I have spent the past 15 years teaching investors how to trade options. This is more important than ever now that the hedging of options accounts for more than 50% of all stock market daily volume. See yesterday’s research piece about “Buy Writes.”
Those who get it make millions, and this year in particular seems to have produced a bumper crop of new fortunes.
It’s really not all that hard, as I know many who are complete dummies on all other matters but earn a decent living trading options. All they need is to follow a few valuable rules that have stood the test of time.
I could add to this list as I possess additional skills and experience that other options traders lack, but the ten tips below are a great start.
After practicing for 55 years, it starts to get easy.
Needless to say, following the Mad Hedge Fund Trader is crucial in best obtaining the correct timing in implementing these rules.
1) Have an investment thesis. Know why you are doing what you are about to do. Focus on events like earnings reports or product launches and try to figure out how the underlying stock might react. Aim not where the puck is, but where it is about to go.
2) Use your research on the stock to decide whether you will buy or sell a call or put option. Don’t delude yourself into thinking you have an educated view of options contracts until you have traded for a while and understand how the stock and options markets work with each other.
3) Focus on options that expire in three months or less. The sweet spot for many investors is about 30 to 45 days, which is enough time to benefit from accelerated time decay (more on that later) and for your stock thesis to work itself out without paying top dollar.
4) Before you buy or sell options, divide the contract’s implied volatility by 16. This will tell you what the options market thinks the stock will do each day through expiration. If the call has an 80% volatility, the call is priced as if the stock will move 5% each day until expiration. If you think the stock will move more, buy the contract, If, you think it will move less, sell the contract. The Rule of 16 is a powerful tool.
5) Good trading is about understanding events and how they are packed into your expiration. Understand everything that could happen to move the stock during your chosen expiration cycle, such as earnings reports, and anything that could move the entire market, like Federal Reserve meetings, elections, and economic reports.
6) Options contracts lose a little value each day. Time decay, or “theta,” is a powerful force that can be monetized by options sales. It’s also the reason that many investors try to trade options that expire in under a month. No one wants to pay a time premium, which you can think of as the inventory carrying cost for owning options. Get time decay right and it’s like having a rich uncle write you a check every day.
7) If you are thematically confident about a stock but unsure of the timeline, many institutions buy options that expire in a year or more to rent exposure to the stock, otherwise known as LEAPS (Long-Term Equity Anticipation Securities). If the stock goes up, the call goes up. If the trade fails, options always cost less than the associated stock, which means that options, when well used, help investors limit risk and enhance returns.
8) Don’t be a pig. If you make 50% or more on your initial trades, take profits. If you make 100% or more, definitely take profits. If you are so convinced that the market is wrong and you are right, take out your initial invested capital so you are playing with house money.
9) Be afraid of excess leverage. One options contract represents 100 shares of stock. Don’t trade 10 contracts if you cannot afford to cover 1,000 shares of stock. All beginners should trade one contract at a time until they develop some mastery of basic trading rules. Never trade “naked” contracts that aren’t covered by cash or stock.
10) Simplicity is everything. Avoid strategies with many moving parts. Many seasoned options traders focus on hitting singles and doubles, creating significant income for themselves. Master buying a call and put and selling a call and put, and then consider spread strategies. Complicated strategies like iron condors and butterflies sound great, but usually make more money for the brokers than you.
When in doubt, remember: Bad investors think of ways to make money. Good investors think of ways to not lose money. The goal is to pay for your own yacht, not your broker’s.
It’s Just a Matter of Learning a Few Tricks
