No matter how many options trading articles you read, all experienced option traders began their trading careers as rookies. It may seem so simple right now — you look at your charts or option chains — and you are ready to place an order. It wasn’t always that easy. So if you are fairly new to trading, I’m going to share some of my insights on things that are important to do before you begin trading options.
#1 – Choose a Broker and Get Approval to Trade Options
When you open a brokerage account for options, it’s not as simple as with a stock trading account.
The industry offers education such as the Characteristics and Risks of Standardized Options document. It also sets limits on the strategies that inexperienced customers can adopt. The logic isn’t always clear. Beginners are allowed to trade some simple strategies, such as writing covered calls, but are prevented from trading safer, less risky strategies like selling credit spreads.
Your broker always allows Level 1 strategies. With options some brokers let newcomers trade anything, others are much stricter. Pick a broker who allows you to trade your desired strategy.
One more item: Open a margin account. You may prefer never to use margin where you borrow money from your broker, and that’s fine. However, most brokers require that option trades be made in a margin account.
#2 – Options are Special: the Greeks
Options are unique in the investment world because they have a limited lifetime and their value erodes over time; they can be used to speculate as well as to provide insurance on an investment portfolio; they can be used to control risk.
We use the “greeks” to measure risk. The greeks are a series of Greek letters, each of which is used to represent a specific risk for a trade. Delta tells us how long or short our position is in relation to the underlying product. A position with 326 deltas earns or loses money at very nearly the same rate as owning 326 shares of the underlying stock.
The greeks serve one purpose. They allow traders to measure the risk of any option position. And the greeks are readily calculated. In fact, your broker provides the greeks and there is no need to do the calculations yourself.
#3 – Paper Trade
The concept of practice trading is controversial. Some people believe that you learn nothing when real money is not on the line. I disagree. There are techniques to learn, strategies to master, and thought processes to experience.
Make some trades in your broker’s paper-trading account before investing real money. The first benefit is to be certain that you understand how to enter orders, especially spread or combination orders. It’s easy to enter such orders backwards – confusing ‘buy’ versus ‘sell’ when the definition of a specific spread is not clear.
Adopting a strategy, watching it play out, managing risk and making adjustments, and deciding when to take a profit or cut losses – each is a major decision and it takes some experience to acquire the skills that give a trader the chance to come out of the trade as a winner.
#4 – Choose Your Underlying Asset Carefully
Yes, you are trading options, but the asset underlying those puts and calls must be chosen with care. If you believe a stock is headed higher and elect to make a bullish trade, it’s a simple matter to choose options on that specific stock. However, if you feel the market is going to be trading over a narrow range and you decide to try to profit from time decay, then it’s best to choose the options of a broad-based index or exchange traded fund.
The more stocks in the index, the better the chance that it will behave when the market turns out to be flat, as you predicted. If you choose an individual stock, then an unexpected news release may affect the price of a single stock, but not the entire market.
Follow Mark on Twitter @MarkWolfinger.