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January 16, 2012  Mon 6:47 AM CT

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Readers frequently ask when they should exit a position, at a profit or at a loss. I will dedicate this note to outline some basic guidelines. Some are my personal opinions based on 15 years of experience in trading, while others are general optionMONSTER guidelines.

5 percent rule: Never allocate more than 5 percent of portfolio in a single option trade. I follow this rule religiously. That is my maximum risk tolerance, whether I am trading $10,000 or $1 million in the portfolio. The 5 percent rule also means that if I am 100 percent invested, I can have up to 20 trades open at any given time. That is more than enough to keep me busy.

Capital allocation: We live in very uncertain and volatile times. Sometimes, it may seem easy to assume that buying common stock is less risky than buying options. That is not true at all. As Guy Adami says, the market takes the stairs up and the elevator down. The primary reason we choose options over common stock is to materially cut the amount of capital at risk of losing while maintaining the upside potential. However, many traders make the mistake of allocating money to an option trade that is more than necessary and well above their risk tolerance compared to buying common stock. That's when you are not trading--you are gambling.

Let's use Apple as an example. You believe in the company, and you think that the stock is going higher. You want to put $10,000 in Apple. You can go ahead and buy as many shares as you can get for $10,000, and that would be fine. But it would be a mistake to allocate all $10,000 into a bullish option trade. The ideal amount that should be allocated to an option trade is the maximum amount that you can afford to lose if you were buying the common stock.

So, if the most you can tolerate is 10 percent loss on $10,000 investment in Apple stock, then no more than $1,000 should be allocated to Apple option trade. This is simple math I do each time I decide how many contracts to buy. Because in the end, if I lose money on my option trade, it is no worse than if had just bought the stock and I am limited to 10 percent max. And if I make money, I am getting same or better performance than the market without risking large sum of capital.  

Capital preservation always trumps aggression for profit. Options have limited lifespan, and they are volatile. You need only a little push in your direction to make good money. The goal isn't to gamble; instead, the goal is to cut capital at risk that comes with buying common stock while maintaining the same upside or better.

50 percent stop-loss: Each time we provide a trade idea, we always end the note with "cut loss and move on" at a 50 percent loss or "take at least half off the table" when you have a double or lose conviction in the trade. First of all, the rule is there to preserve capital in case readers don't get a timely closing update in fast moving market. Secondly, our objective is to always come out on the winning side, but as Jon and Pete will tell you, when trading options you don't need to be on the right side 100 percent of the time to grow the portfolio as long as you follow the discipline to cut losses as fast as you can while letting winners run as long as you can.
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