by Don Wellenreiter

This is a subject that is often written and talked about, but is generally the first thing discarded after trading begins. If you only get one clear message from reading about trading, I hope this article is it. There really is nothing more important. Money management should be your top priority, even above your trading style. It doesn’t matter if your trading program is correct 9 out of 10 times if you let that one time wipe you out.

I’ve seen this happen with several different trading techniques, but most often to those who sell naked options, whether with strangles (also cleverly called neutrals by some), straddles, or just selling one side of the market. Selling options naked is just like playing Russian roulette; one bad turn will kill you. I never “roll” a naked option up or down, those that do are usually either delaying disaster or courting an even greater catastrophe down the road. Yes, the strategy can work once in a while, but you must know when to say “when” and get out of the trade.

If you have used proper money management your maximum loss would only represent 5% of your total portfolio, leaving plenty of capital available for the next trade. The real key to trading is to keep your “powder dry” so that you can be around for the next big move. I have friends that started shorting the S&P in May of 1987, convinced the market was headed sharply lower. Every month they bought put options and sold futures. By August they ran out of risk funds and were tired of being wrong, so they sat on the sidelines mumbling to themselves. Had they not thrown everything at the market between May and August they would have made a fortune in October 1987.

A last note about this subject. I knew a broker that was trying to buy OEX puts on Friday October 16, 1987. The options he was attempting to buy were trading at something like 3-1/8. He decided he would only pay 3 for them and never got filled. When the market crashed that next Monday those options went from 3-1/8th to over 100! So for every option he could have purchased that Friday at $312.50 it would have soared to $10,000 a piece on crash Monday. The lesson here is an old one; don’t be penny wise and pound-foolish. If you believe in the position, just do it. Don’t try to save a few dollars and miss an opportunity for profit.

Always try to take money off the table. In other words, if you start with $25,000 and you are fortunate enough to have your first few trades work your way, have the profits mailed or wired out to you. You eventually want to have all of your original money out of the market so you are only using your profits to trade with. While it is tempting to let your account grow, it is wiser to only play with profits and then, if there is a trade you absolutely have to be in, you can always send the needed funds back. The key here is that if the money is not in your account you, and your broker, won’t be tempted to spend it. Remember, brokers don’t get paid on idle cash.