5 Tips to trade stock options with profit
LAVA Finance blog
5 Tips to make your options trading profitable
If you trading stock options, you most likely wonder:
How to improve my options trading?
How to find the right strategy, and how not lose money?
Then you are in the right place. In this article, we explain how to trade options in the right way, and give you 5 tips, that help you to understand the Stock Options market.
1. IDENTIFY
Every trade starts with an idea or thesis that seeks to profit off an expected future action of a stock price. Some ideas are technically sourced (i.e. based on a chart formation) and some are fundamentally sourced (i.e. based on a company's financial or market position, for example) – some are a mixture of the two.
Most (if not all) traders or investors as active market participants have their own method to determine the decisions they make and the actions they take – it's highly personal and based on their own risk profile and experiences.
There are literally thousands of books on technical or fundamental analysis so I will not cover these subjects here.
The point is you should at this juncture have some framework for identifying trades that provide answers to the following:
Price: at what price do you expect the stock to trade?
Time: when do you expect this to occur?
Basis: why do you think this will happen?
Once answers to these three questions are determined, one can use options to structure a specific trade to exploit an identified opportunity.
2. Choose the Strategy
Once Price, Time and Basis estimates are determined one can begin the process of choosing the option Strategy. (Learn more about core option strategies)
The first step involves choosing the most appropriate structure – basically, this is a mental exercise where you visually/mentally "flip through" the option structure universe to determine an initial short list of structure candidates that best fit your estimates on Price, Time and Basis.
For example, if you think the stock will trade in a range until expiration, perhaps a Condor or Butterfly is more appropriate as these structures profit when the stock stays in a particular range. If you think the stock only goes up from your entry perhaps buying the Calls or doing a long Call (see the Long Call example) spread is the most appropriate choice.
Likewise, if you are not sure if the stock goes up or down but based on your estimates you know it will make a big move, perhaps a Straddle or Strangle buy is the most appropriate. Perhaps you expect a big down move in the stock but want the ability to exit quickly – in such a situation simple strategies like buying Puts would be the most appropriate structure (as opposed to more complex set-ups which would be difficult to quickly exit and book profits) – you get the point.
3. PLAN
Build a plan. The plan is fundamental not only in trading. Everyone who is successful follows a plan, no matter person or company. Athletes have a training plan, companies have a development plan, marketing plan, financial plan, etc. None build a house with no plan. And you must have a trading plan.
The Trading plan must include:
Profit target
How much will be enough, short of maximum profits, for me to close out the position? For example, if this is a Closed structure maximum profit is known at the outset and is equivalent to $3,500. As the stock seems prone to quick moves (both up and down) I decide to set this target to $2,000, well within maximum profit levels. Try LAVA options profit calculator to determine the expected return.
Loss Target
For example, if you are comfortable with a $500 loss (out of total maximum risk of $1,500) – this will be the Loss target which, if hit, will trigger the immediate exit of the trade.
Before you are able to accept this level I of course need to see if it is realistic in the context of the stock – it would be a bit of a waste of capital if you got flushed out of the trade on normal intra-day volatility.
Time Target
Finally, set Time Target: how much time do you want to give the trade where if both Profit and Loss targets are not yet hit, you close out the trade?
In some situations, the time target is the expiration – this is usually for more complex trades such as Butterfly or Condors.
In this situation give the stock the full time until expiration to hit desired price targets.
4. ENTRY
The next step in the process is the exciting part: trade entry execution. At this point, all key elements of the trade are in place and planned: the most appropriate structure was selected and priced, the Risk/Reward was calculated and a specific P&L Plan was determined – now the trade is ready to be executed.
During the entry execution, it is important to remember that you are in control with regards to when you trade and at what at price you trade.
Never Trade at the Bid or Ask
One of the most important execution fundamentals (for both entry and when possible, exit) is to never trade at the Bid or Ask.
The Bid and the Ask, are the current market prices to buy or sell the option (and the space between is the "spread").
The wider the spread, the more important this fundamental becomes and ignoring it will cost you lots of money.
As you control the price you want to trade at on any new position (where if you don't get your price you simply won't trade), you should exploit this approach as much as possible.
A simple yet highly effective approach is to simply initiate trades at the mid-point of the Bid/Ask. For example, assume we only want to buy the 62.5 Puts – the current Bid/Ask is 1.62 / 1.68, so one can sell the Puts for 1.62 or buy them at 1.68.
If we were to buy them at 1.68 we would take an immediate P&L hit of 0.03 per option (= [1.68 – 1.62] / 2).
If we bought 10 Puts for 1.68, immediately after the trade our account would show a $30 loss – not a lot in this example but why leave money on the table?
The superior approach is to execute this as a trader (not a sucker!) – that is, try to get the best price the market will fill.
In this example, we would enter an order to buy at 1.65, the current Bid/Ask mid-point. Once you place the order, there are several potential outcomes.
First, it could be immediately filled – if this happens, pat yourself on the back because this happens probably less than 10% of the time, nice trade!
The most likely outcome will be that your trade order will not fill but will actually shift the current Bid/Ask spread from 1.62/1.68 to 1.65/1.68.
If this price doesn't fill for some time, and assuming the market doesn't move away from you (due to changes in the current share price or levels of volatility), the next step would be to slowly adjust the price one (or more as the case may be) notches.
So in our example, that would involve increasing the price to 1.66.
Either this fills or the Bid/Ask shifts, again, this time to 1.66/1.68.
Let's assume that this new price still doesn't fill; we are thus currently unfilled and at a market of 1.66/1.68.
In this situation all is still well as our initial analysis was predicated on a price of 1.68 – we are simply trying to fill at a superior price to enhance the trade economics. The next step, and given that we are at a one cent mid-point Bid/Ask spread, is to increase the order price to 1.67 – this either fills or shifts the Bid/Ask yet again to 1.67/1.68.
Don't Ignore Implied Volatility Levels!
Prior to executing any trade it is extremely important to check the level of implied volatility (IV) one is buying or selling at – this is crucial to know because changes in implied volatility can drastically (and quickly) impact the premium value of options.
This is one of the primary factors leading new option traders to lose money. For retail traders, special care should be taken when executing single-leg trades such as buying or selling only Puts or Calls.
Avoid buying options with Implied volatility above average!
To determine the level of Implied Volatility we need to compare it. One way is to compare the current IV with average IV for the period (it can be 20,30,60,90,180 days). The other way is to compare the current IV with a Historical Volatility (known as HV).
The main rule for buying options is IV<HV and vice versa if you are selling.
You can check IV, and HV here: CBOE source or using LAVA free options scanner
5. MANAGE THE POSITION AND EXIT
Once the trade is executed your responsibilities as a trader are (obviously) not over.
While a trade is open and live, there are two primary decisions that need to be weighted (usually on a daily basis, of course depending on the strategy):
Do nothing
Exit the position
Prior to this, however, and immediately after the trade is successfully executed for entry, it is important to first "book" the trade on a Trade Journal.
The Trade Journal Booking the trade involves manually recording the primary trade details immediately following the successful entry execution of the trade on a Trade Journal.
These primary details include ticker, date, Call or Puts, Strike and expiration, sold or bought, number of contracts, prices, net position P&L and Loss/Profit targets (and any other information you deem important).
At first glance this appears to be an unnecessary and useless task – why waste the time?
There are several reasons why this is important. First of all, you have written "evidence" (and a reminder as running multiple positions can get confusing) stating your Loss and Profit targets at the inception of the trade when you are least psychologically influenced by the new trade (where P&L = $0).
This will hold you to account when those targets are later triggered which (should) stop second-guessing and mental revisions (often subconsciously) – if your Profit / Loss targets are triggered and you ignore/override them (and the trade goes against you), you have only yourself to blame and no excuses to hide behind!
Secondly, recording one's trades is necessary in order to track the position's running P&L.
Most (if not all) retail brokerages only display P&L for open positions – the P&L from closed positions are simply aggregated in one line item: Yearly (and Monthly) P&L.
This is problematic from an individual strategy management perspective.
Do Nothing
The first option with an open position is to simply do nothing – not all positions need to be adjusted or closed out.
Doing nothing, however, does not mean ignoring the position. It is very important to monitor several elements to keep familiar with and engaged in the trade so as to not become complacent – complacency will kill your returns.
First, always keep an eye on the liquidity status of your positions. As liquidity diminishes so does one's ability to make position adjustments and exit opportunities on an economic basis.
Second, it is important to monitor both the general activity and unusual activity in the options where you currently have an open, do-nothing position.
Monitoring the options flow often provides important insight into potential future movements in the stock. When monitoring option flow focus on where the activity is concentrated (Calls, Puts, Strikes, Expirations) and the type of activity (buying or selling) – this doesn't take long, all one needs is a quick glance at the chains and aggregate trade data to get the insight.
For example, is the bulk of the activity in the Calls or Puts, what Strikes or Expirations? Of those, are the options primarily being bought or sold? Is said activity bullish or bearish and what are the implications (if any) for your open position?
Although following this data on a daily basis often yields confusion (as some days appear bullish while other days appear bearish, thus the sentiment seems to cancel each other out), in some situations a clear trend develops which in fact leads to and foretells the future stock price action.
On some days you may encounter unusual activity such as a huge, "institutional" (i.e. bank, hedge fund, other large asset managers) sized trade – these trades often yield very important insight and thus should not be ignored. You can check options volume and most active-traded strike in LAVA app.
Free trial available both for IOS and Android
Trading is not a sprint but a marathon, follow the plan, don't break your trading rules, be patient, and profit will come.
Good Luck!
Some useful links:
Options Guide
Options volatility scanner
Options profit calculator
How to improve my options trading?
How to find the right strategy, and how not lose money?
Then you are in the right place. In this article, we explain how to trade options in the right way, and give you 5 tips, that help you to understand the Stock Options market.
1. IDENTIFY
Every trade starts with an idea or thesis that seeks to profit off an expected future action of a stock price. Some ideas are technically sourced (i.e. based on a chart formation) and some are fundamentally sourced (i.e. based on a company's financial or market position, for example) – some are a mixture of the two.
Most (if not all) traders or investors as active market participants have their own method to determine the decisions they make and the actions they take – it's highly personal and based on their own risk profile and experiences.
There are literally thousands of books on technical or fundamental analysis so I will not cover these subjects here.
The point is you should at this juncture have some framework for identifying trades that provide answers to the following:
Price: at what price do you expect the stock to trade?
Time: when do you expect this to occur?
Basis: why do you think this will happen?
Once answers to these three questions are determined, one can use options to structure a specific trade to exploit an identified opportunity.
2. Choose the Strategy
Once Price, Time and Basis estimates are determined one can begin the process of choosing the option Strategy. (Learn more about core option strategies)
The first step involves choosing the most appropriate structure – basically, this is a mental exercise where you visually/mentally "flip through" the option structure universe to determine an initial short list of structure candidates that best fit your estimates on Price, Time and Basis.
For example, if you think the stock will trade in a range until expiration, perhaps a Condor or Butterfly is more appropriate as these structures profit when the stock stays in a particular range. If you think the stock only goes up from your entry perhaps buying the Calls or doing a long Call (see the Long Call example) spread is the most appropriate choice.
Likewise, if you are not sure if the stock goes up or down but based on your estimates you know it will make a big move, perhaps a Straddle or Strangle buy is the most appropriate. Perhaps you expect a big down move in the stock but want the ability to exit quickly – in such a situation simple strategies like buying Puts would be the most appropriate structure (as opposed to more complex set-ups which would be difficult to quickly exit and book profits) – you get the point.
3. PLAN
Build a plan. The plan is fundamental not only in trading. Everyone who is successful follows a plan, no matter person or company. Athletes have a training plan, companies have a development plan, marketing plan, financial plan, etc. None build a house with no plan. And you must have a trading plan.
The Trading plan must include:
Profit target
How much will be enough, short of maximum profits, for me to close out the position? For example, if this is a Closed structure maximum profit is known at the outset and is equivalent to $3,500. As the stock seems prone to quick moves (both up and down) I decide to set this target to $2,000, well within maximum profit levels. Try LAVA options profit calculator to determine the expected return.
Loss Target
For example, if you are comfortable with a $500 loss (out of total maximum risk of $1,500) – this will be the Loss target which, if hit, will trigger the immediate exit of the trade.
Before you are able to accept this level I of course need to see if it is realistic in the context of the stock – it would be a bit of a waste of capital if you got flushed out of the trade on normal intra-day volatility.
Time Target
Finally, set Time Target: how much time do you want to give the trade where if both Profit and Loss targets are not yet hit, you close out the trade?
In some situations, the time target is the expiration – this is usually for more complex trades such as Butterfly or Condors.
In this situation give the stock the full time until expiration to hit desired price targets.
4. ENTRY
The next step in the process is the exciting part: trade entry execution. At this point, all key elements of the trade are in place and planned: the most appropriate structure was selected and priced, the Risk/Reward was calculated and a specific P&L Plan was determined – now the trade is ready to be executed.
During the entry execution, it is important to remember that you are in control with regards to when you trade and at what at price you trade.
Never Trade at the Bid or Ask
One of the most important execution fundamentals (for both entry and when possible, exit) is to never trade at the Bid or Ask.
The Bid and the Ask, are the current market prices to buy or sell the option (and the space between is the "spread").
The wider the spread, the more important this fundamental becomes and ignoring it will cost you lots of money.
As you control the price you want to trade at on any new position (where if you don't get your price you simply won't trade), you should exploit this approach as much as possible.
A simple yet highly effective approach is to simply initiate trades at the mid-point of the Bid/Ask. For example, assume we only want to buy the 62.5 Puts – the current Bid/Ask is 1.62 / 1.68, so one can sell the Puts for 1.62 or buy them at 1.68.
If we were to buy them at 1.68 we would take an immediate P&L hit of 0.03 per option (= [1.68 – 1.62] / 2).
If we bought 10 Puts for 1.68, immediately after the trade our account would show a $30 loss – not a lot in this example but why leave money on the table?
The superior approach is to execute this as a trader (not a sucker!) – that is, try to get the best price the market will fill.
In this example, we would enter an order to buy at 1.65, the current Bid/Ask mid-point. Once you place the order, there are several potential outcomes.
First, it could be immediately filled – if this happens, pat yourself on the back because this happens probably less than 10% of the time, nice trade!
The most likely outcome will be that your trade order will not fill but will actually shift the current Bid/Ask spread from 1.62/1.68 to 1.65/1.68.
If this price doesn't fill for some time, and assuming the market doesn't move away from you (due to changes in the current share price or levels of volatility), the next step would be to slowly adjust the price one (or more as the case may be) notches.
So in our example, that would involve increasing the price to 1.66.
Either this fills or the Bid/Ask shifts, again, this time to 1.66/1.68.
Let's assume that this new price still doesn't fill; we are thus currently unfilled and at a market of 1.66/1.68.
In this situation all is still well as our initial analysis was predicated on a price of 1.68 – we are simply trying to fill at a superior price to enhance the trade economics. The next step, and given that we are at a one cent mid-point Bid/Ask spread, is to increase the order price to 1.67 – this either fills or shifts the Bid/Ask yet again to 1.67/1.68.
Don't Ignore Implied Volatility Levels!
Prior to executing any trade it is extremely important to check the level of implied volatility (IV) one is buying or selling at – this is crucial to know because changes in implied volatility can drastically (and quickly) impact the premium value of options.
This is one of the primary factors leading new option traders to lose money. For retail traders, special care should be taken when executing single-leg trades such as buying or selling only Puts or Calls.
Avoid buying options with Implied volatility above average!
To determine the level of Implied Volatility we need to compare it. One way is to compare the current IV with average IV for the period (it can be 20,30,60,90,180 days). The other way is to compare the current IV with a Historical Volatility (known as HV).
The main rule for buying options is IV<HV and vice versa if you are selling.
You can check IV, and HV here: CBOE source or using LAVA free options scanner
5. MANAGE THE POSITION AND EXIT
Once the trade is executed your responsibilities as a trader are (obviously) not over.
While a trade is open and live, there are two primary decisions that need to be weighted (usually on a daily basis, of course depending on the strategy):
Do nothing
Exit the position
Prior to this, however, and immediately after the trade is successfully executed for entry, it is important to first "book" the trade on a Trade Journal.
The Trade Journal Booking the trade involves manually recording the primary trade details immediately following the successful entry execution of the trade on a Trade Journal.
These primary details include ticker, date, Call or Puts, Strike and expiration, sold or bought, number of contracts, prices, net position P&L and Loss/Profit targets (and any other information you deem important).
At first glance this appears to be an unnecessary and useless task – why waste the time?
There are several reasons why this is important. First of all, you have written "evidence" (and a reminder as running multiple positions can get confusing) stating your Loss and Profit targets at the inception of the trade when you are least psychologically influenced by the new trade (where P&L = $0).
This will hold you to account when those targets are later triggered which (should) stop second-guessing and mental revisions (often subconsciously) – if your Profit / Loss targets are triggered and you ignore/override them (and the trade goes against you), you have only yourself to blame and no excuses to hide behind!
Secondly, recording one's trades is necessary in order to track the position's running P&L.
Most (if not all) retail brokerages only display P&L for open positions – the P&L from closed positions are simply aggregated in one line item: Yearly (and Monthly) P&L.
This is problematic from an individual strategy management perspective.
Do Nothing
The first option with an open position is to simply do nothing – not all positions need to be adjusted or closed out.
Doing nothing, however, does not mean ignoring the position. It is very important to monitor several elements to keep familiar with and engaged in the trade so as to not become complacent – complacency will kill your returns.
First, always keep an eye on the liquidity status of your positions. As liquidity diminishes so does one's ability to make position adjustments and exit opportunities on an economic basis.
Second, it is important to monitor both the general activity and unusual activity in the options where you currently have an open, do-nothing position.
Monitoring the options flow often provides important insight into potential future movements in the stock. When monitoring option flow focus on where the activity is concentrated (Calls, Puts, Strikes, Expirations) and the type of activity (buying or selling) – this doesn't take long, all one needs is a quick glance at the chains and aggregate trade data to get the insight.
For example, is the bulk of the activity in the Calls or Puts, what Strikes or Expirations? Of those, are the options primarily being bought or sold? Is said activity bullish or bearish and what are the implications (if any) for your open position?
Although following this data on a daily basis often yields confusion (as some days appear bullish while other days appear bearish, thus the sentiment seems to cancel each other out), in some situations a clear trend develops which in fact leads to and foretells the future stock price action.
On some days you may encounter unusual activity such as a huge, "institutional" (i.e. bank, hedge fund, other large asset managers) sized trade – these trades often yield very important insight and thus should not be ignored. You can check options volume and most active-traded strike in LAVA app.
Free trial available both for IOS and Android
Trading is not a sprint but a marathon, follow the plan, don't break your trading rules, be patient, and profit will come.
Good Luck!
Some useful links:
Options Guide
Options volatility scanner
Options profit calculator
Download LAVA
Options profit calculator and volume scanner
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LAVA is a trading name of LAVA FINANCE Inc.
All investments involve risk, including the possible loss of capital. You may not get back what you have originally invested. The material provided herein is general in nature and does not take into account your objectives, financial situation or needs. This is not an offer, solicitation of an offer, or advice to buy or sell securities.
All investments involve risk, including the possible loss of capital. You may not get back what you have originally invested. The material provided herein is general in nature and does not take into account your objectives, financial situation or needs. This is not an offer, solicitation of an offer, or advice to buy or sell securities.