Options: the quickest way to win

... or die.

First of all, options trading has a very bad press.  It's looked as a very risky and complex investment. Even the SEC forces brokers to ensure that the traders starting on this read the document "Characteristics and Risks of Standardized Options", prepared by the Options Clearing Corporation (OCC), that explains the high risks involved.  Some brokers also evaluates you to see if you have enough financial support and experience to assume the risk.

As with any other type of investment, risk is created by the lack of knowledge. So, if you just start trading options blind and wildly, for sure you will lose money.  Our advice is to invest first your time rather than your money.  Invest tons of time acquiring knowledge on options before even dreaming to stake a cent on this.  After you think that you understand the details, paper trade options to learn the mechanics.

Another myth on options is that they need high mathematics, and therefore, they are hard to learn.  Although the first part is true (it's not rocket science, though) -- but you don't have to deal with the formulas by hand everyday to trade.  The formulas gives you a better knowledge on the concepts, but for trading will have to apply the concepts, and yes, some formulas, but nothing that a spreadsheet cannot handle easily.

This page is not plenty of details of options.  There are a lot of other pages with very didactic material.  We will give you just a summary and will direct you to the best pages to learn about options.

Here's our recommended path for learning on options for the small trader:

1. Basic concepts and terminology. American vs. European options. Exercise options.

2. Basic strategies (naked call, naked put). Nomenclature. Expiration day. Profit / price graphs.

3. In-the-money, at-the-money, out-of-the-money, near-the-money.

4. Intrinsic Value - Implicit Value. When an option is "cheap" or "expensive".

5. Some Greeks: Delta, Gamma, Theta

6. Historical Volatility - Implicit Volatility.

7. Advanced strategies: straddle, strangle

Of course, options trading don't end there.  There are more advanced strategies, but they are not of the interest of the small trader due to the high investments required.

Our preferred sites are: Investopedia and Option Trading Tips. 

Please go and read these pages before continuing.  Be sure that you understand the topics indicated above in recommended path.

Options for the small trader

If you read all of the above you already know some stuff.  Here are some advices for you, as a small trader:

1	Firstly, be careful.  Options is a zero sum game.  That means that when you win, someone else is losing.  There are big players in the game that are plenty of resources and knowledge and that normally they extract money from the game, basically from inexperienced or manipulable players.  That's you.
2	Be careful with the leverage you assume.  Yes, with the proper leverage, you can duplicate the stake easily in days, but also you can loose all of it at expiration time.
3	Avoid playing near-to-expire options, or very out-of-the-money options and if you do, be prepared to lose all your investment.  Their cheap prices can be very attractive, but here the risks involved are very high.
4	Look for options with near-to-zero theta, and near to at-the-money strikes. Normally this implies to buy options to expire in at least 9-12 months and no more than 2 strikes apart.   Any option with less than 6 months to expire is a candidate for selling, as the time decay will start killing you.  With 3 months to expire, selling is urgent as the time decay accelerates.
5	Always compare the Implicit Volatility (IV) with the Historical Volatility (HV).  If IV < HV, the option is cheap, otherwise is expensive.  If you buy an expensive options, you have to have a very strong feeling that the underlying will move in your direction in a reasonable period of time. If not, just avoid it.
6	Analyze the underlying, not the options.  Review the fundamentals and recent price chart. First, you select the stock and decide  (predict) its future movement and time frame. Then, you see which options are available at a cheap price (in the sense indicated above) for that underlying.  Then you make your money management calculation to decide how much to invest (and if you can afford it).
7	Be very disciplined with your stop loss.  For options near-the-money, with a delta around 0.5, a good advice is to put your stop loss in a half of your option entry price.  This means that if you bought a contract for US$ 500 (price=5), you should set your stop loss at 2.5.  It is a good idea to calculate if that stop loss can be hit easily due to the regular "noise" movement of the underlying (regular noise movement = up to 2 x ATR).  If that is the case, don't enter the trade, it's too risky.
8	Also, establish stop loss based on the price of the underlying.  If the underlying hits and surpasses a resistance or support level that indicates that you were wrong in your prediction, sell the option no matter if the option stop loss price haven't been hit.   Sometimes the market reacts slowly and the option price remains high for a while due to the IV, but you have to sell anyway as the underlying is showing clear signs of failure.  You can accomplish this with conditional orders.
9	Always exit a profitable option position by using trailer stops.  Normally, you should be satisfied with your profit if the option price hits the double price you paid for it.  On very rare occasions, it will get a price 2.5x or 3x.  Our advice is to start a trailing stop when the price gets the 1.5x or 2x levels.