15 Rules To Get The Most Out Of Options
Most investors who buy options wind up losing money — usually for the very same reasons that investors lose money in the stock market or any other investment: They let their emotions get the best of them. Plus, they don't realize that options, if abused, can be like playing the lottery or a slot machine. You can't lose more than you spend on each try, but if you play every day, month after month, your cost can add up to an unlimited amount over time.
To avoid these pitfalls and improve your chances for success, follow these rules:
Rule 1. Always limit the amount you invest in options to the amount you can afford to lose. A good rule of thumb for most investors is to keep at least 95 percent of your money in safe or conservative investments. Allocate no more than 5 percent to options. If you cannot afford to lose the 5 percent of your portfolio allocated to options, options might be too risky for you.
Rule 2. Don't invest the entire allocation at once. Spread your funds out over at least one year's time. For example, if you are planning to invest $10,000 in options, that could be $2,500 per quarter.
Rule 3. Unless it's a very special situation, try to avoid options that cost less than $50 per contract. Typically, these are options that have a very low chance of success — because they're so far out of the money or have a very short time remaining, or a combination of both. Moreover, the commissions could be as much as or more than the cost of the option itself. That's usually not a good deal!
Rule 4. By the same token, try to avoid overspending on any one option contract. Typically, if it costs much more than $500 per contract, it's too expensive. To better take advantage of the limited-risk feature of options, keep the cost down as much as possible on each option contract. That also lets you spread your funds around to a wider variety of different options.
Rule 5. Expect losers. Indeed, with options, success can be achieved with many small losers and a few large winners — another reason why you should keep the cost of each individual option low.
Rule 6. Among the losers, don't be surprised if there are some that wind up expiring worthless — a 100 percent loss. To help avoid total losses, try to sell them — whether at a profit or loss — before the last two weeks in the life of the option.
Rule 7. Do your best to buy put options while the market is in a rally mode. (See "Is the Market in Rally Mode?" on page 70 of Martin Weiss' book, Crash Profits.) Or, you can also use more advanced technical tools, which are beyond the realm of this book. If you buy call options, it's the opposite — try to buy on a market correction.
Rule 8. Similarly, seek to sell put options you're holding while the market is still in a short-term declining mode. (Also, see "Is the Market in Rally Mode?")
Rule 9. Seek to buy an even number of contracts of each option. This will give you more flexibility when exiting the position.
Rule 10. When you buy an option — whether a put or a call — always specify the maximum price you will pay based on the last actual trade in the specific option you are buying. As an illustration, if you're buying two contracts of the XYZ option, and its last price was $2.75 per share ($275 per contract of 100 shares), you might tell your broker, "Please buy two contracts of XYZ at $2.75 or better." (When you're buying, "or better" means "or less.") You may adjust the price up a bit to allow for market fluctuations. But the price you specify should not be more than about 10 percent higher than the most recent market price. Your broker can advise you on this aspect, depending on the market conditions at the time.
Rule 11. When you sell an option, always specify the minimum price you will be willing to accept. Following up with the example give in Rule 10, if the XYZ option is now selling at $5.25 per share ($525 per contract of 100 shares) and you are seeking to take a profit on both of your contracts, you would tell your broker, "Please sell two contracts of XYZ at $5.25 or better." (When you're selling, "or better" means "or more.") You may adjust the price down a bit to allow for market fluctuations. But the price you specify should not be more than about 10 percent lower than the most recent market price. Again, consult with your broker for the actual level, based on market conditions.
Rule 12. Don't chase the market. When you specify a buy or sell price, you may not get in or out of the option as you had hoped. If this happens, it can be frustrating, but you should not bend. Instead:
- Wait at least two or three full trading days.
- If your order still has not been filled, review the situation to make sure you still want to go ahead with the trade.
- If it's still within your budget, resubmit a new order based on the most recent price.
- No matter what, do not let your broker buy or sell the options "at the market." There are two reasons at-the-market orders can hurt your performance with options:
- Options can be very volatile, moving up and down quickly in price. If you let the broker buy at whatever the market price may be, you may wind up spending much more than you planned, exceeding your budget and reducing your profit. Similarly, on the sell side, if you sell at the market price, you could wind up giving up much of its value. Between the two sides, what could have been a handsome winner can wind up becoming a mediocre performer or even a loser.
- Options can often be thinly traded. Too many other investors that happen to buy (or sell) at the same time you do could move the market up precisely when you're buying (or move it down precisely when you're selling) and hurt your results.
Rule 13. Do not add to winning positions. This is the opposite of what you may have heard for most other investments, so it may take some time to get used to. However, once an option is clearly in the win column, it's probably too late to get into it and too expensive to buy. There are exceptions to this rule, buy they are few and far between.
Rule 14. By the same token, do not be too hasty to dump losing options. Again, this is the opposite of the advice given for most other investments. With options, it is very common for a loser to suddenly come back from behind and jump ahead into the winning column.
Rule 15. Stop-loss orders (sell stops) are usually not recommended. You should have already taken the steps to limit your risk by (1) budgeting your money carefully; (2) spreading it out over time; and (most important) (3) taking all the steps recommended to keep the cost of each individual option very modest. These three measures help limit your risk and largely replace the function of stops. Moreover, when you do use stop-loss orders, they typically force you to sell your option when the market is moving against you, violating Rule 8.
Two warnings:
- Do not sell short (or write) options. If you do so, you will open yourself up to unlimited risk, defeating the primary goals of this strategy. (There may be a practical value of writing covered options — a strategy for protecting your stock portfolio or for reducing the cost of other options positions. However, these strategies are beyond the scope of this guide.)
- Whenever you invest in options, you should always bear in mind the primary disadvantage: Options are wasting assets. When you buy an option, you are essentially buying time. So, if the market remains unchanged, the value of the option will naturally decline as time goes by. And to profit from options, the expected move has to happen — or at least get underway — before the option expires.
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