To get you better familiar with what we do and how trades are profiled, we have put together this Welcome Guide.
There are a few things you need to know before getting started in options trading, especially the kind of trading we are going to teach you. You will need to learn how a lot of moving parts work in order for a trade to work and what kind of success/ failure the trade could have.
The number one rule we use in trading is to set stops (on most trades, some we will not have stops for) and targets or “entry” and “exit” prices when we are getting in and out of a trade. The trades we teach target 100% returns (or more) and we try to keep losses at 50%.
You will study a lot of charting and you will have to know your stocks.
When we say “know your stocks” that means you will learn ticker symbols and know how these stocks trade. The blog will quote stock symbols, current prices and we will show you charts from time to time to get you familiar with learning to look at a chart. This will help you with "support" and "resistance". You will learn how to keep Watch Lists and discipline yourself on taking profits and losses.
The biggest part of learning to trade options successfully is to know where the money is going before the rest of the public starts jumping in.
For instance, once a sector gets hot, another sector fades. When news comes out about the economy or a specific company, you will learn how to react. The best way we can explain the power of options is this way.
Remember when Enron was tumbling from the $50’s all the way to bankruptcy back in 2001? Back then, it was the biggest story on Wall Street in quite some time and many people lost a fortune. However, when the news started leaking, people could have used put options to protect their portfolios or even their company stock if they had known how to use options.
Of course, we have seen many such disasters and debacles since, but if history has taught us anything, it is that more and more people are managing their own money. And why shouldn’t you?
Another thing that we will teach you is how to tame your emotions. Once you learn to treat your portfolio like a business you will understand your goals which helps take the emotion out of trading.
We have talked about numerous companies in the blog and we have positioned investors to make as much as 100%, 200%, and 800% on such trades. We have played stocks on the way up that have made 2,500% (Dendreon) and we have played stocks to the downside for gain of 880% on AIG.
The portfolios you see on the website are trades that were discussed in the blog. You can reference those trades and what was mentioned in the blog at the time of the trade by clicking on the dates.
As you will learn, we use both call and put options and sometimes we recommend strangle and straddle option trades. To get a better feel on why we used call options on a certain play or why we used put options, follow the trades by reading the articles in the archives that appear on the website. In other words, we want to prove to you that these kinds of returns are possible.
We list each month since we started the blog and the archives also give you some history on how a stock trades. For instance, say you were looking to do a Google trade and you wanted to see how the stock has reacted around earnings or if we have played it in an up or down trend. Simply type in “Google” in the search box and it will list any Google trades that may have been talked about.
The most important thing you will need though is money. A lot of people want to trade options with only a $100 or $1,000. You can start with this amount but one or two bad trades are going to do you in. Our philosophy is to build a solid foundation of wealth and then use some of that for your “riskier” investments. It is possible but we suggest having $2,000 to start your trading business.
You will be amazed once you start seeing how fast a trading account can grow. If you start an options account with $3,000-$5,000, you can easily double or triple that with the right trades in no time.
Also realize that many of the option trades covered in the blog are high risk/ high reward type trades. Our goal is to make 100% on every trade while limiting our losses to 50%. Sometimes in tighter markets those targets might be reduced but if you can do that and get a 75% success rate on your trades (like our track record proves), then you are well on your way to becoming a millionaire. One of our favorite questions to investors is: “What are you doing TODAY to become a millionaire TOMORROW?” In fact, we like it so much we made it our slogan.
Most of all have fun and learn how options work before trading. If you are an experienced trader, then welcome aboard. The one thing you must do is pick a strategy that works for you and practice trading. By that we mean practice on paper first.
Let’s say you don’t have enough money to start a trading account and your goal is to save $3,000 to start trading. While you are doing that, pick a strategy (buying a call or put option) and see how it plays out based on where you think the stock is headed.
Once you see how options work you will see why they are the most powerful tool ever created. You will not find the type of returns that options provide at a poker table, in real estate, or in gambling. To some, option trading is legalized gambling but if you are going to trade options, learn to do it better than the next person.
With that said, we hope you find this trading manual enjoyable and profitable.
One of the most frequently asked questions we get is option position sizing and how much to allocate for each trade. This is always a difficult question to answer and one that affects each investor differently.
What makes it complex is that every investor has a different level of money they can afford to invest along with different levels of income and age. Obviously someone in their 20’s can be a bit more aggressive than someone who is nearing retirement.
When it comes to trading options, the following advice may not be the right choice for you but it should give you a better idea from which to base your decisions. For my options trading account, I do not risk more than $5000 in any one position. For someone that is new to trading options, then your starting point should be a little lower, like $250-$500 due to your lack of market experience. And that would be based on a $10,000 trading account.
If I buy 10 contracts at $2, it’s $2,000. If I do a 20 contract trade at $2 then it’s $4000. I don’t usually buy options that are priced over $2.50 but once in a while I may. These are my comfort levels, based on several years of trading options but I have known investors who have opened option trading accounts with $2,000 and risked half of it on their first trade. Needless to say, if the trade went south, they were either done with options or reloading their trading account. To me, that is gambling, and it’s important to think of trading options as a business and not a “get rich quick” scheme.
You should consider a discount broker and not a full-commission or “service” broker. The fees from the full service broker will be substantially higher and they will usually frown on you (this also comes from my own personal experiences). The discount brokers are pretty reasonable charging anywhere from 75 cents to $1.50 per contract with a $15-$25 minimum. A “broker-assisted” trade could cost in the range of a $45-$60 (or higher) minimum and as much as $2.25 per contract.
Also have an open mind that every option trade is not going to be a winner. With that, you must consider the percentage amount you are prepared to lose if you happen to be in a trade that is not going your way. My set amount is usually 50% depending on market conditions due to the nature of a leveraged position. What I mean by that is – think in lots of 10 contracts – it means you are controlling a 1,000 shares of stock.
In the end, it all comes back to you and what you are comfortable with. These are some of the guidelines that I use but they are important, especially if you are just getting started in option trading. It’s a far cry (and greater thrill) from trading options on paper to when you actually make your first trade. Going in blind will only increase your chances of frustration.
***Our golden rule of thumb and my number one and two rules are setting stops and exit targets. ***
Our expectation for every option trade is at least a 100% return. Once we get there, we set stops and either get out, sell half, or ride the wave regardless if it is a call or a put option. On the flip side, we limit or losses to 50%. Once a trade reaches a 100% return, it is usually maxed out and once a trade is down 50% it usually keeps going lower. There are exceptions of course but in most cases this is the strategy we use.
A stop is when you are forced out of a position because it is going the wrong way. A stop can also be used to protect profits. If your position is up 125%, you want to protect that 100% return by having a stop in place. Traders can get greedy if the see a return of 200% and often give back major gains by not having these stops in place.
An exit target is where we have figured the stock will be trading at once the stock or option has reached our target we move on to the next trade. If your exit target is reached you can sell half of the position and take all of the risk out of the trade because you will have your original investment back.
Sometimes we get lucky and the option zooms past our 100% target and we ride the stock for even further gains. Once this happens, it is easy to set stop to take you out of the position and it gives you more room for to play the volatility.
Once you know how a stock trades and its history on how it reacts to news, then you can start looking for option trades.
***When buying an option, make sure there is plenty of open interest. ***
This 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 the trade executed or at the prices you are looking for. This is where limit orders come in to play and you will learn about them along the way.
The trades we talk about in the blog use out-of-the-money call and put options. We normally recommend that you do not pay more than $2-$3 ($200-$300) for an option contract and we usually get into trades on option contracts that are selling for $1-$2. For instance, if a May 40 call option is priced at $2 then 10 option contracts would cost $2,000.
***Most of the time we use options that are more than three weeks away from expiring ***
This allows plenty of time for the trade to develop but there are times when you will want to play options that may only have a week or two before expiring. These profits are more explosive if you get the direction right but also more damaging if you get the trade wrong.
***Sometimes you will have to sell an option or stock before the news is out. ***
If you are up 100% going into an earnings announcement or an FDA decision, your emotions may get the best of you. Always remember a profit is a profit and not a loss. Consider your portfolio your company that you own. No company likes to take losses and they are always worried about the bottom line.
Some of the option strategies are Long Call, Long Put, Short Call, Short Put (Covered Calls, Straddles and Strangles)
Description: If you buy a call you are hoping the stock will go up in value. If the stock goes up, you hope to sell the call for a higher premium. Or, you can exercise the contract and buy the stock at the strike price.
Call options give traders the right to buy the underlying stock at the strike price until market close on the 3rd Friday of the expiration month.
A call option is in the-money (ITM) if its strike price is below the current price of the underlying stock.
A call option is out-of-the-money (OTM) if its strike price is above the current price of the underlying stock.
A call option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock.
Buying a call means you are bullish (you believe the stock will rise), so you would buy (go long) calls. Buyers have rights. A call buyer has the right, but not the obligation, to buy the underlying stock at the strike price until the expiration date.
If you buy a call option, your maximum risk is the money paid for the option. The maximum profit is unlimited depending on the rise in the price of the underlying asset.
To offset a long call, you have to sell a call with the same strike price to close out the position. By exercising a long call, you are choosing to purchase 100 shares of the underlying stock at the strike price of the call option.
Most option traders do not exercise the option, they simply sell the call (or put).
Description: If you buy a put you are hoping the stock will go down in value. If the stock does drop in value, you hope to sell the put for a higher premium. Or, you can exercise the contract which gives you the right to sell the stock at higher prices.
Put options give traders the right, but not the obligation, to sell the underlying stock at the strike price until market close on the 3rd Friday of the expiration month.
A put option is in-the-money (ITM) if its strike price is above the current price of the underlying stock.
A put option is out-of-the-money (OTM) if its strike price is below the current price of the underlying stock.
A put option is at the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock.
Buying a put means you are bearish (you believe the underlying stock will fall in price), so you would buy (go short) puts. When the put is purchased, it is called an opening transaction. A put buyer has the right, but not the obligation, to sell the underlying stock at the strike price of the option until the expiration date.
Furthermore, if you buy a put option, the risk of the trade equals the money paid for the option, just like a call. A profit will result if the underlying security moves below the strike price. However, the profit is limited because the underlying asset will not fall below zero. To offset a long put, you will have to sell a put with the same terms (strike price and expiration) to "close" out the position.
Short Call (Naked Calls)
If you sell a call you are hoping the stock will go down in value. If the stock goes up, you could be forced to buy the stock. The call option you sold can be exercised and you will have to buy the stock if the calls are ITM.
We do not recommend “naked” trading because it is the riskiest strategy of all options trading.
Here is how it works. If a stock is at $20 and the $22.50 call option for the month is trading at $1, you would place an order to “sell to open” and would collect the $100 for each contract you sold. You are doing this because you think the stock will stay below $23.50.
That is your breakeven point because you add the $1 to the strike price (22.50 + 1). If the stock stays below that level, the option will not be exercised.
Note: I always do the breakeven points to be on the safe side. If the stock is at $22.55, technically, the options could be exercised.
If the stock is at $24, it is above the $22.50 strike price. Whoever owns the right to that option you sold is going to buy the stock from you at $22.50 instead of going to the market and paying $24. So for every option contract you sell short, it would cost you $2,400 because you would have to go out in the market and buy 100 shares at $24 apiece. You would then get back $2,250 if the option was actually exercised but if the stock is at $30 you would be paying $3,000 to get back $2,250. This is why the loss is unlimited.
Short Put (Naked Puts)
If you sell a put you are hoping the stock will go up in value. If the stock goes down, you could be forced to buy the stock at a higher price than what it trading for in the market. The put option you sold can be exercised and you will have to buy the stock if the puts are ITM.
Here is how it works. If a stock is at $20 and the $17.50 put option for the month is trading at $1, you would place an order to “sell to open” and would collect the $100 for each contract you sold. You are doing this because you think the stock will stay above $18.50.
That is your breakeven point because you add the $1 to the strike price (17.50 + 1). If the stock stays above that level, the option will not be exercised.
If the stock is at $16, it is below the $17.50 strike price. Whoever owns the right to that option you sold is going to sell the stock to you at $17.50 instead of going to the market and getting $16. So for every option contract you sell short, it would cost you $1,750 because you would have to buy 100 shares at $17.50 apiece.
You would then get back $1,600 if the option was actually exercised but if the stock is at $10 you would only be getting $1,000. This loss is limited because the lowest the stock could fall to would be $0.
This is pretty much the basics, folks. As you read the blog and get to know us you will really start to understand how options work. Thanks again and good luck with your trades!