Why trade options? Options can both increase your profits and reduce risk. It’s that simple. Option trading sounds complex, but if you follow a few simple rules, you will go a long way toward being a profitable trader. Here are my 5 favorite trading tips.
- The first question that you should ask yourself when you are getting ready to place a trade is not, “How much money can I make in this trade?” The first question you should always ask yourself is, “How much money can I lose if this goes badly?” The answer, by the way, shouldn’t be more than 1-2% of your account.
- Define your exits. At what point, if the trade is going against you, will you get out of the trade. Define that point and stick to it! At what point will you close a successful trade and bank the profit? Define that point and stick to it. Develop a specific plan for the trade and execute it.
- Avoid cheap long calls. Trading is a combination of profits and the odds of actually capturing those profits. Cheap long calls, typically out of the money with only a few weeks till expiration can be very profitable. But the odds are low that you will make money over time. Those options are decaying rapidly and you need a large movement in the stock to profit, and you have to have that movement quickly. These are usually losing trades.
- On the other hand, credit spreads are more often winning trades. Sure the profit won’t be explosive, but it will be much more consistent. Credit spreads should be the foundation of any trading plan. Beginning traders should start with credit spreads. The picture below shows how you can make 21% on a bullish AAPL trade even if you are wrong and AAPL falls 5%.
- For longer term trading (or shorter term investing), stock substitution is an excellent strategy. You could buy 100 shares of Amazon and spend $25,000. Or you could control 100 shares of Amazon by buying an in-the-money six-month call option for $3400. You would get almost the same profit in either case, but with the option strategy, the return on your investment is much higher and the risk is much lower.
Don’t get overwhelmed with dozens of esoteric options strategies. Start with profitable and easy-to-understand trades – stock substitution and credit spreads. Define your exits and know how much you can lose. Follow these 5 tips and soon you will wonder why everyone doesn’t trade options.
Submitted by John Marsland
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