5 Simple Option Trading Tips for the Beginning Investor

Written by admin on July 16th, 2010

Becoming a successful option trader takes a lot of practice and hard work. Leveraging the many option trading tips that are available can help a new investor with less experience learn what has worked well for others. These types of investments can be a wonderful tool if used correctly that can provide a double or even triple digit return in the matter of a few days or weeks. A careless trader, on the other hand, can lose his/her entire investment if they use these investment tools incorrectly.

While there are no guarantees that all investors will become successful, learning as much as possible about these dynamic investment tools is essential. Here are 5 simple option trading tips that I have documented from my past experienced as a trader.

1. Find a Good Online Discount Broker

One of the very first option trading tips that investors should consider is which online stock broker they plan to use. With so many available brokers, it can be difficult knowing which ones are the best. In addition, some brokers offer better tools for stock traders while others specialize in options trading. The best bet for traders is to take some time researching which discount broker offers the best combined services and costs for their trading needs.

Here are a few questions investors may want to find out before opening up an account.

  • What are the commission prices? Most brokers charge an extra commission for each options contract that is placed on top of the standard fees.
  • Does the online discount broker offer free real time quotes? Real time quotes tend to be included at no charge for most brokers, but it never hurts to check.
  • Does the online broker offer both stock and options trading? For convenience, it helps to have an account where an investor can buy stocks online as well as options.
  • What trading tools are offered at no charge through the broker? It helps to open an account that offers free screening tools, like an options chain or options strategy tool that can evaluate potential trades. Getting free tools from a broker could save some money on stock investing software in the long run.

2. Start Simple

If there is one options trading tip that new investors should follow for these types of investments, it is this one. There are so many complex types of options trading strategies that it is virtually impossible to understand them all. From collars to spreads to butterflies, the number of options strategies used to generate profits (and losses) is very large. An investor who does not learn options trading the simple way and uses one of these complex strategies has a very small chance of succeeding.

Investors who start simple and learn to trade options by purchasing calls and puts will be much better off in the long run. Purchasing a call allows the buyer to lock in a share price where they can buy the underlying stock on or before the expiration date. This is consider a bullish investment strategy that provides plenty of leverage for the novice options investor.

Purchasing a put is the opposite of a call. When an investor buys a put, it gives them the option to sell shares of a stock at the strike price of the contract. This simple strategy is considered bearish and provides a unique opportunity to generate profits on a stock that may be falling.

Learning how to trade options like buying calls and puts is a simple and smart way to start.

3. Trade What You Know

Most stock experts recommend trading what you know and the same rule should apply to options. If an investor does not understand what a company does or how they make their money, there is no reason to invest in either the stock or the option. Many inexperienced investors fail to follow this option trading tip and instead follow the hot stock which tends to hurt them in the long run.

An investor who already follows a set of stocks in their portfolio may want to consider starting with these organizations when they begin to trade options. It is also a good idea to gather as much information as possible about the stock, which will help an investor understand its trading patterns.

Trading stocks with little knowledge of a company is risky, but there is usually time to get out and limit ones losses. Due to high volatility, the same cannot be said about trading options in these same companies. A poorly place option trade can become $0 very quickly.

4. Be Patient and Disciplined

This is probably the hardest option trading tip for investors to follow, regardless of their trading style. Options are dynamic and fast moving investments that take a lot of patience and discipline to master. A 1% or 2% dip in a stock price on a bad trading day could mean a 10% or 20% dip in the premium price of an option.

Prior to placing any options trade, it is a good idea to map out a strategy that can be used. While a 10% decrease may seem a little scary to an investor, an option can quickly turn around the other way and be up the same amount and more during the next trading session. It takes a lot of discipline for an investor to hold off from panicking when an options contract has a bad day.

The importance of developing an option trading strategy is critical in these types of situations. If an investor has already defined their acceptable risk and loss on an investment by creating a plan, they can remain calm and patient in a volatile market.

5. Always Have an Exit Strategy

One of the hardest things for investors to act upon is knowing when to take profits or losses. An important option trading tip is to always make sure an exit strategy has been formulated. As mentioned earlier, on a bad trading day, an options contract can be down by a double digit percentage even while the stock is down by just 1% or 2%. Successful options investors will have a set of guidelines to follow as to when to take a loss. Maybe it is 10%, or maybe it is 50%? The point is that it needs to be a number that the investor is comfortable with, or they may end up losing 100%.

Just as it is important to know when to take losses on an options trade, it is critical to know when to take profits. When times are good and the premium on an options contract is going up, the first thing that investors think is to let it ride. This thinking will only lead to missed profits and a potential loss on the investment. A good exit strategy should document when it is time to get out of a position to take profits or a loss.

Final Thoughts

Options are dynamic investment tools that can generate enormous returns often in the double or triple digits. However, not picking up on option trading tips from other investors can lead to a misunderstanding in just how these types of investments should be traded. Trading options carries plenty of risks, which can be minimized by smart and patient investors.

There are two types of investors when it comes to trading options. First there are those that ignore all of the option trading tips and trade blindly. While an investor may get lucky for a while using this philosophy, their luck will eventually change for the worse. The other choice is to leverage the knowledge of other experienced investors which can reduce the risks and allow an investor to maximize their returns.

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