Ten Commandments of Options Trading
While most investors hold mutual funds, ETFs, stocks and bonds, sophisticated investors have increasingly relied on options to diversify and enhance returns. Options provide these traders and investors with a lot more flexibility when it comes to managing their portfolio by enabling them to decide how and when to buy.
In this article, we’ll take a look at ten rules that options traders should follow in order to limit risk and maximize reward.
10. Get Familiar with the Greeks
Trading options without knowing the lingo is like flying a plane without being able to read the instruments. The so-called Greeks provide essential insights into the sensitivity of option prices to changes in the underlying stock, which makes them absolutely essential when it comes to managing risk.
Options traders should at least be familiar with the basics:
- Delta – Measures an option’s rate of change relative to the rate of change in the underlying stock (e.g. spot price value).
- Vega – Measures an option’s sensitivity to volatility, which is especially important in straddles (e.g. volatility value).
- Theta – Measures an option’s sensitivity to the passage of time, better known as the option’s time decay (e.g. time value).
9. Keep Emotion in Check
Inexperienced traders have a pesky tendency to buy high and sell low – it’s simply human nature. For instance, the NASDAQ was trading up over 85% in 1999 during the dot-com bubble and investors still poured some $2 billion per day into the market in February of 2000 at the very top, right before the bubble burst.
Options traders can keep emotions in check by following some tips:
- Big Picture – Always be mindful of the larger macroeconomic picture and avoid buying assets that are clearly overpriced – even if everyone else is.
- Always have a Plan – Traders should always have a plan for their trades in order to take out any possible emotion from buying or selling (see #8).
- Prefer Bargains – If possible, always look for undervalued bargains instead of overpaying and hoping that others pile on at higher prices (see #6).
See Also: Ten Commandments of Futures Trading
8. Plan the Trade, Trade the Plan
The fact that investors sell winners too early and keep losers too long is so prevalent that economists have given it a name – “the disposition effect.” While the causes of the effect aren’t entirely certain, options traders can avoid them by creating a plan before entering a trade and then executing that plan without compromise.
Here are the steps to plan and execute trades:
- Criteria – Set up specific criteria for a trade that must be met in order to avoid impulsively establishing a trade.
- Entry Point – Determine the price you’re willing to pay to enter the trade and set an automatic order if necessary to abide by it.
- Exit Point – Before entering the trade, determine the point at which you’d like to sell and/or conditions necessary to keep the trade open.
7. Mind the Double-Edged Sword
Leverage may be the greatest financial innovation of all time, but it has cost a lot of traders a lot of money. While most traders associate buying stock on margin with leverage, options trading provides its own kind of leverage with unique risk factors that should be carefully considered before entering trades.
Here are some important risks to consider:
- Hidden Costs – Margin involves a very obvious cost up-front, but the costs of options are hidden in things like time decay.
- Total Loss – Buying options may provide greater upside leverage, but the cost is the potential for a total loss of investment.
6. Hunt for the Best Bargains
Value investors like Warren Buffett have consistently outperformed the market for a reason: buying undervalued assets provides a better risk-reward profile. The same principles hold true for options trading where bargain trades can both limit downside and equate to greater upside potential over the long run.
Here are some tips for finding bargains in the options market:
- Compare Volatility. Traders can determine if options are over or under priced by comparing the current implied volatility to recent IV trends. Low levels of IV mean that options may be undervalued by historical means.
- Extrinsic Value. Traders can compare different options on the same stock to determine pricing, but it’s important to look at the extrinsic value rather than the intrinsic value to see what option is really cheaper.
5. Get the Timing Right
Timing is everything – particularly in the options market. Not only do options lose money over time – in what’s known as time decay – but also the leverage associated with options means that timing is equally important for profits. As a result, options traders should spend a lot of their research on properly timing the market.
Here are some tips for timing options trades:
- Get Out Sooner – Options are decaying assets and the rate of decay increases as the expiration date approaches. So, if a predicted move doesn’t materialize, the best option is often selling sooner rather than later.
- Buy Back Earlier – Don’t wait too long to buy back out-of-the-money short options to take risk off the table; often, if you can keep 80% of the initial gains, you should consider buying it back immediately.
4. Keep an Ear to the Ground
Company-specific and economic news can quickly change the market, which means that traders should always be monitoring their positions. For instance, employment reports can significantly influence major indices like the S&P 500 SPDR and the options trading on those indices – especially short-term options.
Here are some tips to keep in front of the news:
- Economic Calendars – Keep a calendar of economic releases on hand and be aware of the major market movers that could influence positions, such as employment reports, GDP reports, or FOMC meetings.
- Sign-up for News Alerts – Sign-up for automatic e-mail or SMS alerts for company-specific news and be aware of major release schedules for things like earnings or SEC filings in order to avoid any problems.
- Have a Plan – Always have a plan in place for potentially bad news, including the price at which you’d like to sell or stop-loss points.
3. Seek out Liquidity
Liquidity isn’t very important until you need it. While many large-cap stocks are relatively liquid, the options market can prove very illiquid, especially when trading options that are very out-of-the-money or very in-the-money. LEAPS and other long-term options can also be relatively illiquid at times.
Here are some considerations to keep in mind:
- Always Stay Liquid – The best way to avoid liquidity problems is to simply keep away from options that are very illiquid and stick to at-the-money or near-the-money options that tend to be more liquid.
- Look at Open Interest – Options traders should generally seek out options with open interest of at least 50 times the number of contracts that they’d like to trade. For instance, 20 contracts should have open interest of at least 1,000 contracts in order to have enough liquidity.
2. Jump into Spreads
Many options traders use spreads in order to capitalize on certain price movements in the underlying stock while limiting risk. “Legging in” to spreads – that is entering different legs of the trade at different times – can be a dangerous game since the strategy can be ruined with a downtick and expose the trader to great risk.
Here are some tips to avoid legging in to spreads:
- Simultaneous Execution – Many options brokers enable traders to not execute spreads unless a certain net debit or credit is achieved. In general, this is the safest way to ensure that you don’t accidentally leg into a spread.
- Immediately Correct – Traders that have accidentally (or intentionally) legged into a spread should correct the trade sooner rather than later, since they may be exposed to unlimited risk in one direction.
1. Be Careful When Naked
Naked trading involves trading options based on the assumption that a trader owns the underlying stock when in reality they don’t own it. For instance, writing a call option without owning the underlying is trading naked. Most traders should avoid these types of situations given the unlimited downside risk to the trade.
Here are some tips to keep in mind:
- Use Spreads Instead – Spreads can cap downside risks without the up-front expense of actually owning the underlying stock. For instance, writing short-term calls against a long-term LEAPS can provide a floor for losses.
- Monitor Events – When trading naked, traders should watch for event risks, such as company-specific or economic news. These market-moving events can quickly turn a naked trade into steep losses.
The Bottom Line
Options provide sophisticated traders with a unique way to build specific strategies, but traders should take certain precautions to limit risk and maximize reward. The ten commandments of options trading listed above can help achieve these goals by avoiding many mistakes that novice (and expert) options traders make.
Did you know that...
- It's wise to periodically assess your liquidity needs, ensuring you aren't forced to sell during unfavorable market conditions?
- Finding non-financial hobbies or stress-relieving activities can balance the emotional highs and lows of investing?
- Maintaining a reading habit of diverse subjects, not just finance, can offer unique insights and analogies for investing?
- Reminding yourself of your successful past decisions can boost confidence during challenging market phases?
- The concept of 'continuous compounding,' while more of a mathematical concept, represents the most frequent compounding possible and is used in some financial formulas?
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- "The best investors are those who are able to identify great companies and hold them for the long term." - Julian Robertson
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