The options market offers both great opportunities for profit and the possibility of loss. Here are ten things I quickly learned through experience that all new traders should be aware of before they begin trading options.
1. Understand how to lose an option trade safely.
The loss on a losing option trade should be limited to the hedge or stop loss level. A trader should never lose more than 1% of their total trading capital on a single option trade. The position size for most long option trades should be between 1% and 2% of total trading capital.
To have a real price level that is technically meaningful, stop losses should be set on the stock chart rather than the option price. Long option risk must be managed primarily through position size, as options can expire worthless. Don’t overtrade or let a losing trade spiral out of control.
2. Patience is an advantage for option sellers but a weakness for option buyers.
Because theta decays daily, an option seller has the advantage of running out the clock on the option buyer if the move is not in the buyer’s favor. The option buyer lacks the luxury of time because they must be correct not only about the direction and magnitude of a price move, but also about the time frame in which it will occur.
Time is a friend to option sellers but an enemy to option buyers. Over time, price action determines who is under pressure.
3. Trade options consistently, but adjust to market conditions.
Consistently trade your system based on your parameters and signals, but don’t take the same types of risks in all market environments and on all charts. Keep an eye on the current market trend of price action and volatility, and adjust size and directional bias to follow the path of least resistance.
Not all market conditions are appropriate for all types of option plays. Understand the distinction and manage option plays accordingly.
4. The most important fundamental for options trading is liquidity.
Only trade in high-volume options to avoid losing a large percentage of your capital on the bid/ask spread when entering and exiting trades. You must trade on option chains that have the liquidity to trade spreads in cents rather than dollars. In addition to commissions, a $1 price difference in the bid/ask spread will cost you $100 to enter and exit a trade.
Also, keep in mind that the best liquidity is in front-month at-the-money options, and option chains become more illiquid as they go deeper in-the-money or out-of-the-money. This must be considered in a winning trade because you may need to roll the option to a more liquid contract. Also, the closer you get to the expiration date, the less liquid the options become, with wider bid/ask spreads. Most option chains cannot be traded because they are insufficiently liquid.
Stick to the top stocks with the most liquid option chains; this makes it much easier to get in and out while avoiding all the small costs in the spreads.
5. Don’t allow a losing option play to spiral out of control.
Before you enter any option play, define your risk. Set capital risk parameters as well as delta, gamma, and theta exposure. Manage risk exposure by moving hedges, rolling options in time or strike, or closing option legs, regardless of the option play.
Always be aware of the current risk/reward ratio in an option play and close it when the risk outweighs the reward.
6. When there is no hedge, short options have an unlimited risk.
It is critical to comprehend the asymmetric nature of option contracts. Long options have a limited downside because the total risk exposure is the contract’s purchase price. This is the most a long option trader can lose, but a contract can increase to any profit price. In terms of magnitude, long options have a favorable risk/reward ratio.
An unhedged short option contract, on the other hand, has the reward limited to the price at which the contract was sold, but the price can go to any level, creating unlimited risk in the absence of a hedge or stop loss set at a buy to close level. Holding a short option contract with no hedge in place can be extremely risky, which is why professionals almost always hedge short options with a cheaper long option or the underlying stock position.
Many legendary traders and hedge funds have been blown up by short options. They may have a high win rate, but a major risk event can wipe out all of their gains. Hedges are low-cost disaster insurance. Always keep risk in mind.
7. Experiment with different watchlists, signals, and plays.
To trade options, an option trader needs a diverse watchlist of option chains with a variety of plays to choose from based on the current market range and trend. The more types of edges you have to execute, the better your chances of success in various market environments.
8. Keep your option trading as straightforward as possible.
A day-to-day option trader does not need to create complex 4-legged option trades to make money. To profit from the options market, a trader only needs a simple repeatable edge. Complexity can introduce risk and unneeded activity. With options trading, only probability, volatility, repeatability, profitability, and risk/reward ratio matter. Profitable options trading can be as simple or as complex as you make it. All that matters is the edge.
9. Option trading theories and live trading are not the same thing.
Due to ego and emotions, learning about options and trading them are very different experiences. Research lacks the element of risk and uncertainty that real capital does.
Be prepared for the stress, emotions, and ego that will accompany capital at risk; don’t let it catch you off guard. Begin with small position sizing and gradually increase it. Prepare to manage your emotions in the markets.
10. Anything is possible.
Accept that anything can happen at any time. Don’t believe that something must happen or that the market cannot go any higher or lower; it can. Many option traders have been ruined when the unthinkable happened, such as the 2008 Lehman bankruptcy, September 11, 2001, and Black Monday 1987. On these dates, many option traders were ruined because they did not hedge their short option risk or were simply overexposed with long options positions.
Paraphrased from original report at https://www.newtraderu.com/2022/08/27/options-trading-tips-ten-things-i-wish-i-knew-before-i-started-trading-options/