Tips for Options Trading
People thinking about entering the options market are often discouraged by the complexity of the matter and the risks involved. The risks of options trading, however, also mean that there are profits involved, and to help you get to them, we’ve prepared these handy tips for options trading. Read on to learn how to trade options and sidestep the pitfalls.
Tips for Options Trading
1. Don’t Be Deterred by the Complexity – Think of Options as Stock Extensions
Stocks are much more straightforward to understand than options but the downside is the lack of flexibility — you hold the stocks and have to decide what to do with them, which increases the risks. So, the first one of our options trading tips is to think of options as a way to reduce risks, not complicated financial derivatives.
They give you flexibility and reduce the risk because you can back down on buying anytime. In stock trading, you are limited to starting bullish (buying stocks) and bearish exposure (selling shares).
Bullish and bearish exposure
They are stock market terms representing optimistic and pessimistic stances toward the market. Bullish exposure means the investor is buying, while bearish exposure means the investor is selling shares.
So, when you buy or sell stocks, you come in with all the capital needed for the purchase. Options trading explained simply meanwhile shows that you are only risking the premium you’ve paid for the options contract. If you see the stock price going down, you can opt out.
2. Growing a Small Options Account Takes Planning, so Make Plans
Spontaneity, emotions, and investment rarely mix well. Come up with a plan to guide you and tweak it as necessary as circumstances in the stock market change.
You can reduce risks by options spread trading, which implies buying and selling multiple options of the same asset (but with different dates and strike prices).
Planning doesn’t mean just how to cut losses if things go south or planning further investments if the investment brings profit. You should devise an exit plan. This implies having upside exit and downside exit points. Think well about the point at which you want to buy or sell. One of the most important tips for trading options is to set a time frame for each because options deteriorate over time.
Options deterioration — when to cut losses on options?
Successful options traders always keep in mind that options deteriorate over time, and the rate they deteriorate speeds up as their expiration date nears. For instance, you’ve bought a call (buy) or put (sell) options expecting something to bump or bring down the shares. If you see that things are not going as planned and the expiration date is approaching, simply pull out and go to the next trade.
In short, do not miss out on a good stock options opportunity because you think it won’t make you enough profit. And don’t hold on to clear losers because you feel the market will turn in your favor.
3. Mind the Bid-Ask Spread and the Liquidity
When you get a quote for any option in the marketplace, there will be a difference between the bid price (how much someone is willing to pay for an option) and the ask price (how much someone is willing to sell an option for). That’s the bid-ask spread.
Often, the bid price and the ask price do not reflect what the option is really worth. The option’s “real” value will be somewhere near the middle of the bid and ask. And just how far the bid and ask prices deviate from the actual value of the option depends on the option’s liquidity.
What is stock liquidity?
Liquidity means that there are active traders buying and selling the stock and its options. High activity brings the difference between the ask and bid price closer together.
Stock liquidity also influences options liquidity, meaning, beginners will be better off with active stocks. Stocks with fewer than 1,000,000 trades a day are usually considered illiquid. In turn, options traded on that stock will probably be illiquid too.
How to pick stocks for options trading
If you are new to options trading, choose stocks with the most liquid options. If we take a closer look at trading options vs. trading stocks we can see that, in general, stock options have less liquidity than their corresponding stocks.
You might want to start with options with a general interest of 50 or more times the number of contacts you wish to trade. To illustrate — if you’re trading 20 options contracts (each one is a batch of 100 stocks), the minimum satisfactory liquidity should be 1,000 contracts (20×50).
You can also use a stock options alert service to send you notifications on important events.
The bid-ask spread
The more options contracts (higher liquidity), the closer the spread on that option will be. The options become most liquid when nearing their expiration date or the strike price. However, you should be careful about the timing. Do not wait too long to trade them.
One of the biggest option trading mistakes is not minding the spread. Namely, 20 or 30 cents spread might not seem like a lot but considering that options are not that expensive (usually go for several dollars), it means that you are losing 10% or more of your profits.
4. Don’t Simply Adopt Common Views Before Analyzing Them
Stock and options trading is an active world. And this activity can make beginners feel like they must always trade. This urge to trade can lead to many mistakes, and they can be costly.
So, it is better to be inactive than to make trading mistakes. However, this doesn’t mean you should fearfully wait in the corner and watch the opportunities pass by. Like most things in life, it is all about balance.
How to be a successful options trader
The best way is to get better at identifying the difference between good and bad trades. Don’t think that trading more and trading smart are the same. One of the most important tips for options trading is this one — do not be influenced too much by the market consensus.
Situations, where stocks make miraculous recoveries on the back of positive financial news or an upbeat quarterly report, are not uncommon. Good options traders can profit significantly when markets are heavily influenced by insecurity or optimism.
5. Don’t Be Greedy
Last but not least on our list of trading options tips is that the desire for profit and greed are similar but different things. Many beginners see seasoned traders pulling off unbelievable stunts. One of them is selling options they don’t own, betting that the contract will expire without the buyer deciding to close the deal.
The option trading profits here are minimal (just the premium they got for the contract), but traders do that often so that the sums can get considerable. However, they are risking a lot if the buyer decides to buy. They have to sell the stocks or the options, no matter how unfavorable it is. The best options trading strategies for beginners meanwhile involve more prudent trades, even at lower profits, rather than adopting the “gambler” mindset.
The Bottom Line
You don’t have to have a sixth sense, the ability to predict the future, or some superhuman instinct to trade options successfully. All you need is to think, analyze, and take moderate risks. Analyzing stock prices might not be your childhood dream, but it can be a key to a better future.
FAQs on Tips for Options Trading
What is options trading?
With an options contract, the trader secures an opportunity to speculate on the price movement of an asset at a predetermined price and time, without the obligation to buy or sell the asset in question. As a result, traders can drop out of the deal at any time and the only thing they are risking is the premium they’ve paid for the contract.
Is buying and selling options day trading?
Day trading and options trading are two different things. Day trading implies that the trade of an asset, commodity security, etc., occurs on the same day, regardless of the type of the asset. So, you can day-trade options, just like any other security.
Is options trading profitable?
Just like any business and investment, options trading can be profitable. But it takes learning and practice for traders to reach a level where they can recognize good and bad deals. Options traders have several ways of making profits if the stock they are trading options for exceeds the strike price. Experienced traders can make profits even if the options contract doesn’t close.
What is the most successful options trading strategy?
There are many successful strategies for traders, but most of them require knowledge, experience, and willingness to take on some risks. Some of them are butterfly spread, long straddle, reverse iron albatross spread, married put, bull call spread, etc. One of the safe option strategies for beginners is selling covered calls, which means you only write contracts on options you own.
What should you not do when trading options?
Traders shouldn’t repeat some of these common mistakes:
- Trading illiquid options (options on stocks that don’t have at least 1,000,000 trades per day). They have a huge spread and you will have a hard time trading them after.
- Waiting too long to close the options contract (because they believe contracts will expire and they get to keep the premium).
- Doubling up to cut losses. Even though options are connected to the underlying stocks, they don’t work or move the same way stocks do. If you buy a stock for $100, and the value slips to $50, then buying more stocks at a low price seems reasonable because it will reduce the average price you’ve paid for the stock to $75. But options work differently, and this strategy is most often wrong. It will just increase risks without offering any benefits.
When is the best time to buy options?
If you want to day-trade options, the market opening (between 9:30 am and 10:30 am ET) is the best time because there is a lot of movement then, and you have the whole day of trading ahead of you. If you are in it for the long run, choose options with far expiration dates because options’ value deteriorates over time, favoring the seller and not the buyer.
How far out should you buy options?
It depends on how much you are willing to risk. In general, you should buy options that expire 30 days after the date you were planning to make your move on. This will give you extra time to decide what to do if things don’t go your way. If you are willing to take risks, options with close expiry dates are a bargain.
Can you lose more than you invest in options?
Options are popular among traders because of the low level of risk involved. Unlike stock trade, where you have to commit considerable amounts, with options, you only risk the premium you pay for the options contract.
You can back down at any moment if you see that the conditions are not favorable, and the only thing you lose is the premium, which is just a fraction of the stock’s price. If you follow expert advice and tips for options trading, there are few risks and many potential gains.
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