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Options Trading -- Remembering the Basic Rules of Trading

By  Jun 24, 2010

Topics: Finance & Investing

Options trading activity has been growing at an incredible rate over the past 35 years or so. The rate of growth has accelerated recently as options have becomes available on a growing number of stocks as well as indices, ETFs and futures.

For those entering the market for the first time, it opens some exciting possibilities. Options can be used as the preferred method for day trading or swing trading, for example. Strategies can be designed to be very high-risk and potentially profitable, or ultra-conservative. In either case, some basic rules of options trading should always be kept in mind:

1. Remember, it’s all about the underlying stock. If you are going to take a position in the underlying stock as part of an options-based strategy, the first step should be the same as if you were going into a buy-and-hold strategy. Pick the company as a first step based on smart fundamental criteria. Remember, you can earn more option income with more volatile stocks, but these are also higher-risk.

2. Keep perspective on both profit and loss potential. It is all too easy to focus on profits based on good timing of an options strategy. Remember, though, that it is just as easy for a position to end up creating a loss. This is easy to overlook in the enthusiasm of the “sure thing” that ends up not acting as you expected.

3. Be aware of the balancing act you have to do between premium levels and time to expiration. The more time to expiration, the more time you have for your strategy to work out. But the longer the time, the higher the option premium will be, too, due to time value. So this is a balancing act, and every options trader has to struggle to pick the option that works best for a particular strategy.

4. Remember that your entry price is not “zero.” It is easy to fall into the trap of thinking of an entry price as the start of price movement. From there, you expect the price to move in the desired direction. In fact, though, all market prices are only the current prices in a series of ever-changing price levels. This means that prices can rise, but they also can fall. Don’t be taken by surprise if some of your trades end up being poorly timed. It happens to everyone.

5. Finally, remain realistic. If you are going to use options as your preferred trading vehicle, you have to know your risks. If you are going to rely on long options, you should know that about 75% expire worthless, not good odds for consistent returns. And if you use short positions, you have to be prepared to have some of your open contracts exercised. With short calls, this means your stock is called away or you have to make up the difference between the fixed strike and the higher market value of the stock. If a short put is exercised, then 100 shares of stock are put to you at the strike, which will be higher than current market value of that stock.

You can do well with options, either as tools for speculation or to manage your portfolio and its risks. The way you use options relies on your risk tolerance and expectations. One thing is for sure: You should not expect to “get rich quick” using options. It could happen, but it is a long shot. And most long shots don’t end well.