11 (Core) Tips for Stock Options Trading Success + Video

Interested in Trading Stock Options? These 11 Key Starter Tips will keep you on the right path. What are Stock Options, Calls, Puts, Expiry… and much more.

This Article, Video, and Podcast cover important knowledge of Trading Stock Options:

  • How Stock Options Trading Works & Risks & Rewards?
  • What is the Difference between Stocks vs Options?
  • Included are my Top 11 Tips and Mistakes to avoid.

Recently I received an email from a registered student regarding Stock Options.

He asked me
“Do you have a system that can help me make money in Stock Options”

He had invested in training, but the training was mostly about how to follow a specific stock options system.

My reply was:

“My advice to you is to invest in your education so you can truly understand how to evaluate stocks and how to make decisions on the future direction of a stock.  Also before you use options you need to be able to make money with regular stocks.

Options have risks (time is always against you) and you need to be able to judge the direction of the stock market as well as the direction of an individual stock.”

What are Stock Options?

Stock Options share some similarities with futures contracts and with normal stocks, but they are inherently different.  Options are simply a contract, you do not own the underlying stock that determines the value of your options contract.  Unlike stocks which you can hold indefinitely, options contracts all have an expiry date, and the closer to the expiry date you get the less your option is worth.

As you do not actually own the stock only a promise to pay the difference between the stock price now and the stock price at some point in the future you will see that the options contract cost as little a 2% to 20% of the cost of owning the stock.

Stock Options are simply a vehicle to achieve a goal.  For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

The best way to understand options is to run through an example.

Stock Options Versus Stocks

For example.  You have $1,000 to invest.

Strategy 1 – Buy the Stocks

You could buy 5 shares of Amazon Inc. (Ticker:AMZN)  at $200 per share.

Total Costs $1000

If Amazon moved up 10% over the next 2 months to $220.

Your profit would be ($220 – $200) = $20 per share.  5 Shares * $20 = $100

A 10% gain.

Strategy 2 – Buy Options on the Stock

You could by one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2013.  The contract value is $10 per share.  Because you will control 100 shares with each contract and you buy one contract, your costs for the trade are $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • At the money means the strike price of $200 per share is equal to the actual stock price.
  • Strike Price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In the same scenario as above the stock price moves 10% to $220.  The difference in price is $20 per share.  The contract was at a strike price of $200, therefore $220 – $200 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000.  A $2000 gain from a $1000 investment.  This means a gain of 200%.

I say theoretically because when you buy an option the clock starts ticking on the time value.  If the stock price took until the final month before expiry to move to $220, then you would have lost all of the time value of the contract which could reduce your profits.  However, if the stock had moved 10% in a single day you would have secured almost all of the 200% and also kept much of the time value in the stock.

What are the risks of options, compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment.  With stocks this is quite rare, stocks rarely move to zero unless the company goes bankrupt.

If the stock price does not move at all in the time period, your investment can also expire worthlessly.

The stock needs to move in the direction you place the bet to make a profit.  If the stock price moves strongly your profits can be quite large.

Strategy 3 – Shorting a stock using options.

Using the exact same scenario but instead of us expecting the stock to increase in value we expect it to decrease.

AMZN has a current stock price of $200

You could by one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2018.  The contract cost $10 per share and there are 100 shares in a contract.  Cost of investment is $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • “At the money” means the strike price of $200 per share has already been reached.
  • Strike Price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In this scenario, the stock loses 10% in value to $180.  The difference in price is now $20 per share.  The contract was at a strike price of $200, therefore $200 – $180 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000.  This means a gain of 200%.

Trading Stock Options Strategies

Stock Options are simply a vehicle to achieve a goal.  For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

For example.  I have $1,000 to invest.

Strategy 1 – Buy the Stocks

I could buy 5 shares of AMZN  at $198 per share. Total Costs $990 + trade costs.

If Amazon (Ticker: AMZN)  moved up 5% over the next 2 months to $207.90.

My profit would be $9.90 per share = $49.50

Strategy 2 – Buy Options on the Stock

I could buy 1 Out of the Money Call Contract for AMZN with a strike price of 200 and an expiry date of May 21 2018

In options speak:

  • 1 contract means I will have control over 100 shares of AMZN
  • Out of the money means the strike price of $200 per share has not been reached
  • Strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date on which the option Contract expires and loses all value.

In the same scenario as above the stock price moves 5% to $207.90.  The difference in price is $9.90 per share.

Theoretical profit would be 100  X 9.90 = $990.  This means a gain of 100%.

I say theoretically because when you buy an option the clock starts ticking on the time value.  If the stock price took 2 months to move to $207.90, then you would have lost all of the time value of the contract which would dramatically reduce your profits.  However, if the stock had moved 5% in 1 day you would have secured almost all of the 100%.

What are the risks of Options compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment.  With stocks, this is quite rare.  If the stock price does not move at all in the time period, your investment can also expire worthlessly.

So in order to share some of my experiences with Options, I have created this Top 10 Tips

11 Core Tips for Stock Options Trading Success

Tip 1 – Understand Technical Analysis

Before trading a single Stock Options Contract you need to understand Technical Analysis.  Not only that, you must have a strategy that pays off.  This means you must have already developed a profitable stock market strategy through which you make a profit.  If you cannot make money in stocks, then you will lose all your money quicker with options.

Tip 2 – Understand Fundamental Analysis

The fundamentals of a stock do have an impact on the direction of a stock.  You need to know what makes a company a good investment and what makes it a bag of garbage.  Do not bet against the fundamentals

Tip 3 – Time Counts Against YouTime Counts Against You In Stock Options

You need to be sure before placing an Options Contract that the stock is going to move before the contract expires.  You will look for more volatile stocks or at least stocks with a strong trend and increasing volume.

Tip 4 – In the Money Options, Out of the Money Options

Understand the additional costs of buying an option in the money as opposed to out of the money.  When you buy an “In the Money Option” it means there is already some intrinsic value in the contract.  This you will pay for in the contract price. Alternatively “Out of the Money Options” are cheaper, but it does mean that the stock price has further to move before the strike price is hit and the option’s intrinsic value is improved.

Tip 5 – Understand Calls & Puts

A Call Contract means you expect the stock price to increase and therefore seek a profit relating to the increase.  When you buy a PUT Option it means you expect the stock price to fall and therefore realize a profit based on the decrease.  This is rather like shorting a stock.  You need to be sure of the direction of the stock.

Tip 6 – Buying Calls & Puts

If you are new to Stock Options Contracts you really need to be a Buyer of Contracts.  In this way, you limit your risk to the amount you have bet on the contract.  Unless you have expert professional skills you should only be a buyer of contracts.

Tip 7 – Selling Calls and Puts – Don’t Do ItBe careful when selling options contracts

If you are the seller of an Options Contract you have the benefit that time is on your side.  Your goal is that the option expires worthless.  Your reward is simply the value you get from the Contract you have underwritten.  However Beware, as a seller of contracts you are taking huge risks, because you will need to pay out an almost unlimited amount if the stock skyrockets and you sold a Call Contract.  Also if the stock price plummets and you sold a Put Contract you will also have huge liabilities.

Tip 8 – Don’t Get Too Complex

When you attend a seminar on stock options they will fill your head with all sorts of complex strategies like Vertical Spreads, Straddles, Bull Spreads, Bear Spreads and Box Spreads.  If you make your trading complex you will not make any money.  Keep it simple.

Tip 9 – Liquidity Matters

Before buying any Options check what the open interest is.  This means try to find out if there is a liquid market in the contract.  There is nothing worse than buying an Options Contract and then you have the shock that it is immediately almost worthless because no one is trading it and no one wants to buy it.

Tip 10 – Profit Volatility

Be ready to see some serious fluctuation in the profits or loss on an option.  Sometimes I see wild swings in potential returns.  An option can show a 25% profit in a few minutes, only to show a 20% loss a few hours later.  An option is a leveraged investment that magnifies your gains and losses.

Tip 11 – Cash Allocation

Do not place your entire investment pot on any single Options Contract.  Use only a portion of your money on options and of that portion do not invest more than 10% or 20% in any one contract.  Remember if your contracts expire worthlessly and you lose all your money, then you have no more chips and you have to leave the table.  You do not want that.

Stock Options Summary

Options are a complex instrument, but the more you understand them the more they make sense.  With experience, you will see that they are an incredibly flexible investment tool.  However, before even thinking about trading options you will need to understand how to pick stocks, evaluate the market direction and formulate a strategic systematic approach to investing.

Options are incredibly volatile and can very quickly lose your entire investment. Options are a numbers game and should only be used by advanced traders who have received specialist training in the topic.

Options are a great tool for magnifying your rewards, but you really need to be a successful stock trader before investing in Options.  Learn how to make money in stocks before you use any leverage on your portfolio.  Try the Liberated Stock Trader PRO Training before you research Trading Options.

Also, a great book to learn more about options is Getting Started In Options by Michael C. Thomsett in our 20 Best Stock Investing Books

Listen to Our Stock Options Podcast

Podcast 009 – Stock Options Trading Top 11 Tips

How Stock Options Trading Works. Included are my Top 11 Tips and Mistakes to avoid.

  • Published: Sun, 25 Mar 2018 23:00:00 GMT
  • Duration: 00:09:54

 

Summary
Tips for Stock Options Trading Success
Article Name
Tips for Stock Options Trading Success
Description
Tip 1 - Understand Technical Analysis Tip 2 - Understand Fundamental Analysis Tip 3 - Time Counts Against You Tip 4 - Understand In the Money & Out of the Money Options Tip 5 - Understand Calls & Puts Tip 6 - Buying Calls & Puts Tip 7 - Selling Calls and Puts - Don't Do It
Author
Publisher Name
Liberated Stock Trade
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