Lesson 8 - Market Gap
The main risk when trading Options is a market gap. A market gap is when the market price of our stock / Index opens significantly higher or lower than the previous closing price. During normal trading, even if the market is going down very fast we can exit our positions with conditional orders and limit the amount of loss. However, with a market gap, there is no way to trade out of the situation: the Market price may open somewhere past our conditional orders and we could be looking at a complete loss for those trades.
In the typical Uncle Bob's Money strategies, we show where to place conditional orders for normal market conditions to exit trades. It is possible with every strategy that we trade to buy additional positions that will act as a limit if the Market experiences a big gap, and it is important to understand that those additional positions usually have a large cost. Aside from the large cost in terms of reduced profits, it can be difficult to calculate which Options to purchase to offset a market gap, and there is no guarantee that those positions will actually help if the market does gap significantly. Our 'insurance' positions may end up being Out of the Money, and while they may significantly increase in value and offset some of our other losses, they may not be valuable enough to offset the losses we anticipated, and we can experience a much greater loss than we ever planned for.
Because of the general risk of trading Options, we recommend limiting Options trading funds to 15% or less of our investment assets. It can be very alluring to put more of our savings into Options because of the incredible returns that are possible. But those high returns have risks. By limiting our Options investments, we don't have to try to figure out additional hedge positions which may or may not save us in a big market move. If for example, we keep 85% of our investment money in cash earning Interest, the main portion of our 'nest egg' is protected, even if the Market suffers a major crash.
The Wall Street Crash of 1929
From September 1929 to November 1929, the stock market went down 40%. These 2 days in particular:
October 28, 1929: −12.82% drop
October 29, 1929: −11.73% drop
By July 1932, the Dow Jones Industrial Average would lose 89% since its high in September 1929.
Just imagine if we had all of our investments in stocks...
Black Monday in 1987
On Black Monday on October 19, 1987, the Stock Market fell 28.3%.
Crash of 2008
Starting on October 6, 2008, "Black Week" saw the Market go down 21%.
Crash of 2011
Starting on Monday, July 25, 2011 through Monday, August 8, 2011 (2 weeks or 11 trading days), the S&P 500 dropped 16.3% (1,337 to 1,119).
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Ever since the Dutch Tulip Bubble in 1637, when at its height some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman, there have continued to be 'Bubbles' and Market crashes.
Yes, it is possible to profit greatly in a bubble, and it's also likely to lose greatly in a bubble. It's hard to gauge when to get out. The next 'trade' always seems like such easy profit and usually too good to turn down, until it's too late.
As a long term investor, it's important to stay focused on the long term. We could trade Options with our Uncle Bob's Money Trading Checklist and Trade Finder and Trade Monitor, and get consistent profits for over 30 years - but that doesn't mean we should look back and say, "had I only invested more."
If we want to guarantee long term survival and profits we have to trade smart and limit the amount of money we invest in Options.
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