The options market presents both great opportunities for gains but also the potential for the risks of losses. Here are ten things that I learned quickly through experience that all new traders should understand before they start trading options.
1. Short options have unlimited risk when they have no hedge.
It’s important to understand the asymmetric nature of option contracts. Long options have limited downside as the total risk exposure is the cost of the contract at purchase. This is the most a long option trader can lose, however a contract can increase to any upside price for profit. Long options have a favorable risk/reward ratio in magnitude.
However, an unhedged short option contract has the reward limited to the price the contract was sold at but price can go to any level creating unlimited risk without a hedge or stop loss set at a buy to close level. It can be very dangerous to hold a short option contract with no hedge in place, this is why professionals almost always hedge short options with a cheaper long option or the underlying stock position.
Short options have blown up many legendary traders and hedge funds. They can have high win rates but one big risk event can wipe out all of those gains. Hedges are cheap insurance against ruin. Always manage risk.
2. Option trading theories are not the same as live trading.
Learning about options and trading them are very different experiences due to ego and emotions. Research doesn’t contain the element of risk and uncertainty that real capital at risk has.
Be ready for the stress, emotions, and ego that you will experience with capital at risk, don’t let is take you by surprise. Start with small position sizing and work your way bigger over time. Be ready to manage your mind in the markets.
3. Trade options consistently but adjust to the market environment.
Trade your system consistently based on your parameters and signals but don’t blindly take the same types of risks in all market environments on all charts. Be aware of the current market trend of price action and the level of volatility and adjust size and directional bias to stay in tune with the path of least resistance.
Not all market environments are suitable for all types of option plays. Learn the difference and manage option plays accordingly.
4. Liquidity is the most important fundamental for options trading.
Only trade in options with high volume so you don’t lose a large percentage of capital on the bid/ask spread when entering and exiting trades. You must trade on the option chains that have the liquidity to trade with spreads measured in cents not dollars. A $1 price difference in the bid/ask spread will cost your $100 to get in and out of a trade in addition to commissions.
Also be aware that the best liquidity is in the front month at-the-money options, and option chains get more illiquid as they go deeper in-the-money or out-of-the-money this has to be considered in a winning trade because you might have to roll the option to a more liquid contract. Also the farther out in time to expiration you go the less liquid options become with wider bid/ask spreads. Most options chains can’t be traded due to the fact that they are just not liquid enough.
Stay with only the top stocks with the most liquid option chains, this makes things much easier for getting in and getting out and avoiding all the little costs in the spreads.
5. Don’t let a losing option play get out of control.
Define your risk in every option play before you enter it. Set parameters for risk of capital as well as delta, gamma, and theta exposure. Regardless of the option play manage the risk exposure by moving hedges, rolling options in time or strike, or closing option legs.
Always be aware of the current risk/reward ratio in a current option play and close it when the risk is no longer worth the reward.
6. Know how to lose safely on an option trade.
A losing option trade should have the loss capped to the hedge or the stop loss level. An option trader should never lose more than 1% of their total trading capital on one option play. Most long option trades should have a position size between 1% and 2% of total trading capital.
Stop losses are better set on the stock chart than the option price to have a real price level that is technically meaningful. Long option risk must be managed primarily in the position size as options can go to zero. Don’t trade too big or let a losing trade get out of hand.
7. Diversify your watchlist, signals, and plays.
An option trader needs a diversified watchlist of option chains to trade with many types of plays to choose from based on the current market range and trend. The more types of edges you have to execute the greater your odds of success through different types of market environments.
8. Keep your option trading as simple as possible.
An option trader doesn’t need to create complex 4-legged option trades to make money that they must manage every day. A trader only needs a simple repeatable edge to profit from the options market. Complexity can add risk and unnecessary activity. All that matters with options trading is probability, volatility, repeatability, profitability, and risk/reward ratio. Profitable options trading can be as simple as you can make it. The edge is all that matters.
9. Patience is an option sellers edge but an option buyers weakness.
An option seller has the benefit of time as theta decays daily and they can run out the clock on the option buyer if the move is not in the buyers favor. The option buyer doesn’t have the luxury of time as they must be right about not only the direction and magnitude of a price move but the time frame in which it will occur.
Time is the option sellers friend but the option buyers enemy. Price action determines who the pressure is on over time.
10. Anything can happen.
Always accept anything can happen at any time. Don’t think something must happen or a market can’t go any higher or lower, it can. Many option traders have been ruined when what they thought was impossible happened, some examples are the Lehman bankruptcy of 2008, September 11, 2001, and Black Monday 1987. Many option traders were ruined on these dates when they did not hedge their short option risk or were simply overexposed with long options positions.