How to Trade Options Using Warren Buffett's Two Rules of Investing ~ The Risk Averse Alert

Sunday, May 18, 2008

How to Trade Options Using Warren Buffett's Two Rules of Investing

Care for a little wisdom of experience revealing what I have learned trading options over the past 20+ years? This should help you exercise all due caution toward the opportunity at hand, so you might assuredly come away a big winner over the weeks ahead.

Be advised that, although I believe chances of scoring a huge success are good, there are a million ways to screw up in the options game.

So, consider taking Warren Buffett's "Two Rules of Investing" to heart. Indeed, in the options game you should take his advice VERY SERIOUSLY.

The Two Rules of Investing

1. Never Lose Money
2. Never Forget Rule #1

Now, let's be realistic. Truth is it's not possible to "never lose money."

And let's be honest, too. Chances are quite good you will lose money trading options. Statistically speaking, most people do.

So, how are "The Two Rules of Investing" of any use?

Well, as you know, I am venturing to risk just $500 to kickoff a series of OEX options trades anticipating the S&P 100 will soon decline in a flurry of selling over the weeks ahead. Therefore, I am abiding "The Two Rules of Investing" simply because $500 is such a tiny stake. Indeed, if I lose it all, I will by no means be ruined.

So, that's one way I suggest applying "The Two Rules of Investing" to trading options. Limit your initial risk capital.

Of course, there is more to be gained keeping these rules in mind as a "low-risk options play" moves from the planning stage to (and through) its moment of execution...

Having read my Risk Averse Alert for some time, you have seen how I have built up the case for a pending stock market meltdown, and furthermore how I have demanded ongoing confirmation of its validity every step of the way. What's more, I will continue doing so once I begin trading.

When it comes to speculating with options it really is so critical to have a keen, well-developed sense of expectations toward the underlying — in my case here, this is the S&P 100 specifically, and the stock market in general. Likewise, it is always best to let your outlook play out for a time without ever taking a position. Demand your outlook's confirmation before you risk one thin dime. Then — once you get this confirmation — start picking your entry spots when you believe there's a high probability the underlying will move immediately in the direction you are anticipating.

This is so key. Surely, you do not want to be holding a highly speculative, out-of-the-money position for days and days while the underlying is moving against you. Likewise, though, you also do not want to be holding a position not decisively moving in your favor.

This is why having some well-substantiated outlook toward the underlying is so vitally important. The surest way to possess this is maintaining such discipline as has you letting things play out for a time before jumping in. Then, you might trade options with a high degree of certainty and confidence.

Read that last paragraph again. Write it down. Put it on your bathroom mirror. Seriously, if you are to be successful trading options, you will do yourself a big favor. Let "fear of loss" keep you ever mindful that, your outlook should be both well-substantiated and confirmed ... always.

All this said, though, let me be clear. There are just so many things that can blow your outlook out of the water. Any one of them can happen in a day, too. So, when this occurs, swallow your pride, step back, and take refuge in this old Wall Street adage:

When in doubt, stay out.

So, one reason I am intent on initiating a "play" with only $500 risk capital is because there's always a chance my outlook might be altered in an instant. Limiting my risk this way helps me maintain financial discipline.

(FYI: I define a "play" as a series of options trades I anticipate making ... should my outlook toward the underlying be confirmed and the opportunity I am projecting come to fruition.)

Sometime early in a "play" I also am intent on taking my initial $500 stake off the table and strictly using the house's money thereafter. This is another way I abide Warren Buffett's "Two Rules of Investing."

Now, as one's outlook plays out and profitable trades have the effect of compounding one's financial reward, confidence naturally builds to form the greatest trap of all. This is manifest by a sensation of invulnerability. And, unless you are careful, it can lead to taking ill-advised positions in the belief your success invariably will continue.

You must never lose your fear of loss, even when you are winning.

The best way to deflect any unwarranted sense of invulnerability is demanding your outlook always justify your position with enough sense of certainty as keeps you alert when you are being proven wrong. Your best chance to limit losses and preserve risk capital comes sooner rather than later when trading options.

Always remember this: opportunities are endless, but with options time is of the essence.

Of course, no useful forecast can be made with 100% certainty. However, once you have multiplied a tiny $500 stake into many thousands of dollars, you will know just what measure of "certainty" is absolutely necessary for assuring success trading options. The secret is keeping your certainty well-grounded in your outlook, rather than in your prior trading success.

Upon experiencing the very volatility necessary for profitably trading options you must continuously ask yourself, "Could volatility soon subside?"

Truth is at some point it will. So, how might you best continue trading the "play" your [well-substantiated] outlook has justified ... and at the same time exercise "The Two Rules of Investing?"


Once you've begun profiting from your outlook and taken your initial risk capital off the table, start shifting into a more defensive posture by increasingly trading at-the-money and in-the-money positions.

As I said earlier, timing is everything when speculating with options. When the underlying is not moving as you had supposed, the "time value" portion of your position could be negatively affected — all the more so when the further from the market is your position's strike.

Though still a risk when playing at- or in-the-money options, "time value" degradation is not nearly as volatile. So, when the underlying is not moving in your favor as decidedly as you had anticipated, you have time to react and protect your risk capital.

Thus, by limiting your "time value" risk when you have the financial wherewithal to do so, you can more confidently "stay the course" abiding "The Two Rules of Investing." Still, it remains abundantly necessary your outlook justifies the speculative positions you take.

When you find yourself still confident in your outlook (because nothing has developed to raise any suspicion whatsoever about its viability) ... and you are high on having multiplied $500 into many thousands of dollars ... make it your mission to increasingly suppose volatility might soon subside. Protect your burgeoning risk capital by trading at- and in-the-money positions.

What I am really getting at here is this: there generally comes a time when confidence in your outlook becomes blurred by your trading success. That's why you are well-advised to exercise some discipline. Trading at-and in-the-money positions buys you time to come to your senses ... should this become necessary, of course.

I might strongly suggest you be vigilant in detaching your financial success from the necessary task of continuously maintaining utter confidence in your outlook. However, speaking from experience I know this is easier said than done. So, I will not pretend my warning here will do.

That is why, as a simple matter of maintaining your discipline abiding "The Two Rules of Investing," you must automatically move to a risk averse posture once you have made some serious bank out of your tiny, $500 initial stake.


Bulls make money, bears make money and pigs get slaughtered. Discipline alone can best assure the pig will not be you.

Once you get good at substantiating an outlook toward the underlying whose options you are trading ... knowing there's a difference between "certainty" and "bravado" ... you begin putting yourself in a position where "The Two Rules of Investing" can keep you from being a financial fool.

It is up to you to maintain discipline. You alone must make "fear of loss" your overriding concern, no matter how much money you have made successfully trading options ... or anything else for that matter.

So, this is how I approach the prospect of scoring huge gains trading options. Truly, experience has formed such wisdom to turn "fear of loss" into the actionable plan I am presenting here for your edification.

If you are to never lose money trading options over the long-term, you must find such discipline within yourself as will prevent you from being a fool.

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© The Risk Averse Alert — Advocating a patient, disciplined approach to stock market investing. Overriding objective is limiting financial risk. Minimizing investment capital loss is a priority.

Analysis centers on the stock market's path of least resistance. Long-term, this drives a simple strategy for safely investing a 401(k) for maximum profit. Intermediate-term, investing with stock index tracking-ETFs (both their long and short varieties) is advanced. Short-term, stock index options occasionally offer extraordinary profit opportunities when the stock market is moving along its projected path.

Nothing is set in stone. Nor is the stock market's path of least resistance always known. More often than not, there are no stock index option positions recommended.

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Integrated Solutions said...

Two rules for investment: keep it simple and diversify.