Four Rules – A Guide for Trading Options
A basic profitable strategy
There are dozens, of ways for trading options, some of them very complex, but we want to start with an effective basic strategy that can be shown to be profitable, easy to follow, and easy to implement.
There are just four “rules”, listed at the end of this piece that provide a simple way to trade options, a field where strategies of varying complexity and risk for trading are numerous.
If you can pick winning stocks, those that go up in price, you can do very well trading the options for such stocks.
The key is whether a chosen stock performs up to expectations by rising in price in the case of a call option, or falling in price in the case of a put option, and doing so within the span of time before the option expires.
Time is the important factor
If the underlying stock does not perform as expected, the option should to be sold on or before a specific pre-set target date. That would mean a loss if there has been no gain at all in the price of the stock and maybe a loss even if it has gained, those possibilities should become clearer as we identify the guidelines later. Reference will be made below to a pre-set “sell by” date.
Loss and gain
With most options, the maximum dollar loss that can occur is the fixed amount of the purchase price paid, whether the option position cost $500 or $5000, that is the most that can be lost if the option is held until the expiration date when it automatically becomes worthless. But the guidelines below establish a fixed date prior to the expiration date of the option, which may allow a smaller loss.
It should be understood, that in this type of speculation, with a series of sensible trades there will probably be some losses, what is important is that a risk management plan is followed that can minimize those losses as much as possible and preserve working capital. Obviously there must be more winners than losers to stay in the game and provide sufficient reward to compensate for the risks involved. There should also be a strategy to maximize gains when they occur, in other words, to not exit a position too soon.
The right stock for the right time
In the same way that any other stock purchase is made, the choice of stock to trade should be made after what is usually termed as “due diligence”, appropriate research in checking out the attributes and prospects of any selected list of stocks. Whether after a short or long appraisal, or for whatever reason, we must assume that a promising candidate has been chosen to make a trade in options using the simple strategy outlined here.
For stocks, or indexes, or for other optionable financial vehicles, there are normally many different options available, offered at different strike prices and for different terms (lengths of time in which the option can be exercised).
As an example, let us assume a decision is made to buy calls. To make the option trade we need to specify the following, the first requirement is fixed, based on the stock chosen after suitable research.
1. name and symbol of the underlying stock (or index)
2. strike price
3. expiration date of the option
Those last two requirements provide a myriad of alternatives. There are many strategies followed in option trading that determine the specifics of the above and the risks attached to those strategies differ. Option trading promises bigger gains but the risks are higher.
Buying a Call, guidelines for a simple option trade:
Avoiding the option strategies of highest risk, the suggested guidelines for a basic call option trade establishes specifics for the strike price and term as follows:
1. The strike price will be “in the money”, at a price below the current price at which the stock is trading. How far below? The delta value noted below can help to determine that. The deeper into the money, the higher will be the option price.
2. The expiration date will be approximately 4 to 6 months after date of purchase
An explanation of why it is “approximately”:
Option contracts expire during different months according to a pre-determined calendar and vary for different companies. The day of expiry is always effectively the third Friday of the month (although it is actually the third Saturday of the month, but there is no trading on Saturdays.) The farther away the expiration date for a given strike price, the higher the option price will be, that’s because more time is being bought. But usually when an option is sold with a month to go before expiration, it should have some dollar value left in it because of the one month of remaining time whereas it will be worth much less the nearer it gets to the expiry date.
3. Important Note: the position will be sold no later than one month before the expiration date. Always. Depending on performance (we) may just exit or we may “roll up” to a later expiration date.
4. Delta, An additional guideline
Explained elsewhere on this site, the delta is a numerical value that varies dependent on the changing price of the underlying stock. It is a useful guide in tracking the stock’s progress and to assess the potential for gain as a stock moves in price.
Choose an option with delta of about 60 to 65
In our next post, to better explain the foregoing, we will provide more details and specific examples to show how the leverage provided by a successful option trade gives a bigger bang for a buck.
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