogether.

In the Complete Leveraged Investing Program, I teach 6 customized option trading strategies that I consider to be "structurally advantaged" for four reasons:

They help me achieve my primary purpose of low cost basis acquisitions
They compensate me for exposing myself to volatility rather than risk (big difference)
They provide easy to understand terms so that I can choose trades where even the "worst case scenario" produces favorable results
They're flexible enough that I can almost always "renegotiate" the terms (and multiple times if I so choose) so that I'm able to continually improve those "worst case scenario" results

Avoiding Option Losses By Avoiding Structurally Disadvantaged Trades

Not to be too binary here but, by definition, any trade that isn't "structurally advantaged" is "structurally disadvantaged."

For example, if I'm in a trade (not an investment) where, at some level, I need to be right about what a stock (share price) is going to do in the short term, I'm putting myself at risk.

That doesn't necessarily mean that I have to pinpoint exactly what a stock is going to do, but if I "need" it to be somewhere over here or I "need" it to NOT be somewhere over there or else I'm going to lose money, that's a potentially catastrophic risk to which I exposed myself solely from own actions and decisions.

Self exposure to potential catastrophic risk comes from two different sources:

The strategy itself (e.g. buying out of the money calls), or
Through some form of over leverage (e.g. overusing margin when selling puts or setting up a large number of credit spreads so that if the trade moves against me, I don't have the capital to repair or adjust the trade, and the best I can hope for is to minimize the loss)

Often these factors overlap, as can be seen in the following example . . .

Example of a Structurally Disadvantaged Option Trade

For example, I could write a $40 cash-secured put for $4K, or I could write 8 $40-$35 bull put spreads for the same amount of capital.

If the stock falls to $36, I'm totally screwed with the bull puts - that is unless I have and/or am willing to pony up $32,000 in cash or margin to convert those bull puts back into cash-secured puts.

It's just too difficult (and expensive) trying to adjust and repair underwater bull puts - in order to roll an in the money position involving short put components to lower strike prices, it gets very expensive to have (and roll) long puts as part of the process.

Not so with the cash-secured put.

The best case scenario is I'm still able to adjust (and continue adjusting) the position in my favor over time, and the worst case scenario (assuming this is a high quality company that I liked at that price in the first place) is that I didn't get as good of a deal as I could have.

Huge difference then between how I set up the two trades - if I get greedy and overleverage, I can bring about my own catastrophic risk.

Many option income traders - knowingly or unknowingly - assume these elevated risks. The conventional approach is to minimize the risk by using small position sizes or to have very disciplined rules about cutting losses early.

Myself, I think it makes a whole lot more sense to avoid the risk altogether rather than attempt to take something inherently risky and "minimize" it.

Summary - Avoiding Unnecessary Option Trading Losses

I know this is an unconventional view. That's because it's not a trading perspective - it's an investing perspective.

But in my opinion - as someone who uses options to make me a better investor, not a riskier trader - the risk of catastrophic losses based on how one trades, in my opinion, is something that can be largely avoided in the first place.

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