Options Trading 101: How to Trade Like a Pro and Minimize Risk

Dear valued readers,

Options trading has recently gained popularity among nonprofessional investors. While Wall Street experts may sneer at the newbies, it is important to recognize that options trading can be a valuable tool for navigating the stock market. To help you avoid looking foolish, we have compiled a list of tips for new options traders.

1. Firstly, have an investment thesis. Know why you are making a trade and focus on events like earnings reports or product launches to help you predict how the stock might react. Use your opinion on the stock to decide whether you will buy or sell a call or put option.

2. When choosing an option, focus on the ones that expire in three months or less. The sweet spot for many investors is about 30 to 45 days, as it allows for time decay to work in your favor and for your stock thesis to play out without paying top dollar.

3. Before making a trade, consider the Rule of 16. Divide the contract’s implied volatility by 16 to determine what the options market thinks the stock will do each day through expiration. This will help you decide whether to buy or sell the contract.

4. Good trading is about understanding events and how they are packed into your expiration. Be aware of everything that could affect the stock during your chosen expiration cycle, such as earnings reports, Federal Reserve meetings, elections, and economic reports.

5. Options contracts lose value each day, which can be monetized by options sales. This is known as time decay, or “theta,” and is a powerful force.

6. If you are thematically confident about a stock but unsure of the timeline, consider buying options that expire in a year or more to rent exposure to the stock.

7. Don’t be a pig. If you make a significant profit on your initial trades, take profits. If you make 100% or more, definitely take profits.

8. If you are so convinced that the market is wrong and you are right, take out your initial invested capital so you are playing with house money.

9. Be cautious of excess leverage. Options contracts represent 100 shares of stock, so don’t trade 10 contracts if you cannot afford to cover 1,000 shares of stock. Start small and trade one or two contracts at a time until you have mastered the basics. Never trade “naked” contracts that aren’t covered by cash or stock.

10. Simplicity is key. Avoid strategies with many moving parts and focus on buying and selling calls and puts, and then consider spread strategies. Optionseducation.org is a free site that will help you learn more.

Remember: Bad investors think of ways to make money. Good investors think of ways to not lose money. Use these tips to avoid common mistakes and start your options trading journey with confidence.