Three Option Trading Hang-Ups You Can Dump in the New Year

Listed stock option converts are on the rise, according to Options Industry Council data. Have you considered joining this flock, but remain handcuffed by doubt? You might start by dumping three common option trading hang-ups and see what happens from there.

Overwhelmed to Begin?

Feeling a bit scared? Of everything option-related, perhaps? Fortunately, there’s a way to experience option trading without risking any money. It’s called paper trading, and in its most basic form, traders play along with the market action without putting on any “live” trades. Instead, they note the entry price of a trade and track any changes.

JUST ONE TOE?

At the thinkorswim® log-in box, simply slide the “button” from Live Trading to “Paper Money.”

If you’re a TD Ameritrade client, the thinkorswim® trading platform offers its version of this dry run. It’s called paperMoney®, and it lets users analyze option trading ideas and place orders in the same way they’d place a real trade. Once a paper trade gets “filled,” users are privy to real-world data such as profit/loss numbers, the greeks, and risk graphs, just to name a few. Fill prices, commissions, and other fees may be different in live trading, but everything else is just about as real as it gets. There’s typically no better place to learn and get experience without risking any capital.       

Risk Management

While you’re getting experience with paper trading, now’s the time to craft and put into practice a solid risk management plan. Before coming off the sidelines, you need to know the answer to some very practical questions, such as “How many contracts should I trade?” or “When should I take my profits?” or "When should I cut my losses?" So let’s look at some guidelines for capital allocation and trade management.

How will you decide how much money to risk in an option trade? The answer differs by trader, but one possible guideline is no more than 5% of total trading capital per option trade. So if your trading account is $50,000, then you could theoretically risk $2,500 in one trade (don’t forget transaction costs). That doesn’t mean you’d be comfortable losing all $2,500, but if the worst-case scenario happens and you lose the entire value of the trade, then taking a 5% hit to the overall portfolio isn’t going to ruin you. But remember, this is just one possible guideline. Some traders risk less—perhaps only 1% per trade. It really depends on your goals and your risk tolerance.

Also, some traders recommend keeping this number roughly the same from trade to trade so that trades are all fairly equally weighted in terms of dollars at risk. Why? You don’t want to win on a trade where you risked 1% only to turn around and lose on a trade where you put 5% on the line.

Once you’ve determined the amount of capital you’re comfortable putting at risk, use that number to determine the number of contracts to trade. For instance, if you’re putting $2,500 to work buying a call spread that costs $1.25, you’d buy 20 contracts on each side of the spread.

A good trading plan covers not only how much money to put at risk on any one trade, but also rules for when to cut losses or lock in profits. Some traders, as a rule of thumb, opt to take profits when the trade reaches a 100% profit, and cut losses and close the trade if it loses 50% of its risk.

Take that call spread, for example: If the spread moves to $2.50, then you’ve hit a 100% profit, less transaction costs. You might then have an order ready to sell the spread. If the spread drops to $0.63, on the other hand, then you’ve lost 50%, our above example would have you sell and cut your losses. You can set alerts that will email you when a trade reaches a certain price—a great way of staying in touch with the market without being glued to a computer screen. Or, you could set up a closing order that activates based on the spread’s price.

Of course, these are just two simple guidelines that may not be appropriate for every option trader or trading style. But they’re a good place to start, especially when you’re practicing. The bottom line here is to know in advance when you’re going to close the trade or make an adjustment.

Sniffing Out Opportunity

So you’ve now gotten familiar with paper trading and your risk management plan is ready to go. But with thousands of optionable securities, where do you start?

Don’t think that you have to go out and find the next big thing. Some traders start by sifting through some of the biggest companies out there. It’s unlikely that you’ll find out anything really important that isn’t already known, and the options on these stocks ideally will have sufficient volume—meaning potentially tight bid/ask spreads. Tight spreads can mean less out of your pocket to enter the trade. Beginning option traders are generally advised to stay away from unknown, illiquid stocks.

What you’re looking for is an opportunity, and that means you need to form an opinion about the stock. Is it going up, down, or nowhere? Once you’ve decided, look at the options for the trade that will profit if your opinion is correct. Formulate your trade plan, including how many contracts you’ll trade and the exit prices that will close your trade. Then “paper trade” your idea and see how it turns out. Try it again with another trade. And another.

Although successful virtual trading during one time period does not guarantee successful investing of actual funds during a later time period, before you know it you could be free of option trading hang-ups, start building confidence, and be ready to trade for real. 

Options trading involves significant risks and is not suitable for everyone. 

The paperMoney software application (and other "paper trading" software, generally)  is for educational purposes only. Successful virtual trading during one time period does not guarantee successful investing of actual funds during a later time period as market conditions change continuously.