Tip 1: Have an exit plan.
It seems very elementary, but some traders will spend numerous hours looking for opportunities to enter a market, but put no thought into how and when they are going to exit. Whether you base your trading decisions technically or fundamentally, you will need to know when you are going to take profits and when you are going to cut your losses. Just because you define your risk when purchasing options, this does not necessarily mean you have to risk it all. Technical traders should look for the area on the chart that proves a change in the markets direction and a point on the chart to take your profit. Fundamental traders should closely track the news that is driving the market and exit when these fundamentals change. Just like you don’t jump in your car without a destination, you don’t want to jump into a trade without one. Trading is emotional and your ability to articulate your trade parameters will only help your long term success as a trader.
Tip 2: Buy the time you need.
The beauty of options is their flexibility. Purchasing options allow for flexibility with the timing on your entry and the timing involved for the market to make its move. That being said, we pay for that time and flexibility. After all, the value of an option is derived from both its time value and its intrinsic value. The more time on the option, the more we are going to pay for it. So if we expect a market to rise or fall within the next few weeks, it does not make sense to buy an option that expires in 12 months. On the flip side, if you are looking for an extended move in a market that could take place over several months, then you want to make sure you buy enough time to allow for that to happen.
Tip 3: Don’t try to pick the tops and bottoms.
Don’t try to pick the tops and bottoms. Like many things in life, markets will tend to follow the path of least resistance. Just like a swimmer would prefer to swim with the current, a market prefers to follow its momentum. From time to time, we might convince ourselves that a market can’t go any higher or lower, but we must resist this urge and stick to our trading plan. Until there is a clear signal that the trend has ended, we must remain patient and wait for the reversal to be confirmed. Anything outside of this is option roulette.
Tip 4: Consider the market’s volatility.
An options premium is valued by its location relative to the underlying futures contract, the time left until expiration, and the market’s volatility. As an option buyer, we want to purchase an option when volatility is low. Increased volatility means that markets are going to trade in a much wider range. That being said, options will be rapidly moving in and out of the money, causing a spike in the options premium. Ideally, we will buy in times of low volatility to allow us to take advantage of the spike in premium if and when the volatility does increase.
Tip 5: Consider your delta.
Your option’s delta should give you a good idea on how your option is going to react to a change in the underlying. The lower the delta, the less the options value is going to fluctuate. The higher the delta, the more closely your option will trade to the underlying futures contract. An option’s delta will help you determine where you will want to be positioned based on the anticipated move. For more on delta, please see my previous article: Going Greek: Understanding Your Option’s Delta.