5 do's and don'ts of options trading
Authored by Puneet Maheshwari, Director, Upstox
Options are an essential tool in a trader’s arsenal. It can potentially deliver profits whether markets are trending up, down, or sideways; can deliver higher returns on a lower capital requirement and most options strategies enable you to know the exact risk and reward before you trade. But, trading in Options comes with a learning curve.
Here is a list of do's and don'ts you must consider before trading in Options.
Do’s
● Learn how options work: Compared to shares and futures, options is a complicated instrument. It is not enough to learn just the basics of options (strike price, moneyness). Learning advanced concepts (strategies, greeks) will help you successfully trade options.
● Research: Understand what moves the price of the underlying asset viz. earnings releases, short-term trends, and market sentiment. Learning technical and fundamental analysis can help you identify potential trading opportunities.
● Trade with a plan: A basic trading plan has four aspects viz. entry price, stop loss, target and position size. Develop a trading plan that will keep you on track and help you decide what to do when the price moves in favour or against your expectation.
● Understand leverage: Options allow you to control a large position in an asset with a small investment. This can lead to large profits if the asset moves in your favour, but it can also lead to large losses if the asset moves against you.
● Set clear and realistic goals: Newbie traders view options as a get-quick-rich scheme. However, most successful options traders would agree that it takes time and effort to learn the nuances of options trading. Start with small goals and build your risk appetite, gradually, as you gain experience.
Don’ts
● Don't mix investing and trading: Most market participants do not separate their short-term trades from investments. Trading requires a different mindset and must be aligned to short-term goals.
● Don't ignore options strategies: You can buy options. You can sell options. And, it is also possible to buy and sell options simultaneously. The strategy you adopt must be in line with market conditions. It goes a long way in determining how much profit or loss you make on the trade. You may also have to change strategies, midway. This is why learning and understanding options strategies is essential.
● Avoid buying far OTM options: An option which doesn’t have any intrinsic value is referred to as an ‘OTM’ or out-of-the-money option. Some traders prefer buying OTM options as they are cheaper to buy and could provide high returns. However, if there is too much difference between the strike price and the current market price of the security, there is a high probability of such options expiring worthless. So, traders will actually end up losing money.
● Avoid selling naked options: It is tempting to sell a naked option because these promise high profits. But these also bear the risk of equally high losses. Trading using an options strategy helps one estimate profits and losses beforehand, and is, therefore, far less risky.
● Avoid trading in illiquid options: Illiquid options are those which have few buyers and sellers in the market. This lack of activity can cause big differences between the prices at which people are willing to buy and sell the options, known as bid-ask spreads. This can make it more expensive and difficult to buy or sell these options, which can harm P&L.
By following these do's and don'ts, you can enhance your options trading journey and increase your chances of success. Patience, discipline and continuous learning are key elements to mastering the art of options trading.