So you want to know where to start in options trading to make more money? That’s great but how do you learn to trade options? Firstly, an option is an agreement with someone that gives you the right, but not the obligation to buy or sell something at a specific price on or before a specific date in the future. That’s all it is; period.
Let’s imagine you just got a job transfer to a new city and you want to buy a house but you want to wait until you know that it’s in an area that you and your family really like and that the new job works out before you buy a house.
Part of your employment contact is that they rent you an apartment for a year and then at the end of the year the company will help buy you a home. The catch is that they will not spend more than $500,000 on a home for you, so that’s your ceiling for home prices.
You start looking at homes that are for sale just to get a feel for the local market and you find what you think would be the perfect house but don’t want to buy it for a year.
The house is on the market for $500,000 but since property has been going up in value lately. You think that in a year the house might be worth $600,000 and if you could be guaranteed to be able to buy the house for $500,000 anytime in the next twelve months that would be great.
Knowing Where to Start in Options Trading
So being a financial wizard, you offer the seller an option to buy the house for $500,000 ($500,000 is the strike price of this option). The seller is not familiar with options so you have to explain to him that you are not sure that you would like to buy the house but you would like to have the option to buy it anytime in the next twelve months for $500,000 And for giving you this option, you will give him $25,000 in cash right now to buy this option (this $25,000 is called the option premium).
You explain to him that at the end of 12 months if you don’t buy it (called exercising the option) he gets to keep the $25,000 you paid him and you will just walk away. (If you don’t “exercise” the option in the next 12 months then you are just letting the option expire.) But if you do agree to buy the house or “exercise the option” he must sell it to you for $500,00 even if the value shoots up to $600,000 or more. He accepts this offer and now you are “long” one house with a call option.
Now what is your risk for doing this? That’s right, just $25,000, nothing more. If you decide to buy it you can, but if you decide you don’t want to buy it, you can just walk away and let the option expire. Either way he gets to keep your $25,000.
Now keep in mind, the house at the end of 12 months would need to be worth $525,000 for you to break even ($500,000 to buy it plus the $25,000 that you paid in premiums to buy the option). But you think it might be worth $600,000 at the end of the year so it’s a good deal for you if it does go up that much.
Basic option concepts are pretty easy to grasp. Where the challenge comes is knowing which options to buy or sell and how to know if the price you buy or sell it for is fair. You don’t want to pay too much for your options and you don’t want to sell options for less than they are really worth.
I am going to cover a whole lot of material in this blog and I think you will have a very good understanding about why options are one of the most fascinating and potentially lucrative tools you will ever use.
Options Risk and Trade Management
Just like in sports, it’s the defense that wins football games, and in trading, it’s going to be the same. You must learn to keep your “opponent” from scoring more points than you do. This is the only way to win.
Risk and Trade Management are two different things and never forget it. Risk Management is controlling the monetary risk you are willing to take before you place a trade, whereas Trade Management is controlling the trade once you are in it. These two things should be focused on even more than trading strategies. You might think this is backward but it’s not. The reason is that even if you know the correct strategy to use to enter a trade but don’t know how to control your risk or to manage your trade once you are in it, then you are doomed for failure.
You must be able to know the amount of money you are going to risk vs. the amount of money you are planning on making. And unlike trading straight futures, you must also know your break-even point.
Your first job is that of being a risk manager and your second job is being a trader. Because if you can’t learn to control risk, then you won’t have the opportunity to be a trader for very long. Fortunately options can be used strategically to control risk.
The first thing that you should learn to look at is how much money you could lose! Doing this is your primary job function as a risk manager. Too many times traders focus on how much money they think they can make and don’t pay close enough attention to how much money they can lose.
Trading options is certainly something that can lead to huge financial rewards if done properly. But let me stress right now that trading options is certainly not a get rich quick scheme. You should look at trading options as a marathon, not a sprint. Plan right now to spend several weeks learning how to trade options before you can expect to make a consistent income.
I’m going to show you how to plan your trades from start to finish. It’s going to be up to you to follow that plan. Keep in mind, that when you plan a trade you are not yet “married” to the trade. It’s during this time you are able to look at it logically without getting emotionally tied to it. However once the trade is placed many people forget whatever the logical reason was for placing the trade and let emotions control the trade. This is usually when losses occur.
Once you have planned your trade, stick with it! Don’t get emotionally involved and start jumping into and out of the markets. If you can’t handle losing money (the risk) then you should not place the trade to start with. Now from time to time, once you are in the trade, you might make adjustments to it. That’s okay but it should be part of your plan from the start and not something that you decide to do because you can’t afford to lose the money. If that was the case, you should not have placed the trade to start with.
Also, stop looking at everyone else, thinking that they know more than you do about the markets and that you should take their advice about a particular trade you are in. You must learn to develop you own style of trading; a style that you are comfortable with, that does not keep you so stressed out that you can’t sleep at night. Nothing is worth losing your health over.
Throughout Where to Start in Trading Options and the rest of my options courses you are going to hear me talk about controlling risk until you are ready to scream at me that “enough is enough”. Well, I’d rather you get upset with me about talking about it too much rather than not enough. Wouldn’t you?
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* Testimonials are not a guarantee of future success. All information is for educational use only and is not investment advice. Trading financial instruments, including Stocks, Futures, Forex or Options on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in any of these financial instruments you should carefully consider your investment objectives, level of experience, and risk appetite. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. The possibility exists that you could sustain losses exceeding your initial investment. You should be aware of all the risks associated with trading and seek advice from an independent financial adviser if you have any doubts. Past performance, whether actual or hypothetical, is not necessarily indicative of future results. All depictions of trades whether by video or image are for illustrative purposes only and not a recommendation to buy or sell any particular financial instrument and do not factor in trading costs in trading examples due to varying commission and fees among traders. The impact on market prices due to seasonal, market cycles or news events may already be reflected in the price. See full risk disclosure. See full risk disclosure.