Options trading is a fun and often profitable way to make money on stocks. If you’re new to options trading, however, then these basic guidelines will definitely come in handy as you initiate your first trades and build your options strategies.
Before we get started, there are a few important things to remember about options trading for beginners and veterans alike.
First, trading options is a great way for investors to manage risk.
When considering an options trading strategy, investors have the option to take positions that reflect long-term results, short-term results, or neutral positions.
That flexibility can be a big factor in mitigating risk.
But, all investment bears risk.
Simply put, it is your responsibility as an investor to manage risk. Options trading has been called gambling in the past, and approaching options without a strategy and an understanding of the fundamentals is quite a bit like gambling.
It doesn’t have to be.
If you are new to the world of options trading, or you want to see if trading options is a good fit for your overall investment strategy, read on for seven simple options trading tips for beginners (plus three mistakes to avoid).
1. Options Are Flexible. Think Flexibly.
Options trading is unlike traditional investing where you simply try to buy low and sell high.
Using options, traders can profit by predicting downturns, stagnation, and general volatility, as well as upturns.
The flexible nature of trading with options means that traders who are new to options have a lot more to consider when making a move. Get ready to look for and seize opportunities in new locations.
With this trading flexibility come new tactics for success, and new tactics lead to new strategies. The “straddling” tactic, for example, allows options traders to profit by predicting a stock’s volatility.
Whether the stock spikes or sinks, the straddle position will result in a win for the trader. This kind of flexible position is common in the world of options trading but rare when it comes to other types of investments.
2. Options Trading Can Be Used to Minimize Risk. Use Options to Hedge.
Options trading provides a way for investors to limit their risks.
If you’re uncertain about the stability of a stock but you don’t want to sell it, options allow you to hedge your position. A common tactic involves purchasing a put option for the stock that will allow you to get out at a good price, even if the stock nosedives.
These types of hedging opportunities are abundant in options trading, and they make a compelling case for investors to dip their toes in the options trading pool.
Of course, there are no guarantees.
Even experienced options traders understand that there is no such thing as eliminating risk completely.
3. Options Trading Lets You Call the Shots. Buy and Sell Stock at a Price of Your Choosing.
Smart options traders use options to fine-tune their general investment strategy. This means making the most of their hard-earned insight into the market.
With options, you can purchase the right to buy or sell a stock at a certain price at a certain time.
While most basic investment platforms will allow you to set your own buy and sell prices for stocks, the buying, selling, and exercising of options can dramatically expand your profit opportunities.
Tactics such as covered calls and cash-secured puts can grant you more control and profit opportunity when it comes to buying and selling stock.
Get right to the heart of successful options trading tactics and strategies.
4. Know Your “Break-Even Points.”
Every option you buy or sell has a break-even point.
Knowing your break-even points can mean steering clear of one of the key mistakes to avoid when trading with options: failing to stick to your strategy.
The break-even point is a specific point (high or low) that a stock price must reach in order for the option owner to begin turning a profit.
Break-even points must account for both the price paid to own the option and the commissions charged on the buy trade and the sell trade.
5. Do Your Research. Don’t Limit Yourself to the Option Chart.
The option chart plots the behavior and pricing patterns of the option itself but doesn’t always provide adequate insight into the behavior of the underlying asset—the stock.
It’s important to understand a stock as best you can before you buy or sell any options associated with it.
My advice: pay attention to option charts but don’t neglect your study of the stock charts.
Remember what trading with options is, at its most fundamental level: positions on stocks. Without the underlying asset there is no option.
6. When Options Trading Go with the Flow. Err on the Side of the Trend Line.
There’s an old investing adage: “The trend is your friend.”
When assessing the value of underlying stocks, don’t try to guess at where you think a sinking stock will plateau or where a rising stock will level off.
Sorry, but you will almost never be right.
You really are gambling if you think you can beat the odds with (educated) guesses.
Always assume that trends will continue.
You won’t be right 100 percent of the time—that’s just how trading works.
But you’ll be right more times than not, and if you have a solid investment strategy, that will be all you need to turn a profit.
7. Know Your Escape Plan. Always Have an Exit Strategy.
When it comes to trading options—just as with trading stocks—leave your emotions at the door. No one is a robot, but trading is business.
Have a plan, stick to the plan, and execute the plan.
This means having a clearly defined exit strategy. Exit strategies aren’t just useful when things are taking a turn for the worse.
It is also important to know when to leave even when things are going your way.
To put it another way, don’t hang on to trades that are going south because you are attached. And don’t linger on trades that have already hit their price targets out of greed.
Would you rather roll the dice on a one-off success or keep your stress levels low and generate predictable income?
I know which one I would choose every time. Don’t deviate from the plan.
Making the right choices when trading options is important, but knowing which mistakes to avoid is perhaps even more important.
A win is always the goal, but sometimes the best we can do is simply not lose. And then there are these three options trading mistakes to avoid at all costs.
* * *
Bonus Tips: 3 Mistakes Options Trading Beginners Must Avoid
1. Maintain a Level Head. Don’t Fall Prey to Sunk Cost Syndrome.
Losses are a very real part of options trading and trading in general.
They happen to the best of us. That’s part of why an effective strategy seeks to minimize risk at every turn.
The big idea here, though, is to avoid falling prey to sunk cost syndrome.
Sunk cost syndrome occurs when someone is taking a financial hit, but, instead of breaking off their commitment, they go deeper into the hole in an effort to salvage their investment.
Sunk cost syndrome comes up quite a bit in the world of habitual gamblers. Rationally, we all know that winning “streaks” are statistical illusions.
But when someone has sunk so much money into a table game or a slot machine, they often feel that the only way to win back their money is by gambling even more.
Needless to say, that’s pretty risky.
When trading options, don’t double down to try to recoup money in a risky environment.
Stick to the plan and maintain a level head. Doubling down on a losing position just means that your losses will be twice as large.
2. Stay Proactive. Don’t Rely on Hope.
Hope is not a strategy. Good intentions, good karma, and a positive outlook are great qualities to have, but none of those alone will drive a profitable options trading strategy.
Rely on facts, rely on trends, and rely on your experience.
Duplicate successes and scrutinize losses.
Do your research and take your time.
Hoping for the best outcome is the same feeling that comes from rolling the dice, and gambling has no place in the world of options trading.
3. Keep Your Head Above Water. Don’t Go Broke!
It may seem like forehead-slappingly simple advice, but don’t clear out your accounts trading options just because the potential to turn a profit is there.
Going broke trading options means a couple of key things went wrong.
Failing to build exit plans into your overall investment strategies means you risk leaving too much money in an untenable position.
It also makes you vulnerable to sunk cost syndrome, or other emotion-based decisions that can derail your strategy.
Some more cliché advice?
Expect the unexpected.
Understand that risk is larger than just your options position, and even larger than the risk associated with the underlying asset (the stock).
Have a disaster plan in place. Don’t let an unexpected event wipe out your account.
The Bottom Line
The bottom line when it comes to profitably trading options is that there is no one-size-fits-all approach.
But you already knew that.
Use options to minimize risk and to inject flexibility into your overall investment strategy. Never forget that options are tied to their underlying assets: stocks. Decouple the two at your own risk.
Don’t fall prey to sunk cost syndrome, and always have a plan.
Always. Have. A. Plan.
Have an exit strategy at all times, and don’t let an unexpected event clean out your accounts.
No matter how you approach options trading, don’t forget to have fun.
The information contained herein should not be construed as ‘financial advice’ and is presented as the opinion of the author. ClydeBank Media does not offer financial investment services and has no ties to any of the funds presented in this list. Please see our full financial disclaimer regarding the information on this blog. Always consult your financial adviser before making investment decisions.