The Five Commandments of Options Trading

The Five Commandments of Options Trading
January 13, 2022 Market Traders Institute

Master traders Tyson Clayton and Chris Pulver are the creators of the groundbreaking Equities on Demand training program which seeks to help you master your equities and options trading game. For more information, watch our Equities on Demand video.

Options have become popular among experienced stock traders as well as novices in the market. They provide traders with flexibility in managing their portfolio and also can help in potentially capturing higher profits.

However, contrary to popular belief, options are not as simple as they are made out to be by some traders. While many think the options market can quickly shoot up their capital, this segment is more complex than stock trading and many traders end up losing money in no time.

That’s why it’s important to have a few rules and strategies in place before you venture out in this segment of the market.

In this article, we will take you through five commandments that we believe options traders should follow in order to try to minimize risk and maximize potential rewards.

Here we go…

#1: Plan Your Trades

This might sound basic, but it helps a great deal in options trading. Because options are vulnerable to time decay and they lose a bit of value every day you hold them. So, time is of the essence and one can attempt to avoid a lot of trouble and losses if the trades are well planned.

With each trade, you should know your…

  • Reasoning and forecast for the options trade
  • Options strategy to follow
  • Position sizing
  • Entry and exit levels

Other than the above, one should also set the holding period for every option trade. That’s because holding the trade for too long decreases the probability of making money.

So, setting the holding period for each trade according to its expiry can be helpful. For instance, carry trades can have longer holding periods and the same should be shorter for the trades in their expiration week.

#2: Mind the Leverage

This step is crucial in options trading because of two reasons. One, you’re trading in an already complex market and added leverage makes things more complex.

And two, trading with leverage can be highly risky in options trading as it can wipe out a large chunk of your invested money very quickly.

Remember that options trading provides its own kind of leverage with unique risk factors. And these factors should be carefully considered before entering any trade.

While trading with leverage, always consider:

  • Total Loss: Options buying may provide greater upside leverage, but there’s a huge cost involved which is the potential of a total loss of investment.
  • Hidden Costs: The costs of options are hidden in things like time decay and leverage only increases them.
  • Margin Requirement: This is the amount of money you should have in your trading account to cover any potential liability you may incur while trading options. And while dealing with leverage, one must check the margin requirements and the costs that may be incurred if they aren’t maintained.

#3: Mind Your Position Sizing

Position sizing involves deciding how much capital you should deploy to an options trade. And it’s important because putting huge capital in one trade will mean blowing up all your invested funds in a matter of days or months.

As options have a very small shelf life, one should only allocate a certain percentage of the total funds to a particular trade. This helps you sustain consecutive losses and be in the game even if any trade doesn’t work as expected. Moreover, it helps spread out your risk and lowers the risk of huge losses.

For instance, position sizing may look like allocating 5% of total funds per trade with an overall allocation of 10% at any given point in time. That means with a $1,000 capital, not more than $100 can be allocated to any single trade.

#4: Have an Options Trading Strategy

The process of trading options can seem complex at times. But it can be made a lot easier by approaching options with a strategy in mind.

There are many strategies which show you the various ways you can trade options and thereby manage your risk and potentially increase your odds of winning.

A few basic options strategies one should learn about are:

  • Long Call
  • Long Put
  • Short Put
  • Covered Call
  • Married Put
  • Protective Put

Some of these strategies involve using options to place a directional bet with a limited downside if the bet goes wrong, while others involve hedging strategies laid on top of existing positions.

Apart from the above, your strategy should include a checklist of parameters that need to be met before placing any trade. This list can include the minimum liquidity level for any trade, sector diversity, maximum level of risk, and more such checks as per your personal preference.

#5: Have an Options Trading Mentor

Options trading isn’t easy and learning to trade by yourself can get confusing and difficult at times. That’s why we believe it’s crucial to have an options trading mentor.

Learning from a mentor who has traveled down the rocky road of options and knows the nitty-gritties can help you take your trading skills to a whole new level.

An options trading mentor can help you…

  • Learn various options strategies
  • Take you through basic concepts and terminologies
  • Choose the right tools and platforms to trade options
  • Develop the right mindset for the options market

…and guide you through many other such lessons.

All these learnings can help you lay your foundational bricks to a solid options trading education and set you up for what could be a successful options trading career.

If you want to try to become a successful options trader, let our analysts here at Market Traders Institute be a mentor to you.

Our senior analysts – Tyson Clayton and Chris Pulver – have co-created the Equities On Demand Trading Room, which we believe is the best place to learn and trade options.

The trading room provides various tools, resources, and simple steps for you to apply Tyson and Chris’ top stocks and options strategies.

For more information on MTI’s stocks and options trading education program, watch our Equities on Demand video.

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