Trading options has exploded in popularity over the last year. The amount of options trades jumped 50% in 2020.
We’re excited to see so many investors and traders take more control over their finances by using the powerful leverage of options.
Whether you’re a veteran trader or someone who just learned how to trade options, there’s always room to grow and fine-tune your approach.
When done right, options trading can be quite simple. And even better, it can help reduce your risk, not increase it.
By using options, your starting costs are much lower than buying stocks outright, so right away you have less money at risk. Not only that, but you can use options to hedge your portfolio against short-term pullbacks or even full corrections.
But how do we actually make money trading options?
Our list of options trading tips is meant to help you do just that. It’s a bridge to get you from knowing the options basics to closing profitable options trades.
There are several important steps any investor can take to be successful trading options. Let’s get started.
Options Trading Tips, No. 1: Quality Options
Start with quality stocks.
That means avoiding the companies that are super speculative, have no trading liquidity, or are all hype. A quick way to test this is to look at the bid-ask spread. If the spread is close, maybe a few cents of difference, the option is likely liquid. If the spread is large, then there might not be much liquidity. That means you could have trouble selling the contract when you want to and may not get the price you expect.
You can make real money trading options on real companies and not have to worry about inefficient markets with wide bid-ask spreads. You want to know that when you hit that trade button, you will be getting a fair market price.
Let’s talk about liquidity for a moment. This comes in two forms. The first is how many shares change hands each day. You could find a company that cures cancer, but if the stock barely trades, it will be very hard to cash in.
The next facet in liquidity is movement. Look for stocks that not only trade, but move. Money Morning’s options trading specialist, Tom Gentile, suggests that good stocks for options trading have 1% ranges between their daily highs and lows.
Finally, avoid low-priced stocks. Remember, 100 shares of a stock priced at $1 have a much lower value than 100 shares of a stock trading at $125 a share. You want money to move on each trade.
Options Trading Tips, No. 2: Pay Attention to Expiration Dates
Don’t marry your trades.
That means you are trading, not buying and holding forever. Options are by nature short-term instruments. Don’t be afraid to be temporarily bearish on a stock that the analysts say is the next Amazon or Microsoft.
Look for options that expire within three to four months. That gives your strategy a little time to work, but not so much that you are paying higher prices and tying up your capital for longer than is truly needed.
Options Trading Tips, No. 3: Pick the Right Strike Price
Buying options that are near the money, with strike prices close to the current price of the underlying stocks, offers the best risk/reward ratio and leverage.
The more in-the-money an option is, the more you pay for it. Conversely, the more out-of-the-money it is, the less you pay, but the less the option will move with the underlying stock.
We recommend looking for options one or two strikes out of the money. For example, for a put option on a $80 stock, you might choose the $70 or $75 strike price.
Options Trading Tips, No. 4: Protect Your Cash
While making money outright with options is the typical goal for options traders, protecting what you have is a close second.
Options can provide inexpensive insurance for your portfolio because you can design strategies where the value of the options you buy can go up to offset any short-term losses in your underlying stocks.
For example, let’s say you own 100 shares of Microsoft, which is trading at $230 per share. You can buy a put option on Microsoft with a strike price of $230 that will increase in value if the stock price falls. The gain in the option will partially offset the loss on the stock if it does go down.
And you can buy puts with different strike prices to vary the percentage of offset you get.
Think of the cost of the option as an insurance premium. It lets you own your favorite stocks through turbulent times since your “insurance policy” will pay out if markets move lower.
Options Trading Tips, No. 5: Keep It Simple
The simpler you make things, the less they cost, and the more likely you are to profit.
For example, you should limit your trading, at least until you gain expertise, to single options and simple spread trades (two options). Leave the butterflies and iron condors (three- and four-option strategies) aside for now.
With just one or two options, you can accomplish most strategies, from simple bets on a stock’s direction to hedging those bets. You can even set up for profit on a stock if it moves quickly in either direction or just sits there and does not move at all.
Don’t worry about advanced spreads and other combinations just yet. Or ever, if you don’t want to bother.
You want to be completely confident in your trade, and the fewer moving parts, the better.
Options Trading Tips, No. 6: Use Options for Income
You don’t always need to swing for the fences with options. Options can be part of a conservative, income-producing strategy.
Covered call writing is a strategy where you sell a call option on a stock you own. You collect the premium for selling the call, and if your stock does nothing, you keep the premium when the call option expires worthless.
The only problem is if the stock goes up a lot in price and you are then forced to deliver the stock to the options buyer at a slightly below market price. That price, by the way, will be higher than when you first put on the covered call trade.
As long as you’re willing to miss out on owning the stock if it races higher, you can turn stocks you already own into income-generating machines.
We suggest selling calls with strike prices two or three strikes above the stock price. That way, you give the stock room to rally a little without having to sell, but the options are not so far out of the money that you don’t collect a decent premium for selling them.
Options Trading Tips, No. 7: Use Time to Your Advantage
Options are short-term tools because they have expirations. Whatever strategy you use has to work by the time they expire. That’s why options are “wasting assets.” Time is a key component of options pricing.
Options prices comprise two components – time value and intrinsic or real value. Real value is the difference between the stock price and the strike price, as long as the option is in the money. A call option with a strike price of $50 on a $55 stock has an intrinsic value of $5, no matter how far away the expiration.
However, time value is totally dependent on expiration. Generally speaking, the longer until expiration, the better chance the option will wind up in the money, and the greater the time value. But as time moves on, especially when expiration gets close, the option’s value will decline, even if the underlying stock does not move one penny.
That’s why it makes sense to tailor your strategy to work with time decay.
Our experts suggest in-the-money options if you want to reduce time decay risk and make money slower, more like a stock. They suggest out-of-the-money options for traders who can accept more time risk in order to make money faster - doubling or tripling their investments.
These are just a few tips to help you mold your options strategy to whatever suits you best. Whether you are looking for fast money or reduced risk, there is a strategy for you. Take your time and learn how to do it the right way.
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