Options Trading Explained
How to trade options
If you know how to trade stocks, you might think you know how to trade options. The two couldn’t be more different, so let’s here’s an options trading tutorial for those of you new to this game.
How to trade options
Options are short-term derivative instruments that have an expiration date: daily, weekly and monthly. For a full explanation of what options are and how they work, read this article.
To get started trading options, you need to know three things:
- The psychology of trading – it’s a mental game more than anything else
- A few basic trading strategies
- What is needed to start trading (software, cash reserves, etc.)
Psychology of trading
Two main emotions govern traders: fear and greed.
If you learn how to keep greed and fear in check, you can trade options over the long term.
You might wonder:
“Why do I only need to worry about fear and greed when trading?”
Well, you fear losing your money. We all do! Unfortunately, when you’re living in a fearful state, you are paralyzed. Opportunities will pass you by, and your portfolio will suffer.
You are also greedy when it comes to money. You want more! When you’re governed by greed, you’ll push the envelope and take on risk (sometimes too much) in order to build your wealth.
And that takes us to the next point.
The easiest way to shorten your career as an options trader is to make high-risk trades. No matter how good your analysis, you can never be 100% sure what the markets will do.
If you want to know how to trade options, take these three rules of risk management to heart. They will keep you in the game of options trading for the long-term:
- Only trade as much money as you can afford to lose. I suggest dedicating 1.5-2% of your portfolio to options.
- Diversify your portfolio across sectors (energy, financial, technology, biotech, healthcare, etc.), countries, and asset classes, so you can eliminate the risk of holding stocks that always move in tandem.
- Keep cash on hand so you can sleep well at night and so can jump into the next big trade. I suggest holding 25-30% of your portfolio in cash.
NEVER go all-in on a trade.
You might get lucky once, but the odds are against it.
How to trade options:
Basic strategies
The best way to learn how to trade options is to start by paper trading classic directional trades. When paper trading, you are not risking anything – except maybe your ego.
You simply use pen and paper to place a trade (aka, write it down). You follow the trade to make sure it’s going in the right direction (up or down) and you “sell” the trade when you have a profit.
Now, let’s talk about classic directional trades. These involve buying put or call options at a specific expiration price on a specific day. Calls increase in value when the price of the underlying asset rises, while puts increase in value when the price of the underlying asset falls.
(Read more about how puts and calls work here.)
As part of my trading service, I send out trade alerts to members every day. Here’s what an options trade looks like in real life:
Buy SPLK Feb 145 Call at 7.3
Let’s decode that:
How will I know when it’s time to sell the call?
When I have a profit, aka, when the price of one option is higher than $7.30. It might be 9.5 or even 15.8 when I sell. I don’t know right now. I will simply keep my eye on the trade and sell when I am ready.
The magic of trading options is the leverage. The $7.30 I paid for one option is only a fraction of the stock price (about 5%). If my direction and timing is correct, I can make a sizeable profit.
If I bought a put option, I will watch for the price of the stock and the option to go down.
Now, you might wonder when to place trades and when to sell them. Well, I am a technician. I know how to read charts and technical and sentiment indicators to understand what a stock is doing and what it might do next. A lot of this is based on experience.
One of the fastest ways to learn how to trade options is by learning from experienced traders in a supportive environment. That’s why we created our chat room, a community that helps you earn while you learn.
How to trade options: first thee steps
Step #1
First, you need to choose a trading platform. Brokers like TD Ameritrade, E-Trade, Fidelity and Interactive Brokers offer fantastic platforms for all levels of traders.
Look for these features:
- Easy-to-use with a full suite of tools
- Online or cloud-based, so you can trade from anywhere
- Competitive commission rates (many offer zero commissions!)
- Educational services, such as charting
- Compatibility with your computer’s operating system
Step #2
Buy three monitors. I have seen traders use as many as 30 monitors, which seems a little excessive. For most traders, three to six monitors are ideal.
Step #3
Commit to continuous learning. It’s the only way to grow and succeed as an options trader. Granted, there are an overwhelming number of blogs, webinars, books and podcasts out there. Find the ones that make sense and work for you – and commit to learning every single day.
Know Your Options
Looking for a “soup to nuts” options trading book, which includes a primer on technical analysis and risk management? Start by downloading a free chapter that will teach you how to analyze technical patterns.