Options trading is an excellent way to generate some extra profits, but if you’re not careful, you can easily lose a substantial amount of your investment. Previous studies have shown that around 75 percent of all options expire worthlessly, and some reports have reported that number to be as high as 90 percent. So, if the majority of options traders are losing money, what is everyone doing wrong? The key is to have a superior options trading strategy.
Keep reading this guide to discover why you need a rule based options strategy and how it can help you become a better trader.
What is an Options Trading Strategy?
Every successful options trader has a consistent strategy they have adopted over the years that keeps them on the right side of a trade. Everyone’s approach may differ slightly – but many of the core concepts remain the same.
Your options trading strategy should be rule based and able to keep you disciplined while trading.
One of the primary reasons it’s so critical to developing a trading strategy is because the stock market is designed to “confuse” short term traders – the stock market prices have even been referred to as a random walk, or highly unpredictable.
A trading strategy should consist of several components, including:
- Entry & Exit points
- A stop-loss
- A target return
Having these components in place before executing the trade will allow the trader to set their emotions to the side and abide by the strategy they have put in place. The best invrstors who trade options contracts follow their own set of rules to stay disciplined and not allow others to get in the way.
Why You Need a Trading Strategy for Options
Many new traders will say forget the strategy and just pick winning stocks. That may work out a few times if you get lucky, but the stock market is one of the best at keeping its participants humble.
With any investment, it’s essential to have a plan, and that holds even more true when it comes to options.
Options are derivatives – meaning they obtain their price from the underlying asset (stock). So, when the price of the underlying stock is moving, the options price will move as well. However, it is not a direct relationship, and other factors can also influence the price of an options contract.
With so many factors determining the price, it can change dramatically in a matter of a few seconds – making having a plan necessary.
A few benefits of having a rules-based options strategy include:
- Keeps you disciplined
- Allows you to cut losses
- Keeps emotions in check
- Manages risk
- Avoids disasters
These listed items are typically the biggest mistakes traders make that can lead to significant losses. Having a plan is essential – how you develop your plan will be unique to your wants and needs.
Step 1: Are You Ready?
The first step in developing a plan is asking yourself, are you truly ready to begin trading options? If you are not quite ready or a little hesitant, maybe consider paper trading first to develop your skills and get you prepared to put your own money on the line.
Step 2: What Are Your Goals?
This will differ depending on the level of experience you have and how much capital you invest in. Try to keep your goals realistic – a 1 – 5 percent profit is a good daily goal.
Step 3: Consider Your Risk Tolerance
This is an important consideration – before entering a trade, its critical to have a level you are willing to risk and have the ability to pull out when a trade hits that level.
Not every trade will work out. You have to be strict with your rules and set a level of risk you are comfortable with.
Step 4: Research & Preparation
Here you will begin researching and discovering what stocks fit “the mold” of your trading style. Some prefer day trading, and others swing trading – its a preference but will determine the types of stocks you will be screening for.
A few things to keep a lookout for when researching is financial reports, stock price history, management,
Step 5: Implementation
Now you screened through stocks to find the ones that fit your trading style. It’s time to implement your research and begin making a profit. Here you will enter your entry and exit points as well as your profit target and stop-loss points.
Step 6: Analyze & Adjust
What is working for you? Note that. If something isn’t working, note that as well.
Now, adjust your trading plan accordingly. You will keep refining it until it is near perfect or works for you.
Popular Options Strategies
Now that you have a trading plan developed, it’s time to start trading options. There are a few popular strategies that most option trading professionals use, these include:
The Long Call/ Put
These are some of the most basic options trades available. Traders will utilize these strategies when they believe the stock price will go up (call), and if they believe the stock price will decrease (put).
The covered call is a little more advanced. Since it is covered, it means the investor must own the underlying shares of the option contract. Then, you will sell (write) a call option on those shares.
By doing this, you are creating a strategy where you can still generate income even though the stock price remains stable.
Another popular strategy where the investor still owns the underlying shares, but this time purchases a put option. This acts as a way to hedge their position and protect it from declines in the share price.
This is the opposite of a long put. Here you will be selling (writing) a put option.
You are betting that the underlying equity will either increase in value or stay the same.
Interested in Learning More About Options Trading?
Trading options is an exciting thing to do – the pure adrenaline rush you get as you initiate a trade. However, options trading comes with significant risks and should only be executed when you feel comfortable doing so.
The best way to stay in the green when trading options is to develop an options trading strategy and keep refining it until you get the results you are looking for.
For more information about options trading, contact us today, and we can help you get started!