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Published: September 17, 2009
Whether you’re a novice options investor or
you’ve been trading options for years, three simple rules could
mean the difference between serious gains and major losses.
Here’s everything you need to know to go from option-less to an
options whiz…
Every day, scores of novice options investors get burned. It’s
not because they’re bad investors, it’s simply because they’re
not following the rules. There’s no question that options are
tricky – it can take years to learn precisely how options work –
but that doesn’t mean that understanding the options game is out
of reach, or that it’s relegated to the big guys on Wall Street.
Despite their complexity, there’s plenty of reason to pay
attention to options. Options provide incredible amounts of
leverage with relatively limited downside. That leverage means
that a relatively small increase in a stock’s share price can
turn into a potentially huge gain in an option for that same
stock. Just look at shares of the ProShares Ultra S&P 500 ETF
(NYSE: SSO), a +5.3% climb in that stock over the course of just
two days in July turned into a +28% profit for investors who
bought one strike of that fund’s September call options.
Put these three must-know rules into play, and your chances of
booking profitable options plays increase exponentially…
1. Think About Value, Not Just Price
Most people think that options prices (also known as premiums)
are tied to the prices of their underlying stocks, but that’s
not entirely true. Like stocks, options trade on the open
market, which means that technically, options investors
themselves set the prices of options through their bid and ask
prices.
That doesn’t mean that you’ll see an option trading way out of
line with its underlying, but it’s certainly not uncommon to see
examples of options prices that don’t mesh with what their
values should be.
That’s because unlike a mutual fund or ETF, which is priced
based on the value of its assets right now, options take
extrinsic variables, like the time value of money into account.
There are a number of ways to value an option, including the
Black-Scholes model and the Monte Carlo method, but if you want
to avoid the mathematical formulations, most financial websites
and trading platforms can come up with an option value almost
instantly. Use that price as a starting point when you decide if
an option is worth your time.
2. Don’t Get Greedy, Use Goals
“Hogs get slaughtered.” No, that’s not some sort of farmyard
to-do list, it’s a phrase Wall Streeters use to remind each
other – and themselves – that greed is the fast track to serious
losses. It’s all too common for investors to hang onto a winning
position too long, hoping for a few extra points, only to see
those gains reverse themselves. That’s especially true of
options, where a position can swing from a double-digit gain to
a serious loss overnight.
Now, that doesn’t mean that you should sell your positions off
as soon as you’re up more than +5% — goals are the secret to
beating this pitfall. Get a grip on greed by setting your target
gains before you enter a position, and stick with them unless
something fundamentally changes in the underlying stock.
3. Take One Play a Week
The only way to make money on
options is to play them – and to
keep making options plays, even if
you’ve just picked a loser. After
your first bad trade, it’s
incredibly easy to give up and just
stick to stocks. But that’s a huge
mistake. The only way to learn how
to use options profitably is to use
them often, so always try to make a
new trade every week.
If money’s the issue, it shouldn’t
be. There are scores of “paper
trading” platforms out there – many
of them free to use – that let you
make hypothetical trades without
risking your real-life capital.
Trading paper for a while can help
build your options investing skills
until you’re ready to put your cash
back on the line.
When deciding on which paper trading
platform to use, it’s best to go
with a broker. Many brokerage firms
will let you test-drive their actual
trading platforms with a practice
trading account. Using the real
platform means that the gains you
get in the virtual world will mirror
the gains you can expect when you
switch to real money – and it also
means that you’ll get used to your
broker’s software and tools.
You Have Options
There’s no question that investing
in options comes with a steep
learning curve. That said,
profitable options plays don’t have
to be a faraway goal. Invest in
options using these three rules and
you’ll be well on your way to seeing
profits from your calls and puts.
-- Jonas Elmerraji
Contributing Editor
Penny Sleuth
This article originally appeared
in
Penny Sleuth. |
