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10 Tips for Trading Options

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10 Tips for Trading Options

10 tips for trading optionsOptions are more complicated then trading stocks, but they offer much greater returns for investors. Once you get a good grasp on how options work you can really minimize your risk and create some explosive returns for your portfolio. The following 10 tips for trading options will help you get started down a path of success as an options trader.

1. Trade Liquid Options

Our first tip in our top 10 tips for trading options is to trade options that are liquidable. When trading options it’s very important to be able to close your position. This is especially true when you are new to trading options. Don’t make the mistake of buying an option that you cannot liquidate because there is no market for it. When looking at an option table look at the options with the most volume to help you determine if the particular option is liquid. Another tip for inexperienced traders is to buy and sell options for large companies such as Apple, Google, Ford, and General Electric because these will have a much bigger market than smaller companies.

2. Know The Expiration Date

Unlike stocks, options expire. If you are not aware of the expiration date then you can lose everything. There are several different expiration dates for options in todays market. It used to be the third Friday of every month. With today’s active market place and the rise of the internet (making trading easier and more convenient then ever before) options now have varying expiration dates. This is one of the first things you should look at, because its also used in determining the value of an option. All other things being equal an option loses value overtime as it nears its expiration (options that are not in the money).

3. The Bid/Ask Spread

The bid/ask spread will usually be much larger for options than for stocks. The market place is smaller and there is a lot of possibilities for each company, whereas they may only have 1 or 2 types of stocks. As a buyer you will not purchase the option for the price shown you will be buying it for the next closest asking price. As for sellers you will be selling to the next closest bid price. If you plan on purchasing or selling an option at market price then its important to be aware of the spread between the bid and the ask.

options trading tips price break

4. Know the Break-even Point

One of the most fundamental rules in business, not just trading options is knowing the break-even point. To calculate the break-even point for an option you need to figure out the premium for purchasing the option, the commission, and the amount the brokerage charges to buy or sell shares when the option is exercised.

Here is an example:
Lets say you want to purchase a call option with a strike price of $150. The premium you are paying for the right to purchase the option is $5.00. The brokerage house charges $1.00 for the options trade and $10 to purchase stock when the option is exercised. For this example the break even point would be $0.16 for every share of the option. Since options are traded in blocks of 100 and the total cost and fees of purchasing the option is $16 ($5.00 premium + $1.00 commission + $10.00 for exercising = 16) you would take 16 and divide it by 100 to get 16 cents per contract.

trading options choices

5. Hedge Your Risk

An options traders best friend is market volatility. When a market is highly volatile (large price swings) there is a lot of money to be made for options traders. Since options have an expiration they are much riskier than investing in stocks are bonds. One way to minimize this risk is to hedge. Let’s say the price of a particular stock is moving 10’s of dollars each day (positively and negatively) and you want to seize this opportunity to earn a lot of money really quickly by purchasing options. It can be hard to predict which way the price will go the next day, but one strategy you can use is a hedge. You can purchase a long and short position on the same stock. Since you can only lose a finite amount of money on the options (your initial investment) and the premiums are relatively small compared to the market swings if you purchase a call option and a short option the only thing you need to happen is to have the market move for you to make money.

Lets say the strike price of a call and put option is $50.00 and the premium for both is $1.00. Well you purchase a call and a put option and the next day the price of the stock goes to $60. Well you lost your $1.00 premium on the put option, but you made $10.00 per contract on the call option. In this instance you have hedged your risk and made a sizeable profit.

6. Trade Options on Stocks You Understand

Options are tied to the performance of a stock. Options give investors a chance to make a much larger return then purchasing or shorting a stock, but they also carry significantly more risk. As a new options trader it’s better to start trading options with companies you understand. Since the price of the companies stock will determine if the option is in the money or not it is a lot better for new options traders to invest in options on companies they have researched, owned previously, or have been watching.

7. Follow The Most Active Calls and Puts

For new options traders it is better to followed experienced traders. If you are looking at an options table and you notice a particular option has much more volume then the rest of the options on the table you know there is a lot of interest in this particular option. This can be a sign of a lot of faith in this particular option. One added benefit of a high volume option is it is also much easier to liquidate and there will be a much smaller bid/ask spread to get the price you want when you do close your position.

8. Learn To Cut Losses

cut losses with options tradingIn options you need to cut your losses before you lose everything. Options are a lot different than stocks, remember they have an expiration date. Normally. when you purchase a stock at $100 per share and the price falls to $60 per share you would invest more since you liked it at $100 and now its even cheaper. Many traders buy shares overtime so they get a lower average price per share. With options this can be extremely dangerous and lead to much bigger losses. Since options expire it may take to long for the stock price to climb back up and you could be in the whole a lot more money then you should. Also you lose everything when an option goes sour, with stocks you still get to hang onto the stock.

9. Dividends and Earnings Reports Impact Prices

One thing new options traders might miss is the effect of dividends and earnings reports. Since stock price is affected by these an options price will be as well. Dividends and positive earnings reports traditionally make stock prices rise and negative earnings reports make stock price fall. Knowing when the company is reporting its earnings and distributing dividends is very important before you enter into a position with an option.

10. Have plan

This is probably the most important step. Options can move fast and they can cost you a ton of money if you do not have a plan. Trading on emotion in general is never a good strategy, with options it can be lethal. Make a plan before you purchase an option and stick to the plan this will save you thousands of dollars over your career as an options trader.

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