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May 05, 2012 - Follow These Options Trading Steps and Trade Like the Pros - By Zacks Investment Research
By: Kevin Matras
Whether you're new to options or an experienced options trader, follow these steps and you can start winning like the pros.
Options trading already has many inherent advantages, not the least of which is the ability to make money in any market direction. Many strategies include a guaranteed limited risk. And you can get started with only a fraction of the money you would normally need to invest in the stock itself.
Step 1: How Much Should You Invest in Each Option?
Determining the right position size is critical for successful investing. Here's how you can determine the right position size for you.
For example: Let's say you would normally invest $10,000 in a stock. If stock XYZ was trading at $50 per share that means you could buy 200 shares. And let's also say you were willing to risk 10% on the trade or $1,000.
Here's how to figure out your option size. One option essentially equals 100 shares. Two options equal 200 shares. If you buy one option at $500, under the worst case scenario, your maximum risk would be what you paid for the option, which is $500. Two options would be $1,000. And that's the equivalent of risking 10% had you invested $10,000 in the stock.
Of course, that's assuming the worst case scenario. Nobody intends to lose their entire premium. But it's a good idea to keep the worst case scenario in mind when determining your position size as this is a fool proof way to manage your risk.
Step 2: How Much Time Should You Get?
As a rule of thumb, if you're buying an option, buy more time than less. Too many people skimp on time because it may cost them a little bit more. But the extra time, even a few weeks worth, can often mean the difference between a profit and a loss. And the extra time is actually the better value.
For example: Below are three options with three different expiration dates. Let's see what they cost and what you're really paying.
• A June 50 call priced at 3.00 or $300 has 6 weeks of time. Divide $300 by 6 weeks. That equals $50.00 per week. So essentially, you're paying $50.00 for each week of time you purchased.
• An August 50 call might cost 5.00 or $500 and have 15 weeks of time. $500 divided by 15 weeks means you're paying $33.33 for each week of time you purchased.
• And an October 50 call might cost 7.00 or $700 and have 24 weeks of time. $700 divided by 24 weeks means you're paying only $29.17 for each week of time you purchased.
This illustration shows that the October call with the most time is the better value because you're paying only $29 for each week of time as compared to $33 and $50 for the others. If the October is a little too expensive and you really don't think you need that much time, the August is still a better pick than the June.
Not only are you paying less for each week of time that you hold onto that option, the additional time will serve you well if it takes a little longer for the underlying stock to move in your direction.
Step 3: Should You Buy In-the-Money or Out-of-the-Money Options?
Every investment decision you make in regard to options should be about how to increase your odds of success. And buying in-the-money options is one of the best ways to do that.
For example: Let's say a stock was trading at $40. If you bought a 37.50 in-the-money call option for $400, that would be comprised of $250 of intrinsic value and $150 of time value. At expiration, if the stock was still trading at $40. the option would have retained $250 of its value. Why? Because at expiration, since there's no time left on the option, the only value left is the intrinsic value, which is the difference between the stock's price and the option's strike price that's in-the-money.
Now let's say you bought a 42.50 out-of-the-money call option instead for $275. That would be comprised of $0 of intrinsic value and a full $275 of time value. At expiration, however, if the stock is still trading at $40, the out-of-the-money call option would now be worth zero ($0). Why? Because at expiration there's no time value left and there's also no intrinsic value either, resulting in a total loss of your premium.
While somebody might have concluded in the beginning that the out-of-the-money calls were better since they were cheaper, you can see at expiration, the cheaper out-of-the-money options were actually the worst investment.
Professional option traders are keenly aware of proper position sizing, the benefits of time and the statistical advantage of in-the-money options.
Start Trading Like a Pro Today
You can apply these three simple steps on your own to trade like a pro and win like one too.
And by smartly applying these rules, you can increase your returns, minimize your risk, and have more confidence than ever before in your trading.
Now there's an even easier way to do this. If you're interested in learning more about how to increase your odds of success in trading options, you may want to look at our Zacks Options Trader. It takes the guesswork out of options trading by doing all the research for you and presenting it in plain language with easy-to-understand signals.
We'll walk you through each trade step-by-step as we present our unique perspective on some of the most popular options strategies, as well as others that some people may never have even heard about. Including my all-time favorite strategies for making money in sideways or down markets.
Plus, you'll receive private daily alerts and commentary that tell you what options to buy or sell, and when to make your moves.
Thanks and good trading.
Kevin Matras Vice President, Zacks Investment Research
Kevin Matras is our world-class research expert who has developed more than 30 market-beating strategies using the Zacks Rank. He also directs our service that combines the Zacks Rank with the best options strategies for today's volatile market, Zacks Options Trader.