THE OPTIONS COURSE
Options, the most flexible financial instrument that exists today, provide unique investment opportunities to knowledgeable traders on a regular basis. However, the entire options arena can be a very complex and confusing place in which to venture, especially for the novice trader. The primary reason for this complexity is the fact that options trading is a multidimensional process; and each dimension needs to be understood in order to trade successfully.
Prior to initiating an options position, there are three main issues to consider: direction, duration, and magnitude. Direction refers to whether the underlying security will move up, down, or sideways. Duration refers to how long it will take for the anticipated move to take place. Magnitude refers to how big the subsequent move will be. In order to make a profit, the options trader must be correct in all three of these categories. This is the primary reason that many people lose money when trading options. They do not accurately understand the three dimensions of an options position.
The first step in taking your options trading to another level is to understand and comprehend the interrelation of direction, duration, and magnitude. Additionally, the trader must use these three different variables in order to provide an edge in the market. It is imperative to be able to combine and exploit these three variables in order to give yourself an advantage; otherwise your trading will become no more than an exercise in giving your money away to other traders.
Many times it is necessary to work with combinations of options in order to give yourself an edge in the market as opposed to just buying a call or a put. This is where understanding spreads, straddles, and various option combinations is helpful. There are a few general rules that I always follow when looking for and constructing option positions. The first is that when I am going to bet on the future direction of a security, I want to give myself enough time to be right. That means I will usually choose long-term equity anticipation securities (LEAPS) for directional trades. LEAPS is a name given to options with expiration dates further than ninemonths away. The second rule is in regard to magnitude or volatility.
When combining different options together, I want to be a seller of expensive options (high volatility) and a buyer of cheap options (low volatility). The third rule is that I want to make time my friend as opposed to my enemy by purchasing options that have plenty of time left to expiration and selling shorter-term options. This allows me to take advantage of the time decay characteristic of an option. These guidelines are a brief summary of the issues that need to be understood when building trades that give you a competitive edge in the market. To the beginner, these issues may seem complex and convoluted; but with a little bit of practice everything should become quite clear.
If you take the time to understand the concepts of direction, duration, and magnitude, you’ll soon be able to start experimenting with a variety of different options strategies. For example, if you want to be bullish on a particular stock, then you can take a longer-term perspective by placing a bull call spread using LEAPS. For shorter-term trades, you can take advantage of time decay by using credit spreads, calendar spreads, or butterfly strategies. Increased comprehension of these basic concepts will enable you to combine short- and long-term strategies together to help you become an even more proficient trader.
As you build experience as a trader, you will become more confident in your ability to make money. After a few successes, traders are more motivated to develop the perseverance necessary to stay with the winning trades and exit losing positions quickly. In the long run, you have a much better chance of becoming successful when you start by acquiring a solid foundation of the option basics. In addition, keep a journal of every trade you make—especially your paper trades—as a road map of where you’ve been and where you want to go on your journey to trading victory. Remember, patience and persistence are the keys to trading options successfully.