Rules for Success in Option Trading

By: Lawrence McMillan

The following is an excerpt from Lawrence McMillan's Reducing the Risk of Option Trading

Rule 1: Trade In Accordance With Your Comfort Level And Psychological Identity

If you are not comfortable selling naked options, don’t worry – even if though such strategies are nicely profitable for some traders, they should not be used if they cause you sleepless nights. If hedged positions drive you crazy because you know you'll have a losing side as well as a winning side, perhaps you should trade options more as a speculator, forming opinions and acting accordingly.

The important thing to realize is that it is much easier to make money if you are "in tune" with your strategies, whatever they might be. No one strategy is right for all traders, due to their individual risk and reward characteristics and accompanying psychological demands.

Rule 2: Always Use A Model

The biggest mistake option traders make is failing to check the fair value of the option before it is bought or sold. It may seem like a nuisance, especially if you or your broker don’t have real-time evaluation capabilities, but this is the basis of all strategic investments.

Rule 3: Don’t Always Use Options

The underlying instrument may be better, especially if options are overpriced or markets are too wide. This is related to the previous rule. Sometimes it's better to trade the underlying futures contract, rather than the options, especially if you're looking for a quick trade. Over a short time period, an overpriced option may significantly underperform the movement of the underlying instrument.

Rule 4: Buying An In-The-Money Call Is Often Better Than Buying The Underlying Instrument; Buying An In-The-Money Put Is Frequently Better Than Shorting The Underlying Instrument.

An in-the-money option has a high delta, meaning that it moves nearly point-for-point with the underlying futures contract. Furthermore, the option's price contains only a small amount of time value premium, the "wasting" part of the option asset. Thus, the profit potential is very similar to that of the underlying instrument. Finally, the risk is limited by the fact that one cannot lose more than the price paid for the option, while you have a much larger risk when owning or shorting the underlying instrument.

Rule 5: Don’t Buy Out-Of-The-Money Options Unless They're Really Cheap

This is really a corollary to the above rule, but it’s important enough to state separately. Obviously, you can't tell if the option is "cheap" unless you use a model. If the out-of-the-money option is expensive, then revert to the previous rule and buy the in-the-money option.

Rule 6: Don’t Buy More Time Than You Need

The long-term options often appear, to the naked eye, to be better buys. Novice traders often feel that the seemingly small extra expense for a longer-term option is attractive. This could be a mistake, especially if you're looking for a short-term trade. The excess time value premium that you pay for a longer-term call, and the resultant lower delta that it has, both combine to limit the profits compared to a shorter-term call.

On the other hand, if you're looking for the futures contract to move on fundamentals, you need to buy more time, because you don’t know for sure when the improving fundamentals will reflect themselves in the price of the underlying instrument.

Rule 7: The Options Positions That Are Equivalent To Long Futures And To Short Futures Are Perhaps The Most Important Ones

Buying a call and selling a put, both with the same terms (strike price and expiration date) produces a position that is equivalent to being long the underlying instrument. Similarly, buying a put and selling a call with the same terms is equivalent to being short the underlying instrument.

Rule 8: Know The "Equivalent Option Strategy" For Every Underlying Instrument

If you trade futures, knowing the "equivalent option strategy" should be mandatory, as it allows you to extricate yourself from a position that is locked limit against you. When futures are locked limit, the options will generally still be trading. The prices of the options provide a price discover mechanism, in that you can see where the futures would be trading were they not locked at the limit.

Furthermore, you can take an equivalent option position opposite your losing futures position, and effectively close out the position at the current level without risking further limit moves.

Rule 9: Trade In Accordance With Your Comfort Level And Psychological Identity

This is the first and last rule and, ultimately, the most important one.