- March 6, 2023
- Posted by: CoachShane
- Category: Trading Article
Trading options can be an exciting way to make money, but it’s important to remember that there are risks involved. To help protect your investments and maximize profits, it’s essential to create a trading plan before you start trading. This blog post will provide tips on how to create an effective options trading plan.
Select a trading strategy that fits your risk tolerance level.
Consider the open interest and expiration when buying calls or puts.
Set limits for how much capital you are willing to risk on each trade.
Understand the mechanics of options trading before getting started.
Be aware that time decay can reduce the worth of your position as expiration approaches.
What is Options Trading?
Before we dive into creating a trading plan, let’s take a quick look at what options trading is. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price on or before a certain date. The buyer pays a premium for this right in exchange for the potential of making a profit should their position move in their favor.
It’s important to note that there are different types of options strategies available as well as different levels of risk associated with each strategy. Knowing which type of strategy best fits your individual needs can be key when deciding whether or not options trading is right for you.
Creating an Effective Options Trading Plan
Now that you have an understanding of what options trading is, let’s look at how to create an effective options trading plan:
Analyze Your Risk Tolerance and Investment Goals
As with any type of investing, it’s important to assess your risk tolerance and investment goals before you get started. Are you looking for long-term gains or short-term wins? Knowing your objectives can help you focus on strategies that will help you reach them.
Knowing what your tolerance to risk is can also help you choose the next item, the options strategy you will trade. As with anything, having a goal in mind will lead you towards the approach to take.
Select Your Strategies and Set Your Limits
When selecting an options trading strategy, it’s important to choose one that fits your risk tolerance level/account size/type of account. If you are just getting started, it may be wise to go with a simpler strategy such as buying calls or puts. While these are more expensive than other strategies and they need a directional move quickly, these are not bad ideas depending on the circumstances.
As an example of a trade using calls, you could buy a call option if you think the underlying asset will rise in price. You are essentially buying the right to buy a certain quantity of shares at a fixed price until a specific date.
Your trading plan for buying calls could be very simple:
Valid setup – Could be a pullback to a moving average and you see a reversal taking place
Check open interest – Your rule could be needing to see 25 times the open interest per contract you will trade
Targets – You may be targeting 100% return and willing to take a 50% loss on the capital you are risking (.5R loss)
Holding time – This will affect the expiration you choose for the option. You may think the move will take 10 days so you choose expiration dates 20-40 days out.
Strike price – We generally look at buying strikes that are 1-2 in the money. This helps offset time decay, especially when trading calls and puts
Imagine you were bullish on RBLX after a pullback and it was trading at $35.38.
We look at 1 strike in the money and look to the $35.00 strike price (28 days out).
Looking at the open interest at over 5000 contracts, we could trade up to 200 contracts.
The cost of the trade, we will choose a mid-price of the bid/ask and imagine we get filled at $3.50/share or $350.00 per options contract. We will target a $7.00 options price and will only risk $1.75 or $175.00/. The cost of the trade is $350.00, we can’t lose more than that.
Now, we manage the trade and if price is taking too long to move, we’d sell the position to close it.
In addition to selecting strategies, it’s also important to set limits for your trades. Decide how much capital you are willing to risk. Some traders will look at 10% of their available capital in a trade with a risk profile of .5 – 2% per trade.
On the other hand, if you have more experience in the market and looking for cheaper trades, then a more advanced strategy such as vertical spreads may be right for you. Our in-house options specialist used to only trade calls and puts. You can read this article about how Mike stumbled upon what is now his favorite way to trade options.
It’s also important to consider the time frame of the strategies you select; some options strategies last only minutes or hours while others can last days or weeks. Again, it depends on what your goals are for your trading.
Understand the Mechanics of Options Trading
Finally, it’s important to understand the mechanics of options trading before jumping in headfirst.
While stocks (the usual underlying in an options contract with retail traders) and options are both financial instruments used for investing/income-producing, there are some key differences between them.
The most obvious difference is that with stocks you own shares in a company (or partial ownership), while with options you are simply buying (or selling) contracts that give you the right (but not obligation) to buy or sell shares of a certain asset at a certain price on or before its expiration date. This means that with stocks, you actually possess them – whereas, with options, you don’t necessarily have the share in hand after making your trade (unless selling covered options where you own shares of the underlying.
You must understand, depending on your strategy, that the longer you sit in the trade, the less worth your position has. As you approach expiration, that time decay speeds up. If the underlying is not acting as you expected, there is no need to sit and wait for the trade (unless it benefits you).
Options trading can be a great way to diversify your portfolio and earn additional income. Regardless of your experience level, it is important to remember several key points when deciding whether or not to trade options: select a trading strategy that fits your risk tolerance level; consider the open interest and expiration when buying calls or puts; set limits for how much capital you are willing to risk on each trade; understand the mechanics of options trading before getting started; and be aware that time decay can reduce the worth of your position as expiration approaches.
There is no right or wrong way to approach options trading, however, having an understanding of these considerations will help ensure your success in this very popular trading approach.
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