Three Basic Rules for Easier Options Trading

Trading options isn’t easy. It is important that investors understand them clearly; if they don’t, they could lose their entire investment, be faced with heavy losses, or end up with a position they never really wanted in the first place if the trade doesn’t work in their favor.

Knowing what kind of options to buy is just the first step. There are many other factors investors have to consider before entering the trade, including the following three considerations:

Keep the Bid and Ask Spread Small

When it comes to stocks, thanks to liquidity in the stock market, the bid—what buyers are willing to pay (bid)—and ask spread—what sellers are willing to sell for (ask)—is usually within $0.01. When it comes to options, this range can be very wide; at times, this range can be more than $0.25.

The bid and ask spread matters because it affects the money you are putting into options. At the very core, a big bid and ask spread can result in losses. For instance, if the bid for an option is at $0.10 and the ask price is at $0.20, an investor will pay $20.00 to buy on contract. If they go right away to sell, they will have to sell for $0.10, or $10.00 per contract—this results in a loss of 50% per option.

Choose Limit Orders Over Market Orders

When an investor places a market order, it essentially means they are buying at the available price—which generally means they receive the ask price. This can have two consequences: first, if the spread is big, they will see a loss right away (as explained earlier); second, if, for example, they want to buy 10 options contracts but there are only two contracts available at the current asking price, they may pay much more than they initially expected to purchase all 10 contracts.

When an investor uses a limit order in their options trading, they are essentially telling their broker what to buy or sell and how much at a specific price or better. For example, if an investor sees a contract priced at $1.50, they can place a limit buy order at that price—the broker will not execute the trade if the options price goes higher than $1.50, but will execute it if the price goes below that level.

Prefer Mental Stops Over Conventional Stop-Loss Orders

Trading options requires a lot of oversight; investors have to constantly watch their position. With stocks, investors can place in a stop-loss order and walk away from their computer. If the stock price reaches their specified loss price, the order becomes a market order and their shares are sold—it’s simple.

But let me explain how stop-loss orders are executed. A stop-loss order triggers when the bid matches the stop price or below. So, if there’s a large bid and ask spread, an investor might see their order get executed significantly below the price they wanted. Remember; unlike stocks, bids and asks on options can be very wild. This results in a magnified loss.

Having a mental stop means an investor watches their position closely and closes it as required. Pre-set prices can be more dangerous than you might think.

 

This article Three Basic Rules for Easier Options Trading was originally published at Daily Gains Letter