What are the Rules for Trading Options? You need to learn what are the mistakes that most option traders make and try to avoid them. Let’s start with the list of option trading guidelines.
Understand how Leverage Works
Leverage is the main advantage of options. As an Investor you can make 10 times more money in option trading than you could make in trading stocks. However, unless you understand how to use leverage, it won’t work in your favor at all. Let’s say that you have $1,000 to invest. You don’t want to put the whole 1000 dollars into options, because you might easily lose the whole amount in the blink of an eye. The best way is to purchase $100 worth of options. By purchasing $100 worth of options you gain the same profit potential as with 1000 dollars worth of stocks. You can leave the remaining 800 dollars in the bank, or use it to diversify your risk.
Control and Diversify your Capital when You Buy Options
You invest money in stocks, but you bet money buying options. Let’s assume you have 2000 dollars to invest in stocks. It does not mean you can put such amount in options at once. Better divide your 2000 into $200, then you can lose ten bets in a row before you lose $2,000. On a few of these bets, though, you may even quadruple your invested money.
Trading Without a Reason – Number 1 Rule for Trading Options
The speculator must find a satisfactory blend of both the stock and the option. Some novice traders like a stock, so they assume one of its options must be satisfactory. Another will find a well leveraged option and neglect an evaluation of the stock. Ultimately, the success of a trade may be largely due to an advance by the stock. In another case, the leverage of the option may be the more important factor. But in every case the ruling reason will be a blend of the two.
Failing to Evaluate a Logical Risk-Reward Ratio
Once you understand the intertwining relationships of leverage, risk reduction, control of capital, and the vital balance between the outlook for a stock and the available leverage of its options, you have the necessary tools to speculate knowing rules for trading options. However, you must have clear-sighted tactical objectives in mind or it will all be for nothing. It is not enough to evaluate a trade. You must set minimum standards. You must know what you are looking for and develop the patience to wait for it. Good traders expect to take losses. The key to success in trading involves keeping losses small and profits large. Good money management and reduced risk in option trading allow you to take ten losses in a row before you lose all of your money.
But what about profits? If you want large gains, you must go for large gains. There has to be minimum standards. You can set it up 100%, 200% or more! If you set it up at 100% it means a doubling of the option. Don’t trade, if you can’t see at least a doubling potential. Don’t think that you can always be doing something. Two or three good buying opportunities a year can make a very good year. Don’t expect more. Often there will be less. Profits come in spurts and there will be long dry spells. There will be whipsaws and they wear most people down. When the opportunities finally arise, people have usually given up.
If you have patience and persevere, every now and then you’ll hit a real big one. It can make up for a lot of losses and then some. This is the reality that defeats most people. If you need a monthly check to keep your confidence up, get a nice government job. Or apply for social security. You don’t have to be brilliant to be successful. But you must be systematic, patient and tenacious.
Underrating the Greatest Disadvantage of Options
The big enemy of options is time. You can buy a stock and hold it for the rest of your life. But options expire and become worthless. When you buy a security, it can go up, down or just sit there. Two of these things are bad for you as an option trader. You can afford to wait only so long. It is amazing how option traders fail to face up to this difficult reality. A month or two may seem like a long time, but it isn’t. There is only one way to minimize the time disadvantage, and it is an obvious one. But most people choose not to face up to it. Buy the furthest out options that you can. This is simple enough but difficult to carry out because far-out options invariably cost a bit more. They carry larger time premiums. The leverage is never as high as the close-in options, so people jump at what looks like the better deal. They greatly underrate the value of time. They don’t like to pay for it. After all, time is abstract and price is tangible, easier to comprehend.
Believe me, extra time is worth paying for. If you are patient enough to be truly selective, you’ll find plenty of opportunities in options that have five, six, even nine months before expiration. If you set a six month minimum, you are virtually certain to do better. You’ll get second and third chances that you never expected. Conversely, short term options expire quickly and the traders don’t get a second chance to make money.
If you can find a six month option projected to at least double, take it – even though what appears to be a much better leveraged option is available for the same stock. This is advice that few will follow, but those who do will be glad they did. This alone will forgive more errors than anything you can do.
Playing an Option like a Stock
It should be clear by now that an option is not a stock. The two big advantages, leverage and risk reduction, are not inherent in stock trading. The big disadvantage, limited time, is not characteristic of stock trading. Most people approach options as if they were low priced stocks. They buy them and sell them when they start to go against them. An experienced and wise speculator looks at option trading as a horse race and does not use stop loss orders of any kind. It is not an investment, it is a bet. Nothing is more ridiculous than a trader who has bought an option for $100 and sold it quickly for $75. At the horse races one loses an entire $100.
So alway mind these rules for trading options I mentioned here. Of course, after you have a good profit running, it is another matter. You don’t want to let that profit slip away. As a rule of thumb, after an option has met the minimum objective, I advise not letting more than 25% of the profit slip away. But before a profit position is established – forget it. It’s just like a horse race. Enjoy it, sit back and sip on a mint julep.