4. Don’t Forget How Much Stock You’re Controlling
Always do a reality check and calculate how much stock you are really controlling when you initiate an option trade. If you buy 20 contracts, remember that you’re actually controlling 2,000 shares of the underlying stock. If you would only normally take a 500-share position in a stock, then you should only buy five option contracts.
Some investors get carried away with options, and end up owning 50 or 100 contracts or more — but don’t realize that their investment can go to zero!
5. Don’t Wait too Long to Take Profits
We’re all in this game to make money and when we see our options trade move into-the-money (i.e., the market price of the stock exceeds the strike price of the option), we are excited by the possibilities. After all, making 100%, 200%, 300% or even higher gains is one of the many benefits of trading options, as a small investment really can go a long way.
But sometimes, folks aren’t happy with their current gains and wait just in case there’s more money to be made. Remember, the bigger the win, the more you can lose. Take some profits off the table while still leaving a portion of your position in the markets so you can take advantage of any additional upside that might be left in the trade.
If you preserve a portion of your winnings from the beginning (for example, if the trade doubles in value from your entry price and you cash out 50% of your holdings), you know you have a shot at more profits, but you’re also protected in case the market or the stock melts down during the life of your contract.
Bottom line: When you’re profitable, take money off the table and call it what it is: a trade!
6. Don’t Just Hope for the Best – Plan Your Exit
There is one important question you need to address before ever getting into a trade: When am I going to get out?
As we discussed in No. 5, if your trade doubles in value, you can decide to take profits in half the position. But what if your trade goes down? You can set a sell stop (in the case of buying options) or a buy stop (in the case of selling them) from the outset so that if the position goes down a certain percentage, you’re automatically taken out of the trade.
Many traders set a “mental” sell stop to head for the hills if their option loses half of its value. But it’s just as easy to tell your broker the specific level at which the trade should be closed. That way, you don’t make a decision based on emotion — just because you “hope” a trade will recover.
Remember, trading is impersonal (i.e., you don’t have time to become overly attached to a particular company or sector), but how much you invest and how you manage that investment are definitely personal decisions. Your options trades require a little more TLC than your regular stock investments, but a little extra effort now can pay off several times over!