Three Rules for Option Trading
I’ve gotten a lot of questions about how I trade options lately. Many of those questions are really roundabout ways of asking if I have any hard and fast rules for trading options. I don’t have many rules that I consider "hard and fast," but I do have three. So I thought I’d share them with you here.
Keep in mind, following these rules doesn’t guarantee you’ll make any money at all. In fact, you may lose money if you only use these three rules. I share them only so you can get a glimpse of my unique trading style. To make these rules work, they must be combined with an overall trading strategy.
With that in mind, here are my three rules…
- Don’t hold an option near term.
- Don’t buy out-of-the money options.
- Don’t hold an option until expiration.
The way these are written, it sounds like a list of what NOT to do. And it is. But these three rules can also be rephrased in a positive way…
- Only buy options with plenty of time remaining before expiration.
- Only buy options that are deep in the money.
- Always trade option contracts before they expire.
These are the only "hard and fast" rules I follow when trading options. From there, it depends on the underlying stock set-up. And there aren’t any black and white rules that address the dynamic forces in the market.
Said another way, there are additional rules that I use. But those rules depend on the stock, the set-up, the timing, and a number of other factors that require closer examination and interpretation.
Perhaps my rules offer a new perspective on how to trade options. After all, many of the experts will tell you to make trades based on the latest news or earnings reports. Personally, I advise against this. Certainly, you want to be aware of the news and what things are happening that affect stocks, but you don’t want to base trades on such transient and unpredictable forces.
Best regards always,
A.J. Brown
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Comments on Three Rules for Option Trading »
John Larsen @ 3:39 pm
I agree wholeheartedly! I am a real “newbie” but I like what I am hearing and reading. By the time I finish with my final options education with your help- watch out!
A.J. Brown @ 4:21 pm
John,
Thanks for the positive feedback! I really appreciate it.
Glad to have you as a reader.
A.J. Brown
putt4par @ 10:13 am
AJ,
There are a couple of trading services out there that promote using cheap, otm options, for short term trades. This goes against some of your rules, so I am wondering if you have tried some of these other services, and had a bad experience?
putt4par
A.J. Brown @ 10:43 am
Hi there putt4par, When you use Out-Of-The Money options, the option premium price is completely a function of the Time Value component. In other words, there is no Intrinsic Value. The Time Value Component is very much a function of volatility and time till expiration as well as many other smaller variables. When you deal with Out-Of-The Money options, the number of variables you are managing goes through the roof. Not only are you managing the variables that go into the underlying stock movement, you are also managing the many variables that influence the option premium price that is now only a function of time value. In other words, there are so many variables and the amount of uncertainty on each is so high, that you are better off guessing. I have been through and bought just about every course and service out there. I’m not sure if the one’s you are thinking about are particularly the one’s I’m thinking about… and, I’m always trying new courses… but, on a whole, I personally have found that these services are nothing more than targeted guesses where you place your trade and then pray and hope it works to your benefit. From a numbers game perspective, sometimes it works out in the end. But, for me, I prefer to be in a little more control. Hope my rant wasn’t too over the top on this one. I’m just very passionate about this topic.
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Ken Long @ 4:09 pm
Very accurate. This is the way that I have learned to respect options. Much like your answer to me under the questions blog, even thought the question was about selling calls. Thats alright I can already see how your thinking goes. And I agree.
Putt4Par, if you happen to read this. I have followed those other services. Thats how I started out. They can be exilarating, profitable, and dangerous. The gains look great on paper because the percentages are so high, but the risk is so great that if you follow proper money managment you can only take a small position. Therfor the dollar gains are often bigger using deep in the money options, which are much more managable. Just try calculating a stop on an out of the money option, they are all volitility and time.
boozwatt.com @ 12:42 pm
The Carnival of Smarter Investing #14…
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