In    Friday’s  options   post,   we talked about the tendency of options traders to become enamored of a particular strategy  simply because the trader is   on   a   brief  winning streak with that specific strategy.  This propensity is particularly dangerous because market neutral income options strategies typically are entered monthly. So   even a mere  four month winning streak—only four successful trades in a row–allows the trader four full months to slowly convince himself that he has in fact found the holy grail and  that his picture will soon appear on the cover of Barron’s as the next great options trader of our generation.

I   work very hard with my mentoring students to keep their capital levels under control until they have an adequate sample of results to be able to prove to me and more importantly to  themselves   that they are ready to trade with more size.   The deal I  make  with them is very simple—you can increase your capital as soon as you have a  LOSING month utilizing the exact strategy  with which you  have been experiencing so much success.

Why? Well, there are several reasons. First off,   a loss allows the student a critical opportunity to take a fresh look at the strategy.  Is the strategy  perfectly valid and have I   simply experienced a predictable loss? Or did the loss itself show me a critical flaw in the strategy that must be corrected?  If there is something structurally flawed in the trade, and it is correctable, then I recommend  that the student employ the same strategy, revised for the flaw,  for a while, at the same capital level,  until it is clear that the kinks have been worked out of the strategy.

Perhaps a more important reason to defer increasing size until a loss occurs,   is the psychological implication of experiencing a   loss   on a trade where the student had  previously enjoyed  a winning streak.  How did the student handle the loss?   Was the student able to take the loss objectively as part of the game, or was he or she devastated?

No one I have ever met LIKES losing on a trade, but I have met many talented traders that can shrug off losses fairly easily.  If the student is easily able to “get back on the horse” after a losing trade with a perfectly valid strategy,   then the current capital level  has proven to be appropriate for that trader, and it is safe to experiment  with  a  judicious increase of capital size.  If on the other hand the trader is devastated by the loss, it may be a sign that the CURRENT capital level is too large and it might be advisable to actually reduce capital size.

So don’t increase capital size until you experience a loss for a particular strategy.  Then you’ll know if the strategy is valid and more importantly, that you can psychologically handle an expected normal loss at your current capital level.

You will save yourself a lot of aggravation, and money,  if you follow this simple rule.