Things To Consider When Option Trading

Option trading is a great way to create an income and hedge your downside risk. Option trading can be done online with platforms like OptionsXpress® by Charles Schwab. With the right knowledge on how option trading works, you’ll find yourself in a better position to take advantage of the opportunities it presents.

Here are some things to consider when you’re trading options.

– The Option Contract Life Cycle: All option contracts follow a life cycle. This life cycle starts as soon as you place an order, and terminates when the contract expires and is assigned or exercised. As the option nears expiration, there’s a point where it lives in a netherworld between live and expired — referred to as “the Greeks” — providing splendid opportunities to be had.

– How Option Contracts Work: It’s important to understand how option contracts work before you place your trade. An option contract is a combination of two options — a call (buy) and a put (sell). The value of an option contract can increase or decrease depending on how the underlying asset moves. On the expiration day, if the price of the underlying asset remains within the range defined by your option, it’s said to be “in-the-money” and has value. If it moves outside that range, then the value of your option contract would go down.

– Understanding Exchange Rates and Volatility: You can have options that are beyond plain vanilla at one end, while other options will be in-the-money, break even or out-of-the money at expiration. The market reacts and moves in terms of a certain price range. When you think of the term ‘expiration,’ it means the end of that band. In other words, a call with a strike price of $170 will expire at $170 if the underlying asset doesn’t go any higher than that point. A put with a strike price of $120 will expire at $120 if the underlying asset doesn’t go any lower than that point.

– The Cost to Own an Option: Buying options is expensive, and you have to be aware of your option costs before you place trades. Buying calls or puts involves the exchange of actual money for an option contract, and this means you have to pay a premium. At the same time, if you’re buying options thinking that they’ll create income for you at an attractive price, then it will cost you more than if you actually purchased the underlying security.

– The Rule of 72: This is a very useful financial tool to help measure the returns on investment from different investment environments. You can use Rule 72 to calculate exactly how long it would take for your investments to double if left untouched, or return those funds back to you (assuming there’s no change in market value). This allows you to accurately calculate how long it would take for your investment to double or return those funds to you if left untouched.

– When a chart is the best tool: You may be able to make trades based on charts, and this is great, but charts only give you one piece of information — price action of a stock or index. It’s very important to make decisions based on all available information — including macroeconomic data (supply and demand), technical indicators (RSI, MACD, etc), and momentum and trend conditions (H&S).

– Positive Entry Signal: You need a reason to enter a trade. In other words, you need a positive entry signal — the technical setup that gives you the confidence to enter the trade. In fact, your reason for entering a trade has to be stronger than your reason to exit a trade.

– Leverage: Leverage can work both ways. It can help you make profits, but it can also have a negative impact on your portfolio in the long run. You want to review how much leverage is in place for each trade, and consider having more or less than what’s appropriate for your trading strategy and goals. When you have too much leverage in place for one trade, then that will bring down your profit numbers and affect your overall performance at every point in time.

– Negative Entry Signal: You need a reason to exit a trade. You should seek to exit a trade when you have a negative entry signal. This is often referred to as ‘profit-taking’ or ‘cutting losses.’

– Margin Calls: When you’re trading options, you’re likely borrowing securities from your broker or lending them out — putting you in the role of an intermediary for your broker’s clients. If the underlying security goes against you, then that would put your account in jeopardy and require additional margin deposit if needed. This is why it’s important to know how much money will be required by your broker based on the level of margin debt, which is different for each option type and underlying security.

– The Two Stops: One of the most important things that you should know about trading options is the two-stop method. It sounds so simple, but it’s important to consider when trading options. It means that if you’re using a specific amount on each trade, then you should consider reducing that amount and moving up to a bigger position only if the trade moves beyond your first stop and continues to build momentum in your direction. If not, then you can move up to limit your risk on each position. By keeping your stops higher than what’s appropriate for a given situation, then you’ll always be able to lock in profits at a point of profit and move stops lower if needed when the underlying security starts moving against you.

– Double Dipping: One of the reasons why we’re hearing about people getting into trouble when trading options is because they’ve made free trades and then tried to play catch-up. This is a form of “double dipping,” and it can be very difficult to do. You need to be aware that you have no obligation to play catch-up points inside a trade. It’s always best not to overtrade, and wait for a point of profit before making plays that are based on catching up.

– Trades vs Positions: When you’re trading options in an account, then your risk exposure will vary based on how much money you have at risk on each trade. You need to know what’s the maximum loss you can take on each trade. When trading options, you’re either in a trade or you’re in a position, and it’s important to make sure that you understand which one of these two scenarios is taking place in your account at every point in time.

– Holding Time: How long do you want to hold an option for? This will help determine the type of options trade that’s appropriate for your situation. You want to capture profits and move on, or wait for options to expire worthless while giving back gains — but don’t try and catch points with “double-dipper” trades.

– Day Trading vs Options Trading: It’s important to determine whether there is any economic rationale for trading options. A common misconception among the public is that options are for trading stocks and that day trading with options is a lot like buying a stock. This couldn’t be further from the truth! Options have their own set of rules and risk management rules; but, how you approach them will, of course, depend on whether you’re day-trading via cash-and-carry or hedging a portfolio with them.

– Exit Strategies: Options can be dangerous because of the multiple strategies used to sell them — they can be traded on margin or financed via an open short position on an underlying stock. This means that you trade options with 3-sided risk. From there, the choices are varied, depending on price action — and there are some that can only be used in specific situations.

– Spotting Manipulation: You want to be able to spot manipulation, both when it’s taking place and in retrospect. This will help you avoid getting caught up in the markets at the wrong time. Manipulation can occur in many different ways — but it’s best to understand what it looks like vs what genuine price action is all about.

– Know Your Idiosyncrasies: Some people will only trade certain styles of options on a consistent basis, and they don’t want to deviate from their style for any reason at all. This is fine — as long as they stick to what they know. But it’s important to understand what your own idiosyncrasies are so that you don’t allow the markets to ‘get over on you’ — especially when it comes to trading options.

Who Are The Authors?

Brooks and his team have a range of experience in using options for profits, and they have strong expertise in many different styles of option trading. They also have a variety of experience from the world of semi-professional trading, where options can be used on a consistent basis. In their experience, options are useful for the following reasons:

Trading with Options as an Alternative to Arbitrage. This is not a new concept — arbitrage originally was found in options. Today, arbitrage has become so widespread that it is best to think of options as a sort of inverse version of arbitrage. That is, if you have a profit target on an underlying asset where something isn’t moving in the direction that you need it to move, you can create a trade that generates income from price movements in different directions (it can be either profits from selling options at or near expiration or options contracts on future trades). As the market moves in one direction for a while, for example, making it difficult to execute trades in that direction, you can turn around and create a trade that has you taking advantage of price movement in the opposite direction as an alternative or counter-strategy.

I hope this helped!