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Option Trading Basics - Build Your Knowledge Base!

Posted by Pete Stolcers on November 11, 2008

In today’s option trading blog I will address some important concepts for the novice option trader. Options trading gets so much press these days that it’s hard for traders to determine where to go and who to trust. I believe there is a natural progression to the whole process and it can’t be rushed. Options are not a get rich scheme that you can jump into. Do people make a lot of money trading options? Yes, they also lose a lot of money. The risk and reward is elevated and every mistake is magnified. Here are some points to consider if you are just getting started.

1. Become a good stock picker first. Before you can become a good option trader, you need to be able to analyze stocks. Options are merely an extension of your stock opinion.

2. Read, read, read. I would start with books on technical and fundamental analysis. John Murphy and Martin Pring have authored excellent books on technical analysis. Peter Lynch, William O’Neil and Warren Buffet have written excellent books fundamental analysis.

3. This is hard work and only the top 5% of you will succeed. Be prepared for long hours and extensive research. If you think you can pay $3000 and park butt in a seminar for a weekend to learn all you need – guess again. Spend the money on books, data feeds and research tools and you will be better off. Trust me, the guy lecturing at the nearby Holiday Inn does not have all the answers.

4. Learn all that you can about option trading. Larry McMillan is the best known author for option trading books. He is a close friend and I consider him “the authority” on option trading. The CBOE also has some great free infomation.

5. Trade options as an extension of your portfolio. Options give you the flexibility to structure risk and reward. They don’t have to be a speculative “take a shot – make a lot” instrument. Use them to hedge and generate income.

6. Keep the strategies simple. You should not engage in these strategies: delta neutral, gamma neutral, back-spread, ratio back-spread, iron condors, butterflies, calendars. They are Market Maker strategies that DO NOT work on a retail basis.

7. Be properly capitalized. If you do not have $10,000 of speculative risk capital, you should not be trading options. The $10,000 should represent no more than 10% of your total portfolio. I shutter when someone with a $2000 IRA asks me how to get started in option trading. Options are not a newly discovered vehicle to financial freedom. They are a complex, dynamic product that will strip you of everything the second you let your guard down. If this describes your situation, keep putting money into your IRA and read trading books while you save enough to get started.

8. Set realistic expectations. If I make 25% a year (regardless of market conditions) I’ve met my goal. If I do better than that it is a banner year. Asset Managers would kill for these types of returns. Can I achieve them because I’m smarter than they are – no. I’m smaller and I can get in/out of positions quickly without driving the price. I am also willing to take small lucrative positions that would not generate enough of a return to make it worth their time. You will hear people talk about making 20% per month. Before you sign up for their advice/mentoring, ask them for the last two years of brokerage statements. You’ll hear lots of excuses and you won’t see one account statement. My favorite is, “I’m so busy teaching I can’t trade.”

9. Be prepared to lose money. After 17 years I still have a ton of losing trades. It’s just part of the process. In the beginning you might have a losing year or two before you get in the black. This is the easiest business to start and the hardest one to grow.

10. See both sides of the market. If you aren’t comfortable shorting, you might as well try to become a one-armed professional golfer. When you see both sides, your perspective is much clearer and your confidence is kept in check. You need to be able to make money when the market is going up or down.

11. Spread out your capital and never allocate more than 10% to any one trade. When possible, scale into positions. After you climb aboard the “leverage train” you’ll realize that it’s actually a roller coaster. Diversification and dollar cost averaging will help you control your emotions.

12. Establish solid resources. Yahoo Finance, Earnings Whisper and CBSMarketWatch are all I need for news. eSignal and RealTick are my trading platforms. These are a few of the blogs I visit: The Kirk Report, Trader Mike, Alpha Trends, The Daily Options Report.

13. Take inventory and build a system around your schedule, knowledge, prior success, risk tolerance and investment objectives. I have written an entire blog on this subject.

This option trading blog may raise as many questions as it answers. If that’s the case, use the Ask Me feature on the menu bar and submit a question. If I highlight yours, you’ll get an answer and you’ll be able to select a free one month subscription to the OneOption research product of your choice.

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Option Trading Comments

  • On 12/16, Rajesh Kandaswamy said:

    Pete,

    I am learning quite a bit from your blog. Regarding Calendars and Back spreads, why do you say that they won’t work for the retain investor? Aren’t they just simpler version of Diagonal spreads in a way? Would like to understand more.

    Thank You,
    Rajesh

  • On 12/19, Pete said:

    Hi Rajesh,

    Your question needs to be answered in an article to do it justice. In general, I don’t like calendar spreads at all. You don’t want the stock to go up or down. An analyst once told me it is like trying to land a 747 on a football field and I agree. As for ratios and backspreads, there might be reason to use them in lieu of a long straddle/strangle when volatility skew exists. However, I’m not big on straddles or strangles because you are nuetral the stock. Ratios also require too much adjusment and have too much slippage. If you look through my Categories and select Option Strategies, you will see articles I have posted on nuetral trading and straddles.

  • On 12/19, Rajesh Kandaswamy said:

    Pete,

    Thank you for your response. I will read those articles as well.

    - Rajesh

  • On 01/10, Bruno D. said:

    Very nice!

    I have been trading options for about 2 years now, more seriously this last year. I switched to IB, which proved very instrumental to lowering my transaction costs enourmously and helped me achieve strategies like scaling much easier. You bullet point list outlines a lot of things I’ve come to learn myself. I also try to keep things simple, do not use any complex strategies and use options solely for leverage, sometimes I even trade stocks when I’m less comfident of a trade to diminish leverage.

    Recently I had a enlightning moment with TA, seems like I finally can “read a chart” lol. I also don’t believe much in complex TA (like Elliot Wave, etc), I like to keep it simple here too, moving averages, RSI & MACD, that’s it. I think TA is inherently flawed in a way since it relies on the past and nobody can predict the future. Hence I try to focus my approach on probabilities, always trying to see two sides of the trade (or rather I try to guesstimate future price ranges and assign a probability to each).

    I’m also a software developer, I’ve started building a system to generate trading signals that I’ll eventually apply, stuff that I all do by hand right now (TA, checking charts, etc). It’s easy to “automate” many of these things, at least to identify potential setups and allow me to keep an eye on much more stocks that I could normally do.

    Anyways, you have a nice blog, I’m putting you in my favs smile

  • On 01/15, Eric said:

    I totally disagree:
    “Keep the strategies simple. You should not engage in these strategies: delta neutral, gamma neutral, back-spread, ratio back-spread, iron condors, butterflies, calendars. They are Market Maker strategies that DO NOT work on a retail basis.”

    Perhaps you are told they do not work? I have been trading these strategies ever since I figured out that straight calls/puts were a terrible idea. I strongly advise to trade these strategies as I have consistently turned a profit implementing credit spreads month and after month. Only work for the MM’s? PLEASE!

  • On 01/15, Pete said:

    Hi Eric,

    We can agree to disagree! I have 17 years of experience under my belt. Yes, I’ve made money on those strategies for periods of time and then the walls come crashing down. When you take in nickles and dimes with a high probablility of success, you can go for big stretches and not lose. All it takes is one bad trade to strip away a year’s profit. You’ve been trading them for two years with a declining IV enviroment where premiums have reached a historical low and you should be making money. You have not been put to the test - yet.

    I’ve also managed risk for thousands off-floor traders and I can tell you they suffered the same fate. When the market returns to a more normal state of volatility, I’d like to hear back from you. 

    Within my post I did not mention credit spreads, debit spreads or diagonals. That’s because I use them extensively and they are great strategies.

    You should also read the title of the blog. This post is intended for novice traders and I beleive that they should not engage in complex strategies they don’t understand.

  • On 01/15, Eric said:

    Pete,

    I understand what you are trying to convey, but credit spreads (Iron Condors, (Iron) Butterflys) can all be initiated at a credit, which I trade.

  • On 01/15, Eric said:

    Pete,

    Also no bad blood here smile I respect your experience and what your saying, just wanted to shed light on those strategies.

  • On 01/15, Pete said:

    Absolutely no bad blood. How can I get angry with someone who makes blogging worthwhile and is passionate enough to post! I have a few posts on non-directional trading under my Categories section. They are extensive and I think you’ll have a better idea of where I’m coming from.

    In the 80’s, many people were raking in money selling naked puts. It was like taking candy from a baby and as long as they were far enough out of the money - it was a cash machine. Traders were going years without a losing month. When the #$%% hit the fan it wiped them out and the firms clearing their trades.

    Butterflies and condors don’t pose the same risk, they are a much slower death when they stop working. The point is that they do stop working. You are giving up too much of an edge for it to be an optimal approach to options.

    If it is working for you, stick with it. Just know when to stop.

  • On 01/15, Eric said:

    I suppose they keep working under present and past market conditions because I will make adjustments when I need to—rolling up or down my verticals or putting on addition verticals on the sides where my strikes may be threatened. But in the future, who knows!

  • On 11/14, tom said:

    Thanks Pete, I’ve been trading for 3 years and the 13 points that you’ve written are what i’ve learnt the hard way, some that i have yet to learn.

    For beginners, i really couldn’t emphasize enough on point 3, 7, 8 and 9. Of late, I hear that options trading is an automatic money making machine, typically a propaganda popularized by seminar organizers. There is a lot of hard work and be prepared for a roller coaster in the first year of trading.

    happy trading!

  • On 02/07, Matt said:

    I have never traded anything before but I want to learn and start because I am young.  What book or list of books should I be looking at to get the proper terminology and good insight into beginning trading?  Also, once I read these books do I work for someone or is it better to do it with your own money and stick with it that way?  Is that what you do or do you work for someone?  I am just trying to get a feel of how this all works. 
    Thanks

  • On 02/08, Pete Stolcers said:

    One of the best resources for free educational information on option trading is www.cboe.com.

  • On 02/15, Jean Paul said:

    Dear Pete, as a novice trader I am working through tons of websites and blogs to educate myself as much as possible before placing that first trade and I have to say this article is one of the most sensible ones I have come accross, sofar!
    Thanks and keep up the good work!

  • On 02/15, Pete Stolcers said:

    Thank you. Keep reading. You could spend months on my blog alone. There is a search feature where you can search articles by keyword. Good luck!

  • On 09/04, Bill Hein said:

    I certainly appreciate all of the comments concerning the subject of “finding” good, reliable option educational and advisory services.  It is no wonder that a retired professional has such a difficult time trying to learn to trade effectively and consistently. I have found it to be a most frustrating .and difficult task.  Gentlemen/Ladies there are many sharks in the water; some posing as legitimate well-known trading Gurus.

    I have been trying to learn to trade options (which includes that the traders skills must be developed to analyze Market Trends and consider appropriate News, select and evaluate the better underlying stocks and know enough about options to choose/evaluate strike, expiry month, Greeks, IV, volume, etc.) I have “tried” many advisors thinking their software assets are better than what I can afford and relied too greatly on their RECO’s.  It has just not worked. 

    In parallel with this frustration, for 2 1/2 years, I have read many books and visited many websites. I think a trader has to become as independent as possible with respect to costs of education and trading Setups. I also have come to the conclusion that the information found in books, videos, and selected educational websites are the answer and not these high-priced seminars. Can you honestly be persuaded to think that you can trade options after a two, three day or one week course?

    I have just found www.1options.com and I am very impressed. I believe after reading Pete’s articles I will have no reservations about using some of his advisory services for a portion of my trading.  To give the independence I desire (unless there are better suggestions), to buy INO.com Market Club for triangle trading and options on those stocks that are optional. INO gives you short term predictions on the market and now also perhaps Pete’s Scanner. . Other sources might be TradingMarkets with their Power Rating in nearly every sector and trading strategy imaginable. For option selection and Eval I am leaning to PowerOptions, www.poweropt.com, I am not sure about their picking capabilities but the tools analyze every strategy and every premium value with time..

    The sources I have not liked and in some cases I have been burned are: Steve Sarnof’s Option Hotline; Ken Trester (He is a great writer but not much of a picker), Bernie Schaeffer (shun); ChangeWave Option Weekly (WOW); DeathCross Trader. And one major rip-off is Failsafe Options @www.stockoption-trading.com. Some lesser disappointments have been DON Fishback’s ODDS; Optionetics with Platinum Express and IBD On-Line (O’Neil). .). Early on, I bought an Options University Option Course, it was OK but just strategies that you can read/copy strategies at www.888options.com and www.cboe.com. It did not teach option trading.

    Now, some help, does anyone have experience with the following option/stock advisorys: DayTradeTeam; Dr.”J”, Jon Najarian Option Trader; Red Oak Capital; Gryphon “Raging Bull”; Ken Trester Fast Option Profits (quick, small trades); Investment House has a Option Service and a good educational site; Profitable Options and Trotter’s Stock Option Volatility Trading.

    Stock Selection Software: Decision Bar; Vector Vest and Omni Trader.
    Option Selection Eval Software:  OptionVue5, expensive and Option Wizard

    Another subject for another day is “Option Selling”.  I do not like the vertical credit spreads but is selling naked PUTs any better?  Seems as if the received premiums per contract are small but you don’t dare buy a slew of contracts for fear of being exercised or heaven forbid receive a margin call.  Can you incorporate sell stops for protection for these trades? And how do you monitor your margin account to prevent having to come up with a load of money? I have been in an IRA where you can’t short because you can’t have a margin account, so margins are an important subject to me as I know little about the subject.

  • On 09/04, Pete Stolcers said:

    Hi Bill,

    WOW - Thanks for the information. It will certainly help other readers. 

    I do not track other advisory services so I don’t know how reliable they are. In fact, I make it a point not to read other research. I prefer to operate in a vacuum so that I can formulate my own opinion.

    I hope your post prompts others to share their experiences.

    If you are looking for a naked put writing course I have an online video course for sale. Let me know and I will cut you a deal (I appreciate your post). Once a year I host a 2 hour webinar for students past and present. I cover key concepts and I highlight a current opportunity or two. I am due for one of my webinars in the next month. Don’t be fooled by the title - “Covered Call Writing - The Right Way!”. This is a put writing course.

  • On 09/08, Bill Hein said:

    Thanks Pete for replying to my Post of 09/04.  I believe I have found a home at your sites and blogs. In this confused world of the want-to-be trader with a burning desire to excel but still not quite sure of core trading strategies plus the studies and efforts of acquiring the important skills of determining the right side of the short-term market, impact of news/events and consistently choosing the better underlying stock for the option plays.  These trading elements must be in place before I break my fast and begin full-time trading again.  I pulled-back for the very reasons cited above.

    During my Fact Finding (or Discovery) I am having difficulty with the sell or write side of options.  Even if the reward per contract is limited (or very small) how can you ignore the increased probability of winning plays?.  I have read it is likened to switching sides at a gambling casino with the house odds now in your favor.  But frankly, credit spreads and writing naked Puts cause me some concern that could limit my trading tactics because of being fearful which perhaps can be minimized with being better informed.

    It seems to me that successive option writes on the same owned underlying stocks could be at least, one way to go. You could keep in check the stock and number of shares to hold and not have so much of your assets tied up in stocks.  Then trade, trade again, and again the corresponding write options. I am currently skimming thru two books on the subject, “Covered Calls and Naked Puts”, by Ronald Groenke and “The Complete Guide To Option Selling”,by James Cordier and Michael Gross.  I will read them throughly; but now, having discovered your writings I want to read them as well. PLUS I may take you up on the purchase of “A Naked Put Writing Course” your online video course for sale.

    I would appreciate and value any advice, comments and recommendations from you and your regular blogers and knowledgeable traders.

  • On 09/08, Pete Stolcers said:

    You are doing the right thing. Read as much as you can and some of the concepts will resonate. You will find your own trading personality over time.

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