Too many new traders see stock options as lottery tickets, chips in a casino, or a path to getting rich quick. They are not. They can be used as tools for the transference of risk from one person to the other. They can be used to buy insurance on a portfolio of stocks. Options can even be used in place of margin when a trader wants to apply leverage to a trade. However no trader should start trading options until they have been educated in how their pricing model works and the dangers and pitfalls of trading them.
Fish see the bait, but not the hook; men see the profit, but not the peril. – Chinese proverb.
When trading options you must understand how much risk lies in your specific option trade and what the odds are of its success. The Black-Scholes option pricing model does an excellent job of pricing in known variables of time and volatility into options. The pricing model works best the closer an option is to expiration but the accuracy of pricing gets more fuzzy and unpredictable the farther out an option is to expiration. Implied volatility does not predict direction of the movement it projects the amount of movement possible before expiration.
Option traders really have to understand the concepts of Delta capture so they are rewarded for being right directionally and also the potential for Gamma to play a part in big wins buying options or huge losses selling options based on the probabilities of an option expiring with intrinsic value. If the trader does not understand these concepts they need more homework before they trade any options.
There are a few ways to have an edge with trading options: #1 Following the chart and trading in the direction of the trend using options. #2 Always manage your risk on every trade allowing your wins to be bigger than your losses in the long term. #3 Many option traders make the mistake of trading too big with options; all the same rules of risk management apply to options as they do for stocks. Don’t catch lottery fever and blow up your option trading account. #4 You can convert a winning stock trading system into a winning option system by using options for robust entries in place of stock. #5 it is possible to design a high winning percentage system selling options but I would advise credit spreads over naked options. Option trading is no different than any other kind of trading, just more leverage and speed of movement.
- The first question to ask in any option trade is how much of my capital could I lose in the worst case scenario not how much can I make. You can lose a high percentage of the capital you have in an option trade so keep it small in comparison to your total account size. I suggest never risking more than 1% of your trading capital on any one option trade.
- Long options are tools that can be used to create asymmetric trades with a built in downside and unlimited upside. The leverage is already there, if you position size correctly based on the normal amount of shares you trade you will stay out of a lot of trouble with losing a lot of money.
- Options should only be sold short when the probabilities are deeply in your favor that they will expire worthless, also a small hedge can pay for itself in the long run creating a credit spread instead of a naked option with unlimited risk exposure.
- Understand that in long options you have to overcome the time priced into the premium to be profitable even if you are right on the direction of the move.
- Long weekly deep-in-the-money options can be used like stock with much less out lay of capital to capture intrinsic appreciation in the underlying stock.
- The reason that deeper in the money options have so little time and volatility priced in is because you are insuring someone’s profits in that stock. That is where the risk is: the loss of intrinsic value, and that risk is on the buyer of the option contract.
- When you buy out-of-the-money options understand that you must be right about direction, time period of move, and amount of move to make money. Also understand this is already priced in.
- When trading a high volatility event that potential price move will be priced into the option, after the event the option price will remove that volatility value and the option value will collapse. You can only make money through those events with options if the increase in intrinsic value increases enough to replace the Vega value that comes out. This is why it is so hard to make money when holding options through earnings, the move is already priced in and that extra value is gone the next morning the options open for trading.
- Only trade in options with high volume so you do not lose a large amount percentage of money on the bid/ask spread when entering and exiting trades. You have to find those few option chains that have the liquidity to trade with spreads measured in cents not dollars. A $1 price difference in the bid/ask spread will cost your $100 to get in and out of a trade on top of commissions. Also be aware that the best liquidity is in the front month at-the-money options and option chains get more illiquid as they go deeper in-the-money or out-of-the-money this has to be considered in a winning trade because you might have to roll the option to a more liquid contract. Most options chains can’t be traded due to the fact that they are just not liquid enough.
- When used correctly options can be tools for managing risk by limiting capital at risk exposure and capturing huge trends, used incorrectly they can blow up your account.
Options are great tools that can be used to build up your trading account if you’re trading them right. If trading them wrong you can quickly lose your trading capital to slippage, bid/ask spreads, and the sellers of option contracts.
“Forget the cheese; just let me out of the trap!”
About Steve Burns: Steve is an published author and long time blogger via his site NewTraderU. He is an avid options trader and trend follower. Follow Steve on Twitter: @SJosephBurns