Options trading strategies and advice is cheap to come by in the Internet era; discussions of beta numbers and changes in volatility are available from hundreds of options-specific advice blogs and strategy posts. Advanced trading strategy can be a wonderful thing, though it’s not often the kind of advice new traders need to hear.
It can’t be said enough, derivative trading of any type can bring with it a lot of risk. According to the CBOE, some 30% of all options contracts expire totally worthless. The advice below, easily the best options trading advice you’ll ever get, is designed to protect investors from the volatility of the options market. Many options traders could have avoided big losses by following the three easy principles below.
Manage Your Money
A common suggestion made to new traders is to only invest so-called “risk capital” on options contracts. This dovetails nicely with the common advice to gamblers that they avoid “betting the rent money.” Options traders could learn a lot from the gambling community and its approach to financial management. It’s easy to think of a game like blackjack as an investment made with the hope of being able to cash out at a profit down the line.
Yes, there is the potential for a big return with certain types of contracts and certain positions, but it makes sense to consider the worst-case scenario for each investment. Investors who take time to think about what’s at stake before the contract is purchased are generally more successful than those who approach each opportunity with an eye on the upside.
Managing an investment portfolio, like managing a stack of chips at the roulette wheel, means risking only a certain portion of an investor’s budget on trades. This prevents newcomers putting big chunks of their investment capital into a single contract. Some beginners may benefit from dividing their total trading capital in half, depositing one half in an account that draws interest, and beginning their trading career with the other half. This protects half of an investor’s total risk capital from beginner’s jitters.
The concept of the unit bet, also popular in betting strategy guides, makes sense as a financial tactic for options holders. For trading purposes, call it a unit buy, a percentage of an investor’ total capital that the investor is willing to risk on a single trade.
Develop and Maintain a Game Plan
The biggest mistake new traders make is not doing enough homework before they start. All options traders should be operating according to a larger game plan, sometimes called a trading plan. This blueprint should be drawn up well before trading begins – consider it a type of risk management. The discipline necessary to create and follow this game plan is a key factor in security trading success.
Why is this game plan so particularly important for the options market? Changes happen in this market as fast as in any other, if not more so, and a trader’s game plan (designed ahead of time) helps them stay prepared to make a move as soon as necessary.
What goes into an options trading plan? Traders should decide first how they’re going to approach the market, whether they’ll dump a big portion of their capital on traders early, or move more gradually into the as-yet unfamiliar market. Investors should also consider the balance of their overall options portfolio and its place in their even-larger overall financial plan. Some options traders prefer to have an even number of puts and calls. Another important decision – how much and how soon will a portfolio be diversified across a wide variety of sectors?
A final must-have on any securities trader’s game plan is an outline of when the investor will take profits and when they will cut losses, depending on the nature of the contract in question. A good game plan will explicitly outline the situations that lead to either of these events, and know exactly when to trade, when to exercise, and when to give up and allow a contract to expire. The consistency of action this allows makes for a better long-term approach to the market.
Trade Only in Low-Risk Situations
The options market does provide opportunities for low-risk, high-reward trades. They are not plentiful, but they’re not impossible to find. Smart traders know to stick to these opportunities, where investors have little to lose but much to (potentially) gain.
Patience is as important in the options market as in any other financial proposition. Consistently successful traders only make a move when they have a high chance of success. There is value in watching the markets for days at a time, making no moves, rather than moving too often and putting capital at risk. Newcomers to the market are easily swayed by advice in forums and from investor friends and make the mistake of jumping in too often.
How does a trader identify these low-risk opportunities? It requires a combination of an understanding of market cycles and the ability to spot under- and over-valued contracts. Some investors rely on the bigger picture, concerned more with the overall trends of a financial market, while others spend hours researching and testing strategy. It doesn’t matter how an investor implements a strategy once the low-risk investment has been identified, only that they wait until their risk is low to purchase contracts.
The most successful options traders in the world are those that have the discipline to create and follow financial, risk management, and risk mitigation plans, as described above. Ultimately, it’s that discipline that lies at the core of successful strategies. Discipline is how options traders learn to wait patiently for a beneficial market condition before they get involved in a contract. Provided investors can learn from their mistakes, and learn to continue on with strategies that have worked (even a little) in the past, they will maintain their risk capital for longer and find more success in the long-run.