How To Start Trading Options
Before you start trading options, I would set few simple rules:
- Start small and increase your allocation as you get more confidence.
- Start with simple strategies and gradually move to the more complicated ones.
- Always have your exit plan in advance. Always know how much you risk per trade.
After you gain some knowledge, start paying more attention to the options Greeks. If you want to make money with options, you have to gain at least some basic knowledge about the Greeks. If you ignore them, you will lose money in options trading, guaranteed.
If I had to choose three most important things in options trading, I would choose the following:
- The theta factor.
- The impact of the IV (Implied Volatility) on the options prices.
- The relationship between risk/reward and probability of success.
The theta is a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. When you buy options, the theta is your enemy. When you sell them, the theta is your friend.
Remember that theta accelerates as we get close to expiration. Unless you want to hold the trade only few days, always buy options with longer expiration. The impact of the negative theta on those options is minimal, and you give yourself more time to be right. With shorter term options, you can be right on the direction and still lose money due to the negative theta impact.
The IV is one the most important parameters of the options pricing. It is also the most overlooked one, especially by novice traders. Apple (AAPL) options would be a perfect example of the impact of the IV, as I demonstrated in one of my Seeking Alpha articles. I described a trade which was initiated at March 16 when the IV of the Apple options was at 41% and the stock at $585. A week later the stock was up just 1.8% but the trade produced a whopping 50% gain, due to a huge drop in the Implied Volatility. At the same time the 600 calls actually lost almost 20% while the stock was up 11 points.
Last but not least is the relationship between the risk/reward and the probability of success. Those two parameters are directly related. You can have a trade where you risk $4 to make $1. This sounds like a terrible risk/reward, but it will usually have a high probability of success, meaning that your chances to make that $1 are pretty high. Of course you have to make sure that if something goes wrong, you limit your loss and don’t lose the full $4.
On the other hand, if your trade is risking $1 to make $4, the probability of success of such trade is usually fairly low. So it is ultimately up to you to decide if you want many singles and few bigger losers or few homeruns and many smaller losers.
Options trading is all about probabilities. Put the probabilities to your favor and you will succeed.
About the Author:
Kim Klaiman is an active options trader and founder of SteadyOptions. He trades mostly non-directional strategies, like pre-earnings strangles and iron condors. Likes to trade strategies with negative correlation.
SteadyOptions provides combination of options education and trade ideas using variety of Non-Directional strategies for Steady and Consistent Profits.