Four Must-Know Rules to Profit from Options

By: panny1

Whether you’re a novice options investor or you’ve been trading options for years, four simple rules could mean the difference between serious gains and major losses. Here’s everything you need to know to go from optionless to an options whiz…

Every day, scores of novice options investors get burned. It’s not because they’re bad investors, it’s simply because they’re not following the rules. There’s no question that options are tricky – it can take years to learn precisely how options work – but that doesn’t mean that understanding the options game is out of reach, or that it’s relegated to the big guys on Wall Street.

Despite their complexity, there’s plenty of reason to pay attention to options. Options provide incredible amounts of leverage with relatively limited downside. That leverage means that a relatively small increase in a stock’s share price can turn into a potentially huge gain in an option for that same stock. Just look at shares of the ProShares Ultra S&P 500 ETF (NYSE: SSO), a 5.3% climb in that stock over the course of just two days in July turned into a 28% profit for investors who bought one strike of that fund’s September call options.

Put these four must-know rules into play, and your chances of booking profitable options plays increase exponentially…

1. Think About Value, Not Just Price

Most people think that options prices (also known as premiums) are tied to the prices of their underlying stocks, but that’s not entirely true. Like stocks, options trade on the open market, which means that technically, options investors themselves set the prices of options through their
bid and ask prices.

That doesn’t mean that you’ll see an option trading way out of line with its underlying, but it’s certainly not uncommon to see examples of options prices that don’t mesh with what their values should be.

That’s because unlike a mutual fund or ETF, which is priced based on the value of its assets right now, options take extrinsic variables, like the time value of money into account. There are a number of ways to value an option, including the Black-Scholes model and the Monte Carlo method, but if you want to avoid the mathematical formulations, most financial websites and trading platforms can come up with an option value almost instantly. Use that price as a starting point when you decide if an option is worth your time.

2. Don’t Get Greedy, Use Goals

“Hogs get slaughtered.” No, that’s not some sort of farmyard to-do list, it’s a phrase Wall Streeters use to remind each other – and themselves – that greed is the fast track to serious losses. It’s all too common for investors to hang onto a winning position too long, hoping for a few extra points, only to see those gains reverse themselves. That’s especially true of options, where a position can swing from a double-digit gain to a serious loss overnight.
Now, that doesn’t mean that you should sell your positions off as soon as you’re up more than 5% — goals are the secret to beating this pitfall. Get a grip on greed by setting your target gains before you enter a position, and stick with them unless something fundamentally changes in the underlying stock.

3. Take One Play a Week

The only way to make money on options is to play them – and to keep making options plays, even if you’ve just picked a loser. After your first bad trade, it’s incredibly easy to give up and just stick to stocks. But that’s a huge mistake. The only way to learn how to use options profitably is to use them often, so always try to make a new trade every week.

If money’s the issue, it shouldn’t be. There are scores of “paper trading” platforms out there – many of them free to use – that let you make hypothetical trades without risking your real-life capital. Trading paper for a while can help build your options investing skills until you’re ready to put your cash back on the line.

When deciding on which paper trading platform to use, it’s best to go with a broker. Many brokerage firms (including Thinkorswim, Scottrade, and optionsXpress) will let you test-drive their actual trading platforms with a practice trading account. Using the real platform means that the gains you get in the virtual world will mirror the gains you can expect when you switch to real money – and it also means that you’ll get used to your broker’s software and tools.

4. Understand Options Greeks

When you hear traders talk about the Greeks, they don’t mean Plato or Socrates.
They’re talking about the series of calculations that are used to determine the value of options. The calculations are designated by various letters of the Greek alphabet, from which they get their name.

On our agenda today is delta.

Every option, whether call or put, has a delta attached to it. Generally you can find this information on your broker’s Web site.
A call has a positive delta, and a put has a negative one.

If an option is at the money, usually the call option will be a delta of +.50 and the put option will be -.50.

Thus, if the GBP/USD is currently trading at 1.6400, the 1.64 call option has a delta of +.50 and the 1.64 August put option has a delta of -.50.

As the pair moves up in value (that is, the sterling appreciates against the dollar), the sterling calls will increase in value. As of this writing, they are trading at $2.51 x $2.63. With the delta at +.50, that tells us that for every penny the sterling increases in value (which would be measured as 100 pips), the option will increase 50 cents. Thus the delta is the measure of the rate of change in the value of the option as compared to the value of the underlying asset.

The reverse is also true. If the spot price fell 1 cent, or 100 pips, the value of the put option would increase by 50 cents.
We also have another inverse relationship to consider. If we are holding put options and the spot price increased, the value of the put option would FALL by 50 cents. Same is true of the call. A 100-pip or 1-cent decrease in the underlying spot price would make the option fall by 50 cents.

So if the pound is at 1.6400, and we are looking at the August 1.64 calls, let’s say we go ahead and we buy them right now at $2.63 ($263). We believe the sterling is going to rise and the options are going up in value. If the spot price goes to 1.6500, we can expect the call option to move up 50 cents in value to $3.01 x $3.13, giving us a return of 38 cents per position.

However, at that level, the delta has changed (actually it always changes as the price changes, but for the sake of simplicity we won’t go into that detail). At this point the delta is nearly +.60. So now for every cent the spot moves up, our option will increase by 60 cents. By the time that the call option is deep in the money, it will have a delta of 1.00. That means that for every 100 pips, or 1-cent move, in the spot, the option will move a corresponding 100 cents. The same is true for a deep in-the-money put. It will eventually reach its maximum delta of -1.00, at which point it will move in lockstep with the spot price.

How does this help us? Mainly in terms of entries and exits that we would like to plan in advance.

You Have Options

There’s no question that investing in options comes with a steep learning curve. That said, profitable options plays don’t have to be a faraway goal. Invest in options using these four rules and you’ll be well on your way to seeing profits from your calls and puts.

Bill Jenkins

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Bill Jenkins is a contributor to The Penny Sleuth, which offers unbiased commentary from expert analysts and authors about penny stocks.

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