Hey everyone, this is Kirk, here again at

optionalpha.com. And welcome back! You made it to Week 3. Thank you so much for checking

out this video tutorial. I commend you for continuing on with this course, and I know

you are learning a ton about options or you really wouldn’t be here on Video #3. You would’ve

kind of stopped with Video 1 and 2. So, I know you’re committed. And in this week’s

video, I’m going to go even deeper into understanding risk and the business of options trading.

And I know this is a hot topic, so that’s what we’re going to get into. But before we

do that, let’s recap what we talked about in Video #1 and Video #2 quickly. So, Video #1: We talked about why options

versus stocks, right? This is a whole premise, right? Why are we even considering options

versus stocks? In Video #2, we talked about – Okay, we understand that we’re going to

trade options, but what are the top options pricing principles? So, that’s what we’ve

covered in Video #2. Now, right now on Video #3, we’re going to talk about risk and the

fulltime aspect of trading as a business. And then in Video #4 which will come out in

a couple of days, we’re going to take a detailed look into the strategies that I use month

after month to generate income, and we’re going to go over some examples, live with

market pricing, at least live at the time that I’m going to record the video. All right, so let’s get started. Remember,

paper, pen, and notes. There’s going to be a ton of information here. You can go back,

watch this video a million times. It’s all completely free. And oh yeah, I forgot one

more thing. As always, if you have any questions or comments as I go through this, please add

them below to the section. I will get to everyone to answer right away. All right, so let’s talk about that big scary

word, “RISK” right? And this is the thing that everyone is concerned about with options

trading. What’s the risk? It’s risky. It’s this. It’s that. It has unlimited risk. There’s

so much risk being thrown around that I think it can get confusing for new traders, and

even for experienced traders, what the real risk is. Now, remember in Video #2, we talked about

the markets being random and trading based on probabilities, right? You remember that

in Video #2. And it’s true. The market is 100% random. And with this distribution graph

up here, this kind of emphasizes what we talk about. It’s the fact that the market makes

random movement. And those random movements can be plotted to probabilities and percentages

over time or standard deviations if you ever learn a thing about options trading as it

relates to probabilities. So, what we do here is we take that graph

and we flip it sideways, so it can visually show you what we’re talking about. So again,

just as a review, if this is the S&P or the SPY, then we have this probability graph that

says, “Okay, the vast majority of the time, the S&P is going to close within this range

in a given time period. And then as that time period expands, the probability that it gets

to these further edges increases because we’re giving the market more time. So again, the more trades we can place, the

more the probabilities will work themselves out over time. Think about each one of these

little dots here as a specific trade. So, the more times you can place trades, the more

times you’re going to have probabilities work themselves out over time. And that’s the name

of the game. Well, here’s the one question that I get asked

a ton, and I also ask myself when I got started in options trading. If we’re supposed to trade

on probabilities, then factoring in commissions over time, we will just end up losing money

because a few big losers will overshadow all the small winners. It’s a zero sum game. And

again, this is the number one question, the big question that everybody asked, but nobody

answers. If options trading based on probabilities really works, and it’s not a zero sum game,

how do we overcome it? Well, let’s use an example to really drive home the spirit of

this question, what we’re getting to with this whole zero sum game. So, let’s take this example (and we’re going

to use it throughout the course of this video) that we sell a 15 strike, 16 strike, XYZ,

whatever it is, call spread. Now, we take in a credit of $30 and the risk is $70. Remember

that the width of the strikes is 1, and we took in a credit of $30, so our risk is $70.

Our probability at that first strike, the 15 strike, of losing money is 30%. It makes

sense. We’ve taken a credit of $30 and we’re taking in a probability of risk of losing

of 30%. So, if there’s a 30% chance I lose $70, and a 70% chance which is the inverse

that I make $30, then if I keep making this trade over and over, how do I really make

money, right? Even with commissions, I make money, I lose money. 30% of the time, I make

a lot. 70% of the time, I make a little. So, how do we break the cycle and start making

money with options trading, right? Well, to help us get to our answer, we first need to

review two quick points. First: You have to start trading more often, lots of data points.

We talked about it before. But again, think of each of these red dots here as a single

trade. What if I only made five trades all year long? The odds get skewed, right? So,

think of these red dots as single trades versus the blue dots which are thousands and thousands

of trades all year, maybe not thousands, but hundreds of trades. So, if you only make a couple of trades during

the year and it’s just these five red dots, then at some point, you might have a really

great trade, you might have a really bad trade. But you’ve only made five trades, so how do

you know if the probabilities are working themselves out over time? And even though

you think you are “saving” money on commissions by trading less, you’re actually crippling

your success right from the start. By not trading on probabilities and by focusing too

much on commissions, you cripple yourself from the start because not only do you have

really bad trades that lose money consistently, but you also are paying commissions to basically

give money to the market, right? The second thing is: We must keep our trade

size small. And we talked about this in Video #1 and #2. 2% to 5% of max risk per trade.

So, when you trade too large a position, you run the risk of the underlying stock, making

that one in one million move against you, and we call this the tail risk. It’s this

type of move. It’s that way out of the probability range type of move. So, if you trade too large

and this happens, you blow up your account. But if you limit your trade size, then 1,

2 or even 3 trades that make the impossible move won’t hurt you. It won’t blow up your

account. And again, let’s use an example of how we figure out the right contract size

because we’re talking about it, so let’s figure out how we figure out the right contract size

to manage risk using the 15/16, XYZ call spread example from before. So, let’s say you have an account size of

$10,000 which is a pretty average account size for those of you who are getting started.

You may have more, you may have less. The max risk per trade what says 2% risk of your

account size. So, that means that 2% of that would be a max risk per spread of $70. Since

you have $10,000 times 2%, and the max risk per spread is $70, that means that you can

trade at most, 2.86 contracts. Now obviously, we can’t trade 2.86 contracts, so you can

roll it up or roll it down, and maybe you roll it up to 3 contracts. So, you can trade

3 spreads to keep your max risk at 2% of your account size. And remember that the odds of going bankrupt

investing just 5%. So, we talked about 2%, but investing just 5% of your money in each

trade is one in 3.49 billion. See, this is the thing that most traders in this industry

don’t get when they get started. It’s they think that they have a little bit of money,

so they need to scale up their risk per trades. So, they got $10,000. They need to trade $1,000

per trade. And that’s totally the wrong way to go about it. You’ve got to keep your trade

size small. And we’ve driven home these points multiple

times now, and I think you get the picture, right? And if you don’t, you need to keep

watching these videos over and over. So again, how do we break the cycle of the zero sum

odds? It’s really simple. #1: We talk about volatility and strategy. And #2: We talk about

waiting for profits. And again, this whole idea and concept of risk management comes

down to these two things: Volatility and strategy and waiting for profits. So first, we must understand where implied

volatility is on a particular stock and select the right strategy. We go over this in our

ultimate strategy guide here at optionalpha.com which you’ll have access to if you sign up

for our free trial and membership. I put this #1 on my list because 90%+ of option traders

force their strategy into a market situation. You see, they tried to take a strategy and

mold it into the market, instead of taking what the market gives you and creating a strategy

out of that situation. So again, remember that our distribution curve

becomes much, much taller and much more centered when volatility is low, so the stock is not

going to move as much. But when the distribution curve flattens out, that’s when high volatility

is in the market. And that means that there’s a higher likelihood that the stock makes bigger

moves up and down. So, if volatility is extremely high, then

you shouldn’t be buying options. You should be selling them. And this is the #1 thing

again, that people misunderstand. They think that just because a stock made a really strong

move in one direction that that means you can sell option premium. But that’s not the

case. If volatility is high, you need to be selling. If volatility is low, you need to

be net buying or at least not selling. See, most traders get this completely wrong

and you can see how they already position themselves to lose money. And it doesn’t have

anything to do with the direction of the market. So, a lot of people will email me and say,

“Hey Kirk, I can’t quite figure out the direction of the market.” But the real underlying thing

that they’re missing is that they are still playing the wrong side of volatility. You

have to be a net option seller when volatility is high, and you have to be a net option buyer

when volatility is low. Forget the direction of the market. You get that right, and you

can be wrong in your direction and still make money in this business. So #2 – We’ve talked about volatility, right?

#2 is waiting for profits. Now, we need to give ourselves enough time to let the probabilities

work themselves out, until the trade shows a profit. This means that on defined risk

spreads like the 15/16, XYZ call spread, we need to learn to keep the trade on and working

until it shows a profit. Period. End of story. So, exit the trade only when it makes 40%

to 60% of the total possible profit. So, let’s again, use XYZ call spread as an

example. We took in a premium of $30. That means that we would start to buy back the

position around $15 in price where we’ve made about $15. So, that would mean that we’d make

50% of the potential profit. The potential is only $30. That’s all we took in as a credit.

So, we’ll start to exit the trade when we show a nice little profit of about 50% of

the premium that we could collect. See, again, this is where most people get

this whole thing wrong. If you’re going to really trade based on probabilities, then

you have to let the probabilities work themselves out all the way to expiration. When we look

at trades and it says it’s got a 30% chance of being a winner, that doesn’t mean it’s

got a 30% chance of being a winner today or tomorrow. It means sometime between now and

expiration. So, if you don’t see a profit, you have to

let that trade on. And you have to wait because that 30% chance of being winner, 70% chance

of being a winner, whatever it is, is between now and expiration. And you don’t know if

it could be the last day before expiration that that trade shows a profit. So, no more closing the trade early when it

hit some magical percentage loss number, take the max loss if necessary. Remember: This

is why we trade small, so that we can let these probabilities work themselves out over

many, many opportunities, and wait for profits on each and every trade. So again, let’s drive this home with just

an example here on the chart. So, we have SPY. And you know SPY is going to be range

bound. All markets are range bound in cyclical. So, if we have a trade that centered around

164 which I’ve kind of highlighted here in blue, then at some point, even if we trade

the bullish side of the market, we can wait for the market to come back around, or if

we trade the bullish side of the market, we can wait for the market to come back around

before it shows a profit. And that’s what we need to do as traders.

We need to understand with options trading and probability trading that the market doesn’t

make our probability move the next day. We have to be patient and vigilant to let the

market work itself out and let those probabilities work themselves out over many, many occurrences

over time and over months. Remember that keeping our trade size small

and selecting the right strategy at the time we place a trade is all the risk management

we need to do. That’s it. That’s all we need to do. If we’ve traded small, we’ve traded

the right side of implied volatility, we’ve selected a strategy and kept our position

small, that’s everything we need to do. We can afford to let the trade ride all the way

to expiration if we need to because it’s not going to blow up our account by going against

us. Again, if we’ve done this properly, do not

trade too big, then we can afford to let the trade ride until it shows a profit since the

loss will not bankrupt us. It’s been proven many times in market research that doing these

two things alone are able to reverse the zero sum game and consistently make money trading

options. Wait for your probability to show itself a profit, and then exit the trade. Now, think about it honestly for a minute

while the whole concept sets in for a bit. And again, I understand that this is probably

unconventional. Most people don’t talk about this. But if most people talked about this,

then we’d all be making money trading options. But we’re not. Most people are losing money

because they’re not doing this. Though it seems unconventional – Like I just said, in

nature, the reality is 90% of us or more of retail options lose money year after year

after year. And yet, we hear the same thing time and time again. “Let your winners run.

Cut your losers short.” Blah, blah, blah… It’s all a bunch of crap. People who make real money in this business

consistently know that they need to do things different. So before I finish, I want to show

you how you can treat options trading as a fulltime business without the big time commitment,

right? You’ve got a job, you’ve got a family. I understand. I had a job, I’ve got a family,

I’m a new father right now with a beautiful baby girl, so I understand the huge time commitment.

But like any successful business, the key to your success trading options is to have

a system in place. Not just go with this whimsically, not just try then, try then, try a little

bit here, try a little bit there. You’ve got to have a system in place to be successful. So, here’s a quick 7 step system that you

can use to scan, analyze, and make better options trades with less time. #1: I need

you to create a small watch list of between 20 and 40 stocks that have highly liquid options

activity, okay? So, this is highly liquid options activity. What does that look like?

On the left side, we have SPY. Notice the volume and open interest for the November

options. 30,000, 112,000 contracts compared to – And I just threw up a stock, NNN which

has basically no volume. One contract was traded somewhere in November. That’s not a

good example of a highly liquid stock with options. #2: Two times per day. Once in the morning

and once in the afternoon, go through your watch list for any glaring opportunities to

make a trade, okay? So, this doesn’t mean that you have to sit in front of your computer

screen. Lord knows I don’t do that anymore. I do not sit in front of my screen all day,

looking at the market and watching every tick. Twice a day, right after the market open,

and right before the market close in the afternoon, I go through my watch list and see if there’s

any trading opportunity. So, what does this look like? It looks something

like this. Something that’s really, really prominent on the chart, something that shoots

up or jumps down or some big move in the stock that makes it a little bit easier to possibly

choose some sort of a directional play. It doesn’t look like this where the market is

just kind of trading sideways and it hasn’t really moved a lot. That’s not a glaring opportunity.

Again, let’s not pigeonhole ourselves from the beginning by just making a directional

call when we really have no additional edge in the market. #3: Once you have a stock in mind, determine

first if it’s currently high implied volatility or low implied volatility, okay? And that,

we [Unintelligible] in the strategy guide that we have posted inside the membership

area. #4: Next, you need to pick the market assumption

about future direction. Are you bullish, bearish? Is it sideways? And again, here’s where you

can use some simple technical analysis. You don’t have to get crazy about this. You don’t

have to have 72 different technical indicators up. But you just want to have some sort of

underlying assumption about where it’s going to go. And again, when you have stocks that

are really, really glaring, like the one that we had before where it’s just really, really

high move in the market, then you can make a better assumption about where the market

might move next. So again, here’s where you can again, determine

where you think the market might go. Do you think it might go sideways over the next month?

Do you want to make a trade on either end of the market where you’re kind of trading

like a long strangle or a long straddle because you just don’t know where it’s going to go,

you just know it’s going to make a big move. Whatever the case is, you want to make some

sort of directional assumption. #5: Then once you’ve made that directional

assumption, then you select the best strategy to fit the current market conditions. Again,

don’t force a strategy that doesn’t fit. If you have low implied volatility, you’re not

going to be selling strangles. Those are high implied volatility trades. And again, this

is where people get this really wrong. They take a strategy that they like to trade, like

an iron condor or a butterfly or whatever the case is, and they force that strategy

in each and every stock that they come across. You can’t put a square peg into a round hole.

It does not work. So, what does this look like? This visually

looks like this chart that we’ve talked about. You take all the factors that go into it and

you find that pricing, the value, the everything, the rate of return, the timeline. Where do

you think it’s going to go? And all of that stuff factors into one strategy or two strategies

that might be best for that particular situation. #6: You need to go to the order tab in your

broker platform and then determine what probability level you want to trade. So, we know what

side of the market we’re on. We know where implied volatility is. We know what strategy

we want to trade. Now, we need to determine what probability level we want to be at. Okay, so let’s take that credit spread example

that we had from before where we’re going to sell a credit spread. In this case, we’re

going to go to our broker platform. And looking at the January options just for now, we have

a probability of being in the money or a probability of a loss of about 29% on the January 173

strike price. So, if I wanted to trade a 70% chance winner, a 30% chance loser, I would

go to the 173 strike. That’s how I figure out exactly where my probability is and exactly

where I want to place the strikes for that particular order. And #7: You place the order being sure to

take in a premium that is consistent with your target strategy. Again, we talk about

this in other video tutorials, but it’s worth mentioning here. You want to make sure that

you’re taking in a nice little profit, that you’re not selling a spread at an 80% probability

level, but only taking in $5. It really doesn’t make it worth it, and that is where commissions

start to eat up a lot of your profits. But really, that’s it. 7 quick steps. So, stop making it so complicated and just

make the trade already. You go through this logical progression in all of your trading,

let the winners ride, right? Wait until you actually find that probability of success

till it shows a profit, then exit the trade. No more managing risk, no more managing losers,

no more exiting trades early. That’s all it is. These quick 7 steps. So again, have a

system and work through the system ruthlessly each day. If the strategy doesn’t fit or the

pricing is bad, move onto the next trade quickly. Don’t over think this. So, questions people usually have: Do I know

where current volatility is? This is what you need to understand when you’re making

a trade. Did I select the right strategy? Am I on the right strategy or am I trying

to force it? High probability of success. Is my strike price that I’ve selected a high

probability strike or am I just trading a 50/50 bet? Did I give myself enough time?

Are you trading the front month contracts or the back month contracts? Typically, I

like to trade all of my strategies anywhere between 45 and 60 days out. I’ll still trade

in 30 days some contracts, but implied volatility has to be really high. And finally, is my

position size small enough? Am I managing risk with my position size? And again, go

back through this video if you need help with that. So, I hope you guys enjoyed this. And next

week, I’m going to cover the exact strategies that I used to trade options regardless of

market directions for income. And I’m going to go over that with some live charts, at

least, live at the time that I record the video, so you guys understand exactly what

I look for when selecting strategies. And I’m going to work through the entire process

that I just laid out for you here, only with a couple of different strategies, so you won’t

want to miss it. I’ll be going through some real positions

like I said, and some examples that you can use to see exactly how I pull all of this

information we learned here together. So until then, please add your feedback, comments,

questions below. And oh yeah, if you found this really helpful, please share it online

with other people that might need this information. Again, this is completely free, so I want

you to be able to be open and share this with other people. Let’s change this industry by

educating everyone who’s out there.