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5 Tips for the Option Buyer

April 25, 2011 by Nick Metzger| Tips & Strategies

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.

Options on Futures Contracts: A Trading Strategy Guide

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Filed Under: Tips & Strategies

About Nick Metzger

Nick Metzger serves as a Senior Broker with Daniels Trading. Nick earned his B.A. in finance and economics from Northwood University. Along with his success in the classroom, Nick excelled on the baseball field as a 4-year starter and team captain. Upon graduation, Nick carried his determination on the field to the financial markets. He began his career with a firm that specialized in option trading where he learned how to evaluate market fundamentals with a technical overlay for timing trades.

Craving employment with a firm offering more diverse execution services, Nick relocated to Chicago and joined Daniels Trading. Since joining Daniels Trading Nick has broadened his execution offerings. He now prides himself in matching clients assets with a wide array of trading opportunities including, broker execution, online trading, automated trading systems, and managed futures.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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Risk Disclosure

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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