Index Option - Trading options video 20 part 1

Today we are going to talk a little bit more about risk management. Risk management is really the business that we're in. When you think about it, we are really in the insurance business. What we are doing is we're collecting premium. We are collecting Theta from other traders, who are taking directional bets. Our business is just to be the guy who manages the risks. We have a lot more freedom than market makers and specialists on the floors do. We get to take the trades that we want, at the price we want. In today's video, what I would like to talk about is risk management - specifically, risk management as it applies to our business. Any business is going to have risk. I mentioned in the previous video the four main risks that you have, plus price, obviously. Price is a risk. That's what makes the markets go up and down. People have different opinions of price. They trade accordingly. Whether they win or lose, that's what makes a market. What I would like to do today is talk about risk management. That means that you have to think about your portfolio. I would rather have you in the mindset of being a manager of your business, your trading business, and the thing that you are managing is the risk. Any business is going to manage risk. If you go to a bakery, or a gift shop - any kind of business has risks. For example, a bakery. You go to a bakery. They have cakes, cookies, all kinds of baked goods. Muffins and cinnamon doughnuts and cinnamon rolls. If it's a big bakery - even if it's a small bakery - what do you think their primary risk is? To me, just looking at a bakery, I would say that probably, their risk is the purchase of wheat, or flour, butter, eggs. Those commodities that they need in order to make their product. That's the big risk to them. The bigger the bakery, the more flour they are going to need, the more eggs they're going to need, the more butter or margarine, or whatever they use. Those are risks that they need to manage. A lot of the time, they can pass on those costs. What happens if flour prices and wheat prices have really skyrocketed in the last few months? Now, their costs are so much higher, but there is only a little bit of price movement that they have in their product themselves, when they sell it to the consumer, after their labor costs, electric, utility costs. The raw materials, which is the flour, eggs, and butter - they don't have a lot of control over a lot of their business. They can fluctuate their prices. When their costs go up, maybe they can raise the price of some of their products a little bit. I think the consumer would probably still purchase in a certain range, but once the prices got above that range, they would see a dramatic cut in their sales. If prices go a little bit high, people are going to look around for alternatives, and they may end up going someplace else. Their risk is the raw material cost. They also have labor cost, and labor costs are also a risk. Those are even harder to manage. Flour, eggs, and butter is probably one of their main costs, and one of the risks of their business. If those basic commodities rise in price dramatically, then it's going to cut down on their profit margin, and they may even lose money. How do they manage those risks? A lot of times, what they can do is purchase ahead of time. They can place their orders now for a certain price, to be delivered at a future date, at the price today. If they think flour, eggs, or butter is going up in the next 90 days, they might place a large order today at a fixed price, so that they don't have to pay the price 90 days from now. Those prices might be a lot higher. It also ties up more of their capital. They also have storage costs. They have to keep this stuff someplace. They are buying a large order now, that will last them for several months. They have storage costs, and they have original costs. Even though they think that they're buying it at a lower cost, they have other costs associated with holding that commodity for a long period of time. Those are the kind of risks that a bakery would have. My point is that every business has risks. It doesn't matter what kind of business it is. The primary risk of our business, as I mentioned - there were four of those. One of those really has to do with the allocation of capital. In this particular trade, we are getting down toward crunch time in our positions. We are actually less than five days away from expiration. Let's just take any symbol here, and you can see that counting today, we have six days until the last trading day. When we get to Monday, we will have four days before the last trading day. Today is a Saturday, so we're doing this over the weekend. Our primary risk, going into expiration, is the fact that the price can move dramatically against us. It can wipe out the potential profits that we have accumulated. Let's take a look at our positions. Let's block out the QQQs. Our primary position was the Diamonds, the EEM, the IWM, and the SPY. Those were our four main positions. I added the QQQs, and I'll tell you why. The whole point of this video is those QQQs, so I will talk about those. In the Diamonds, we have an open profit of $177. Our EEM isn't doing quite as well. However, the Theta has increased dramatically. That was a little bit of a difficult position to manage. We're only up $13 on that, but we do have a small profit. Our IWM position is up $228. Our SPY position is profitable at $370. Our total open profit on our portfolio for this month is $783.50. Now, remember, we're only doing one or two contracts on these. These are very small positions. I will tell you again, you want to do very small positions, or you want to paper trade. Paper trading has its place. I would do paper trading for several months, if I were you, doing one or two contracts. I know it's really boring, and it's not exciting at all, but that's good. Boring is good. You want to develop the skill set that you need in order to manage your business in paper first, doing one or two contracts paper trading, and then going to live trading, with only one or two contracts on each of these types of positions. You're going to be in a better place, because you have the skills. What we are trying to do is develop the skills