Options trading can be a very lucrative way to increase your wealth in the markets. Gains of 50%, 100%, and 200% are not unusual.
But too many would-be traders think options trading is too complex or is just another way to lose money. That couldn't be further from the truth, and we're going to show you exactly how easy it is to get started with our quick beginner's guide.
With a relatively small amount of money, you can control more stocks than you could by owning them outright, which naturally magnifies the market's movements.
Of course, such leverage means that you have to be careful. Bad trades can become very bad losses if you don't know what you're doing.
The problem is that many beginning investors approach options just as they do stocks. They might have a bullish opinion on a stock, buy an active call option on that stock, and then watch their option decline in value, even as the underlying stock itself moves higher.
Their market call was right, but their options strategy was wrong.
Getting a good education on options is critical for success. Not only must you keep track of the underlying stock's movements, but you must understand several other factors that control an option's price.
These factors – called "the Greeks" due to their Greek letter titles – include volatility, time to expiration, sensitivity to time, speed at which options prices change relative to the stock price changes, and even more.
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While it might seem complicated to take in at first, it's easy enough to get started and bank profits.
Fortunately, Money Morning's options trading specialist, Tom Gentile, is an expert teacher and put together the four rules to know in order to profit from options while minimizing losses.
These money management rules are critical, and while risk control sounds boring, your wallet will be fat and growing at the end of each month.
And it all starts with learning to control risk…
Options Trading Rule, No. 1: Understand Your Risk Level Before You Do Anything
Seasoned traders know that they can only risk a small percentage of their capital on any one trade. That way, no matter what happens (including losing the entire value of the trade) your portfolio will survive to trade again tomorrow.
Although it's a personal decision between you and your financial advisor, Gentile recommends that a $25,000 account dedicated to short-term trading risk no more than 2% ($500) on any one trade.
As you become more successful, you should still adhere to the 2% rule, but remember, if your account doubles, so will the dollar value of any single trade.
Options Trading Rule, No. 2: Set a Stop-Loss Approach
We've all heard the old Wall Street saw that says you should let your profits ride but cut your losses short. That means if your trade starts to lose value, there should be a predetermined price at which you throw in the towel and close your position.
Losing, say, 25% on your trade is far, far better than losing 50% or even 100%.
You can set a stop-loss order to trigger when your trade loses a certain percentage in value or a specific dollar amount. But in either case, you must respect your stops and get out no matter how you "feel" about it.
To be sure, there will be times you get stopped out and the market suddenly turns around without you. That is just part of the game, especially with options. Not every trade can be a winner.
But if you have discipline with your stops, over time you will have some winners, some losers, some really big winners but – most importantly – no really big losers.
Options Trading Rule, No. 3: Determine Your Position Sizing
Position size and maximum risk level go hand in hand. If you decide that $500 is your maximum risk for any trade, you can only trade $500 divided by the price of the options contract. For a contract trading at $100, you can trade five contracts.
This is important to know when deciding what specific options to trade. Some may be priced above your limit. And that's a sign you'll want to sit out the trade. Chasing big wins with bigger positions is a quick way to lose your money.
Instead, focus on opportunities within you pre-determined position size until you've built up enough of a war chest to go after bigger targets. There are plenty of triple-digit profit opportunities at any contract price level.
Options Trading Rule, No. 4: Adapt Your Trades to Your Account Size
As a newcomer to options (or any trading) you have certain restrictions on what you can trade. A small account cannot buy hundreds of shares of a high-priced stock. In fact, it may not be able to buy even one share of a $1,000-per-share stock under the 2% rule.
Therefore, trading will have to be limited to lower-priced stocks and basic options strategies. Options strategies using three or four different options may still be out of reach under the 2% rule.
But just like the previous rule, it's more important to stay with simple trades within your account size than to chase a more complex trade that could bust your portfolio.
Minimizing risk is the most important step in learning to trade options profitably. If you can do that, you're already well ahead of the curve.
The next step is finding the right opportunities.
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