Profitable Ways to Trade Options

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Options Trading
Options Trading

Options Trading and Your Financial Situation:

Trade options in accordance with your financial situation. Never risk funds that you cannot comfortably afford to lose. Although trading options can yield huge profits, there is always the risk of a loss. If you are trading with funds that may be needed for other purposes, the axiom, “You never make money with scared money,” may well apply. Your buy/sell decisions might be based on factors external to the market, which can severely decrease your chances of being successful.

We recommend that you devote about 20 percent of the funds that you would have invested in common stocks in option recommendations and invest the remaining 80 percent in riskless instruments such as Treasury Bills. Use options to maximize your chances for profits on your risk capital.

Options Trading and Your Temperament:

Trade options in accordance with your temperament. Even if you are trading with your risk capital, you may be the type of individual who prefers to sacrifice some profit potential to reduce the chances of a total loss. In this case, more conservative strategies, such as covered call writing, are more suitable for you. On the other hand, if you prefer to maximize your profit potential and are willing to take an increased risk of large losses to achieve this objective, your strategy would be to purchase individual puts and calls outright.

Diversify:

A major advantage of trading in options is truncated risk, whereby your loss is limited to your initial investment, yet your profit is theoretically unlimited. Diversification will allow you to use truncated risk to its maximum advantage. While some of your positions will inevitably be unprofitable, each profitable position can offset several unprofitable trades. For example, assuming equal dollars invested in each of five option positions, a bottom line profit will be achieved if three of the positions yield profits of 100 percent, even if the remaining two positions result in total losses.

Diversification should be two-dimensional. This is accomplished by purchasing calls and puts (see below for a discussion of puts.). You are then insulated from the impact of overall market movements.

Put Options :

Trade in puts as well as in calls. Many people believe that the only way to make money in the market is to take a bullish position on an advancing stock. This orientation is compounded by the general fear of selling short, where one’s loss is theoretically unlimited. You can take a bearish position by buying a put, yet enjoy the advantage of limited risk offered by all options. Remember also that ex-dividend stock price adjustments help put owners, while they are a negative for call owners (see #24 for a discussion of ex-dividends.)

Target Your Profits:

Set your profits objects in advance. You should calculate your target exit point at the time you make your option purchase. By doing so, you will avoid the consequences of one of the major stumbling blocks to achieving trading profits – greed. It is virtually impossible for most investors to set reasonable profit goals once an option has advanced substantially in price. That “extra point” or “extra half-point” becomes a moving target with each advance in the option’s price. It is not surprising that, more often than not, the target is not achieved, and the investor is forced to panic out at tumbling prices (thereby becoming a victim of stumbling block number two – fear).

Protect Your Capital:

You can protect your trading capital by using the appropriate asset allocations. Also, aggressive traders should always establish a closeout date to exit a position that has not achieved its profit objective. For instance, in aggressive option trades, this date should be one to two months prior to option expiration. By establishing a closeout date, you protect your trading capital by avoiding the accelerated deterioration in option premium (time decay) that occurs in the final month of trading. (Put selling trades, on the other hand, is designed to take advantage of this time-erosion component of options.)

The Best Broker for Instant Executions:

Use a broker who has voice contact (i.e., a direct telephone connection) to the options trading floor. This is not the only factor in choosing your broker, but in the fast-moving options market, a voice contact broker offers instantaneous connection to the options trading floor. This gives you a better chance of entering a trade at or below the maximum entry price that we use in our recommendations.

Keep Your Commission Costs Down:

Shop around for attractive commission rates. Of course, commission rates should not be the only factor involved in selecting a broker. However, since options trades are of very short duration, the cost of a “round-trip” commission can have a significant impact on your bottom line. Many of the discount brokers have sharply reduced the cost of trading options. Also, a number of traditional full-service brokers are willing to discount their full ticket commissions for active options accounts. It never hurts to ask. Discount brokers advertise regularly in Barron’s, Investor’s Business Daily, and The Wall Street Journal.

When to Ignore Your Newspaper:

Don’t be misled by the closing options prices as listed in your newspaper, as many of the less-active options do not trade throughout an entire market session. In fact, the many of these less-active options will often have their last sale early on in the trading day. (For that matter, it’s entirely possible for an option to not trade at all on a given day.) Naturally, if the underlying stock makes a significant move later in the day, the closing options prices could be far out of line. Since complete option volume figures are not generally published, it is not possible to use printed volume as a gauge for the timeliness and accuracy of the closing price.

Interpreting Options Quotes:

Don’t be confused by apparent discrepancies between an option’s last sale and the bid/asked quotation. The options market is very fast moving, and adjustments are made quickly in response to price movements in the underlying stock. These adjustments are most quickly reflected in the bid/asked quotation. For example, if an option is quoted at “2 bid, 2.25 offered” with the last sale occurring five minutes ago at 1.95, be assured that the “true current market” is reflected in the bid/asked quotation. Be sure to incorporate the proper option pricing information in your trading decisions.

Be Careful at the Opening Bell:

Never place an order to buy or sell an option “at the market” on the opening. Even the more actively traded options are not very liquid in early trading, so market orders are likely to be executed at unfavorable prices.

Beware of Market Orders:

Confine your market orders during the day to the most actively traded options, such as index options. In most cases, you will get better executions with limit orders. If you are in a hurry to execute, buy at the offering price or sell at the bid price. As a compromise, you can give your broker discretion to execute your order at a price five or 10 cents away from the current market. This protects you from sudden changes in the market, and eliminates the “anything goes” possibility inherent in market orders.

The 4:00 p.m. Trap:

Never put yourself in a situation where you must close (or feel you must open) a position right before the closing bell. Most options are not very liquid late in the session and, like the situation at the open as described above, market orders will likely get filled at unfavorable prices. You’re better off waiting for the following trading day.

Maximizing Your Liquidity:

Use volume and liquidity data to help determine the proper size for each option position. If every option were characterized by large trading volume and small “bid/asked” price spreads, the amount you invest in each option would be based almost solely on your financial situation and temperament, as well as by the need to diversify. Unfortunately, this is not often the case.

For example, let’s say you wanted to buy 10 contracts of a particular call option, but discovered that an average of only three contracts per day were traded over the past few weeks. In checking with your broker at midday, you learn that the option is bid at 10, offered at 11.25, and that no contracts have traded as yet. This presents a very difficult situation for the potential buyer of 10 contracts. You may be able to purchase all 10 contracts at 11.25, but this is a very large premium (12.5%) over the bid price. Worse yet, you may only be able to buy two or three contracts at 11.25, with the remainder at 11.50 (or more). If you conservatively decide to place a bid at 11, your order may not execute for days (or at all, if the underlying stock price rises). Even if you ultimately buy all 10 contracts, it could be in separate transactions of one, two, or three at a time, thus costing you significant additional commissions. Furthermore, the stock price may have moved against you while you were acquiring the options, making your option purchase price unattractive.

Solution: Avoid such options unless you are buying one or two contracts (this, however, results in relatively high commission costs). If you are very interested in the underlying stock, try to find an option on the same stock with a different expiration date and/or striking price that has greater volume and liquidity.

Or: Perhaps there is a comparable stock in the same or similar industry with more attractive options.

Use Limit Orders Intelligently:

Watch your limit orders carefully (or have your broker watch them for you). You cannot walk away from limit orders the way you can with stocks. Since the true value of an option directly depends upon the price of the underlying stock, your “bargain bid” of 15 minutes ago may eventually be executed at a very disadvantageous price. For example, take a stock at 50 with a call option bid at 6 and offered at 6.50. You bid 6, the stock drops quickly to 48, and you are the proud owner at 6. Unfortunately, you shouldn’t have paid more than 4.50 at a stock price of 48.

The moral: You should be in constant contact with your broker on outstanding option limit orders to check whether they should be revised or canceled.

Avoid the Thundering Herd:

Don’t stampede into an option. Options often take a little while to get rolling once the underlying stock starts a big move. The ideal time to buy the option is in this “percolating stage” just before the public rushes in. If you wait much longer, you will find yourself “stampeding with the herd” and paying “retail plus” for your option. Even if you are very enthusiastic about the underlying stock, it is usually best to stand aside at this point and wait for more favorable price relationships. Amid the enthusiasm and euphoria of the moment, ask yourself whether you really should be buying an out-of-the-money option that has already advanced a full point on a move of 1.25 points in the underlying stock!

How to Handle a Partial Execution:

Don’t be overanxious on a partial execution. After you have placed an order to buy 10 options at 8.75, your broker may get back to you saying, “You bought five at 8.75, it’s your bid at 8.75 for the remaining five, the option is offered at 9.25.” Instead of immediately paying the extra 50 cents for the five options to fill your total order, wait a while. Since it is “your bid,” any options that come in to be sold at the market or at 8.75 (or less) will be yours (up to a limit of five, of course). Your chances are pretty good as long as the underlying stock remains in a reasonable trading range. Of course, you and your broker should remain in close contact so that adjustments can be made in your order to respond to significant movements in the stock.

Demand Reasonable Executions:

Don’t be afraid to question what appears to be a bad execution. For example, you may have entered a “buy at the market” order for an actively traded option, where the bid/asked spread was “10 bid, 10.50 offered.” If your broker reports that you purchased your options at 10.75, while the current bid/asked spread remains unchanged and the underlying stock has traded in a narrow range, you are entitled to an explanation. Your broker can obtain from the trading floor a sequential listing of all trades in that option before and after your execution. If the execution still appears out of line, it can be appealed to the exchange itself. Two important points to remember: The best way to help avoid this situation is to place limit orders through your broker. Also, try to be objective about the overall quality of your executions—it is usually the excellent ones we forget very quickly.

Percentages and Bid/Asked Spreads:

Don’t lose track of the concept of percentages when looking at bid/asked spreads. Always look at the spread as a percentage of the bid price. It is one thing to decide to pay the offering price when the bid/asked is “15 bid, offered at 16.” You are paying 6.7 percent more than the bid price (1÷15) to achieve an immediate execution. It is quite another thing, however, to “pay asked” when the spread is “3 bid, offered at 3.65.” That “mere” 65 cents extra translates into a premium of 21.7 percent more (0.65÷3) than the bid price. Although this does not mean that you should never pay the extra 65 cents, you should definitely factor these percentages into all of your trading decisions.

How to Understand Option Pricing:

An options trader must be aware not only of the expected direction of the underlying stock, but also the expected magnitude of the movement (volatility) that the options market assumes to price the option. For example, if the options market is pricing for a 10-percent gain in the stock over a given period, and you correctly project a 20-percent gain over the same period, you will make money buying calls on that underlying stock. Thus, options traders will have a major edge if they have a method to determine the likely price change of a stock over a given period and then can assess the relative attractiveness (or unattractiveness) of the option premiums. This is important not only in short-term options trading, but doubly so in LEAPS and longer-term trades because of the added time for a stock to move. Volatility considerations are of primary importance for options players when the focus is on the magnitude of a move, rather than the move’s direction.

Option Expirations and How to Handle Them:

Be aware of option expiration dates and times. Options cease trading on the third Friday of the expiration month. If your option is in the money, it would still be possible to exercise the option if you notify your broker prior to 5:30 p.m. eastern time (you should always alert your broker in advance in these situations). Exercising a call would involve purchasing the shares of the underlying stock at the exercise (or striking) price, while exercising a put would involve delivering the shares of the underlying stock in exchange for consideration equal to the number of shares delivered times the exercise price. We do not recommend exercising your equity options, due to the large cash outlays and relative high commission costs involved. Instead, we recommend selling your in-the-money options prior to expiration.

Profit from Index Options:

Profit opportunities abound in index options. These options allow the investor to take a leveraged position on the movement in the overall market. Index options can be used in a number of different ways to maximize your profits and reduce your risk. One of the most exciting ways to use index options is very short-term trading, with holding periods of one day to two weeks. While short-term index option trading has tremendous profit potential, many traders are unsuccessful due to buying overpriced options, inaccurate market forecasts, and trading on a hunch or emotion. The key to successful index option trading is having a disciplined, unemotional approach that can reduce risk while maintaining the reward potential.

Keep Your Eye on the Bottom Line:

Investors trade options to achieve worthwhile bottom-line profits in a relatively short time frame. The big advantage in options trading involves truncated risk – you can never lose more than your original investment, but your potential profits are theoretically unlimited. Successful options traders almost always have more losing trades than profitable trades, but they still achieve substantial bottom-line gains. How? Their winners yield far more dollars per trade than are lost in their losing trades. It only takes two $2,000 profits in five separate $1,000 investments to achieve a minimum 50-percent bottom-line gain, assuming that all three remaining positions lose 50 percent each. Never look for perfection from your option trades. A reasonable “batting average” will still yield large profits. Just as in baseball, a “.400 hitter” in options trading is very rare indeed.

Ex-Dividends and How to Handle Them:

Keep careful track of ex-dividend dates. On the day a stock trades ex-dividend, its price will be adjusted downward by the full amount of the dividend. As this date approaches, options premiums reflect the upcoming “automatic decline” in the stock’s price. To the uninitiated, put option premiums will appear inflated and call option premiums deflated, particularly if the stock pays a large dividend. For example, if a $50 stock is going ex-dividend for $1 the next day, the closing options prices will reflect a stock price of $49. An analysis of option premiums based upon the $50 price would be inaccurate and possibly quite costly to the uninformed investor.

Solution: Ex-dividend information for all stocks can be found in Barron’s, Investor’s Business Daily, The Wall Street Journal, and Daily Graphs chart books. Or, ask your broker.

How to Handle Stock Splits and Stock Dividends:

Keep careful track of stock dividend/stock split dates. On the day a stock dividend becomes effective, all option striking prices are adjusted. For example, if XYZ stock is selling at $100 and has declared a 100-percent stock dividend (or a “two-for-one” stock split), the option with a striking price of 100 will have a striking price of 50 on the effective date of the stock dividend. Furthermore, a holder of 10 contracts with the 100 striking price will become a holder of 20 contracts with a new striking price of 50. In the case of an odd stock dividend of less than 100 percent (for example, a 50-percent stock dividend or “three-for-two” stock split), new odd striking prices will be created. In the case of our $100 stock, the 100 striking price will become 66-5/8 and will be listed in the newspaper as XYZ o 66-5/8. The o indicates that this is an old or pre-split contract. In the case of a stock dividend of less than 100 percent, the post-split contracts are adjusted differently. In our “three-for-two” example, a holder of 10 contracts prior to the split would still own 10 contracts, but each contract would represent the right to purchase 150 shares rather than 100 shares. The true premium of such a contract would be the published premium increased by 50 percent. Upcoming stock dividends/splits will have a significant impact on the terms (or quantity) of your outstanding options contracts. Complete information on stock splits and stock dividends for the stocks underlying all recommended options can be found in Barron’s, Investor’s Business Daily, The Wall Street Journal, and Daily Graphs chart books. You can also ask your broker.

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