Options Trading – Tips of the Trade

Options trading can be a full time job for some stock and option investors. For others, you might only spend a couple of minutes a day or a week adjusting and checking your positions. No matter how you use options(you should at least consider using options investing), there are some general option trading rules of thumb that you should keep with you. Perhaps even have them printed and posted where you do your trading.

1. If your trades are aimed at more than 30% annual returns, you are probably taking on more risk than is necassary. You may not be able to sustain those returns for the long-term. Consider lowering your expected returns by using a stronger hedge technique that offers some more down side protection. This way you are better protected if you’re predictions are wrong or if market conditions turn unfavorable.
2. When writing options for income, you will generally make a higher annualized return by writing options every month or every other month rather than every 6 months or 1 year.
3. Beware of the AM settlement. Some index options settle using opening prices for the stocks in the index on expiration Friday morning. This can be dangerous for 2 reasons. Firstly, a lot can happen between close of trading on Thursday and open of trading Friday morning. Your position may be out of the money on Thursday, but settle in the money based on the opening prices of Friday. Secondly, you are taking on that risk of something happening with no recourse in your trading. You are totally at the whim of the market for that 15 hours. Taking on risk without having an escape plan is hardly ever a good idea. Consider closing those short index options earlier and not waiting to see if you get hit on expiration morning.
4. Option trading is not appropriate for all of your life savings. You should only be using funds that you would consider to be “at-risk”. These funds should be a reasonable portion of your total trading portfolio. Remember, the best way to manage your investments is to use multiple positions in multiple sectors/industries and multiple security classes to properly diversify your money. If any one bad trade could significantly dent your investment capital, you are not diversified well enough.
5. If you are using long call options in lieu of buying stock, that is, forming a synthetic covered call by buying a long-term option and selling shorter term options against it, remember that you are in a leveraged position! The long-term option was cheaper to purchase and will swing much wider than just owning the stock would. Consider not purchasing the same dollar amount of options as you would have if you had bought the stock, this way the relative risk of a large equity position will be balanced with the relative risk in a smaller leveraged position.
6. If you are trading vertical spreads remember that for each credit spread, there is a parity debit spread trade that will act much the same if you prediction is right. Usually, one of these trades will be mis-priced and offer an advantage over the other. Check both parity trades before you open the position. Also consider if an iron condor trade might be appropriate as well.

[tags]option trading, covered call, iron condor, option investing[/tags]