Most people enter the options trading game with the idea of buying some short-term options and simply watching them skyrocket to big profits. This is the allure and “pot of gold” at the end of the options rainbow.
But after a few losing trades, reality usually sets in — and newcomers have to realize that, if they are going to survive long enough to hit it big, they must have a game plan to get there.
Before you begin buying options, you must decide how much of your investment capital you feel comfortable putting at risk. Losing streaks are a fact of the game, so never put all of your capital into buying options.
You should set aside only a small portion with which to speculate — 10% is an ideal maximum for most investors. I can’t stress this enough — smart portfolio management means being diversified among stocks and options.
Commission costs are also an important consideration when deciding how many option contracts to buy and how frequently you want to trade. You might pay anywhere from a couple of dollars to $20 or so per trade in commissions, depending on the brokerage platform you use, so start with enough capital to be able to buy at least four option contracts per position. That way you’ll reduce commission costs per trade, giving you a chance to stay in the game longer and increasing your chance of profit.
Your ability to manage your money will determine whether you succeed as an options trader.
The major risk with buying options is that because they have a predetermined time limit, options are a “wasting asset.” Every day that passes costs you, and your option could expire worthless.
Inexpensive options are usually the best plays. They give you the most leverage, the percentage returns are better, and if the market or stock goes against you, you are risking less. More important, you’re able to spread your capital over more positions, increasing your odds of winning.
A big advantage of buying options is knowing your risk in advance. You simply pay your money (the premium) and wait to see if the stock does what you think it will — which is rise if you buy a call option, or fall if you buy a put option.
If the stock price rises above the strike price specified in your call option, you win your bet. And if the stock falls below the price specified in your put option, you also win your bet.
But if the stock does not behave the way you thought it would you lose your bet, as well as the money you paid for your option. Don’t be dismayed by this. Even the pros only win their bets about 20% to 30% of the time when they buy cheap options.
Fortunately, we know how to increase your odds of winning. So you have a better chance to profit if you follow our strategies.
Price is the key to success in the options market. When you pay too much for an option, the odds get stacked against you.
Undervalued and low-priced options give you two advantages. First, you are risking less money when you buy a cheap option. It is much easier on the pocketbook to lose $50 than $500 if the option expires worthless. Second, if the stock crosses the strike price (putting it “in-the-money”) before your option expires, you not only win your bet but your percentage gains will be more than had you bought a more expensive option.
Finding underpriced options is simple in theory but in the real world it takes an enormous amount of work. We have developed a computer pricing model that does this better than anyone else. This model is to put to work every week in my Maximum Options trading service.
Just as important as selecting the right option to buy and paying the right price is knowing when and how to take profits. Most option buyers lose not because they take the wrong positions, but because they fail to take profits properly.
With options, your first objective is to protect profits, and your second objective is to hit home runs. Most important, when your option begins to profit you must be ready to act.
The best way to do this is to know exactly what you will do with a position when the option hits a specific price. Deciding this in advance, and sticking to your decision when the time comes, removes a lot of emotion from your decision making.
When you buy an option, you should decide in advance what your target price for the option will be. If the option hits its target price, sell half your position (for example, if you bought four contracts, sell two of them). This takes most of your original money off the table. Capital preservation is paramount when you speculate with options.
Then, let the rest of your position ride for possible future gains, using a 5% trailing stop on the underlying stock. A trailing stop can be a “mental” stop, though more and more brokerages are allowing this to be done automatically. The trailing stop adjusts when the stock moves in your direction, and stays the same when the stock moves against you.
For example, if a call option you own hits its target price, sell half of your position. Then if the stock keeps rising, hold the option and adjust the trailing stop higher so that it is never more than 5% under the current stock price. But if the stock falls, do not adjust the trailing stop.
The process is reversed for a put option. If the stock continues to fall after the option hits its target price, keep lowering the trailing stop. But if the stock rises, do not adjust the trailing stop.
Another key for taking profits — if your option is in-the-money and enters its last week before expiration, close the entire position and take profits. Don’t wait for it to expire.
Taking half of your profits at the target price serves two beneficial purposes. One, it forces you to take some money off the table, protecting you from a sudden reversal in the stock price. And two, it leaves money on the table for possible future gains. Protecting profits and preserving capital is critical when you’re buying options.
As important as taking profits is cutting losses. Losses are part of the game, and if you don’t take them and move on you will soon be out of the game.
There are two ways to cut losses. One is by setting a stop loss on the underlying stock. If the stock closes below (for a call option) or above (for a put option) its stop loss, close the option position the next day.
Another way to cut losses is to use the option price. If an option falls in value by 50% after you buy it, sell it and close your position.
We can’t stress this enough — if you do not cut your losses quickly, you will not last as an options player.
That, in a nutshell, is the best way to maximize profits with short-term options. It is a system that takes profits when they are available, and cuts losses when necessary. Most important, it removes emotions from your decision-making. Follow this system and you’ll have your best shot at real success when you buy options.
The key to long-term success as an options speculator is to hit home runs. And the key to successful investing with options is to buy extremely cheap ones.
Cheap options have the potential for spectacular gains. But finding those that are inexpensive and have the potential for a home run is not easy. You need tremendous patience.
You may have to enter a lot of orders before you get one filled at your price. More cheap options expire worthless than don’t, so you must have the patience, discipline and resources to keep trying for a home run.
Try to find options that are priced under $1.50 and whose strike price is close to the market value of the stock. Make sure the options are underpriced and have a probability of profit of at least 20%. To get your best deal, try to buy put options on stocks that are rallying and call options on stocks that are falling.
Most important, try to buy options on stocks that have the potential for surprise volatility. Stocks tend to fall much faster than they rise, so buying put options tends to be a better bet on surprise volatility.