5 Ideas for the New Options Trader

Avoid Beginner Misstakes

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Options Education: Helpful Ideas. Pixabay.com

The option is one easy to understand investment tool. However, understanding how options trade in the real world requires a more sophisticated understanding. Thus, it is very likely that the brand-new trader will make money-losing mistakes when using options. To help you get off to a good start when making your first few trades, I compiled a short list of useful suggestions:

Suggestion 1. Before making any trades; before opening a brokerage account; get acquainted with the most basic concepts about options.

Sure, there is far more to understand, but without a minimal understanding of the basics, you will be trading blind.

Suggestions 2-5: If you buy some call options because you believe that the price of a specific stock will move higher, and if your prediction is correct, you may lose money. The previous statement is difficult for the novice to believe. However, it is true because it is important to buy options that suit your market expectations. If you have no such expectations, then buying options is not your best choice. Consider this scenario:

  • A stock is priced at $41 and you buy calls with a $45 strike price because the options did not cost a lot of money. You hope that your investment ($45 per option) quadruples.
  • You are not sure when the anticipated rally in the stock will occur, but you decide to buy options that expire in two or three weeks because they are less expensive than longer-term options.
  • You submit a to buy these options at the asking price or you submit a market order because you are anxious to make the purchase before the stock starts to rally. You do not bother to estimate the fair price for these options.
  • Holding onto your positions too long is a losing practice. Too many people buy options and hold through the expiration date. 

    If you do anything in the list above, your chances of earning money from the trade will be much smaller than if you practice sound thinking and planning. The above list represents unsound thinking.

    When you have a market bias and buy options (calls when bullish) or puts when bearish), you want to have a trade plan. That includes both a profit target and a maximum acceptable loss.

    One of the important factors in determining the target profit is to have some ideas as to when you expect the stock price change to occur. If you are bullish or bearish, and if you "just know" that the stock price will double (or fall by 50%) within one year, then it would be very foolish to buy short-term options. If the one-year options are too expensive to buy, then do not buy them. Solution: Find an alternative strategy that allows you to earn a profit, even when the stock price does not change. For example, sell an out-of-the-money put spread when bullish.

    Suggestion 2: The options expiration date is important. Do not choose options with a random expiration date.

    When a stock is $41 per share, it may not seem that $45 is that far out of the money (OTM). However, the strike price is a full 10% higher than the current stock price -- and 10% represents a very significant price change over a short period of time.

    For that reason, buying these options -- especially when the time frame is only a few weeks  -- is not a sound practice. The stock is simply not going to move that far that quickly. There is one special situation that traps inexperienced traders. When news (such as an earnings announcement) is pending, everyone understands that unexpectedly good or bad news can result in a large change in the stock price. Thus, there is a much greater than usual chance that the  stock could jump 10 to 20% overnight, making it tempting to buy those options. However, keep in mind that the option sellers are also aware of the possibilities and they price the options significantly higher than when no news is pending. In other words, you can buy those options, but they will not be cheap (in terms of what they are truly worth).

    Suggestion 3: Buying OTM options is a losing game for the vast majority.

    The price paid for options is truly important. The novice may not care about the difference between paying $0.35 and $0.50 for OTM options, but that $15 per contract makes a very significant difference in the trader's long-term results. There is almost never any reason to enter a market order when trading options. My message, to you, the novice trader is: never use market orders with option trades. Similarly, there is no good reason to enter a limit order to buy at the ask price. Make an effort to buy at a lower price. The reason is that market makers seldom show (publish) their true bid and ask prices because there are always people who pay the ask price (or sell at the bid price) and market makers would earn less money if they showed a lower ask price. So, if the bid is $0.30 and the ask is $0.50, enter a bid at $0.40, which is the midpoint. If your order is not filled within five to 10 minutes, and if you are willing to pay more than $0.40, then increase the bid to $0.45. ​

    Suggestion 4: No market orders and always try for a better trade execution than the visible bid/ask quote shows.

    Suggestion 5: When the stock price does not behave as expected, get out of the position and salvage some of your money. There is no need to wait for expiration. You cannot expect to predict what happens in the stock market consistently. 

    Take these trading ideas to heart and your entry into the option world will be painless (or at least less painful).