There are many profitable option trading strategies, but none of them work unless you are willing to stick to a set of guiding principles. I employ a number of rules that are helpful in maximizing profits, limiting losses and, most importantly, taking the emotion out of trading that all of my subscribers should take the time to understand.
In this article, we’ll go over my basic trading philosophy, why I decide to take profits or cut losses when I do and how these decisions will be used to limit risk, all of which will prepare you before you make your first options trade.
Rule #1: Taking Profits
My expectation for every option trade is at least a 100% return. Once a trade reaches a 100% return, we can either:
- Exit the trade completely.
- Sell half of the position, place a protective stop on the remaining half and keep riding the wave.
Once the option premium has reached my target, I typically close the position and move on to the next trade. As an alternative, if the 100% profit target is reached, I might instruct you to sell half of the position. For example, if you bought 10 option contracts for a particular trade and I instruct you to sell half of the position, you would sell five and keep five open in your account. This takes all of the financial risk out of the trade because you now have your original investment back, and you are only trading with “the house’s money.”
Sometimes an option will zoom past the 100% target, in which case we can ride the stock higher or lower (call or put option) for even further gains. Once this happens, we would place a stop order to protect our profits if the stock turns against us. Now that the option is profitable, we have a bit more flexibility with where we place our stops, and we can allow more room to accommodate market volatility.
We may also take profits on our trades BEFORE reaching the 100% profit if we feel something has changed dramatically with the company since the trade began.
Rule #2: Stop Losses and Stop Targets
I try to limit losses to 50%. Once a trade is down 50%, we usually cut our losses and move on. On some occasions, however, I may decide to give the trade some additional wiggle room. Keep in mind that if you have your 50% stop loss entered as an actual order, you will be forced out of the position. Occasionally, I will use “mental” stops rather than stop limit orders so this does not happen. However, most of the time if we place a stop on a trade, it will be an actual “hard” stop limit order.
Setting stops and exit targets is my most important trading rule. Traders can get greedy and often give back major gains by not having these protective profit stops in place, which is why we’ll use them to take the emotional aspect out of our trading strategy.
Rule #3: Understanding Stock History
I love researching the market, and I’ve spent countless hours studying different individual stocks. As you start to do your own research, you will see patterns emerge. Once you know how a stock trades historically and how it reacts to news, then you can start looking for option trades and put the probability of success on your side.
Once you get to know a stock’s “personality” and understand how pending news — good or bad — affects it, then you have already won half of the battle. Remember — it’s not whether the news is good or bad. It is only how that specific stock reacts to the news that matters.
Rule #4: Open Interest
When I recommend an option, I make sure there is plenty of open interest. Open interest is basically the same as a stock’s average daily volume. When a stock or option has low volume, it can be harder to get trades executed at the prices you want. This is where limit orders come in to play. When you place a limit order, you are saying you are willing to pay or receive no more than a certain price.
Rule #5: Out-Of-The-Money (OTM) Options
Most of the option trades I recommend are slightly out-of-the-money call and put options. I do not place trades that are too far out-of-the-money. These options almost always expire worthless. In other words, if a stock is at $50, I am not going to buy a call option with a strike price at $80, or buy a put option with a strike price of $30 (unless it is a LEAP). The odds of the underlying stock moving 40% in either direction in six weeks or less are slim.
Occasionally, I may consider buying LEAP options. LEAPs are longer-term options that won’t expire for six months or even several years. This allows time for a stock to make the significant move you are looking for.
I normally do not recommend options that cost more than $2.00 ($200) per contract, which is why we usually go with out-of-the-money options, as they are usually much cheaper. Most of the options I recommend are priced between $0.50 and $1.50 per contract. Keep in mind that if an option has a premium (cost) of $1.00, then 10 option contracts cost $1,000.
Rule #6: Giving Option Trades Enough Time
Normally, I buy options that are at least more than three weeks away from expiration, which usually allows enough time for a trade to develop. However, there are times when we will want to play options that may have one to two weeks before they are set to expire. These profits will be more explosive if we get the direction right, but also more damaging if we get the trade wrong.
I will also occasionally recommend options with one to two months until expiration. These trades carry less risk because there is a lot of time premium built in due to their far-away expiration dates. These trades can sometimes lose up to 80%–90% and still come back to return profits in excess of 100%, depending on the action in the underlying stock. I have had a few trades look like complete duds only to rebound and generate stellar returns.
Rule #7: Selling Before News Announcements
Sometimes we elect to sell an option before news for the underlying company actually breaks. For example, if we are up 100% on a trade going into an earnings announcement or an FDA decision, we won’t get greedy. I refuse to let emotion get the best of us! Always remember that a profit is a profit — not a loss. Consider your portfolio like your own company. No company likes to take losses, and they are always worried about the bottom line. Don’t let a winning trade turn into a loser.
Rule #8: Position Sizing & Money Management
There are no strict rules about how much money you should start with to trade options. However, please know that option trading is “speculative.” This means you should only trade with money you can afford to risk. A speculative account might make up 10% or less of your overall trading account and investments. The bottom line is this: Do not use you entire nest egg to trade options!
Consider risking only 5% of your trading account on any one position. For example, if you have a $10,000 trading account then risk no more than $500 per position. In a worst-case scenario, you would need to lose 20 trades in a row before you would be out of the game.
If you are new to trading options, then your maximum position size might only be 2%–3% of your trading account balance. Increase your position size as you gain confidence and get some winning trades under your belt.
Before placing an actual option trade, you must decide the following:
- How many contracts you are going to buy?
- What will your profits be if the trade moves in your favor?
- How much money you are putting at risk?
Always keep your maximum position size in mind. If you are buying more expensive options, then you will need to reduce the number of contracts you buy.
The Bottom Line
Option trading requires discipline, and my trading strategy is designed to make staying disciplined and unemotional extremely easy.
As you can see, I make sure we take every necessary step to ensure that we collect profits when they are available, limit losses before they occur and only choose options with strike prices and expiration dates that maximize our chances for success.