Are You Trading In The “Sweet Spot”?

If you trade long enough, it’s bound to happen at one time or another. In fact it happened to us recently over at my premium service, Income Trader.

Let’s say you have a trade idea in mind. You do the research on the company. You decide what kind of trade you’d like to make. Then you determine a range at which you feel comfortable executing the trade.

Then, all of a sudden… prices move outside of the range. What to do next?

I want to touch on this quickly today, because there are some important things to keep in mind when this happens.

First of all, it goes without saying that I’m a big believer in determining what price you’d like to pay before executing a trade. If you’re not doing this already, then I strongly encourage you to start.

With most of our put-selling trades over at Income Trader, we’re technically receiving premiums, but the same principle applies. And when I determine a range for our trades, this typically isn’t a problem. We’re easily able to fill our orders. However, in the rare times when that doesn’t happen, it’s important to stick to the range. Here’s why…

The recommended range for my trades represent the risk/reward “sweet spot.”

I don’t pick my recommended ranges out of thin air. It is a specific calculation that takes both risk and reward into account and then pinpoints a fair value for the option. If the contract is trading for significantly more than that fair price, it means the option is riskier, and therefore more likely to be exercised. If the contract is trading for significantly less than that fair price, it means the option is more likely to expire worthless, but we won’t get a worthwhile return for the trade. (Better to keep that capital available for the next trade that has a more generous return.)

The “sweet spot” is a price right around the contract’s fair value — high enough that we’re getting a worthwhile return but not so high that we’re taking on unnecessary risk.

Why Risk Management Is So Important

Risk management is extremely important to why our strategy is so successful. But you’re ultimately the best judge of what risks you can and can’t tolerate.

For example, taking the trade in question above the range worked out fine this time… but there have been plenty of weeks where the market has dropped unexpectedly and sent option premiums soaring. I take special care to avoid this kind of unfortunate situation, which is why our win record is one of the highest in our industry.

Managing risk is always important, but it is especially so during times of increased volatility like we have experienced throughout 2020.

Now, none of this is meant as a lecture. I know that many of my readers take my trades regardless of whether it falls within my range. I also know of many readers who look at the recommended contract and then trade a similar, more aggressive strike or expiration date. And there’s absolutely nothing wrong with that. They’re not breaking any newsletter rules… I’m not going to come to your house and wag my finger at them.

In fact, I think it’s great. The point is, YOU should feel in control of your portfolio.

Action To Take

As I’ve said before, everyone’s risk levels are different. And regardless of whether you’re one of my premium subscribers or not, I want my readers to be able to sleep soundly at night. So if you can sleep soundly while making more aggressive trades, that’s awesome! Keep doing what you’re doing.

Over at Income Trader, in the rare cases where the option doesn’t close within my recommended trading range on the the day of the alert, our official recommendation is to cancel your open orders. From that point on, I won’t be following the trade or providing further updates.

The point is… if you aren’t thinking about the risks you’re willing to accept when making an options trade (or any other trade for that matter), then start today. Don’t simply make a trade because you feel like you need to be trading. (For example, in our case, don’t take an unacceptable risk for selling a put just because you want the income.)

A great way to do this is by using limit orders to specify the price you want. Don’t simply take what the market has to offer you at the time.