Steps in Trading Options

What Are The Steps To Take In Trading Options?

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Steps in Trading Options - Introduction

Trading options is very different from trading stocks itself. In stock trading, the only decision you need to make is whether the stock would go up or down and then just buy or short the stock. However, stock options, as a complex derivative instrument, require a more complex decision making process in order to make a profitable trade. In options trading, you could lose money even if your outlook on the underlying stock is correct if you get the decision making process for which option to trade and how to trade it wrong.

There are many ways to trade options. Options can be used for hedging, arbitrage, as well as directional speculation. This options trading tutorial shall outline the steps involved in making a directional speculation using options.

Overview of the Steps in Trading Options

There are four main steps in the process of trading options for directional speculation; Outlook, Planning, Entry, Exit. Directional speculation means using options to profit from a upwards, downwards, neutral or volatile outlook on the underlying stock using various outright or options spreads strategies. These steps in trading options assume that you have a good understand of the basics of options trading.

Step 1: Outlook

In stock trading, the most important outlook is whether a stock is going upwards or downwards. However, in options trading, the more specific your outlook, the better you would be able to use an options strategy that fits that exact outlook resulting in better return on investment.

The there are three main components to crafting an outlook in options trading; Direction, Price Target and Time Span.

Direction

In options trading, not only can you profit from an upwards or downwards move but also from a sideways and multiple directions at the same time! However, the more directions you wish to profit from simultaneously, the lower your return on investment becomes due to bigger capital outlay or margin. When trading options, the more accurate and precise your outlook is, the better your return on investment becomes.

Steps in Trading Options and Roll Up Example : Assuming AAPL is about to stage a breakout and two options traders, John and Mary would like to profit from this breakout. John is uncertain about the direction of the breakout but is certain it will be significant. Due to this uncertainty, John settled for a Long Straddle options strategy which is capable of profiting from both an upside and downside breakout. Mary is certain that when AAPL breaks out, it will be to upside. She went for an aggressive Long Call Options strategy which profits to upside and loses it all if it doesn't. AAPL finally breaks out to upside and Mary makes a profit of 100% while John makes a profit of 20% on the same move due to lower leverage.

Price Target

In stock trading, having a price target merely allows you to know when to sell for profit. In options trading, having an accurate price target means that you could make a higher profit than an options trader without a price target or an inaccurate one. That's right, its not essential to have a price target when trading options but if you do, you would be able to return a much higher profit than without. Having a price target means not only predicting that a stock is going to go upwards but also to what price is it likely to move up to.

Steps in Trading Options and Roll Up Example 2: Two options traders, John and Mary, have the same bullish outlook on QQQQ and decide to profit by trading options. QQQQ is trading at $35. John is uncertain about how far up QQQQ will move and decides to keep the upside open with a simple Long Call Strategy. Mary is certain that QQQQ will not move higher than $40 by expiration and decides to maximise return on investment using a 35/40 Bull Call Spread. QQQQ rallies to $40 as predicted and John made a 100% gain while Mary made a 150% gain due to the lower cost of a bull call spread versus a long call.

Time Span

One of the main differences between trading options and stocks is that options have fixed expiration dates while you could hold stocks perpetually. Because options have definite expiration dates and that there are many expiration dates to choose from, you would be able to maximise your return on investment by not buying more expensive options with longer expiration dates than necessary if you have an idea of the approximate length of time the stock will take to meet your price target.

Steps in Trading Options and Roll Up Example 3: Two options traders, John and Mary, have the same bullish outlook on QQQQ and decide to profit by trading options. QQQQ is trading at $35. Both John and Mary are both certain that the QQQQ will hit $40 before it pulls back and both of them decided to go with the 35/40 Bull Call Spread. However, John is uncertain if the price target of $40 can be met within the month and decided to go with options that expires 3 months later. Mary is certain that the price target of $40 can be met within the month and decided to go for front month options. For the longer expiration date, John paid a total debit of $5.00 while Mary paid a total debit of only $1.50. QQQQ rallies to $40 as predicted by expiration of the front month options. John makes a 120% gain while Mary makes a 150% gain due to the much lower cost.

As you can see from the examples above, you will get much better returns when trading options when your outlook is precise and accurate.

Step 2: Planning

After you have your directional, price target and time span outlook figured out, it is time to plan for trade. Planning for the trade involves deciding what options strategy and how much money to use. As such, there are two main components in the planning phase; Choice of Options Strategy and Capital Commitment.

Choice of Options Strategy

There are hundreds of standard known options strategies and literally countless possible combination using options. All options strategies serve specific outlooks which is why the outlook phase is so important. Without a clear and specific outlook, you can get overwhelmed and confused by the sheer number of options strategies. Looking back up at example 2 above, you can see that John and Mary's choice of options strategies are different because Mary had a more specific outlook than John. Mary chose an options strategy that fits her outlook perfectly, allowing her to make a higher return on the same move on QQQQ than John.

Options strategies can be broadly classified as credit spreads and debit spreads. Beginners could simply skip credit spreads due to the margin involved and the fact that most brokers would not give beginners that high a trading account level. Debit spreads are typically risk limited options strategies which can lose only as much money as you have committed and are executable from low account levels.

Your choice of options strategy must also be governed by your understanding and expertise in the chosen options strategy. All options strategies need to be practised through paper trading and thoroughly understood before apply real money to them. Never choose an options strategy you have never previously paper traded.

Capital Commitment

An extremely important aspect of options strategy is deciding in advance how much money you can afford to lose in any one trade and then choose a strategy that keeps its maximum loss within that limit. This is also why you keep hearing veteran options traders say that you should only trade options with money you can afford to lose. This is because for all debit options strategies, the maximum loss is the full amount invested in the position itself. As such, if you throw all your money into that one trade that goes bad, you could lose all your money overnight. This has also led to all the horror stories of people breaking their fortunes in options trading.

Step 3: Entry

Once you have determined your outlook and planned your trade, it is time to make an entry and get committed. If you are trading options outright, meaning either buying or writing single legged call options or put options such as the Long Call strategy, entry is a simple matter of making your order using the Buy To Open or Sell To Open order. However, if you are using a multi-leg options strategy such as the Bull Call Spread, most brokers would allow you to put it on as a single simultaneous order by filling out an order form with all the options involved in the position or you could choose to "Leg" into the position by finding the best timing on your own to enter on each option involved in the position. Legging takes experience and if improperly done, could nullify the possible profits of the position, therefore, make sure you practise legging on your virtual trading platform before going real.

After you have entered the position, you should also set a stop loss point for your position in accordance to your outlook based on either stock price (using contingent or conditional orders) or options price. If you are trading only with money you can afford to lose and is willing to undertake the possibility of a full loss, you could go without a stop loss point. For instance, if I wish to lose no more than $100 per trade out of a $10,000 fund, I would simply buy options only with $100 and let the position run to profit or full loss.

Step 4: Exit

Eventually, all options positions must be exited in one of 4 ways; Exercise, Assignment, Roll Forward or Close. Exercising means exercising your right to buy or short the underlying stock voluntarily if you decide eventually to hold a position directly on the underlying stock for the longer term. Assignment means options that you are short on are being exercised by whoever bought those options and you too end up with a position in the underlying stock or your stocks being called away from your account in the case of writing call options. Roll forward means closing your expiring options and opening further month ones in order to remain invested and to close is simply to Sell To Close long options positions that you hold or Buy To Close short ones.

Don't Know If This Is The Right Option Strategy For You? Try our Option Strategy Selector!

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