Anytime nonprofessional investors are part of a major investment trend, Wall Street’s commentariat warns that surging stock prices will soon fall from grace faster than Jerry Falwell Jr. But what really annoys them are the masses horning in on the action.
Sneering at the newly minted Robinhood and Reddit hordes trading options on stocks like
(MSFT) doesn’t do anyone any good. I prefer to share some tips on how best to play the game.
Consider this an options trader’s primer aimed at helping the increasing number of investors who are learning one of Wall Street’s greatest secrets: Options can help you better navigate the stock market.
• Have an investment thesis. Know why you are doing what you are about to do. Focus on events like earnings reports or product launches and try to figure out how the underlying stock might react.
• Use your opinion on the stock to decide whether you will buy or sell a call or put option. Don’t delude yourself into thinking you have an educated view of options contracts until you have traded for a few years and understand how the stock and options markets work with each other.
• Focus on options that expire in three months or less. The sweet spot for many investors is about 30 to 45 days, which is enough time to benefit from time decay (more on that later) and for your stock thesis to work itself out without paying top dollar.
• Before you buy or sell options, divide the contract’s implied volatility by 16. This will tell you what the options market thinks the stock will do each day through expiration. If the call has an 80% volatility, the call is priced as if the stock will move 5% each day until expiration. If you think the stock will move more, buy the contract, If you think it will move less, sell the contract. The Rule of 16 is a powerful tool.
• Good trading is about understanding events and how they are packed into your expiration. Understand everything that could happen to move the stock during your chosen expiration cycle, such as earnings reports, and anything that could move the entire market, like Federal Reserve meetings, elections, and economic reports.
• Options contracts lose a little value each day. Time decay, or “theta,” is a powerful force that can be monetized by options sales. It’s also the reason that many investors try to trade options that expire in under a month. No one wants to pay a time premium, which you can think of as the inventory carrying cost for owning options.
• If you are thematically confident on a stock but unsure on the timeline, many institutions buy options that expire in a year or more to rent exposure to the stock. If the stock goes up, the call goes up. If the trade fails, options always cost less than the associated stock, which means that options, when well used, help investors limit risk.
• Don’t be a pig. If you make 50% or more on your initial trades, take profits. If you make 100% or more, definitely take profits. If you are so convinced that the market is wrong and you are right, take out your initial invested capital so you are playing with house money.
• Be afraid of excess leverage. Options contracts represent 100 shares of stock. Don’t trade 10 contracts if you cannot afford to cover 1,000 shares of stock. All tyros should trade one or two contracts at a time until they develop some mastery of basic trading rules. Never trade “naked” contracts that aren’t covered by cash or stock.
• Simplicity is everything. Avoid strategies with many moving parts. Many seasoned options traders focus on hitting singles and doubles, creating significant income for themselves. Master buying a call and put and selling a call and put, and then consider spread strategies. Optionseducation.org is a free site that will help you learn more.
When in doubt, remember: Bad investors think of ways to make money. Good investors think of ways to not lose money.