$25K Options Trading Challenge

1. Options Trading: Leverage Small Capital for Big Gains

It really intrigued me because the returns that were being projected were disproportionately higher than what you would get if you executed a similar strategy with stocks.

Options amplify returns. Options contracts allow you to control 100 shares of a stock with a fraction of the capital required to buy the shares outright. This leverage can magnify your profits significantly, turning small price movements into substantial gains. For example, instead of buying 10 shares of a $1000 stock for $10,000, you could buy a call option controlling 100 shares for a fraction of that cost.

• This leverage is a double-edged sword, as losses can also be magnified.
• Options are not like stocks; they have a time component.
• Options are multidimensional beings with their own delta, theta, gamma, rho, and implied volatility.

Accessibility for small accounts. Options trading opens doors for investors with limited capital to participate in the market. With options, you can control a large position with a small amount of money, making it possible to grow a small account into a larger one. This is especially useful for those who cannot afford to buy many shares of high-priced stocks.

• Options level the playing field for everyone.
• Options allow you to participate in price movements that would otherwise be inaccessible.
• Options can be used to generate income, hedge risk, or speculate on price movements.

Strategic use of leverage. The key to successful options trading is to use leverage strategically and responsibly. This involves understanding the risks involved, managing your position size, and having a clear trading plan. It's not about blindly buying calls and puts, but about using options as a tool to enhance your trading strategy.

• Leverage should be used with caution and discipline.
• Options trading requires a deep understanding of the market and the various factors that affect option prices.
• Options can be used to create a variety of trading strategies, each with its own risk and reward profile.

2. The Market is a Two-Sided Game: Find Your Edge

The stock market lets you take any side, and theoretically it is a fair game.

Fairness in the market. Unlike other markets where you are limited to being a buyer, the stock market allows you to take either the buy or sell side. This two-sided nature makes it a theoretically fair game where no participant has an inherent advantage.

• You can buy or sell stocks, and you can also buy or sell options.
• This flexibility allows you to profit from both rising and falling markets.
• The market is a level playing field where everyone has the same opportunities.

The zero-sum myth. The idea that the stock market is a zero-sum game, where one person's gain is another's loss, is a common misconception. While it's true that for every buyer there is a seller, the market is not a zero-sum game because value is created over time.

• The market is not a casino where the house always wins.
• The market is a dynamic system where prices are constantly changing.
• The market is a place where you can create wealth if you have an edge.

Gaining an edge. To succeed in the stock market, you need to find an edge that gives you an advantage over other participants. This edge can come from various sources, such as technical analysis, fundamental analysis, or a unique trading strategy.

• An edge is something that gives you a higher probability of success.
• An edge is not about luck, but about skill and knowledge.
• An edge is something that you develop over time through experience and learning.

3. Trade Market Extremes, Not News

Never chase a stock on news. It is a battle you will never win!

News is already priced in. By the time you hear about a piece of news, it's likely that the market has already reacted to it. Chasing stocks based on news is a losing strategy because you're always late to the party.

• News travels at the speed of light in today's interconnected world.
• Algorithms can trade news faster than any human can.
• By the time you hear the news, everyone else has already heard it.

Mean reversion strategy. Instead of chasing news, focus on trading market extremes. Stocks tend to revert to their mean, meaning that when a stock moves too far in one direction, it's likely to move back in the opposite direction.

• This is a contrarian approach that goes against the herd mentality.
• This strategy involves buying when a stock is oversold and selling when it is overbought.
• This strategy is based on the idea that markets are cyclical and that prices tend to fluctuate around a central point.

Patience and discipline. Trading market extremes requires patience and discipline. You need to wait for the right opportunities to present themselves and avoid the temptation to jump into trades based on emotions or FOMO (fear of missing out).

• Patience is a virtue in trading.
• Discipline is essential for sticking to your trading plan.
• Trading is not a sprint, but a marathon.

4. Technical Indicators: Your Trading Compass

The key to successfully using technical indicators is to narrow them down to 3-5 indicators that work for your particular style of trading.

Tools for market analysis. Technical indicators are math-based tools that traders use to analyze past price movements and predict future trends. These indicators help you identify potential trading opportunities by providing insights into price momentum, volatility, and trend strength.

• Technical indicators are not crystal balls, but they can provide valuable information.
• Technical indicators are based on historical data, but they can be used to make predictions about the future.
• Technical indicators should be used in conjunction with other forms of analysis.

Focus on a few key indicators. It's easy to get overwhelmed by the sheer number of technical indicators available. The key is to narrow your focus to a few indicators that you understand well and that align with your trading style.

• It's better to master a few indicators than to be a jack of all trades.
• The best indicators are the ones that you understand and that work for you.
• The goal is to find indicators that help you make better trading decisions.

Core indicators for this strategy. The author uses a combination of five core indicators: Bollinger Bands, Keltner Channels, ADX (Average Directional Index), and RSI (Relative Strength Index). These indicators help identify price extremes, trend strength, and potential trend reversals.

• Bollinger Bands measure volatility and identify overbought and oversold conditions.
• Keltner Channels help avoid low volatility periods.
• ADX measures the strength of a trend.
• RSI measures the momentum of a price movement.

5. Debit Spreads: Control Risk, Maximize Returns

The nice thing about this call vertical is that the Time Decay of the long call is cancelled out by the Time Decay of the short call (i.e. the one you sold).

Defined risk strategy. Debit spreads, such as bull call spreads, allow you to participate in the market with a defined risk. You know exactly how much you can lose on a trade before you even enter it.

• This is in contrast to buying naked calls or puts, where your risk is unlimited.
• Debit spreads are a great way to manage risk, especially for beginners.
• Debit spreads are a great way to control your emotions.

Time decay advantage. One of the biggest advantages of debit spreads is that they neutralize the negative effects of time decay. The time decay of the long option is offset by the time decay of the short option.

• This means that you don't have to worry about your options losing value as time passes.
• This is a major advantage over buying naked options, which are subject to time decay.
• This allows you to hold your positions for longer periods of time.

Doubling your money. Debit spreads allow you to double your money with a relatively small move in the underlying stock. This is because the profit potential of a debit spread is capped, but the risk is also capped.

• This is a great way to generate consistent returns.
• This is a great way to grow a small account.
• This is a great way to take advantage of market extremes.

6. Credit Spreads: High Probability, Defined Risk

For a trade that has almost 95% of success, this is a sweet deal.

High probability trades. Credit spreads, such as bull put spreads, are high probability trades that have a higher chance of success than debit spreads. This is because you are selling options, which means that you are on the side of the market that has a statistical advantage.

• Credit spreads are a great way to generate income.
• Credit spreads are a great way to take advantage of time decay.
• Credit spreads are a great way to profit from sideways markets.

Defined risk. Like debit spreads, credit spreads also have a defined risk. You know exactly how much you can lose on a trade before you even enter it.

• This is important for managing risk and protecting your capital.
• This allows you to trade with confidence.
• This allows you to sleep well at night.

Risk-reward tradeoff. The tradeoff with credit spreads is that the reward is lower than with debit spreads. You are risking more to make less, but the probability of success is higher.

• This is a tradeoff that you have to be comfortable with.
• This is a tradeoff that is worth it for many traders.
• This is a tradeoff that is based on your risk tolerance.

7. Earnings Season: Navigate with Caution and Strategy

Earnings are unpredictable. Irrespective of whether earnings are good or bad, the market’s reaction is almost impossible to gauge.

Avoid binary events. Earnings announcements are binary events, meaning that the outcome is either good or bad, and the market's reaction is unpredictable. It's best to avoid trading stocks that have earnings coming up in the near future.

• Earnings are a gamble, not an investment.
• Earnings can cause wild price swings that can wipe out your account.
• Earnings are a time of high volatility and uncertainty.

Switch to indexes and ETFs. During earnings season, consider switching to trading indexes and ETFs instead of individual stocks. Indexes and ETFs are less volatile than individual stocks and are less likely to be affected by earnings announcements.

• Indexes and ETFs provide diversification.
• Indexes and ETFs are less risky than individual stocks.
• Indexes and ETFs are a great way to stay engaged in the market during earnings season.

Post-earnings continuation trades. After earnings are announced, the stock price often makes a significant move in one direction. You can take advantage of this by trading in the direction of the initial move.

• This is a continuation trade that is based on the momentum of the stock price.
• This is a great way to profit from earnings announcements without taking on the risk of trading before earnings.
• This is a great way to use the market's reaction to earnings to your advantage.

8. Market Corrections: Protect Your Capital, Seize Opportunities

When a correction or pullback happens, it is time to use 30% more from your cash reserves to put on additional trades.

Cash is king. During market corrections, it's important to have cash on hand to take advantage of the opportunities that arise. This means keeping a significant portion of your portfolio in cash at all times.

• Cash is a safety net that protects you from losses.
• Cash is a source of dry powder that you can use to buy stocks at a discount.
• Cash is a valuable asset during times of uncertainty.

Limit portfolio allocation. Limit your portfolio allocation to 30% of your account value and keep 70% in cash. This will help you avoid getting wiped out during market corrections.

• This is a conservative approach that prioritizes capital preservation.
• This is a way to manage risk and protect your portfolio.
• This is a way to ensure that you have enough cash to take advantage of opportunities.

Bailout trades. During market corrections, you can use your cash reserves to put on "bailout trades" that can help you recover from losses. These are trades that you put on in the opposite direction of your losing trades.

• Bailout trades are a way to hedge your portfolio.
• Bailout trades are a way to reduce your losses.
• Bailout trades are a way to turn a losing situation into a winning one.

Last updated: January 19, 2025