First, thanks to all who commented or wrote to me about the trader development stage model, I was quite surprised and heartened by the response.
When I was in the process of assembling my initial draft of the trader stage development model, I had in mind a novice trader that was focusing primarily on stocks, but perhaps occasionally trading ETFs. With respect to options, my sense is that for the most part, novice traders avoid options entirely or take an occasional gamble on a potential big winner by buying out of the money calls or puts.
Looking at the model, however, it quickly dawned on me why so many traders have trouble making the transition from trading stocks to trading options. I asked myself two questions:
- What is the motivation for a stock trader for jumping into trading options?
- How far has the trader progressed in terms of the stage development model at the time he or she decides to trade options?
The situation is only marginally better for traders who make the jump to options after advancing to stage two and are grappling with how to cut losses while letting winners run. With options positions much more volatile than stocks and spreads much wider, many of the exit strategies that work well for stocks do not work as well with options. Further, some traders become confused about whether to use the options, the underlying or both as their cues for when to exit. On a personal level, while I think mastering the art of exiting positions is a critical success factor for anyone who trades stocks, I found that porting the lessons I learned about stock exit strategies to options was nowhere near as easy as I had hoped.
Even for those traders who have reached stage three of the development model, options will be difficult to trade profitably, but these traders should understand most of the hurdles to success and what it takes to overcome them. Still, edges that work for stocks don’t necessarily work for options and risk management becomes much more complicated and difficult.
The bottom line is that for those stage three stock traders who are interested in augmenting their trading with options, their time and effort will likely be rewarded. On the other hand, for those traders who are still mired in stage one and stage two of their development process, options are almost certain to be a disaster and result in large losses.
If you are thinking about making the jump to options, make sure you undertake an honest self-assessment before diving in and be sure to make risk management your number one priority.
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