In the last five newsletters in this series we looked at a series of issues to select the right stock option. This newsletter will cover the final step, Graceful exits, along with a recap of the items previously discussed so you will have an easy reference tool at your disposal.
Below is a list of the eight essential elements to consider when purchasing options:
1. Option Month - what month should your option expire
2. Strike Price - what is the best choice
3. Delta - what delta should you consider
4. Time Value - how much time value should you pay
5. Bid & Ask - How much should the spread be
6. Open Interest - is open interest important, what is the requirement
7. Money Management - how much to put in one trade
8. Graceful Exits - if the trade does not go the way you hoped
RECAP and GRACEFUL EXITS
There are a number of things to consider when you place an option trade:
1. Option Month - What month should your option expire?
* Avoid using front month options, the next month to expire, except for insurance or selling naked or bull put spreads, etc"
* Select an expiration month at least one full month out for a 1 - 2 day trade
* Select an expiration month four months or more out for a trade over 2 days
* Select an expiration month over 9 months (LEAPS) for a trade over two weeks
2. Strike Price - What is the best choice
* The best way to select the right strike price is to use the delta and time value rules that follow. It should force you to automatically select the right strike price. However, if there is a conflict then do better than the rules.
Example: You end up selecting the option to buy with the worst time value - so then go to a strike price that has a better delta than the minimum requirement or to the next month out to get the better option that does not fail any of my rules.
* b) Here is a basic rule of thumb to get you close to the right option to consider for a short-term trade with a delta close to .70:
Short term trade in the money usually takes about $5 in the money.
Expensive stocks take about $10 in the money
High Volatility stocks could be as much as $20 in the money (EXPENSIVE)
3. Delta - What Delta should you consider?
* 1 - 2 days in the trade Delta .70+
* Over 2 days in the trade Delta .40+
* Over 2 weeks in the trade Delta .25+
4. Time Value & Cash Value Considerations
* Make sure if you are buying an option not to buy the option with the highest time value in it. (Time value = Premium - In the Money)
* If you are selling to open a trade (selling a naked put or writing a covered call) then selling to open an option with the highest time value is GREAT!
5. Bid & Ask - How much should the spread be?
* Minimum option spreads are 5 cents on options under $3 and 10 cents on options over $3 (these are my favorite when I can get spreads this small)
* Maximum for short term trades is 25 cents or less
* If you must trade a stock with a large spread, be in that trade for more than a few days and get in on a serious low or high to play the downside so you can recover from this spread" remember you don't make your first penny of profit until you can cover your spread between the bid and ask!
* Don't forget to try to get a deal in the spread if possible to reduce the bid x ask spread up front costs you have to cover to make that first penny.
6. Open Interest - Is open interest important? What is the requirement?
* Minimum requirement is 100 contracts or don't do the deal! Anytime you can get open interest in the thousands it is even BETTER! It makes your entrance and exit easier and the bid x ask spread tend to be much smaller.
7. Money Management
* How much in one trade: If you are trading with small funds, try to be diversified by trading an exchange traded fund like the QQQQ since you have to put a large amount of your funds in one trade. This will at least help you to be diversified in 100 stocks at one time. Once your funds have grown, I like to not put more than 5 - 10% in any one trade. Also don't have all your trades in the same sector.
* When do you have enough to retire? You want to have set aside two years of living expenses in addition to your trading funds before you retire.
* Diversification: Don't have all your investments in the stock market. Real Estate is a nice compliment, as well as residual earnings from perhaps writing a book.
8. Graceful Exits - If the trade does not go the way you hoped.
* The most important thing that you can learn to become a successful trader is how to pull the plug when the trade goes wrong! If you cannot get good at this then you should NOT be trading!
* As a general rule of thumb on stock don't let it go more than 8% against you and on options no more than 20% against you to run for the door fast. There is nothing worse than having no funds left to live to trade another day.
* Once you discover the power of pulling the plug fast when a trade goes wrong, and you see how much better the trade goes when you finally can enter it at the right place, you will wonder why you ever felt the need to stay in a bad trade! You can really make some sweet money pulling the plug and fixing a bad trade!
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Content Source: Better Trades Education System for their BetterTrades Workshops
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