Option trading is not for the faint hearted because it entails risk and you must be risk tolerant. I am sharing these rules from my 30+ years of option trading experience with you so you can get a feel for my technique. I prefer to use spreads since the sell side reduces my exposure and finances some of the trade.
I don’t like to trade news but prefer fundamental analysis to determine the strength of the stock and technical indicators to confirm the direction (call or put) of the trade. The news will not affect a strong stock for long. Remember good stocks fall on market news and sometimes fall in sympathy with bad stocks but do rebound faster.
- Options Time – Always buy enough time for your options trading strategies to work. Don’t buy near term options unless your trading style is that of a riverboat gambler. I like to open call spreads and put spreads that have 90 to 230 days left before expiration. Options like stocks are affected by economic and political factors. The difference is that you can continue to hold a stock that turns down and wait for it to come back. With options, the clock is ticking and you must close them or they expire worthless. It’s much better to close a losing position at a small loss than wait for it to expire for zero and a big loss.
- Options Trading Discipline – Always watch your option trades and if the strategy is not working get out and move on to another trade. Never fall in love with a stock or option, close the position if time is running out and it’s losing money. Never hope that it will get better if you are 60 days or less because it usually doesn’t get better. Don’t hold options until expiration – close your position before expiration and the sooner the better. Don’t let them get to zero. Try to keep losses small.
- Options Volume or Open Interest – Always buy stocks or options with high volume or high open interest so that there is a market and price advantage when you wish to exit the position. Thinly traded stocks don’t increase in value as much or as fast as actively traded stocks. If you are looking at options over 90 days look at the current month option and open interest for clues to what it will be 90 days or more from now. If the open interest is weak in the current month, the probability is that it will also be weak in the future month.
4. Options Price – Option call spread or put spread prices can be very close from one month to the next. If you add another 30 days, it might be pennies a day and yet you have 30 more days for your strategies to work. If you use spreads, buy in the money options and sell out of the money options. Put the odds in your favor.