Making Money In Options
Perhaps a widespread phenomenon in the equity markets today is the leveraged use of options. Although most money is made selling options — the right to buy or sell the underlying instrument, the average trader has not reached the level of skill as necessary to gain consistent profits. Traders who believe a stock will go up in price typically buy call options — the right to buy; on the other hand, those who believe a stock will go down in price will buy put options — the right to sell. Since there are so many factors that go into selecting which option to purchase brokerages make their clients sign disclosures where they understand the risks involve grand losses. Trading options is definitely a tricky business.
There is, however, a way to participate profitably without having to learn complex formulas.
1. Only buy options with a minimum ‘delta’ of .80 — call option | -.80 — put option
The delta is simply how much the option premium is likely to move relative to the movement of the underlying stock. You’ll want the option to move as closely as possible. In the case where you’re wrong you’ll want to know as soon so you can to cut your losses and reexamine your trading plan from the safety of the sidelines. When you’re right it doesn’t take much – about a fifty cent movement to get into a profitable situation. Making Money In Options
2. Compare open interest between calls and puts — excessive open interest in either one ‘Beware’
Unsuspecting traders load up on cheap options believing this to be an opportunity. They fail to notice the overwhelming open interest associated with a particular option. Open interest is a good indication of sentiment and since the crowd is usually wrong this may be a great opportunity for sellers to profit through time decay. Time decay is an option seller’s best friend. Excessive open interest in the option you’ve selected, relative to the opposite direction, ought to serve as an indicator to reevaluate your trading plan.
3. Buy yourself some time — avoid trading options with less than one week left to expiration
During the last week leading to option expiration price action is typically volatile. Since the time factor works against the option buyer and it accelerates the closer to expiry it’s best to buy options with a later expiration month than the current one. Since you’ll need at least a fifty cent movement in the underlying stock you should allow enough time for your trade to materialize.
Bonus: If the long term trend is up — only buy call options | long term trend is down only buy put options.
Oftentimes people try to trade both directions on the same stock. Although this may be a profitable strategy for those glued to their monitors it makes trading more stressful than it should be. Identify the long term trend based upon the weekly charts and only trade in that direction. Making Money In Options