Options are depreciating assets and require a little more finesse than trading stocks. Be patient to get in, and know your exits. Here's a few tips to keep in mind when trading options. These are rules of thumb--part of knowing the rules is also knowing when the break them.
- Don't buy an option just because it is cheap. The only reason to buy an option is because the underlying security looks set up to make a decent move.
- Never play deep out of the money options. These are alluring because they are so cheap–but they are cheap for a reason. It may be exciting to buy 100 options for 3/8 and lay in bed at night praying for them to go to 10 (taking $3,800 and turning it into $100,000) but it happens almost as frequently as hitting a lottery number. If you are trading for an adrenaline rush, you would be better served jumping out of planes or playing craps with your rent money.
- Never, ever, ever put in a market buy order before the open. This is like walking onto a car lot and handing the salesperson a blank check. "Just write in whatever amount you think is fair." By doing this, you will almost always pay the high price of the day or even the week. Give the stock a chance to open and for the excitement of the opening bell to cool off.
- It is almost always a bad idea to chase a stock–it is even worse if you want to buy options on that stock. This always results in a bad entry price. It is tough to make money trading options if you consistently get bad entry prices.
- Never put all your money into one play. Don't bet the farm. You might turn $3,000 into $20,000 by doing this. But it is just like going to Vegas and betting it all on red with each spin of the wheel. Sure, you might win 5 in a row, but it only has to hit black once to wipe you out. We hear so many stories of people who ran an account to zero on one trade. If your goal is to run your account to zero, bet the farm.
- Try not to hold more than five different positions. If you are trading with a smaller account, say $2,000.00, keep it to two positions. There is no way you can react quickly if you can't even remember what you own.
- It is usually not a good idea to hold a position over an earnings report. Recently, seventy percent of all stocks have been getting whacked right after the number is released. Remember, stocks rise on anticipation of news–not the actual news. Use the options to play a potential pre-earnings stock run up, then get out a few days before the actual earnings are released. Also, if after earnings the stock makes a huge move up or down, there is another good short term option play using intraday support and resistance.
- Never place a market order for a thinly traded option. As if by magic, the bid and ask will move up 2 points just after you place your order. Think of it this way. If you were walking down the street and saw a $20 bill, you would probably reached down and pick it up. Market makers do the same thing. Place a limit order near the ask and be patient.
- The longer you hold an option, the greater the risk. Pick your exit points and get out. If you have calls on CMGI with the expectation that it will run up to its 20 day moving average at $150–you should be selling at $149 and get out. (Of course that was written about a year ago. Today it would be, "On a run to $5 sell it at $4.90"). If the stock breaks through, you can always get back in. Conversely, if the stock isn't doing what you thought–it's falling through what you though was support–get out. You can always get back in. This takes us to our next rule.
- It's best not to hold a losing position overnight. Of course when you are swing trading options and not watching the market, this is tough to do, but good to keep in mind. If it is not working out on day one, it probably won't work out. Take the loss, or reduce your target to even and try to get out the next day. You can always get back in. Hundreds of thousands of options expire worthless every month. Be one of the few who followed this rule and got out at a decent price.
- Never let a profitable position turn into a loss. Once you're making money, move your stop up to breakeven
- The trend is your friend. Try not to bet against a market or sector. If Internets are tanking, don't be so eager to catch a falling sword (instead of stopping at support–your hands–the sword slices right through and keeps on falling). Let the market prove itself to you that it has turned around. The majority of stock movement is due to market/sector movement, not stock fundamentals.
- If your position has doubled, sell at least half of it and put in a trailing stop for the remaining position.
- Emotion is your enemy, logic is your friend. Never trade on emotion. If you find yourself thinking, "It has to go up!" Get out. Or, "It can't go down any further!" Get out. The market does not care what you think or hope. It certainly could care less that you want to surprise your spouse with a trip to the Galapagos Islands. It is ruthless and makes its own rules. Past performance is not a guarantee of future results. Just when you think it can't get any worse, it can get a hell of a lot worse. Don't be like the guy on the E*Trade commercial who is yelling at his quote screen, then jumps out the window into his front yard. (If you find yourself doing this, it is probably a good time to sell and go for a run). Calm, cool, and collected.
- Never buy on impulse. If you just heard the news, it is already too late. Plan your buys during non market hours. Once the bell rings your mind is clouded, emotion takes over. Plan your strategy, execute your plan. When in doubt, stay out. Cashflow is king. It is very easy to make 25% every two weeks but very hard to make 100% routinely. 25% on $2000 every two weeks for a year is $13,000. Take a steady profit over and over and over.
- Never try to make up all your losses on the next trade. Go play golf. The $150 you spend on a round of golf will be far cheaper than all the money you would have blown in the market "trying to make it all back."
- Okay, you've found a stock at a support level and you want to buy some call options. Which ones do you buy? You want to look at just "in the money" or "at the money" calls. For example, if YHOO is setting at support at $160, you would want to buy the $155 (slightly in the money) or $160 (at the money) calls. These offer a combination of your best leverage with minimal premium decay. Which leads us to our next tip.
- Be careful which series you purchase. In the above YHOO example, let's say that it is September 15. The September option series will expire in a few days (the third Friday of every month). Do you buy the September series or go the next month out and buy October? Go the next month out and buy October. With short term option trading, you generally want to stick to the near month option series until you get about two weeks from expiration. At this point it is a good idea to go out to the next month. If you are wrong on an option that expires in four days, the premium will disappear faster than you can type in your panic sell order.
- Successful traders take time off from trading! Take a week off every month and regain your objectivity.