Section 7: Trading Small Accounts

The Broker: Friend or Foe?

Since the advent of the Internet, never before has the stock market been so accessible to the common man or woman who has the wherewithal to trade. Lately, there isn’t a single news or financial channel in the media that you won’t be inundated with online broker ads. Ameritrade, E*Trade and Scottrade, to name a few, advertise 24/7, each competing for your business. The unspoken implication is that you can take the bull by the horns, open up an account for as little as $500, and trade your way into financial freedom. Or can you?

Naturally, it isn’t as easy as they make it sound, and one of the primary reasons is due to the broker himself. Unless you begin with a massive amount of money, the fees that each of them charge for each trade (called commissions) can eat you alive, destroying any chance of success. That is, of course, unless you handle the problem properly.

Let’s take Scottrade, for example. According to their promotion, you can open a trading account for as little as $500, and their commissions are a mere $7 per trade. At a glance, this sounds reasonable, but let’s take a look at what would happen if you took them up on their offer. In fact, let’s give Scottrade the benefit of the doubt and say that you start with twice their minimum---$1,000---and that your first few trades are successful.

On the first day, you decide to trade three different stocks (which sounds smart, not wanting to place all eggs in one basket), and we will call these stocks A, B and C. In a couple of days, stock A advances 5%, stock B trades sideways for no gain or loss, while stock C performs poorly and loses about 2%. Because you are approaching a long weekend, you decide to sell all three stocks to begin Monday with a clean slate. With stock A very much ahead, and with B and C only slightly behind, it appears that you are ahead of the game. But in reality, you have lost!

Here’s why. By dividing your $1,000 three ways, you paid about $330 for each trade. But you also paid Scottrade $7 six times (one each for the buy and one for the sell), or $42. Stock A gained +5%, or $16.50. Stock B gained 0%, while stock C lost $6.50. Buy selling all three, you paid Scottrade another $21 (because you just made three more “trades” buy selling). Your net result is as follows.

Action	Result
Three stocks, buy:	$1,000
Three stocks, sell:	$1,010
Net gain:	+$10
Cost of commissions (buy and sell):	$42
Net result:	-$32

You can see from the table what the problem is with small accounts. Even though a few trades performed reasonably well, the broker commissions made it impossible to pull ahead. In fact, this example uses one of the lowest commission rates available, so the problem is even worse with more expensive brokers.

But let’s say that you realize commissions are relatively expensive, so instead of playing three stocks, you place the whole $1,000 on a single stock. Perhaps this would be a solution, except for one problem: You have to gain at least 1.4% on your trade just to break even. Remember, it costs $7 to buy and $7 to sell, so your net gain has to exceed $14 to make a profit, and it only gets worse if your broker charges more than this (Ameritrade, for instance, charges $10.99, or $21.98 for a buy/sell roundtrip). Again, commissions on small trading accounts will nickel and dime your money into a downward spiral, unless you have some exceptionally successful trades---and without any losers.

Hence, the first barrier to trading for the nearly broke is to find a solution to the commission problem. But first, let’s examine the typical solutions that low-stakes traders consider, and what is wrong with each of them.

Solution 1: Large Accounts

The most obvious solution to the commission problem is to increase the size of your account, say if you could muster up $100,000 to trade. Then again, the material herein is about trading for the nearly broke, so we can assume that anything that is anywhere near this amount is unrealistic. More than likely, you have access to a few thousand dollars, at best.

Solution 2: Loading Up

Another solution to the commission problem is to muster up as much as you can (say $5,000 or $6,000), and “load up” on a good trade. While this is a little more realistic than setting up a giant account, it is still wrought with danger and undue risk.

The reason is that you would need to trade the entire account on a single stock, and while that would probably overcome commissions if the trade went well, it can also take a large bite out of your account if the trade doesn’t go your way. What if the stock loses 2, 3, 4 percent or more? You can get wiped out in a hurry by making a series of bad trades, something that can happen even to seasoned veterans. Hence, “loading up” is a poor solution.

Solution 3: Penny Stocks

A popular (but often unsuccessful) solution to low-stakes trading is to trade inexpensive, or penny stocks. These are stocks that trade below $5 per share, often lower than that, and sometimes even below $1 (which is where the term penny stock is derived). The idea is that shares are so cheap that you could buy hundreds, or even thousands of shares, and all that needs to happen is for the stock to make a strong move to the upside.

Newcomers to the stock market will inevitably think about this strategy, envisioning the windfall potential of a $0.25 stock advancing to $0.35, or $0.50 or even more. One could conceivably double or triple an investment if this occurred. But that’s the catch, one could double or triple an investment if this occurred, and that is a big ‘if.’

The truth is that penny stocks are cheap for a reason. Certainly, some of them do rise from the dead and soar into the stratosphere, but most of them do not. Outside of getting tremendously lucky, by the time you found a penny stock that did this, you would probably go broke.

There is a way to trade inexpensive stocks successfully, providing that you follow strict rules and guidelines. This will be discussed at length in a subsequent chapter. For now, let’s assume that trading penny stocks is a poor solution, particularly if you don’t know what to look for and how to trade them.

Solution 4: Buy and Hold

If the cost of commissions is the primary barrier for making money on stocks with small amounts, then why not just buy a few shares and hold them for long periods of time? After all, that what most financial advisors would tell you to do.

But frankly, the success rate of buy-and-hold is a myth, and one of the most widespread falsehoods ever inflicted on the public. If nothing else, you would have to buy the correct stock(s), and at the correct time, which is a tall order, even for seasoned professionals. Furthermore, one bad apple would spoil your whole portfolio.

Part of the reason why buy-and-hold is such a widespread myth is because almost everyone has heard success stories about owning Microsoft since the 1980’s, or IBM since the 50’s, and now they are worth twenty thousand percent more today. The problem is that these are exceptions, not the rule. For every IBM and Microsoft, there are thousands of others that went nowhere, or went bankrupt.

Another reason why buy-and-hold seems reasonable is that people often buy into managed funds, such as mutual funds, and in many cases, the funds grow in value over reasonable periods of time. But if we are taking about your own trading account, where you are the “fund manager,” it is highly unlikely you will obtain the same results as the fund manager who has $billions at their disposal. A fund manager, with $billions, can diversify across many stocks and commodities, whereas your $1,000 account will barely buy 20 shares of stock.

If you would rather invest into mutual funds, that is fine, but this does not solve the problem of making your own trades, with small amounts, to overcome the commission problem. Mutual funds are OK for long-term investments, but what about short term trading?

A Way Out

As discussed in the previous section, the primary barrier to small stakes trading is the broker’s commission. Even if you use a deep-discount broker, most trades will require at least a 2% gain just to break even. Typical solutions to this problem are penny stocks, buy-and-hold, or an “all-or-nothing” approach (betting your entire stake on a single trade). None of these are viable strategies, they are all problematic and likely to result in losses.

One might conclude that successful trading with a small account is a lost cause…or is it? What if I were to tell you that there is a way to place only a couple of hundred dollars at risk, but with a chance to double or triple that investment quickly?

Allow me to introduce the method of choice for small-stakes trading, and perhaps the only reliable way to overcome the barriers that are inherent with limited resources: Stock options.

All About Stock Options

Options are essentially trading agreements between a shareholder and potential shareholder. Quite literally, a stock option is a contract to buy or sell a stock at some specified price for a predetermined period of time.

Let’s say, for instance, that I owned 100 shares of Apple Computer (AAPL), which traded around $25 per share. If I chose to do so, I could enter a contract with you to sell 100 shares of AAPL at $25 anytime in the next 60 days, regardless of where the stock traded during that period of time. To obtain this purchasing right, you would pay me a premium of, say, or $2.00 per share. This premium grants you the right (but not the obligation) to buy 100 shares AAPL at $25/share, anytime during the next 60 days. Once the 60-day period has commenced, the contract expires, and is void.

This is known as a call option, which is the right---but not the obligation---to purchase stock at a fixed price for a certain period of time. In this case, the purchase price (also known as the strike price) is $25, and the time frame is within 60 days. Note that this is merely an example, as many different strike prices and/or time frames can be specified. For instance, I might sell you the right to buy AAPL at $27.50, or $30.00, for the next 30 days, or 120 days, or even several months.

The purchaser of the call option is hoping that AAPL rises above $25 before the options expire. If apple tripled in price, the seller still has to honor the $25 price, as long as it is within the time frame specified in the contract. But regardless of the outcome, the contract seller keeps the premium that the buyer paid for the options.

This begs the question, why would anyone enter such a contract? If the option buyer thought AAPL was moving higher, why wouldn’t he just buy the shares at $25 instead of paying the $2.00/share premium? For that matter, why would the option seller lock into a fixed price, missing out on possible gains for his shares?

There are a number of reasons why an options contract is advantageous to both sides. Perhaps the buyer is short on cash, in which case, paying $200 versus $2,500 right now is advantageous. Another reason could be to mitigate risk. Let’s say that instead of AAPL rising in price, it plummets to $12.50. Had the buyer purchased the straight shares, the loss would have been $1,250 versus $200 for the options contract.

The seller, on the other hand, might enter such a contract if he felt that AAPL is likely to trade sideways, or move up only marginally, or even move down a little. In this case, he could obtain a $2.00/share premium on his shares, regardless of how the stock performed. Remember, the seller of the options contract keeps the collected premium no matter what, and in this case, the seller made $200 for his 100 shares, whether or not the contract is ever exercised.

Put Options

The other type of option contract is the put option. This is a contractual agreement that grants the right to sell a stock at a specified price, within a predetermined time frame. In this case, the put option is the opposite of the call option, because the purchaser of the contract is granted the right to sell shares, not buy them.

Understanding the put option is often difficult for newcomers to trading, so let’s look at it more closely. Essentially, the seller of a put option contract is agreeing to purchase shares of a stock at a predetermined price. For the sake of demonstration, let’s say he agrees to purchase 100 shares of IBM at $75. If IBM were to rise in price, say to $90, the contract seller is in great shape, because the obligated price is much lower. But what if IBM plummets to, say, $50? The contract obligates him to buy IBM at $75, which would result in a substantial loss.

Why would anyone assume such a risk? There are a number of reasons, the most obvious one being a way to make profit on shares of stock that are not even owned. Let’s say that the put option seller charges a $3.00/share premium for IBM, agreeing to buy the shares for $75 anytime during the next 30 days. Now let’s say that IBM closes at $76 by the time the options contract expires. The seller has just made $3.00 per share---yet never owned a single share of IBM.

Of course, had IBM dropped well below $75.00, the seller of the contract would have had to buy the shares at $75, creating a loss. But that was the risk he was willing to take, which is all part of the world of trading.

Now let’s take a look at why anyone would buy a put options contract. If you examine the nature of the put option carefully, you will notice that the value of the contract rises or falls inversely to the stock price. In the case of the IBM put option contract, the value of the option increases if IBM falls, and decreases if IBM rises (this is because the contract seller gains the advantage if the stock rises, whereas the buyer of the contract gains if the stock falls). Hence, a put option contract could be purchased as a hedge against potential losses.

Let’s use the case of IBM again. Let’s say that an investor buys 10,000 shares of IBM at $80/share, or $800,000, which is a substantial investment by most standards. One way some investors reduce their exposure to risk is that they will but put option contracts with a strike price near or slightly below the price of the stock. In this case, put options could be purchased, at a small premium, which would grant the investor the right to sell shares of IBM at, say, $75. If IBM were to plummet, he is “guaranteed” to be able to salvage the investment for a much smaller loss.

Summary of Options Trading

Call options grant the right, but not the obligation, to buy shares of stock at a specific price for a fixed period of time. Put options grant the right, but not the obligation, to sell shares to someone else at a specific price for a fixed period of time.

Buyers and sellers of option contracts “hope” for the opposite results. A buyer of a call option hopes for the underlying stock to move higher, while the contract seller wants the opposite. The buyer of a put option hopes for the underlying stock to move lower, while the seller wants it to move higher.

Options – A Trading Vehicle

Where an options contract gets interesting is the fact that it can be bought and sold, like any other commodity. And, like stocks, these contracts go up and down in value as the underlying stock changes prices. Options contracts are readily available through most brokers, and they can be traded online.

In fact, trading options, like a commodity, could be the method of choice if you have limited funds. The reason is that an options contract allows you to leverage hundreds of shares of stock, but at only a fraction of the cost of the stock itself. And remember, options contracts can be bought and sold, through a broker, just like you can buy and sell stock. When buying an options contract, you are never obligated to own any of the underlying shares of stock, and options sell for fractions of the price of the corresponding shares. Yet, the value of the contract rises and falls in a magnified proportion to the underlying stock, which is what is meant by leverage.

Using the AAPL example from the previous chapter, buying 100 shares at $25/share would cost $2,500. Buying the same number of call options, however, might cost less than 1/10 of the stock, or $200. But here is where it gets interesting: If the underlying stock moves in your favor, the value of each option increases in value, but at a greatly magnified level. In fact, a successful options trade might return the same amount, dollar-wise, than the equivalent stock purchase at ten times the price.

Here is how this can happen. Suppose AAPL is trading at $25.00, and you decide to buy 100 options for AAPL at $2.00 each, or $200. Within a day or two, AAPL advances $1 to $26.00. Here is where the leverage comes in---the value of each call option has also increased $1. Your options contract has just appreciated by 50%!

If you look at this carefully, you will notice the potential power of options trading. Had you purchased 100 straight shares of AAPL at $25 each, and the stock advanced to $26, you would have made $100 profit. Had you purchased the options contract instead, you would have also made $100, yet you had to put up far less capital at risk. Percentage-wise, there is no contest, as illustrated in the tables below.

100 Shares, AAPL	Options Contract	Straight Shares
Cost of purchase:	$200	$2,500
Value (if AAPL moves +$1):	$300	$2,600
Gain:	$100	$100
Percent gain:	+50%	+4%

Hence, options trading can become a powerful strategy for low stakes, high percentage return, because you can leverage hundreds of shares, but at a fraction of the cost. Notice that in the above example, you have placed less than 1/10 the money at risk for essentially the same returns, dollar-wise, which is what makes options trading so attractive.

The Downside

Considering the magnificent gains that are possible by trading options, and realized with such a minimal investment, what are the reasons not to trade options? At a glance, trading options seems too good to be true, and indeed, there are several disadvantages to trading options versus the direct stock, as follows.

- Potential losses. The phenomenal gain that can be realized with options is a double-edge sword. You can lose just as much, and just as quickly as you can gain. Certainly, you can realize double-digit percentage gains, but you can also experience losses of equal or greater magnitude. In fact, if an options trade doesn’t go your way, you can lose 100% of your trade---an unlikely scenario if you just traded the direct stock. So the downside risk has to be taken into consideration if you start trading options.

- Time decay. Unlike buying straight shares of stock, an options contract decays over time. For example, if you bought AAPL stock at $25 per share, you would lose $0 if the stock continued to trade at $25 indefinitely. But if you bought an options contract on AAPL, the value of your contract becomes worth less and less as it approaches its expiration date, even if AAPL hasn’t moved a single penny. With stock, you can “wait it out,” but you do not have such a luxury with options.

- Poor spreads. A spread is the difference between a stock’s bid and ask prices (the bid is the highest price anyone is willing to pay, while the ask is the lowest price anyone is welling to sell). Option quotes also have a bid and ask price, but more often than not, the difference between the two can be huge. It is not uncommon to get an options quote with a 15% or 20% spread.

The reason why the bid/ask spread is so critical is because you can rarely buy an options contract at anything other than the ask price, and you can rarely sell one at anything other than the bid. Hence, with a wide spread, you are technically under water 10 to 20 percent or more, right from the get go. Your trade has a lot of ground to make up just to break even.

- Criticism from peers. Most of the Wall Street masters insist that options trading is filled with excessive risk, and they will probably caution you about the perils of puts and calls. In fact, when setting up your brokerage account, you will be asked to sign an affidavit that you understand the grave dangers of options, that you know what you are doing and that you are neither a poor widow nor an orphan. Friends and family (that know something about stocks) may even equate options with problem gambling, not unlike dice or roulette. While none of this is a bona fide downside, it can be a negative factor to consider, as the psychological impact might affect you adversely.

Workarounds to Options Pitfalls

As stated in the previous chapter, options trading could be the strategy of choice for limited resources, mostly due to the limited risk exposure, but with large potential for gains. A relatively small trading account between $1,000 and $5,000 could leverage the same amount of stock that could be traded for ten times that amount. But options trading is not without risk, and if the pitfalls that are inherent with options trading are not handled properly, losses can be substantial.

Pitfall #1: Huge potential losses

Options trading can certainly yield windfall profits, relative to the size of your trade, but they can also result in windfall losses. You could take a 50% or even a 100% hit just as easily as you could win the same amount. So how do you work around this problem?

The answer is trading size, limiting the size of your trades to a manageable level. One rule of thumb that I like to use is to limit the size of an options trade to the same quantity as I would buy for the straight shares.

Let’s say, for instance, that the total buying power of my trading account was $10,000. Let’s also say that I would normally trade ½ of my buying power when trading a stock. So if I wanted to buy a $25 stock, I could spend $5,000 to buy 200 shares. Given these parameters, then if I decided to buy options instead of the stock, I would purchase 200 options.

Since options are valued for only a fraction of the associated stock, I am automatically limiting my exposure by following this same-quantity-as-stock rule. In the case of a $25 stock, if call options sold for $2.00 each, I would be investing only $200 instead of $2,500. You can immediately see that my exposure to losses has been reduced by an appreciable order of magnitude, relative to my trading account size, even if I lost 100% of the options trade.

But here is where it gets interesting. If the trade goes my way, I stand to gain as much---if not more---than the equivalent trade for the straight stock. Don’t forget the table that we displayed in the previous chapter:

100 Shares, AAPL	Options Contract	Straight Shares
Cost of purchase:	$200	$2,500
Value (if AAPL moves +$1):	$300	$2,600
Gain:	$100	$100

Notice that an options trade has the potential of returning the same profit, dollar-wise, as the equivalent trade in the underlying stock, yet at only a fraction of the risk. But what about the downside?

Should the trade turn against me, the same principle applies: I lose approximately the same amount, dollar-wise, than trading the same quantity of stock. But again, because I put up only a fraction of my total account, the loss is manageable---assuming that I apply sound principles of cutting losses quickly.

This same-quantity-as-stock system is particularly useful for small accounts, where you would otherwise have to put up ½ or even all of your account to realize decent gains if you traded the stock. Whereas, if you allocate a fraction of the same amount for an options trade, then you are able to open many more positions at once, which by definition, tends to further minimize your risk (“diversifying”). While you might only be able to make one trade at a time for straight stock, you could make many simultaneous trades using options---each one of which is only a small fraction of your buying power.

Alternate System

One alternate method that works as well as the same-quantity-as-stock system is to simply allocate a predetermined fraction of your total account size for each options trade. The following table can offer a guideline for this method.

Trading Account Size	Recommend allocation per trade
$1,000 - $2,999	1/5
$3,000 - $4,999	1/8
$5,000 - $14,999	1/10
$15,000 +	1/10 (don’t exceed 1/10)

The table above is not a hard and fast rule, but merely a guideline. A more conservative approach would be even smaller amounts than suggested, while a more aggressive approach could be slightly more. But the idea is to reduce your exposure so you can live another day if a trade doesn’t work out.

Gambling

If you talk amongst trading circles, sooner or later you will hear someone warn you about the risks of trading options, and that there is always someone that knows someone who was ruined by playing options. But in almost every case, these heavy losses were due to over-allocating the trade.

I can’t emphasize this enough, because once you violate the system outlined above and go hog wild, you set yourself up for some real serious losses. The mistake, while understandable, goes as follows. You have a $5,000 account. You see a call option that you like, and it is selling for $1.25. Instead of buying only 500 options like you should, you start getting sugar plum fairies in your head, envisioning the windfall you can make by loading up. You buy 3,000 options for $3,750, going for the kill, envisioning a giant payload. I can almost guarantee what will happen, and so can Mr. Murphy---the underlying stock will plummet, and suddenly, your $3,750 trade will be reduce to $1,100. You have now lost more than half of your entire stake! Just one more stupid trade like that, and you are destroyed.

I call this error “SFS,” or the Sugarplum Fairy Syndrome. While it is true that the trade could have gone your way for a windfall, this is pure gambling, and has no place in the world of sane and sensible trading. It is gambling because you have assumed far too much risk in relationship to your account size.

So remember that rule---never trade more options than you can easily recover if you lose. The rule of thumb is that you should be able to take a 100% loss of a single trade without losing more than a single digit percentage of your entire account. And, of course, you would have cut your losses long before losing all of your trade---but that will be discussed in a later chapter.

Consistency

Almost as important as reducing the size of your trades is the rule of consistency. If you decide that each trade will be 1/8 of your buying power, then stick to that. Don’t do 1/8 today, then ¼ tomorrow and 1/20 the next day. Jockeying your allocations like that is a sure road to failure, because Murphy’s Law will demand that you lose your biggest trades and win your little ones. Be consistent!

Pitfall #2: Time decay

The fact that an options contract decays in value over time can be a serious problem. If I were to buy a $200 options contract, and the underlying stock remained unchanged, my $200 would begin to decay as the contract approached its expiration date. In fact, if the stock remained unchanged until the contract expired, my value would be reduced to $0. This depreciation is unique to options, because if I would have purchased the stock instead, my value would have remained unchanged.

How do you work around this problem? The answer is simple enough: Don’t hold them too long. If an options trade doesn’t go my way after two or three trading sessions, I will dump the contract, even at a loss.

This rule has a subtle advantage for another reason, and that most successful trades tend to turn favorable almost immediately, at least that has been my experience over the years. I usually find that if a trade goes under water right out of the gate, and/or just grinds sideways for long periods of time, it rarely works out in my favor. More often than not, it is best to cut it loose---it’s “dead money.” This is especially true with option contracts, as they will depreciate on their own, all else being equal, due to their inherent decay.

Hence, options trading should be rapid, in-and-out. Never hold longer than 2 or 3 days, especially if the trade is not going well.

Pitfall #3: Bad spreads.

A spread is the difference between a stock’s bid versus ask prices, which is all part of the quotation system in the market. The same holds true for options, only in many cases, the spread between bid and ask for options is unacceptably large.

The reason this is such a problem is because when you buy an option contract, you usually have to buy at the option’s ask price. When you sell, you usually have to accept the bid. So if the difference between the two is very wide, you take an effective hit just by entering the trade in the first place.

Stock, on the other hand, tends to move with much tighter spreads. A typical stock with decent volume tends to trade fractions of a percent between its bid and ask. A $10 stock, for instance, might hold a bid if $10.00 and an ask of $10.01 or $10.02.

But options often have spreads that are a chasm wide. Let’s say you are interested in a call option whose bid is $1.00, with an ask price of $1.25 (which is not uncommon, I see these all the time). Because options are not as liquid as stocks (not as many are traded), it is next to impossible to buy at anything lower than the ask price, or sell at anything higher than the bid. If you can only buy at $1.25, and sell at $1.00, you have effectively taken a 25% loss, right out of the gate. I do not need to point out that this is unacceptable, since your trade would have to advance more than 25% just to break even. That is a tall order for any trade, even an options trade.

The workaround to this problem is to trade only options whose underlying stock trades in very high volume. As a rule, options for stocks that trade in high volume tend to have much better bid/ask spreads. While option spreads will rarely be as tight as their stock brethren, higher volume will at least reduce the range to an acceptable level.

By today’s standards, high volume for a stock would be at least 2,000,000, preferably 5,000,000 or more shares traded each day. Unfortunately, this narrows your field for option choices, but it is the only workaround for bad spreads.

Rule: Never trade an option with a bid/ask spread more than 10%. Usually, high-volume stocks will often provide options with spreads much less than that.

Pitfall #4: Criticism from peers.

This “pitfall” is more psychological than practical. Nearly every professional will caution you about the “gambling” aspects to options trading, and many of then will have stories about people they have known that were ruined from options.

The workaround to this is easy: ignore them. More specifically, by using common sense and proper discipline, options trading is not only lucrative, it is the only workable strategy for low stakes.

In fact, options trading is actually less risky that ordinary trading, because you place far less capital at risk. Don’t listen to the critiques, and instead, apply the necessary skill and discipline to this style of trading, and discover the advantages for yourself.

A Summary of Workarounds

- Limit the size of your option trades to a small fraction of your total buying power to minimize risk. Be consistent with that size. Never fall for the “Sugarplum Fairy Syndrome,” loading up on an option trade to make a killing. It rarely works out, and you could lose more than you could ever recover.

- Avoid the problem of time decay by making quick, rapid trades. Don’t stay with the same options trade longer than three trading sessions.

- Trade only options with high-volume, underlying stocks. Otherwise, the spread between the bid and ask prices tend to be unacceptably large.

- Use the proper strategies and discipline in this book to overcome the grave perils that the “professionals” warn you about.

Penny Ante