Trading stock options can be extremely favourable from a risk – reward perspective, but it can also be extremely confusing where one ‘minor’ overlooked detail can ruin everything.
When I first started trading Options I never looked at these factors, yet they were the reason why the market moved in my favour while my Options were gaining nothing in value. Options trading is quite obscure and tricky, but it’s also the best way to trade, as long as you follow these tips you are likely to do much better as a trader:
Option Trading Tips
- Don’t buy cheap out-of-the money Options! These Options have a very low Delta, which means that if Delta is for example 0.15 you will only make $0.15 for every $1 the stock moves in your favour! Cheap is nice but there must be a good reason why the market offers those much more expensive Options don’t you think?
- Don’t expect a stock to make a huge move unless it has often done so in the past! A stock that historically moves 2% a month, is very unlikely to give you that ‘certain’ 7% move on the daily chart, no matter how ‘sure’ it looks on the recent chart you’d better check it going back 3 years and figure out the average monthly fluctuation.
- Don’t ignore implied volatility! Make sure you buy Options whose implied volatility is at a relative historic low. Also bear in mind that it is out-of-the money Options that are much more influenced by shifts in implied volatility than in-the-money Options.
- Always buy Options with at least 3 months to expiration! Options lose 50% of their time element (Or extrinsic value) within the final 30 days of their term. Again, it is out-of-the-money Options that suffer most.
Options lose 50% of their extrinsic value’s time premium in the final 30 days:
Generally stock Options trade in an obscure way, and it is impossible by just looking a stock chart to make an informed decision about trading the Options offered on that stock. That is because the stock chart tells you nothing about the probability of price going up or down over the next X days, and it tells you nothing about implied volatility. You have seen the most important Options trading tips to use in your trading, but implementing them in your Option trading is another story. Generally, most people have a poor understanding of probability and statistics (Which is what keeps casinos and lotteries in business), and successful Options trading absolutely requires you to re-evaluate the way you look at random events and be able to measure probability more accurately. The most deceptive data are the daily stock charts, they can easily fool you into thinking that a given stock will trend 5% in a month, because of a previous low or high, but if its statistics says that it cannot move by more than 3% then you would be gambling.