Many seasoned stock traders are already familiar with basic money management principles, and these same rules of the road can also be applied to options trading. Before you begin playing calls and puts, let's review some of the most crucial guidelines for money management.
You should play calls and puts only with dedicated trading capital -- never with your savings, next month's mortgage payment, or any other cash you can't afford to lose. Not only is this good common sense, but it helps to keep irrational emotions out of your trading decisions.
Never risk all of your trading capital at one time, or throw all of your available capital into a single trade. The ideal investing approach should combine a mix of stocks, options, bonds, and cash, with exposure to a variety of sectors and a mix of bullish and bearish trades. The idea is to position your portfolio in such a way that you're not overly vulnerable to a downturn in stocks or weakness in any one particular sector.
Determine your target exit points on each trade, and don't stray from those goals. Before you enter that initial trade order, you should already know your target profit and maximum acceptable loss on the position. In the heat of the moment, emotions such as fear and greed can be the root cause of poor decision-making. Creating a concrete plan can help you avoid these common pitfalls.
Adhere to a maximum entry price (or, for option-selling strategies, a minimum entry price). The price at which you enter each trade plays a crucial role in determining your ultimate profit or loss on the position, so it makes sense to determine -- in advance -- how much you're willing to pay for the option. To help you stick with this rule, use limit orders instead of market orders to control your entry price.
Make the principle of convexity work for you by dedicating a fixed percentage of your capital to each trade. Assuming you commit 10% of your available investing capital to each position, you'll be plowing more dollars into each trade after a winning streak, while fewer dollars will be at risk after each loss.
Use partial closeouts to lock in profits or manage losses, particularly when an option makes a sharp move early in its lifespan. For example, if you've bought 10 contracts and the position jumps to a 100% return early, you might choose to close out five of your contracts. This way, even if you take a total loss on the remaining five contracts by expiration, you're guaranteed to at least break even on the position as a whole. Alternately, if you're facing a 100% loss early in a trade, you might close out half the position if it recovers to breakeven. This ensures that you'll lose no more than 50% on the position.