Ten Things to Consider BEFORE You Buy an Option

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Dr. Edward Olmstead, Professor, Northwestern University

Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies

 

We recognize that when it comes to trading options, there's a lot of information to absorb and most people may not have the time to review every detail, so we put together a "cheat sheet" to help you get started.

 

Should you want to explore any or all of these points further, more detail for each item on the check list is provided in our options blog. Following each of these steps does not guarantee a successful trade, but it reduces the risk of a bad trade and that can make a big difference in your overall trading record.

 

Ten Things to Consider BEFORE You Buy an Option

 

1. Determine how much of your total investment funds you are willing to use for the high-risk trading of options. Once you have determined an appropriate amount for your options trading capital, allocate only about 15% of that capital per option trade.

 

2. Make sure you are using an options friendly broker. The trading platform for your account should display option prices in real time and easily allow you to execute a trade when the time is right. Live help should be readily available when you need it. Commissions should not be excessive.

 

3. Anticipate events that might impact the price action of the stock associated with your option. Check on upcoming earnings release dates, FDA decisions, court rulings, ex-dividend dates, etc. Such events can even be the basis for timing an option trade.

 

4. Review price trends, not only for your stock of interest, but also for the industry that includes your stock, as well as for the overall market. The cliché "The trend is your friend" is good advice in trading options. The more trends going your way, the better are your chances of success.

 

5. Select an option that gives you the best opportunity for a successful trade. The cheapest option is rarely the best choice. Choose an option with an expiration date that gives the underlying stock ample time to make the expected move in price. Keep in mind that in options trading, time is money.

 

6. Learn how to enter an option trade at the best available price. Follow options prices in real time, and enter a limit order that is most likely to be filled. Avoid market orders.

 

7. Set up a scheme to track your option trade with daily entries in a spreadsheet. It is important to develop a feel for how an option price changes in response to changes in the stock price and the passage of time.

 

8. Have an exit plan for profit. Decide on a reasonable move in the stock price for a suitable profit to be achieved in the option. The amount of profit will depend on how quickly the stock price reaches the desired level. If the profit comes quickly, you might consider holding on for a bigger gain, but remember that options are time limited. Don't be greedy.

 

9. Have an exit plan to limit loss. Identify a stock price level that suggests a failure of the move that had been anticipated. When the stock price reaches the failure level, exit the trade to limit loss. Not all option trades will be winners, so it's important to exit a losing trade early and preserve capital for future trades.

 

10. Gain access to a program that includes an options calculator or risk graph display. Having an unbiased source to check the profit and loss characteristics for your trade is a valuable tool. Some brokers provide such a tool on their trading platform.

 

 

Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.