My latest book is the Idiot’s Guides: Options Trading.
Like so many pursuits, trading is something that requires practice and refinement. Options trading is as much about hedging as it is about speculation. The process matters. As much as you want to jump in and start making options work for you, you’re better off taking a little time and paying a little attention to the details. Following a series of steps might not be glamorous, but it makes a difference in your ability to stay trading for the long term.
Learn About Options, Not Strategies
It might seem like options trading is about learning a lot of complicated strategies with kooky names. A lot of new options traders think they need to learn the complicated stuff first.
In fact, it’s the opposite. Start with the basics: what a put is, what a call is, what it means to write and to buy, and how the prices change. Also: what are the commissions that your broker will charge you, and how will they affect the strategies you want to try? A lot of sure things turn out to be losers as soon as the costs are considered.
If you understand the basics, you’ll be able to think about the payoffs as you put trade ideas. Focus on this before worrying about butterflies, condors, and Christmas trees. The simple stuff will carry you through.
Are You a Hedger or a Speculator?
Although most options traders hedge sometimes and speculate at others, they generally find one perspective or the other seems more normal to them and their overall portfolio. That, in turn, informs their research and their trading strategies.
Knowing what you want to do will influence your approach to the market. It helps to know your investing goals. Sure, you want to make as much money as possible, but there are some constraints: the amount of money in your portfolio, the number of years until you need the money, and your personal preferences. Keep those in mind when planning and evaluating your trades.
Have a Trading Plan
You aren’t trading options for your health. You’re doing it for something. What? That’s your business, not mine. But it is your business! So start your trades with that in mind. Think through what you plan to trade, and why, and with what limits for your money and your risk.
A trading plan does not have to be complicated. Not at all! Many traders make a few notes in a notebook or on a spreadsheet. The habit of thinking through a trade matters, not the way in which it is recorded. Take the time to figure out what you want to do before you place the trade.
Determine Your Money Management Strategy
When you see a great trade, you might be tempted to put all of your money into it. Why not get the great profit from the sure thing, right?
There are a few problems with this perspective:
- The big one is you want to have multiple trades in place. The easiest way to improve performance for a given level of risk is to diversify. Good diversification requires dividing your money among several investments and trades.
- Furthermore, if your one great idea fails, then you don’t have any money left for the next trade. Keeping some powder dry will keep you in the game for the next trade.
- Managing money is a key component of successful speculative trading. Hedgers should pay attention, too, so as not to pay too much for the insurance benefits of options.
Remember the Sources of Options Value
Options have both intrinsic value and time value:
- Intrinsic value is related to the price of the underlying and the option’s value when exercised.
- Time value – also known as extrinsic value – is related to the likelihood of exercise given how much volatility is in the asset and how much time there is until expiration.
Both values matter. An option isn’t exactly like the underlying asset. Pay as much attention to volatility as to whether or not the option is in the money in order to keep an edge.