What are Options?
Options are a type of derivative security. The right to buy is called a call option and the right to sell is a put option.
Call and Put Options
For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. An option is out-of-the-money if the price of the underlying remains below the strike price (for a call), or above the strike price (for a put). An option is at-the-money when the price of the underlying is on or very close to the strike price.
The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility.
Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.
Tips for Option Trading Success
- Options are best used as risk-reducing investment tools, not instruments for gambling.
- Manage risk carefully. Do not hold any position than can - in the worst case scenario - cost more than you are willing to lose.
- Be careful about the number of option contracts you trade. It's easy to over-trade with inexpensive option contracts - especially when selling.
- Don't go broke. Never allow an unexpected event to wipe out your account.
- Do not expect miracles. Do not buy options that are far out of the money just because they are 'cheap.' The chances of success are tiny. Not zero, just tiny.
- Selling naked options is less risky than buying stock. But, like stock ownership, there is considerable downside risk. Exception: It's reasonable to sell naked puts - but only if you want to buy the shares, if assigned an exercise notice.
- Limit losses. The most effective way to accomplish that is to buy one option for every option you sell. That means selling spreads, rather than naked options.
- Hope is not a strategy. When a position goes bad, consider reducing risk. Doing nothing and hoping for a good outcome is nothing more than gambling.
Avoid these Mistakes to be successful in Option Trading
Mistake #1: Buying out-of-the-money (OTM) call options
Trading OTM calls is one of the most difficult ways to make money consistently. If you're new to options trading, consider another strategy first.
Mistake #2: Using an all-purpose strategy in different market conditions
Depending on the market, you'll want to tailor your options trading strategies. Trading the long spread is a tried-and-true approach that you should understand.
Mistake #3: Not having a definite exit plan prior to expiration
Even when an option trade is going your way, it's crucial to have an exit plan in advance. Otherwise, how will you make the right move at the right time?
Mistake #4: Making up for past losses with risky "doubling up"
When a trade moves against you, it's tempting to ignore your tolerance for risk and make a rash decision. Don't. Instead, try another approach to mitigating your losses.
Mistake #5: Trading illiquid options
The biggest drawback to this strategy is that, if you initiate or adjust an option position that's associated with low activity, you run the risk of losing money due to poor pricing.
Mistake #6: Waiting too long to buy back your short options
Don't wait until it's too late to make your move, and don't think that squeezing every last penny out of a trade is worthwhile. Do the right thing.
Mistake #7: Failing to factor earnings and dividend date into your strategy
Avoiding trades with pending dividends is a commonsense approach to investing in options. Understand how the trading season impacts stock volatility and can inflate option prices.
Mistake #8: Not knowing what to do if you're assigned early
From the beginning, keep early assignment in mind. If you think about it strategically, you won't be caught in a bind if there's an irrational and disruptive market event.
Mistake #9: Failing to use index options for neutral trades
Trading neutral on big indices may not sound exciting but this approach can shield you from costly market volatility.
Mistake #10: Legging into spread trades
This is a common mistake among rookies and experienced traders hoping to squeeze the last few bucks out of a trade. Do not fall for it!