Options Trading Basics

Options Trading Basics:
Today I am going to discuss a basic strategy for buying call and put options. Let me caution everyone that options carry some additional inherent risk over buying or selling short the underlying security because options contracts expire, and you are leveraging your money, which carries additional risk as well. This is not meant to be a comprehensive lesson, but more of an introduction to the basic concept. I would suggest, if you are interested in buying puts and calls, that you find some additional options education and you paper trade several positions before putting real money on the line.

Here are 3 keys to make simple options trading more successful:

Find highly correlated call and put options with a delta coefficient of 0.8 or better. The best correlated options to their underlying securities are the options with a high delta coefficient, commonly just referred to as the “delta”. This is the ratio comparing the change in the price of the underlying security to the corresponding change in the price of an option. For example, with respect to call options, a delta of 0.8 means that, for every $1.00 the underlying stock increases, the call option will increase by about $0.80. For put options, the delta coefficient, on the other hand, will be negative, meaning with a -0.8 delta, for every $1 the underlying security goes down, the put option will go up roughly $0.80.

Find call and put options with more than 500 contracts outstanding. A call or put options is a contract that gives the owner the right, but not the obligation, to buy 100 shares of the underlying security. The fewer contracts that are outstanding, the more thinly held the option is. Avoid thinly traded call and put options with fewer than 500 contracts outstanding, as these options will have lower liquidity and inherently higher risk. The higher the open interest, the better. Also note that open interest is different than daily trading volume, which has little or no effect on open interest.

Use risk management rules to avoid overleveraging. This is VERY IMPORTANT! Call and put options are much less expensive than if you were going to purchase shares of the underlying security, often many times lower. Therefore, it is tempting to want to purchase more call or put options than is prudent from a risk management perspective. For example, if you want to keep your risk profile in your account to a maximum of 1% risk for any specific position and, to do that, you would be purchasing 100 shares of a given stock to maintain that risk profile, you would be limited to purchasing 1 call option contract that controls 100 shares to keep the risk profile the same. If you purchased 4 call options contracts, you would be controlling 400 shares and, with the equivalent stop loss levels, would be carrying 4 times more risk than the 100 shares you would have purchased based on the 1% risk in the example above. Therefore, it is important to calculate the number of underlying shares you would purchase of the underlying security and then purchase the corresponding number of contracts to control that number of shares. For example, if you would purchase 200 shares of a stock you should only purchase 2 call options contracts. This will keep you from overleveraging your account on that position.

Follow these 3 rules, find options with a high delta (0.8 or higher), open interest above 500, and don’t over-leverage or buy too many contracts for your risk profile. These rules may help trading call and put options in an effective and successful way for you to trade the stock market. Again, make sure, if you are interested in options trading, that you paper trade first and get some additional options training before you put live money on the line.