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Options Trading -- Rules of Trading to Keep in Mind

Posted August 4, 2011

Topics: Finance & Investing

Options trading activity has grown at an amazing rate for the past 35 years. This accelerated once options became available on most listed stocks plus indices, ETFs and futures. This expanded trading market opens many possibilities. Options can be used as the vehicle for day trading or swing trading. Strategies can be very high-risk or very conservative.

In either case, some basic rules of trading should always dominate:

1. It is all based on the underlying stock. If you take a position in the underlying stock as part of an options-based strategy such as covered call writing, the first step should be the same as if you enter a buy-and-hold strategy. Pick the company 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 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 performing as you expected.

3. Be aware of the balancing act between premium 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, 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, all market prices are only the current prices in a series of ever-changing 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, be realistic. If you use options as your trading vehicle, you have to know your risks. If you rely on long options, remember 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.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to several blogs: CBOE, Seeking Alpha and the Global Risk Community.