Options trading are the trading of options contracts. Options are contracts under which purchasers get the right but not the obligation to buy or sell an asset for a specific price before a specific date. While this may sound like vague propositions, options contracts are regulated and binding contracts with strict terms and conditions.
Under a contract, the purchaser has the option to buy or sell an asset. The purchaser does not buy the asset. The purchaser buys the option to purchase an asset which is called an underlying asset in options trading terms. The seller in does not have an option to hold on to the asset. The seller is obliged to sell at the underlying asset at the agreed price when the purchaser exercises the option.
Types of Options Trading
The two classes in options trading are, ‘Puts’ and ‘Calls’. When a purchaser exercises a ‘Put’ option, the purchaser has the right (but not the responsibility) to sell a predetermined amount of the underlying asset at a certain price called the, ‘Strike Price’.
When a purchaser exercises a ‘Call’ option, the purchaser has the right to buy the predetermined amount of the underlying asset, regardless of the current market price, at the strike price before the contract terminates. The seller is legally bound under the options contract to sell the underlying asset at the contracted price and cannot demand the market price.
Benefits of Options Trading
The main benefit in this type of trading is leverage. The purchaser can buy the underlying asset when the price of the underlying asset is high at the agreed price rather than the market price and sell the underlying asset at the market price to make a profit. The other benefit is protection. The purchaser is protected when the price of the original asset is low the purchaser will lose a specific quantity of the original asset at a fixed agreed price. By exercising a ‘put’ option, the purchaser can resell the original asset to the seller. Thus options’ trading has a built in insurance against the volatile movements of the market.
Shortcomings of Options Trading
Options’ trading comes with risks and is not for everyone. Options traders run the risk of losing their entire investment in a short period of time. Options unlike assets can lose value as the date of expiration comes closer. In some cases the risks involved in options trading are caused by restrictions imposed by government regulation.
How to Improve Your Options Trading
Here are 7 actionable steps you can start today to improve your options trading.
Learn and Master Options Trading Fundamentals
It is imperative that you understand the basics of options before you venture out and learn intermediate to advanced option trades. It’s the order in life. It’s the reason why we learn how to do basic math and subtraction before we go into division and multiplication.
You need to know everything about “puts” and “calls” — from how they work and when it’s best to use them. This also includes knowing everything related to them like expiration dates to where they are found on basic option tables. Skimming over the basics to get into more advanced trading is simply gambling.
Choose an Option Trade That You Love and Master It
A great way to improve your options trading is by mastering a bread and butter trade. Learn all the ins and outs of your practice by back-testing historical data, testing current conditions using paper trades, and reading about your favourite trade in books.
When you completely understand the intricacies of your go-to trade, then you’ll be able to better recognize situations and markets that your trade will flourish in. In turn, you’ll receive a higher probability of success and profit.
The key is to stick to a basic trade like an iron condor or credit spread. No advanced layered trades.
Read Books on Options Trading
Technically, they don’t have to be all about options trading since there is overlap in every investment book. The goal is to learn different approaches to trading the market. You’ll learn about things you have not known about before and you’ll even be able to refine your original trading strategy.
One great takeaway from reading books is that you can also learn more about the hidden trading factors you don’t see every day like investor psychology or market psychology.
Streamline Your Technical Analysis
If you are looking at 6+ more technical indicators and use multiple technical analyses concepts against other technical analyses concepts, then you’re probably doing yourself a disservice.
Simply learn and use the basics like MACD, support/resistance, trending channels, divergence/convergence, and moving averages.
Wait for Opportunities
This is a huge problem for novice traders. It was even an issue for me when I started trading. I would have a few stocks on my watch list that I wanted to get into, but knew it wasn’t the right time. And then when I’m not looking the stock takes off. On a few occasions, I have actually chased stocks that eventually turned against me.
These types of situations hurt in 2 ways: 1) dents your ego and 2) dents your portfolio balance.
If you have the same issues, don’t fret. Luckily, it’s been well documented that more often than not, solid annual portfolio performance is often caused by having a strong exit plan.
Document and Learn From Your Previous Trades
Every trade is a learning experience. Don’t focus solely on losing trades, but also look at your winners. There is always something you can learn.
For losing trades, look into why the trade lost or possible ways you could have prevented it from happening. Analyse your entry, the adjustments you made, the exit, and the overall market behaviour.
For winning trades, look into why the trade won and possible ways you could have even profited more. Analyse your entry, the adjustments you made, the exit, and the overall market behaviour.
If you notice, it’s the same analysis for both types of trades. After a few trades, you’ll begin to recognize key characteristics to why some trades win and why some trades lose. From there, you’ll be able to recognize what adjustments need to be made in order to mitigate a loss or increase profit gain.
Continue to Learn From Successful Traders that still Trade
When you have a mentor, they will often look over your shoulder and ensure that you are setting yourself up for the best trade possible for the current market. You’ll know that their advice is sound when you see them trading their own recommendations.
I find that it’s quite suspect to receive trading advice from someone that doesn’t trade themselves.
If you don’t think you need on-going options trading education and assistance, ask yourself these questions: Why do professional athletes have coaches? Why do Fortune 500 companies hire consultants? Why does the President have advisers?
The answer to all of these questions is simple:
Mentors hold you accountable, help you define & reach goals, are on the outside looking in, and they can provide a wealth of knowledge when dealing with the subject matter at hand. Basically, mentors help you become better traders.
If you are serious about options trading, then it’s worth your time to try a few of these steps out today. The more you hone in and apply a laser-like focus on your skills, the easier it will become to identify opportunities to make money in the market.