09 Aug Top 5 things to know before trading Stock Options
Option trading provides many advantages from trading other types of instruments such as Stocks, Forex, Bonds, etc. To fully realize the power and flexibility offered by options, one must have a firm grasp on a few key fundamentals which will help preserve trading capital and ultimately structure risk in a favorable way in order to minimize losses and maximize on profitable positions.
One of the most common complaints from newer traders who jump into the options market too quickly always seems to be “I don’t understand why I lost money,even though the direction of the trade went in my favor”. I too was perplexed by this behavior when I first started trading options and have since learned why this was happening, so I could “flip” those negative aspects of the option contract and actually turn them into profit.
A quick breakdown and short explanation of some of the more important aspects of option trading might help to clarify:
1. Risk Management
This is probably one of the most misunderstood components of trading in general, but especially in options trading. Too often, newer traders start off with a small account (say $2000) and put on trades which put more than $300 of their capital at risk per trade.
To understand why this is a killer, let’s look at a scenario:
If I were to say that for every $1 dollar I risk, I want to make a possible $3 return (a good system in its own right). Well, If I were to put $300 on the line for every trade I make, it would only take about 6 bad trades to wipe out my whole account!
Let’s look at another scenario:
If I were to allocate a fixed percentage of my entire capital base (remember, that your capital base is always changing), then I could control my risk much more effectively. For example, on my same $2000 account, risking a percentage of my capital, say 3%, would allow me to risk $60 per trade and my risk amount would increase as my account got bigger and vice-versa.
One could say that this is a much more consistent system that allows you to withstand a larger amount of losing trades to take advantage when the winners come around.
2. Broker Commissions
For newer traders with smaller accounts, broker commissions can be another silent killer. Just please remember, that the negotiation of better brokerage fees with your broker should be an on-going conversation.
If you feel that you are doing adequate volume with your broker, yet you are still on the same fee structure as when you started trading with them, call them on the phone and see what they can do for you – you might be surprised of the outcome.
3. The “Greeks”
No, we’re not talking about the great philosophers; we’re talking about the Option Greeks, the main ones being: Delta, Gamma, Theta, Vega. Each of these “Greeks” have a purpose in the option contract.
In my video course, we refer to them as the ‘variables’ in the contract…moving pieces of time decay, percentage of movement, implied volatility, etc. It sounds complicated, I know. When you’re new to options, these terms might scare you a bit, but I can assure you that once you learn their function, you can use them to your advantage in structuring your risk – which is essentially what trading is all about!
Hedging is essentially structuring your risk in your portfolio to where you are protecting your positional bias by taking a portion of the “other” side of the trade, in the case it goes against you. For example, say I thought that stock “XYZ” was going to break out to the upside and I bought 6 Call options. I might want to protect myself in the trade in the case I was wrong, and simultaneously by 3 Put options, in case “XYZ” crashes and I lose the amount of money I risked on the Call options I bought. If “XYZ” does crash (meaning the stock goes lower very quickly), at least I have my 3 Put options which are making money – offsetting my losses (and sometimes even making a profit) while my Call options expire worthless.
Although the above example is very simplistic, hopefully it gives you an idea of how Hedging can protect your capital in the
case of unexpected market moves.
5. Implied Volatility
Implied Volatility is a very important player in the world of Option pricing. In reference to the above complaint by newer traders regarding, “”I don’t understand why I lost money, even though the direction of the trade went in my favor”…well, implied volatility is more often times than not, the culprit in this situation.
In order for the market to put a price tag on an option contract, it first needs to assess the amount of potential risk that is associated with holding the contract – this is the function of implied volatility in a nutshell. More simply, if implied volatility is rising, the price of the option is going higher and vice-versa. So what happens when you buy an Option contract which already has exceptionally high implied volatility, then the stock moves higher while the implied volatility drops really low? Well, that’s one of the causes why newer traders don’t profit from the option market as much as they should. The trick is, to put implied volatility on your side so you know instinctively when to buy an option and what price is a “bargain”.
Although this is just a small taste of the power and flexibility which options provide, hopefully this article will inspire you to learn more about each one of these aspects, which will ultimately make you a better options trader.