Trading, especially options, can be very exciting and rewarding. Having said that, you should not be trading options before learning at least the basics about how to trade them. Options are very different from stocks, and there are more factors that go into the pricing. Many view it as a get-rich-quick scheme, while others think it is gambling. I am here to say it is neither, but you have to know the rules before you can trade them if you want to be successful. Here are eight dos and don’ts for options traders.
1. Do not always swing for home runs or put all your money into one position
Do not buy options contracts way out of the money with hopes that it will turn $100 into $5,000. When you do this, you have a very small chance of winning long-term and most would say this is gambling. If, by chance, you do strike it rich, you will give it back eventually as this is not a winning strategy.
2. Do go for base-hit trades with a consistent and steady return
These trades have a high probability of winning and a low chance of losing. Stick with 5%-10% allocation per trade. Make sure you properly hedge or one bad trade could result in giving back all your profits.
3. Do not change your strategy based on commissions your broker may charge or to accommodate a small account
If you take a trade or don’t take a trade because you don’t have a big enough account, wait until you have the proper funding to execute your trading strategy.
4. Prove out your trading strategy with a sim account
This is always the best practice. I have seen new traders lose lots of money just trying to understand the platform with which they are trading on. Also, they make strategy mistakes. Go in sim until you are profitable for consecutive months. Don’t go to the school of hard knocks and lose money while you learn.
5. Do not trade on margin if you don’t understand it
If you don’t know how margin works, do not use it to trade. Early on I had a margin call and these are never fun trying to find the money to make your brokerage whole. It can mess up a lot of your existing trades if you have to liquidate.
6. Fund your account over what you intend to trade with
Give yourself a buffer here. If you intend to trade $5,000, put $7,000 in your account. The more the buffer, the better off you will be, especially if your first few trades are losers.
7. Do not expect to get rich quickly or any significant income from a small account
Start little, save, then get big as you grow. Too many times I have seen new traders put everything into one trade. When that trade goes south, they lose lots of money then double down with higher risk. When this too is lost, they are done trading. Don’t be that person.
8. Move on from losing trades – do not chase
If you see a big move that a stock has already made and you want to join the party, think twice. Once an underlying is extended, there are low-risk trades. If you are leveraged with options, it is an even lower chance to win. Many traders make money by jumping on the train late. Sooner or later, if you do make money this way, you will give it back over time. This is a losing strategy.
Options when bought are purchased at a debit to the buyer and should be considered assets. So when you buy options, the money is debited from your brokerage account. It’s exactly like buying a stock.
As mentioned above you can also sell an option, without owning the shares. Options when sold are sold at a credit to the seller. When you sell an option, it should be considered a liability and money is added to the brokerage account at the time of sale. Not many things are guaranteed in the market, but this is. However, you can’t withdraw this money until the trade has been closed. Usually, this money is used to offset the margin required for selling the options.