Larry McMillan is one of the most well-known experts in the options space. He has been a professional for over 30 years. As we repeat often at Wall St. Cheat Sheet, Larry has become a legend by mastering the most basic principles of strategy and risk management. Exotic ideas have come and gone, but Larry McMillan is still at the top of his game.

Background

Larry: I was initially attracted to options because there are many more strategies to use when making trades. As soon as I experienced the benefits of customizing my trades with options, I traded them from that point on. In 1976, I went to Wall Street as an options strategist for a retail firm. I have been a professional ever since.

Advice

Damien Hoffman: What is one of your favorite options strategies for individuals?

Larry: One of my favorites is the pairs trade — also known as the hedge trade. Directional trading can be a lot of fun, but when it’s bad it’s very bad and when it’s good it’s very good.

Damien: Speaking of volatility, what are the basic risk management techniques individuals need to succeed as options traders?

Larry: First, you need an options model so you know what you’re getting into. Otherwise you will overpay for the option and it will eventually come back to harm you. If you understand the implied volatility of your position, you will have a much better chance of profiting.

Second, you need a limit on risk. You must have a hard stop and pay close attention to the position — whether the position is hedged or not. I’ve seen hedged positions lose a fortune. Just think of Long Term Capital Management. They are the perfect example that hedges are protections, but not full guarantees against losses.

Once you set a stop limit, you need to adjust the stop over the life of the position as market conditions change. If you are fortunate enough to have winning positions, you probably want to adjust your stops to lock in profits along the way.

Lastly, new traders must remember that you can’t use one strategy all the time. Things change and if you don’t adapt you will eventually get bitten.

Damien: Larry, you’ve trained a lot of traders. What are some of the most common mistakes you’ve seen over your long career?

Larry: One of the biggest mistakes is trading without an edge. For example, someone may sell put options when the market is high and volatility is very low. Then, of course, when the market falls and volatility explodes you are dead.

Another big mistake is over-concentrating capital into one position. In that case, if the one position goes bad, you can be out of business.

Another big mistake, which is related to what I said about limiting risk, is walking away from positions rather than keeping a close watch on them. I know people who in 1987 who had open positions with no stops and were in Europe on vacation when the market crashed. Unfortunately, they came home to find no money left in their account.

Damien: Larry, thank you for taking the time out of your busy schedule to chat with me.

Larry: My pleasure. Anytime.

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