Module 7: Risk Management

Introduction

You now have an impressive toolkit: you understand options fundamentals, pricing, basic strategies, and intermediate strategies. You could start trading tomorrow.

But here's the uncomfortable truth: most options traders lose money.

Not because they don't understand options. Not because they can't analyze markets. They lose because they don't manage risk properly.

Risk management is what separates successful traders from everyone else.

You can be right 80% of the time and still go broke if your position sizing is wrong. You can master the Greeks and still blow up your account if you don't use stop losses. You can understand every strategy and still fail if you trade emotionally.

This module covers the most important lessons in trading:

• Position sizing principles (how much to risk per trade)
• Stop loss strategies (when to exit losing trades)
• Portfolio construction (diversification and correlation)
• Adjustment techniques (managing trades in trouble)
• Psychology and discipline (your biggest enemy is yourself)
• Common mistakes (and how to avoid them)
• Creating a trading plan (systematic approach)

This module might save your trading career. The strategies in Modules 4-6 are tools. This module teaches you how to use tools without cutting yourself.

Let's begin with the most fundamental principle.

The Golden Rule of Risk Management

Never Risk More Than You Can Afford to Lose

This sounds obvious, but traders violate it constantly.

Wrong mindset:

• "This trade is a sure thing, I'll risk 50%"
• "I just lost, I need to make it back quickly"
• "This stock can't possibly fall more"
• "I'll risk rent money, but I'll definitely make it back"

Right mindset:

• "I'll risk 2% of my account on this trade"
• "If I'm wrong, I'll accept the loss and move on"
• "I'll trade with money I can afford to lose completely"
• "Protecting capital is more important than chasing gains"

The principle: Your first job is capital preservation. Your second job is consistent gains. Your last job is hitting home runs.

The Math of Losing

Understanding drawdown math is crucial.

If you lose 10% of your account:

• You need to make 11.1% to get back to breakeven

If you lose 20%:

• You need to make 25% to get back

If you lose 50%:

• You need to make 100% to get back

If you lose 75%:

• You need to make 300% to get back

The deeper the hole, the harder the climb. This is why protecting capital matters so much.

Example: Two Traders

Trader A (Aggressive):

• Starts with $10,000
• Risks 20% per trade ($2,000)
• First trade loses → Down to $8,000
• Needs 25% gain to recover
• One more loss → Down to $6,400
• Needs 56% gain to recover
• Psychological pressure mounting

Trader B (Conservative):

• Starts with $10,000
• Risks 2% per trade ($200)
• First trade loses → Down to $9,800
• Needs 2.04% gain to recover
• Five losses in a row → Down to $9,000
• Needs 11.1% gain to recover
• Mentally stable, can keep trading

Which trader survives long-term? Trader B, every time.

Position Sizing: The 2% Rule

What Is the 2% Rule?

Never risk more than 2% of your account on a single trade.

Some traders use 1%. Some use 3%. But 2% is the standard that balances growth with safety.

How to Calculate Position Size

Formula:

Position Size = (Account Size × Risk %) / Risk per Share

Example 1: Long Call

Account size: $50,000 Risk per trade: 2% = $1,000 Trade: Buy $180 calls @ $5

Position size: $1,000 / $5 = 200 shares worth = 2 contracts

If calls expire worthless, you lose $1,000 (2% of account).

Example 2: Bull Call Spread

Account size: $50,000 Risk per trade: 2% = $1,000 Trade: Bull call spread, $5 debit per spread

Position size: $1,000 / $5 = 200 shares worth = 2 spreads

Maximum loss is $1,000 if spread expires worthless.

Example 3: Credit Spread

Account size: $50,000 Risk per trade: 2% = $1,000 Trade: Bull put spread

• Spread width: $10
• Credit received: $3
• Max loss: $10 - $3 = $7 per spread

Position size: $1,000 / $7 = 142 shares worth ≈ 1 spread

Maximum loss is $700 (1.4% of account).

Adjusting for Win Rate

If you have higher win rate, you can potentially risk slightly more:

Strategy with 70% win rate: Could risk 2-3% Strategy with 50% win rate: Stick to 1-2% Strategy with 30% win rate: Risk 1% or less

The logic: Higher win rate = more margin for error. But don't get cocky—markets change.

Portfolio Heat: Total Risk Across All Positions

Portfolio heat is your total at-risk capital across all open positions.

Conservative: 6-10% total (3-5 positions at 2% each) Moderate: 10-15% total (5-7 positions) Aggressive: 15-20% total (but dangerous)

Never have more than 20% of your account at risk across all positions. One bad event could wipe out everything.

Example:

Account: $50,000 Max portfolio heat: 10% = $5,000

Current positions:

• Position 1: Bull call spread, $1,000 at risk
• Position 2: Iron condor, $800 at risk
• Position 3: Long put, $600 at risk
• Position 4: Covered call, $500 at risk (if assigned)
• Total at risk: $2,900 (5.8%)

You have room for 2-3 more positions before hitting 10% portfolio heat.

Scaling In vs. All-In

All-in approach: Risk 2%, enter entire position at once.

Pros: Simple, max exposure immediately Cons: If wrong, full loss; if entry timing poor, stuck

Scaling in approach: Risk 2% total, but enter 1/3 now, 1/3 later, 1/3 later.

Pros: Better average entry, flexibility, less pressure Cons: Miss some gains if immediately right, more complex

When to scale: Uncertain timing, want to test thesis first, volatile markets.

Stop Losses: Knowing When to Exit

Why Stop Losses Matter

Without stop losses:

• Small losses become big losses
• Hope replaces analysis
• Emotional attachment grows
• Recovery becomes impossible

With stop losses:

• Losses are contained
• Capital preserved
• Emotional discipline maintained
• Can move on to next opportunity

Types of Stop Losses

1. Percentage Stop Loss

Rule: Exit when position loses X% of value.

Common thresholds:

• 25% for aggressive traders
• 50% for moderate traders
• 75% for conservative traders (rare—why let it get this bad?)

Example:

Buy call for $5 (risk $500 per contract)

• 25% stop: Exit at $3.75 loss = -$125
• 50% stop: Exit at $2.50 loss = -$250
• 75% stop: Exit at $1.25 loss = -$375

Pros: Simple, mechanical, emotions removed Cons: Might stop out during normal volatility

2. Time-Based Stop Loss

Rule: Exit after X days if not profitable.

Example:

Buy 45-day option

• If not profitable after 20 days, exit
• Don't let time decay eat remaining value

Pros: Prevents Theta from destroying position Cons: Might exit before thesis plays out

3. Technical Stop Loss

Rule: Exit if stock breaks key technical level.

Example:

Bull call spread on stock with support at $95

• If stock breaks below $95, exit spread
• Support break invalidates bullish thesis

Pros: Based on market structure, logical Cons: Requires chart reading skill

4. Delta-Based Stop Loss

Rule: Exit if Delta indicates low probability of profit.

Example:

Buy ATM call (Delta 0.50)

• If Delta falls to 0.25 or below, exit
• Probability now too low to justify holding

Pros: Greek-based, probability-driven Cons: Requires monitoring Greeks

Stop Loss Strategy by Position Type

Long options (calls/puts):

• Use 50% stop loss
• Or exit with 2-3 weeks remaining if unprofitable

Debit spreads:

• Use 50-75% stop loss
• Or exit if stock moves against you significantly

Credit spreads:

• Use 2× credit received stop loss (e.g., collected $2, stop at $4 loss)
• Or exit if short strike is tested

Iron condors:

• Use 2× credit received stop
• Or close tested side and manage remaining side

Straddles/Strangles:

• Exit if position loses 50% with no volatility event
• Or close after big move (captured gains)

The Discipline Challenge

Setting stop losses is easy. Following them is hard.

Common excuses traders make:

• ❌ "It'll come back, just give it time"
• ❌ "I'll wait until tomorrow to see"
• ❌ "It's only down 60%, my stop was 50%, close enough"
• ❌ "Maybe I should average down instead"

The right approach:

✓ "My stop is hit. I exit now. No exceptions." ✓ "I was wrong. I'll take the small loss and move on." ✓ "My trading plan says exit. I follow the plan."

Remember: The market doesn't care about your feelings, your rent, or your thesis. If you're wrong, you're wrong. Accept it and exit.

When to NOT Use Stop Losses

Selling options for income:

If you're selling covered calls or cash-secured puts with the intention of holding the underlying stock, stop losses may not apply the same way. You might be okay with assignment.

Long-term LEAPS:

If you're holding 1-2 year options as stock substitutes, short-term fluctuations may not matter. But you should still have an exit plan if fundamentals change.

Portfolio hedges:

Protective puts are insurance. They're supposed to lose value if the market rises. Don't stop out of insurance just because it's not paying off.

Adjustment Techniques

Sometimes you can salvage losing trades through adjustments rather than exiting. But be careful—adjustments can also increase risk.

When to Adjust vs. When to Exit

Adjust when:

• Thesis still valid, just timing was off
• Position has time remaining
• Adjustment reduces risk
• You have capital/margin available

Exit when:

• Thesis is wrong (fundamentally changed)
• Position near expiration
• Adjustment increases risk
• At max portfolio heat

Common Adjustments

1. Rolling (Extending Time)

What it is: Close current position, open new position with later expiration.

Example:

Bull call spread losing, 10 days to expiration:

• Close current $100/$110 spread @ $3 loss
• Open new $100/$110 spread (45 days out) @ $6
• Net cost: $3 additional

Effect: More time to be right, but increased risk.

When to use: Still bullish, just need more time.

2. Rolling and Adjusting Strikes

What it is: Roll to later expiration AND adjust strikes.

Example:

Sold $100 put, stock at $95 (in trouble):

• Close current $100 put @ $6 loss
• Sell new $95 put (45 days out) @ $5
• Net cost: $1 additional

Effect: Lower strike (less risk of assignment), more time, but increased cost.

When to use: Accept you were wrong, want lower risk.

3. Adding a Hedge

What it is: Add another position to reduce risk.

Example:

Long call losing as stock falls:

• Buy a put to hedge downside
• Now have synthetic straddle
• If stock bounces, call wins; if continues falling, put helps

Effect: Reduces directional risk, costs premium.

When to use: Uncertain about direction, want protection.

4. Closing One Side

What it is: In a spread, close the losing side, keep the winning side.

Example:

Iron condor, stock moved up, testing call side:

• Call side losing
• Put side profitable
• Close put side, take profit
• Manage call side separately

Effect: Lock in partial profit, reduce risk.

When to use: One side clearly safe, other side in trouble.

5. Converting to Different Strategy

What it is: Close current strategy, enter related but different strategy.

Example:

Long call not working, still bullish but less confident:

• Close long call
• Enter bull call spread (reduce cost, cap upside)

Effect: Adjust risk/reward profile.

When to use: Conviction changes but not reversed.

The Danger of Adjustments

Adjustments often:

• Increase risk
• Increase capital commitment
• Turn small loss into large loss
• Are emotional responses, not logical ones

"Hope is not a strategy." If you're adjusting just to avoid taking a loss, you're making a mistake.

Better approach: Accept the loss, exit, find a better trade. Don't throw good money after bad.

Diversification and Correlation

Why Diversify?

Don't put all your eggs in one basket. Even the best trade can go wrong.

Diversification reduces:

• Single-position risk
• Sector risk
• Strategy risk
• Correlation risk

Position Diversification

Spread across:

• Multiple stocks (5-10 different underlyings)
• Multiple sectors (tech, finance, healthcare, etc.)
• Multiple strategies (some bullish, some neutral, some hedged)
• Multiple timeframes (some short-term, some longer)

Example: Well-Diversified Portfolio

Account: $50,000 Portfolio heat: 10% = $5,000 at risk

Positions:

1. AAPL bull call spread (tech) - $1,000 risk
2. JPM bull put spread (finance) - $800 risk
3. JNJ covered call (healthcare) - $500 risk
4. SPY iron condor (broad market) - $1,200 risk
5. XLE long put hedge (energy) - $600 risk
6. MSFT calendar spread (tech) - $900 risk

Total: $5,000 risk across 6 positions, 5 sectors, 6 strategies

This is diversified. If one position fails, it's 20% of your risk, not 100%.

Correlation Risk

Correlation: How much two positions move together.

Problem: Diversifying across 5 tech stocks isn't real diversification. If tech sector crashes, all 5 lose.

Solution:

• Check sector exposure
• Balance long and short positions
• Include hedges or market-neutral strategies
• Monitor overall portfolio Delta

Example: Hidden Correlation

Apparent diversification:

• AAPL bull call spread
• NVDA bull call spread
• MSFT bull call spread
• GOOGL bull call spread
• META bull call spread

Reality: All tech, all bullish, all lose if NASDAQ drops. This is concentrated risk, not diversification.

Better approach:

• 2 tech positions (AAPL, MSFT)
• 1 finance position (JPM)
• 1 healthcare position (JNJ)
• 1 energy position (XLE)
• 1 market hedge (SPY puts)

Strategy Diversification

Don't just use one strategy. Mix:

Directional: Bull call spreads, bear put spreads (profit from movement) Income: Iron condors, covered calls (profit from time decay) Volatility: Straddles, strangles (profit from big moves) Hedges: Protective puts, market puts (insurance)

This balance ensures:

• Profit in different market conditions
• Some positions offset others
• Reduced portfolio volatility
• More consistent returns

Portfolio Greeks

Monitor your portfolio's total Greeks:

Portfolio Delta:

• Positive Delta: Net bullish (profit if market rises)
• Negative Delta: Net bearish (profit if market falls)
• Zero Delta: Market neutral (profit from other factors)

Portfolio Theta:

• Positive Theta: Net time decay collector
• Negative Theta: Net time decay payer

Portfolio Vega:

• Positive Vega: Benefit from rising IV
• Negative Vega: Benefit from falling IV

Example: Balanced Portfolio

Positions:

• Bull call spreads: +150 Delta, -10 Theta, +50 Vega
• Iron condors: -5 Delta, +40 Theta, -80 Vega
• Protective puts: -80 Delta, -20 Theta, +40 Vega

Portfolio totals:

• Delta: +65 (mildly bullish)
• Theta: +10 (collecting time decay overall)
• Vega: +10 (slightly benefit from IV rise)

This portfolio is slightly bullish, collecting time decay, and fairly neutral on volatility. It's balanced.

Trading Psychology and Discipline

The Enemy in the Mirror

Your biggest trading enemy isn't:

• Market makers
• Hedge funds
• Algorithms
• "The market"

Your biggest enemy is YOU.

Every trading mistake—overtrading, revenge trading, ignoring stops, overleveraging—comes from within.

Common Psychological Traps

1. Fear of Missing Out (FOMO)

Trap: "Everyone's making money on this stock, I need to get in NOW!"

Result: Chase trades, buy at tops, ignore analysis, overpay for options.

Solution:

• Stick to your watchlist
• Wait for your entry signals
• Remember: there's always another trade
• If you missed it, let it go

2. Revenge Trading

Trap: "I just lost $1,000. I need to make it back immediately!"

Result: Increase position size, take bad trades, compound losses.

Solution:

• Step away after a loss
• Review what went wrong
• Only return when emotional neutral
• Never increase risk to "make it back"

3. Recency Bias

Trap: "My last 3 trades won, so I must be on a hot streak!"

Result: Overconfidence, increased risk, ignoring process.

Solution:

• Judge yourself over 50+ trades, not 5
• Good traders lose 40-50% of the time
• Follow your process regardless of recent results

4. Confirmation Bias

Trap: "I'm bullish, so I'll only look at bullish evidence."

Result: Ignore contrary data, hold losers too long, miss warning signs.

Solution:

• Actively seek contrary opinions
• Play devil's advocate with your thesis
• Set objective exit criteria before entering

5. Loss Aversion

Trap: "I can't sell now, I'll lock in the loss. If I hold, maybe it'll come back."

Result: Small losses become big losses, miss other opportunities.

Solution:

• Accept that losses are part of trading
• Take small losses before they become large
• Every held losing position has opportunity cost

6. Overtrading

Trap: "I'm bored, let me find something to trade."

Result: Trade without edge, death by a thousand paper cuts, increased transaction costs.

Solution:

• Trading is boring most of the time
• Wait for high-probability setups
• Quality > quantity
• Set max trades per week

7. Analysis Paralysis

Trap: "I need to analyze more before entering. Let me study this for another week..."

Result: Miss good opportunities, overthink, never execute.

Solution:

• Define entry criteria clearly
• When criteria are met, act
• Perfect is the enemy of good
• Some uncertainty is normal

Building Trading Discipline

1. Create and follow a trading plan

Written rules for:

• What you trade (specific strategies)
• When you enter (entry criteria)
• How much you risk (position sizing)
• When you exit (stop loss and profit targets)

No plan = gambling.

2. Keep a trading journal

Record for every trade:

• Date and time
• Strategy used
• Entry price and reasoning
• Exit price and reasoning
• Profit/loss
• What you learned

Review monthly. Patterns emerge: What works? What doesn't? When do you make mistakes?

3. Treat trading like a business

You're the CEO of your trading business:

• Set quarterly goals
• Track performance metrics
• Control expenses (commissions, slippage)
• Manage risk (capital preservation)
• Plan for taxes

4. Separate trading capital from living expenses

Only trade with money you can afford to lose completely.

If losing your trading account would affect your rent, food, or obligations, don't trade with that money.

5. Set time limits

Don't stare at screens all day:

• Check positions 2-3× per day
• Set alerts for key levels
• Live your life outside trading

Overmonitoring leads to emotional decisions.

6. Have an accountability partner

Share your trading plan with someone (spouse, friend, trading buddy):

• They hold you accountable
• You're less likely to deviate
• Someone to discuss trades with objectively

The Mindset of Successful Traders

Successful traders:

• Accept losses as part of the business
• Don't take trades personally
• View trading probabilistically
• Focus on process, not outcomes
• Are patient and selective
• Continuously learn and adapt
• Manage emotions proactively

Unsuccessful traders:

• Can't accept being wrong
• Take losses personally
• Expect certainty in uncertain markets
• Focus on individual trade outcomes
• Are impulsive and active
• Think they know everything
• Trade emotionally

Which are you? Be honest.

Common Mistakes and How to Avoid Them

Mistake 1: Buying Far OTM Options Because They're "Cheap"

The trap: "$0.50 options are cheap! I can buy 20 contracts!"

The reality:

• Low Delta (0.10-0.20) = low probability of profit
• Need massive move to profit
• Usually expire worthless
• $0.50 × 20 = $1,000 lost

Solution:

• Focus on probability (Delta), not price
• Buy closer to the money (Delta 0.40-0.60)
• Fewer contracts with higher probability > many contracts with low probability

Mistake 2: Holding Options Until Expiration

The trap: "I'll wait until expiration to see if I'm right."

The reality:

• Time decay accelerates near expiration
• Extrinsic value evaporates
• Gamma risk increases (wild swings)
• Small winners become losers

Solution:

• Exit 2-3 weeks before expiration
• Take profits at 50-75% of max gain
• Don't wait for perfection

Mistake 3: Not Understanding Implied Volatility

The trap: "This option looks cheap at $3!"

The reality:

• IV Rank is 90% (very expensive historically)
• After event, IV will crush
• Even if directionally correct, you lose

Solution:

• Check IV Rank before every trade
• High IV = sell options
• Low IV = buy options
• Understand volatility crush

Mistake 4: Ignoring Transaction Costs

The trap: "I'll trade 50 times per month for small gains."

The reality:

• Each trade costs commissions + bid/ask spread
• $0.65 per contract × 2 sides × 50 trades = $65+
• Spreads can cost $0.10-0.20 per contract
• Death by a thousand cuts

Solution:

• Trade less frequently
• Use limit orders to control entry/exit
• Account for costs in profit calculations
• Prefer quality trades over quantity

Mistake 5: Overleveraging

The trap: "This is such a good trade, I'll risk 20%!"

The reality:

• One or two losses and you're crippled
• Recovery becomes impossible
• Psychological pressure is intense

Solution:

• Never risk more than 2% per trade
• Keep portfolio heat under 10-15%
• Size positions properly
• Remember the drawdown math

Mistake 6: Not Having an Exit Plan

The trap: "I'll figure out when to exit after I enter."

The reality:

• Emotions take over
• Hold losers too long
• Sell winners too early
• Inconsistent results

Solution:

• Define exit before entering (both profit target and stop loss)
• Write it down
• Follow the plan
• No exceptions

Mistake 7: Trading on Emotion

The trap: Revenge trading, FOMO, holding losers out of stubbornness.

The reality:

• Emotional decisions are usually wrong
• Losses compound
• Discipline breaks down

Solution:

• Follow mechanical system
• Step away when emotional
• Stick to trading plan
• Remember: it's probability, not personal

Mistake 8: Ignoring Earnings and Events

The trap: "I'll hold through earnings, my call will make money when they beat."

The reality:

• Volatility crush erases gains
• Unexpected results cause gaps
• Binary events are dangerous

Solution:

• Check earnings calendar before trading
• Exit before earnings unless specifically trading volatility
• Don't hold through major events
• IV expansion before events makes options expensive

Mistake 9: Averaging Down on Losers

The trap: "My call is losing, I'll buy more to lower my average cost."

The reality:

• Throwing good money after bad
• Increases risk when you're already wrong
• Compounds losses

Solution:

• Never average down on options (they expire!)
• Take the loss
• Move on to better opportunity
• Capital has opportunity cost

Mistake 10: Not Adapting to Market Conditions

The trap: "Bull call spreads always work for me!"

The reality:

• Market conditions change
• What worked in low volatility bull market fails in high volatility bear market
• One-trick ponies get destroyed

Solution:

• Learn multiple strategies
• Adapt to current environment (high IV vs. low IV, trending vs. choppy)
• Be flexible in approach
• If market changes, change with it

Creating Your Trading Plan

A trading plan is your rulebook. It removes emotion and ensures consistency.

Components of a Trading Plan

1. Goals

Time-based goals:

• Monthly: 2-3% account growth
• Quarterly: 6-10% account growth
• Annual: 25-40% account growth

Note: These are realistic options trading goals. Don't expect 100% per year consistently.

Process goals:

• Make no more than 15 trades per month
• Follow my stop loss 100% of the time
• Journal every trade
• Review performance monthly

2. Strategies You'll Trade

List specific strategies:

• Bull call spreads (in low IV)
• Iron condors (in high IV, neutral markets)
• Covered calls (on stocks I own)
• Protective puts (when market uncertainty high)

And when you'll use each one.

Don't trade every strategy you know. Pick 3-5 you understand deeply.

3. Position Sizing Rules

My rules:

• Risk 2% per trade maximum
• Max 10% portfolio heat
• No more than 3 positions in same sector
• Close position at 50% loss

Write down your specific rules.

4. Entry Criteria

For each strategy, define:

• What makes a good entry?
• What indicators do you use?
• What market conditions are needed?

Example (Bull Call Spread):

• Stock in uptrend (above 50-day MA)
• IV Rank < 40% (options not expensive)
• Clear catalyst ahead (product launch, etc.)
• Risk/reward at least 1:1
• Delta between 0.40-0.60

Don't enter unless all criteria met.

5. Exit Criteria

Define both:

Profit target:

• Exit at 50% of max gain for credit spreads
• Exit at 75% of max gain for debit spreads
• Exit with 2-3 weeks remaining if profitable

Stop loss:

• Exit at 50% loss for long options
• Exit at 2× credit for credit spreads
• Exit if thesis is invalidated (technical break, news)

Write down specific, mechanical rules.

6. Time Commitment

How much time will you dedicate?

• Market hours: 30 minutes in morning, 30 minutes at close
• After hours: 30 minutes for research/journaling
• Weekends: 2 hours for weekly planning and review

Be realistic. If you have 1 hour per week, you can't actively trade complex strategies.

7. Review Schedule

When will you review performance?

• Weekly: Quick review of open positions
• Monthly: Full review of all trades, win rate, profit factor
• Quarterly: Strategy assessment, goal check

8. Continuing Education

How will you improve?

• Read one trading book per quarter
• Watch 2 webinars per month
• Paper trade new strategies before using real money
• Review and learn from every loss

Sample Trading Plan

Name: [Your Name] Account Size: $50,000 Risk Tolerance: Moderate

Goals:

• Monthly: 2-3% growth ($1,000-1,500)
• Process: Max 12 trades/month, 100% stop loss adherence

Strategies:

1. Bull call spreads (low IV, uptrends)
2. Iron condors (high IV, neutral markets)
3. Covered calls (income on holdings)

Position Sizing:

• 2% risk per trade ($1,000)
• Max 10% portfolio heat (5 positions)
• Max 2 positions in same sector

Entry Criteria:

Bull call spread:

• Stock in uptrend (above 50-day MA)
• IV Rank < 40%
• 30-45 DTE
• Risk/reward ≥ 1:1

Iron condor:

• IV Rank > 60%
• 30-45 DTE
• Price range support/resistance clear
• Collect ≥ 1/3 of spread width

Exit Criteria:

• Profit: 50-75% of max gain
• Stop loss: 50% loss or 2× credit
• Time: Close with 3 weeks remaining

Schedule:

• Daily: 30 min morning/close
• Weekly: Position review (Sunday)
• Monthly: Full performance review (first of month)

This plan is my law. No trade without checking criteria. No exit without checking rules.

The Power of Backtesting and Paper Trading

Paper Trading (Simulated Trading)

Before risking real money on a new strategy:

1. Paper trade for at least 20 trades
2. Track results honestly (use real quotes, account for slippage)
3. Review performance (win rate, profit factor, max drawdown)
4. Only move to real money if profitable

Paper trading teaches:

• Strategy mechanics
• Entry/exit discipline
• Emotional responses (even fake money creates feelings)
• Time requirements

Most brokers offer paper trading accounts. Use them.

Backtesting

Backtesting means: Testing your strategy on historical data.

While you can't perfectly backtest options (historical options data is expensive), you can:

• Test stock entry signals on historical charts
• Simulate spread outcomes at historical stock prices
• Calculate if your system would have been profitable

Simple backtest example:

Strategy: Buy bull call spreads when stock crosses above 50-day MA

Backtest process:

1. Find 50 instances where this occurred (past 5 years)
2. Simulate spread outcomes (assume you held 30 days)
3. Calculate win rate and profit factor

Results:

• 28 winners (56%)
• 22 losers (44%)
• Average win: $300
• Average loss: $250
• Profit factor: (28 × $300) / (22 × $250) = 1.53

Interpretation: Profitable system (profit factor > 1.0), but not amazing. Marginal edge.

Decision: Maybe refine further before trading.

Dealing with Losses

Losses Are Inevitable

Accept this truth: Even the best traders lose 40-50% of the time.

You will have:

• Losing trades
• Losing days
• Losing weeks
• Maybe even losing months

This is normal. What matters is your response.

The Right Way to Handle Losses

1. Take the loss according to your plan

Don't hope, don't average down, don't adjust beyond reason.

2. Journal the trade

• What was my thesis?
• Was my analysis wrong or was timing wrong?
• Did I follow my rules?
• What can I learn?

3. Review for patterns

If multiple losses in a row:

• Am I following my plan?
• Has market regime changed?
• Am I trading emotionally?
• Do I need to adapt?

4. Take a break if needed

After 3-4 losses in a row, step away:

• Don't trade for a week
• Clear your head
• Come back fresh

5. Don't change your position sizing

After a loss, do NOT increase risk to "make it back." Keep position sizing consistent.

Learning from Losses

Every loss teaches something:

Loss type 1: Wrong analysis

• Learn: Improve analysis process

Loss type 2: Right analysis, wrong timing

• Learn: Be more patient, give trades more time

Loss type 3: Ignored stop loss

• Learn: Improve discipline, follow rules

Loss type 4: Black swan event

• Learn: Sometimes it's bad luck; manage risk accordingly

The only truly bad loss is the one you don't learn from.

Advanced Risk Metrics

For more sophisticated tracking, monitor these:

Win Rate

Formula:

Win Rate = Winning Trades / Total Trades × 100

Example: 30 winners out of 50 trades = 60% win rate

Target: 55-65% is excellent for options trading

Profit Factor

Formula:

Profit Factor = Gross Profit / Gross Loss

Example:

• Total gains: $15,000
• Total losses: $9,000
• Profit factor: $15,000 / $9,000 = 1.67

Interpretation:

• < 1.0: Losing money
• 1.0-1.5: Barely profitable
• 1.5-2.0: Good

• 2.0: Excellent

Max Drawdown

Definition: Largest peak-to-trough decline in account value.

Example:

Account high: $55,000 Account low (after losses): $48,000 Max drawdown: $7,000 (12.7%)

Target: Keep max drawdown under 15-20%

Sharpe Ratio

Definition: Risk-adjusted return (how much return per unit of risk).

Formula: (Return - Risk-Free Rate) / Standard Deviation of Returns

Higher is better. Sharpe > 1.0 is good, > 2.0 is excellent.

This is advanced and requires Excel/software to calculate properly.

Key Takeaways

Before moving to Module 8, ensure you understand:

✓ Never risk more than 2% per trade; protect capital above all else

✓ Position sizing determines long-term survival—master it

✓ Stop losses are mandatory—no exceptions, no hope, no waiting

✓ Diversify across stocks, sectors, strategies, and timeframes

✓ Adjustments can help but often make things worse—be careful

✓ Your psychology is your biggest enemy—trade mechanically, not emotionally

✓ Common mistakes kill accounts—avoid them through discipline

✓ Have a written trading plan and follow it religiously

✓ Paper trade new strategies before risking real money

✓ Losses are inevitable—accept them, learn from them, move on

✓ Track metrics to improve over time—win rate, profit factor, max drawdown

Self-Check Questions

Test your understanding:

1. You have a $40,000 account and want to follow the 2% rule. What's your maximum risk per trade?

   Click to reveal answer

   Maximum risk = $40,000 × 2% = $800 per trade. This is the most you should risk on any single position, regardless of how confident you are.

2. You bought a call for $5. At what price should you exit if using a 50% stop loss?

   Click to reveal answer

   Exit at $2.50 (50% loss). When the option is worth $2.50 or less, you exit immediately, no matter what your thesis is or how you feel about it.

3. You have 6 open positions, each with $800 at risk. What's your portfolio heat?

   Click to reveal answer

   Portfolio heat = 6 × $800 = $4,800 total at risk. If your account is $40,000, this is 12% portfolio heat, which is moderate to aggressive.

4. Why is averaging down on losing options usually a mistake?

   Click to reveal answer

   Options are wasting assets that expire. Averaging down increases risk when you're already wrong, compounds losses, and wastes capital that has opportunity cost. Unlike stocks, options have time decay working against you, making recovery even harder.

5. What's the formula for profit factor, and what does a profit factor of 1.8 mean?

   Click to reveal answer

   Profit factor = Gross Profit / Gross Loss. A profit factor of 1.8 means you make $1.80 for every $1.00 you lose. This is a good profit factor indicating a profitable trading system.

Practice Exercise: Risk Management Plan

Create a risk management plan for this trader profile:

Trader Profile:

• Account size: $25,000
• Risk tolerance: Moderate
• Trading experience: 6 months
• Available time: 1 hour per day
• Goals: 3% monthly returns

Questions:

1. What should the maximum risk per trade be?
2. What should the maximum portfolio heat be?
3. What stop loss strategy is appropriate?
4. How many positions should be open simultaneously?
5. What diversification approach should be used?
6. What review schedule makes sense?

Solutions:

Click to reveal detailed solutions

1. Maximum risk per trade:

$25,000 × 2% = $500 per trade

With 6 months experience (still learning), stick to 2% maximum. Don't get aggressive yet.

2. Maximum portfolio heat:

Moderate risk tolerance suggests 10-12% portfolio heat

= $2,500-$3,000 total at risk

This allows 5-6 positions at $500 each.

3. Stop loss strategy:

For long options: 50% stop loss For spreads: 50-75% stop loss or 2× credit for credit spreads Time-based: Exit with 3 weeks remaining if unprofitable

Rule: Write down stop loss BEFORE entering every trade. Follow it without exception.

4. Number of positions:

5-6 positions maximum

Why:

• Portfolio heat: $2,500-3,000 / $500 risk = 5-6 positions
• Manageable with 1 hour/day
• Enough diversification
• Not overwhelming for 6-month trader

5. Diversification approach:

Stocks:

• No more than 2 positions in same sector
• Aim for 4-5 different sectors
• Example: 1 tech, 1 finance, 1 healthcare, 1 energy, 1 consumer

Strategies:

• Mix 2-3 directional (bull call/put spreads)
• 2-3 income (iron condors, covered calls)
• Consider 1 hedge position

Avoid: All bullish or all in one sector

6. Review schedule:

Daily (30 min):

• Check open positions
• Monitor for stop loss violations
• Look for new high-probability setups

Weekly (1 hour, weekend):

• Review all open positions
• Plan next week's potential trades
• Check economic calendar
• Ensure diversification maintained

Monthly (2-3 hours):

• Full performance review
• Calculate win rate, profit factor, max drawdown
• Review trading journal
• Adjust approach if needed

Quarterly (half day):

• Deep performance analysis
• Compare to goals (target: 9% quarterly)
• Identify patterns in winners/losers
• Consider new strategies or eliminate weak ones

Additional recommendations for this trader:

Education (ongoing):

• Spend 30 min per week learning
• Paper trade any new strategy for 20 trades before using real money
• Read 1 book per quarter

Risk controls:

• No revenge trading (if lose 2 trades in a row, take a day break)
• No FOMO (don't chase trades that have already moved)
• Journal every trade (what worked, what didn't)

Psychological:

• Accept that 40-50% of trades will lose
• Focus on process, not individual trade outcomes
• Celebrate following the plan, not just winners

With these rules, the trader has:

• Clear position sizing ($500 per trade)
• Defined risk limits (10-12% portfolio heat)
• Diversification framework (5-6 positions, multiple sectors)
• Review structure (daily, weekly, monthly, quarterly)
• Room to grow as experience builds

After 6-12 months of consistent profitable trading with these rules, the trader can consider increasing position size or portfolio heat slightly. But not before proving discipline and consistency.

What's Next?

Congratulations! You now understand the most important aspect of trading: risk management.

You can have the best strategies in the world, but without proper risk management, you'll fail. With solid risk management, even mediocre strategies can succeed over time.

Remember these principles:

• Protect capital first, profit second
• Size positions correctly (2% rule)
• Use stop losses without exception
• Diversify intelligently
• Trade mechanically, not emotionally
• Keep learning from every trade

In Module 8: Practical Trading, we'll tie everything together. You'll learn:

• How to scan for opportunities
• How to place actual trades
• Order types and execution
• Tax considerations
• Tracking and analyzing performance
• Building a sustainable trading routine

You've learned the theory. Now let's apply it practically.

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Ready to continue? Proceed to Module 8: Practical Trading