Before The First Trade
To the New Options Trader
It's understandable for anyone to be anxious when getting ready begin trading options. Perhaps a friend told you about a lucky trade where he/she earned a small pile of money -- and you are being encouraged to follow suit.
On the other hand, perhaps, you read about some horror stories from the options world or maybe your broker warned you that options are high-risk items and that it is best to ignore them.
The truth is that options are not risky. However, people who make trades before they fully understand how options work -- that is very dangerous. It is also quite common. There is far more to options trading than buying calls or puts when you "just know" where the price of a specific stock is headed.
Options do not represent the path to instant riches. Nor are they something to fear. Options are designed to reduce and manage risk. When used conservatively (i.e., by making risk-appropriate trades with limited losses), options increase your chances of earning money -- when compared with buying stock.
Do you know how options are priced in the marketplace? It is not simply a question of supply and demand as it is with the pricing of stock. When newbies make trades, hoping for the best, they are very likely to lose money. Yes -- very likely because they buy the wrong options and pay too much for them.
Let's get one thing straight right now: Hope is not a strategy.
Have patience. Read the free educational material that is offered by the OCC (Options Clearing Corporation) and your broker. These provide basic information that can help you get started trading options with an understanding of how they work.
Find a good book for rookies. View free video lessons. Take the time to learn.
This may not be obvious: options are not stocks and the marketplaces treat them very differently. In simple terms, the price of a stock is driven strictly by order flow, and that, in turn, is often driven by news or rumors.
Options are derivatives. That means the value of an option is derived from the value of something else. That something else is a specific stock or stock index. Option pricing is much more complex – and there are other factors at play, in addition to the price of the underlying stock. No one can buy or sell options without an understanding of those factors. It's not complicated, but never trade without knowing that you understand how options are priced.
A typical trade for a rookie trader is the purchase of a call option. When the stock price rallies and the option loses value, they are understandably surprised. The educated trader understands why option prices rise and fall and avoids this trap. The passage of time and the volatility of the underlying stock play a large role in the market price of all options. This is not true for stocks.
Get up to speed first. Trade later.
Do not join the herd of anxious traders who buy some options first -- and only later do they try to understand what they bought.
Follow me on Twitter.