The One Rule You Must Follow When Trading Options

| July 22, 2019 | 0 Comments

innovationWhen people talk about options trading, the conversation often turns to ultra-risky strategies like buying a call or put options — ahead of an earnings number in the hope of being on the right side.

The upside in getting lucky on such an unpredictable event is a big, fat profit.

The downside when you’re wrong? 100%.

As in, the underlying stock gaps against you, rendering the options worthless, and you’ve got nothing left over.

Being wrong on the direction is clearly an easy way to lose money.  But an often overlooked cause of most losses is not having an understanding of the behavior of option pricing.

One of the biggest mistakes people new to trading options make is not taking into account implied volatility, which is a measure of the expectation or probability of a given size move in a given time frame.  More simply, implied volatility provides a gauge as to whether an option is relatively cheap or expensive based on past price action.

I can’t tell you how many times I’ve heard people say “options don’t work” because they bought puts or calls ahead of earnings, the stock moved in their direction but the option barely changed in price.  Even when a company such as Apple or Salesforce delivers blow out earnings and the stock pops 10% and 5% respectively, both well above what the options had been pricing in, the profits in buying out-of-the-money calls was dampened by the nearly 50% decrease in implied volatility immediately following the report.

One could have bought a lower cost spread and achieved the same returns but with less risk.

The more insidious cause for losses is not grasping the nature of time decay or theta.  Options are a wasting asset. If you buy a call or put outright and the underlying moves in your direction but at a slow pace, the option will not gain in value.

Too many times people turn a position into one based on hope than probability.  It is crucial to choose the right strike, the right time horizon and right strategy that align with your thesis.  Understanding option pricing behavior will allow you to turn probabilities in your favor.

The less-sexy – but more lucrative — reality is that the best options traders grind out steady profits using a variety of strategies, looking to consistently earn 2% to 4% a month, with an occasional kicker from speculative bets like the aforementioned earnings plays.

2% a month doesn’t sound like a lot, but compounded over a year, it adds up to 27%. That’s more than three times the average historical return for the S&P 500.

Stretch that monthly gain from 2% to 4%, and the annualized profit is on the order of 60%.

Most importantly, these numbers shows the power of consistently hitting high-probability singles rather than swinging for low-probability home runs every time we step up to the plate.

Extreme risk-taking could mean that you’re up 100% one month — and down 50% the next.

You do that, and you’re right back where you started – but possibly with an ulcer and new heart medication.

I’ll tell you right now, the most underappreciated, and in my opinion, the one options trading rule you can’t break is this:

Never put on a trade that can take you out of the game altogether if it moves against you.

This is even more true with options than it is with equities because options can move a heck of a lot faster.

Keep in mind that even my most speculative positions start with defined parameters including price limits for entry and exit points, and a set stop-loss limit order in place once the position is executed unless the risk is particularly.

Why? Because again, I never want to give up my gains – or get knocked out of the game altogether — on one bad trade. I want to keep each and every position on a tight leash so I can pro-actively manage risk, and even increase profitability by adding/subtracting to positions on the fly.

All positions start with a target price and a stop loss level.  These may be adjusted over time but the risk remains defined.

This basic rule is your starting point for options trading.

Note: This article originally appeared at Option Sensei.

 

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Category: Options Trading

About the Author ()

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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