Book Review Series:  The Rookie’s Guide to Options – Chapters 6-7

By July 14, 2014Book Review

These two chapters might just be the most critical in the whole book. You’ll see what I learned about volatility and risk management, how I’m totally looking at volatility the wrong way and why chapter six set me straight.

Implied Volatility…Predicting the craziness of children

I never know what my children are going to be like in the morning. They can be super mellow or from the fame of Talledega Nights, “all hopped up on Mountain Dew!”

Yeah, I just quoted something from Ricky Bobby’s movie…sue me.

Generally, though I can estimate their craziness, or volatility, tomorrow based on how they were today. It’s not a perfect measure, and if you ask my wife she might view it differently. But between us we’re probably able to roughly predict how our kids will act tomorrow.

It might seem kinda crazy, but implied volatility is the same.

It predicts the volatility of the stock based on its historic volatility. If a stock was all over the place for the past six months, you can generally guarantee it’s going to be just as crazy tomorrow. Stocks don’t bounce all over the place one day to barely move the next.

When it comes to options trading, volatility is your friend, especially when you’re selling options.

In my post on my trading strategy, I mention focusing on stocks which are Popular, Volatile, Established and Cheap. In this post I discuss volatility in terms of Beta, a measure which examines the volatility of a stock in relation to one of the stock indexes (i.e. S&P 500).

When it comes to options trading, this is wrong.

Yup, that’s right, I’m wrong to use Beta as my measure of volatility. And I’m not afraid to admit it. After all, that’s what this site is about…learning the art and science of options trading.

What I should look at is Implied Volatility (IV). Implied volatility examines the volatility of a stock in relation to itself, not another stock or index.

And it’s the option seller’s best friend.

You see, the higher IV is, the more premium is built into the option price. So, naturally, a stock with a higher IV should be what I target in my strategy…not those with a higher Beta.

Let’s bring back my buddy CLF and look at a real example.

According to Ivolatility.com CLF’s current volatility is around 50. So, what does that mean?

If I was to sell the Aug 13 Put with an IV of 54, I would earn a credit of $36. If the IV was in the 20s, I would get about half that or $18. In the 90s, double it…$72.

IV makes a HUGE difference! And it’s really that simple. I’m sure we could complicate and confuse the topic even further, but why? That pretty much sums up what needs to be known about IV.

Expect in the not too distant future to see a new article on how I use IV in choosing stocks and which IV levels to shoot for.

So, we’ve covered volatility, what about risk management?

Spinning the Roulette Wheel…and putting it all on seven

Chapter 7 gives us all the details on risk management, but you can really boil it down to two simple rules.

Don’t put all your money in a single trade.

And…

Be conservative to minimize your losses.

Look, if you’re worried about losing money when options trading then there are definitely strategies which can help you minimize those losses. However, you have to adopt them and maintain them.

No, “Well, just the one time I’ll…” or, “Yeah, but this is a sure winner…” and then proceed to dump 90% of your account into a single trade and lose it all.

That can happen with options. And it can happen quick.

Let me be clear, it is possible to lose 100% of your trade, which is atypical for stocks (unless you owned Enron). However, adopting conservative individual trades which can minimize your losses will set you up for success rather than massive failure.

Unfortunately, I can’t tell you what your risk management should be. Risk is an individual thing. You have to determine your level of comfort with your trades.

A rule of thumb I’ve seen in a variety of places throughout the Internet is 2-3% of your account. Is this the right level for you? Only you know.

I tend to be willing to take on higher levels of risk. Admittedly, some of that is because I didn’t know what I was doing at the time! However, as I continue along this journey I’ll clarify exactly what my risk management strategy is so you can figure out how to create one for yourself.

Putting it all together

Implied volatility and risk management go hand in hand. Options with higher IV tend to be riskier because they are volatile…mind blowing, I know. But those options also pay better.

Finding the right balance of IV and risk management is something each individual trader will have to work through. I, nor anyone else, can tell you how much of your money you should risk on an individual trade.

We’ll come back to both of these topics in the near future as I highlight how I tackle the problem of selecting a stock with the right IV. I’ll also walk you through how I determined the level of risk I’m willing to take per trade and the steps I took to arrive at that answer.

I sincerely hope you’re enjoying this series and getting some value out of it. I honestly enjoy constructive criticism, so let me know what you think by posting a comment below and telling me what your risk management process is.

I can’t emphasize enough the impact this book is having on my options trading knowledge. So far, it’s worth more money than the $500 course I signed up for. If you’re just getting started, like I am, I highly suggest getting a copy of The Rookie’s Guide to Options and following along as we go!

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