Avoid call options that are out of the money: While most investment markets focus on the trend of buying low and selling high, this approach doesn’t work when it comes to options trading. Putting your money on out of the money call options often devolves into little more than gambling, and there are more effective ways of gambling that have much higher odds of success. Additionally, making these types of trades can make it difficult for you to understand why the trade failed to return a profit which makes the whole thing an exercise in futility.
To understand why out of the money call options are a poor choice it is important to keep in mind that when you purchase an option, you are saying not only that you know how the underlying asset is going to move but also when that move is going to occur. If you make a mistake when judging either, you are going to be out the premium you paid for the option along with the cost of the commission as well. What’s worse, your funds will then be tied up until the option expires meaning you may miss out on a preferable alternative in the interim. Remember, in order to see a return on this type of trade the underlying asset of an option that is out of the money needs not only to increase, it also needs to reach all the way to the strike price.
Know when to use varying strategies: Options trading offers up a wide variety of different strategies to ensure you don’t end up trying to fit square pegs into round holes. For example, buying on spread will sometimes be an excellent way to capitalize on various market conditions, but only if you are aware of the specifics beforehand. Not only will focusing on a single strategy cost you money in the long run, but it will also skew your results by calculating false losses that were not indicative of the strength of the system in question.
Know the spread: A long spread is made up of a pair of options that are similar in every way except one has a higher strike price than the other. The option with the higher cost is being purchased while the other is being sold. These options can be either puts or calls. Long spreads comprised of calls are bullish, and those comprised of puts are bearish.
Despite the fact that when the time lapse hurts one-half of the spread, it helps the other, spreads ultimately hurt your profit potential in most cases. This is because one-half of the pair is practically always going to expire unless the underlying asset is extremely volatile. With that being said, if you are interested in reliability above all else then they are still a good choice.
Always have a clear point of entry and exit: To trade in the options market successfully, it is important to always have a clear idea of the ideal entry and exit points you are going to utilize. Not only will doing so help to mitigate the influence that emotion might have on each trade, but it will also ensure that you remain in the black over the long term. While it can be difficult to exit a trade when there is still the potential of money on the table, it is important to keep in mind that the potential for loss is also ever present. Setting a reasonable exit point and sticking with it is going to generate a larger profit over a prolonged period of time, guaranteed.
Avoid doubling up: If you are in the middle of a trade that appears to be going well and it suddenly turns around apparently at random, it is only natural to want to do anything you can to save it. Unfortunately, the best option virtually every single time is going to be to cut your losses and move on. In this situation, it is important to keep in mind that options are derivatives which mean the price is likely to change, and ‘doubling down’ is likely only going to lead to a greater overall loss.
While doubling down might feel like the right move at the moment, if you take the time to consider the amount of related time decay you are dealing with it can help to clear your head. If you still can determine what the right course of action is going to be all you need to do is to take an extra moment to clear your head and consider what you would have done in this situation if you weren’t already committed. Nine times out of 10 the correct decision is going to be just to cut your losses and move on.
Stay away from illiquid options: Illiquidity measures the speed at which a specific option can be either bought or sold without causing the price to shift noticeably. Liquidity, on the other hand, can be thought of as the chance that the second trade of a given underlying asset will take place at the same price as the first. The stock market tends to be more liquid than the options market simply because there are fewer options related to each individual stock. As a result, you are automatically 10 percent more likely to end up on the losing side of a trade if you choose to move forward with an illiquid option.
Be willing to buy back short options: While, in theory, it might seem like buying back short options at the last moment is the best choice, this practice is sure to hurt you more than help you in the long run. It may be tempting to hold onto profitable options in order to squeeze the maximum return out of each investment, but you need to be aware that the potential for a reversal is always lurking in the shadows. Instead, a good rule of thumb is to buy back options that are currently at 80 percent of your ideal return or higher and let the extra take care of itself. While it may hurt to leave some potential profit on the table, it will improve your overall reliability, netting you a profit in the long run.
Keep earnings and dividend dates in mind: It is important to keep an eye on any underlying assets that you are currently working with as those who are currently holding calls have the potential to be assigned early dividends, with greater dividends having an increased chance of this occurrence. As owning an option doesn’t mean owning the underlying asset, if this happens to you, then you won’t be able to collect on your hard-earned money. The Early assignment is largely a random occurrence which means that if you don’t keep your ear to the ground, it can be easy to get caught unaware and be unable to exercise the option before you miss the boat.
Along similar lines, you also want to be aware of when the earning season is going to take place for any of your underlying assets as it is likely going to increase the price of all of the contracts related to the underlying asset in question. Additionally, you will need to be caught up on current events as even the threat of influential news can be enough to cause a significant spike in volatility and premiums as well. In order to minimize the additional costs associated with trading during these periods, you are going to want to utilize a spread. Doing so will minimize the effect that inflation has on your bottom line.
Respond to an early assignment in the right way: When it comes time to sell the options you have purchased it is important to keep the possibility of early assignment in mind. To avoid unpleasantness, you are going to want to avoid lower-striking the long option in order to generate enough of the required underlying asset. Rather, you are going to want to place the long option onto the open market which will provide you with the chance to profit from the premium caused by the remaining time. You can then use your new funds to purchase the underlying asset that you are on the hook for, netting a profit in the process.
When you come up against an early assignment, it is important not to let your emotions get the better of you. Remember, the early assignment is more or less random so there is little you can do to prevent it from happening. Other traders aren’t always going to make the best choices, and all you do is to roll with the punches. All you can do is to try and negate the chances of it affecting you as much as possible by being prepared for it depending on the mood of the market and its current level of volatility.
If you are going to utilize a spread, do it all at once: While purchasing a spread in a two-step process might seem like a good way to maximize profit, in reality, you are playing with fire. Specifically, purchasing a put or a call and then waiting to purchase the other half of the spread often leaves you open for the possibility of a reversal that will cost you more than what you would have made had things gone your way. Purchasing a spread as a single unit minimizes the number of variables that you have to contend with and increases your chance of success in the long term.
Take advantage of index options: Index options are a safe choice when the market is currently sporting a high degree of vulnerability. Index options are much less likely to experience sudden changes to a majority of news reports unless the results are extremely far reaching. The larger the index, the more likely it is that it will remain neutral.
On the other hand, if the market is in a holding pattern then you are going to want to consider short spreads on indices. In order to do so, you are going to want to choose an option pair with different strike prices in the standard fashion. This will largely remove time decay from the equation while also guaranteeing that you will make a profit as long as prices don’t decrease.
Avoid making trades you cannot afford to lose: Regardless of how airtight your trading system appears to be, it is important to make it a habit of never investing more than you can afford to lose. No single trade is ever going to offer up enough of an incentive that taking the risk of knocking yourself out of the trading game entirely makes sense. Ensure that you know your limits beforehand for the absolute best results. In fact, a good rule of thumb is to never commit more than 2 percent of your total trading capital to any one trade. If you take this into account, then you would have to make 50 bad decisions in a row to lose all of your capital. If this occurs, you are likely focusing on the wrong investing and should consider your options carefully before continuing.