If You Can't Do This, Stop Buying Options  | BY Keith Kaplan
CEO, TradeSmith |
Options trading is one of those life skills that’s difficult to master, but very rewarding for your effort. It’s the trading equivalent of driving a motorcycle instead of a car. There’s more to remember while you’re doing it. If you don’t, you’re in big trouble… because the risk is much higher. Still, the rush of riding on two wheels is hardly ever matched by four. Options are much the same. The risk floor is higher, but it still varies depending on what you’re doing. Selling options for income is decidedly much lower risk – like a three-wheel motorcycle or “trike,” let’s say – and that’s why it’s the main way I trade them. The tradeoff for that is a greater degree of complexity… and higher requirements for starting capital. That’s why, when most traders start with options, they speculate by buying options instead. That’s something you have to accept if you’re going to buy options. You’re speculating. And by speculating, I mean you can lose all your money, quickly, if you don’t get a very specific outcome. And the longer you don’t make money holding an option, the more likely you are to lose it all. If selling options are like riding a trike, buying them is like trying to pull off a wheelie all the way across the Golden Gate Bridge. Tricky, but potentially very rewarding. Once you accept those realities and decide you still want to speculate, then you’re ready. And to help you out even more, I have three golden rules to buying options which I’ll show you today. They’ll help you mitigate some of this risk. And they’re the opposite of what most newbie traders like to do when they start. Stick around till the end, and I’ll also show you a speculative options idea turning up in our Options360 software… Three Golden Rules for Buying Options Rule #1 is simple. No matter how tempting it is, no matter how right you think you are, and no matter how much you stand to make if you’re right, never double down on a losing options trade. This is the single most common mistake new options buyers make. They treat options like they’re stocks that have infinite time to recover… assuming they can just “average in” or “buy in tranches” as you would with a stock. That doesn’t work because options have a factor called time decay, where the value of the option deteriorates rapidly in the last 30 days until it expires. If you’re in an options trade that hasn’t moved in your favor, and especially if it’s set to expire in the next month or two, then don’t buy more of it. You’re better off either sitting through the volatility to see if it turns around… or calling it quits and accepting a small, but not complete loss. Rule #2 takes a little more explaining. New options traders scanning through the chain are too often tempted by those strikes way out of the money (explainer on moneyness here). Those $0.10 “lotto ticket” style trades that only pay off if the stock pulls a wicked move in a matter of weeks or days. The first reason this happens is obvious enough. They’re moonshots. They’ll pay out big if the very slim odds turn in your favor. But the other reason people are tempted by them is, like a lotto ticket, trading these doesn’t cost much. A $0.10 option costs $10. You, me, and a lot of people you know have almost certainly spent $10 on something sillier than an opportunity to make money. Once again, though, lotto tickets and far out-of-the-money options are cheap for a reason. They’re most likely a waste of time and capital. Trade closer to the money, and you’ll experience less volatility and higher odds of winning, generally speaking. And that brings me to Rule #3: keep your bets small. With options, your trade size should be some small fraction of what you’d normally initiate a stock position on. Say you buy a stock with $1,000; well, maybe $200-$300 is a good size for an options trade. That’s because, if you buy too many options contracts, you’re exposing yourself to far more leverage than you’d normally have in a stock. This amplifies how quickly you lose money, which as we’ve discussed has a direct impact on your emotions and ability to reason. Assume every option you buy has a high potential for going to zero, and your position size should adjust naturally. Now, this isn’t all to say that buying options is some fool’s errand. It can and does make money if you do it the right way. That leverage cuts up just as much as it does down. So, now that you know of three bad newbie habits to avoid, and accept the overall risk of buying options, let me give you an idea to test out yourself… One High-Odds Options Idea from Options360 Here at TradeSmith, our Options360 software suite includes a bunch of different tools you can use to screen the market for opportunities. It’s powered by our Probability of Profit algorithm – the lynchpin of the system. It shows you the likelihood that an options trade will pay out based on the volatility picture unique to each underlying stock. I just went into Options360 and set it to look for any opportunities involving long call options or long put options. This one caught my eye: 
This is a put option on video streaming company Roku (ROKU). Essentially, this represents a bet that ROKU stock will go down by about $2.50 per share between now and Dec. 20. One put option at the $75 strike on ROKU costs $665, so this might be on the pricier side for a first-timer. The reason the cost (or "premium") is so high is because this option is pretty close to the money. Because of that, it has a high likelihood of gaining intrinsic value. It’s much less of a “lotto ticket” than a far out-of-the-money option. And that’s part of the reason this option has such a high Probability of Profit. Our system shows it having an 88% chance of being profitable by expiration. Take a look at these key stats on ROKU as well, which inform the POP score: 
A side-trend means the stock is more vulnerable to a quick pullback than if it were in a strong uptrend. If you’re new to buying options, this ROKU put might be a great paper trade for you to get your feet wet. Just keep in mind everything you read today, whether you trade this with real money or a paper account. Don’t double down, don’t stray too far out of the money, and don’t get greedy – with this or any other speculative long-options trade. All the best,  Keith Kaplan
CEO, TradeSmith P.S. If you're already far along in your options trading education, Options360 might be a great tool for your kit. In addition to finding trades like the ones I showed you today (and many more), Options360 also generates top options plays and emails them straight to your inbox. Learn more here. | 
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