Perhaps the most difficult aspect of buying and selling options is self-discipline. If you do not set your own policies and trading rules regarding when to close positions, how to reduce risks, or exactly what you hope to achieve, then it will be difficult to profit from trading options.
The successful options trader is one who understands the importance of self-discipline and has the ability to open and close positions in accordance with predefined trading rules, even when you are tempted to do otherwise. The fast-changing nature of the options market, the steady pressure of ever-closer expiration dates, and the different factors that affect the time value of an option all require that you be aware of how time works for or against you in order to maximize your profits. You need to establish policies in two broad areas: First, know why you are using options, and second, know your exit point.
Know your purpose for trading options
Are you using options for leveraged speculation? If so, then you better have proper market timing tools to trigger precise entries and exits. Are you using options for added income from your stock holdings? Then know which of your stocks have options with high implied volatility levels so that the option selling is worth the effort. Finally, are you using options to protect against losses in your investments? If so, in addition to using protective puts, you should also consider the collar strategy, used by countless institutions every day.
In short, understand what category of option trader you fall under.
Have an exit strategy
You need to think about possible scenarios and decide ? in advance ? when you will close a position. You could hold options until expiration day or exit the week prior. If you have bought an option, you should identify a profit sell point as well as a loss bail out point. You might decide to sell if you double your money (on the upside) or lose one-third (on the downside). Rules like that, no matter what the specific exit points, define a specific event where action should be taken.
Consider your risk exposure
For example, let's say you are short calls and expiration day is near. The stock is one point out of the money, and the option is now worth only 10 cents. Should you wait for expiration and, considering that the option is close to the money, take the risk the stock will jump before the option expires? For a dime per contract, it might be prudent to just close out the position, just in case the stock did rise at the last minute.
If you follow your rules and resist the temptation to make exceptions, then you will most likely succeed. Without standards for getting out at the right time, you would certainly fail. Neither stocks nor options can be treated as separate parts of the portfolio. They should work together. You will get the greatest benefit from trading options when you learn to use them as part of your overall investment strategy.
Jim Graham is OptionVue's Product Manager and develops and enhances the company's OptionVue 5 Options Analysis Software to meet the real-world needs of institutional and individual options traders. You can find more valuable options trading information at www.OptionVue.com.
