Options Trading Tips to Live By
Many of the tips that I’m sharing with you today come from over 20 years of trading experience. Remember, there’s no correlation between complex concepts and profitability; and I urge all of you to follow these simple trading tips diligently.
Options liquidity is generally 10% to 20% of the underlying asset and that makes it necessary to use limit orders at all times, regardless of the option that you are trading.
Avoid purchasing options that are very far out of the money because they appear to give high degree of leverage, but the odds of them expiring in the money is incredibly low majority of the time.
The impact of implied volatility on the price of options can be substantial and can completely distort and grossly over-value the price of an option. Therefore, you should know ahead of time the implied volatility level of each option before you initiate either a long position or a short position.
Before you begin trading exotic strategies, learn and focus on simple positions that don’t require numerous options to form a spread. Combination spreads that hold several long and short positions rarely work out and will end up costing you more commission than the potential profit on the trade.
Day trading options may seem like a viable choice, but liquidity levels make the spreads between the bid and offer unusually large and can cause you to risk much more than you originally intended when entering the trade as well as the profit potential that can be gained by opening the trade and closing the trade during the same day.
Attention Directional Traders
If you are a directional trader and buy options, consider entry methods that rely on low volatility levels or pullbacks instead of breakouts.
These entry methods rely on low levels of implied volatility and when the underlying asset breaks out and begins moving, the option begin increasing in value very quickly; because implied volatility levels increase drastically, making the option overvalued and undesirable for buyers.
Because options liquidity is relatively lower than the underlying asset, the time of day you enter the trade can have a significant impact on your fill price.
Entering orders during certain time periods of the day, such as near the opening or the closing when volatility is high will result in worse price fills.
While entering orders during calm periods, such as mid-day, when volatility levels are lower, can help you gain a substantially better price fill.
Do not sell premium without some type of protection in case of unforeseeable price moves. Selling naked options seems like a good idea because the majority of options that are out of the money expire worthless.
However, before the option expires it may inflate substantially in value; causing you to have to put up a massive margin deposit to continue holding the position till it expires.
For Example
It’s very easy for an option that was worth $100.00 to inflate into a $2,000.00 contract in less than 24 hours.
If you sold 100 contracts and brought in $10,000.00 in premium, the same options would be worth $200,000.00, and you would have to either liquidate your account or come up with $200,000.00 in cash to cover the position till expiration.
Don’t always assume that expensive options should be sold and cheap options should be purchased. You will find that the majority of the time overpriced options are expensive because positive earnings or take over news is expected from the company.
Similarly, you will find that the majority of “underpriced” options are cheap because the probability of these options becoming valuable before expiration is very low.
When I began trading options, I made the mistake of selling options because their implied volatility was very high, only to learn that the underlying stock was a takeover candidate and the options continued moving higher, multiplying in value over the next two weeks.
You should avoid legging into spreads because you run the risk of the underlying asset moving against you before you had the chance to enter both (all) sides of the spread.
Furthermore, entering the trade as a spread allows you to negotiate a better price fill the majority of the time, because you are combining multiple positions into one.
Always Know Your Exit
Never enter an options trade without having a predefined exit plan. Before you initiate the trade, your mind is completely objective since no risk is assumed.
Once you enter the trade and assume the risk that comes with an option position it becomes very difficult to stay neutral and manage the trade without a predefined set of rules to guide you along the way.
When planning your exit, always take into account the best-case scenario and the worst-case scenario in the event that the position goes against you.
Don’t underestimate the value of basic option sentiment such as open interest and put call ratio. These very basic tools can alert you to sudden changes in both price and overall momentum of the underlying asset.
By following these simple options trading tips, you will avoid very simple mistakes that can make the difference between winning and losing.
All the best,
Roger Scott
