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How to Trade Stock Options

There is no "one size fits all" option strategy that you can use in all situations.

First, decide if you are bullish, bearish, or neutral in your opinion about a stock or the market itself.

Then decide if you are very bullish, mildly bearish, mostly neutral but with an upside bias, etc. Now you have narrowed down the choice of a strategy quite a bit.

Use the Strategies page on this web site to show the possible strategies that fit your outlook. Now you can fine tune your selection. Do you expect volatility to rise with an upcoming earnings date? Do you expect a move this week or sometime in the next three months? Do you want to get in on a breakout or breakdown and do almost as well as owning or shorting the stock? Do you want to take a longshot with a very small portion of your capital? Do you think a recent selloff or correction has gone too far?

If you are not already familiar with the strategies that might benefit from your assumptions, read about them from links on the strategies page. Be sure to understand how the stock price, the time to expiration, and the implied volatility will affect your selected option position. Read the practical information in The Option Greeks.

Check prices for the strategy on the stock or ETF you have selected. If there is a wide bid-ask spread (greater than .30 or so), you might want to avoid those options. A wide bid-ask spread usually means the options are thinly traded. With a thinly traded option you might have trouble entering and exiting when you want to, and you might have to pay too much for both the entry and the exit.

Determine your maximum risk on the trade, either from the calculation shown on the strategy page, or by using option graphs. If you are just starting out, avoid using strategies where your maximum risk is not known in advance. Make sure your maximum risk is a very small percentage of your account size, such as 1-2%. This means that if you have a $10,000 account, you should only take a $100 to $200 risk on any one trade. This small risk will allow you to keep trading and developing your skills even if you have several losses in a row. Take option trading risk very seriously, remembering that options have an expiration date. You don't have the possibility of just waiting for your positions to recover their value, as you might if you owned stock.

Enter the trade with your broker using a limit order at the midmarket price (the theoretical price midway between the bid and ask). If you are entering any type of standard option trade such as a spread or a butterfly, use your broker's spread trading feature to reduce your commissions.

If no one takes the other side of your trade within 5 or 10 minutes, and the trade still looks good, "give in" .05 or .10 on your limit ($5 or $10 per contract), and wait to get filled. If you can't get filled .05 or .10 off of the midmarket prices, it might be best to look for other opportunities. Don't chase after a position, giving in more and more on your limit. You will likely be filled right when the stock starts to move against your position.

Understand that because of the bid-ask spreads, almost every option trade you enter will show a loss as soon as you enter the trade, even if you enter at midmarket prices. This is because your broker will probably show the trade's value as if you had to buy back any short options at the ask, and could only sell any long options at the bid, in other words, at the worst prices available. This "loss" does not mean your strategy is already in trouble.

Unless your strategy was to take a "long shot" on a quick stock movement, most option strategies will take some time (days or weeks) to develop. During this time, the stock or other underlying is probably not going to move in lockstep with your expectations. But, you should make sure your expectations are still within the realm of possibility, and cut your losses short if things aren't working out.

Remember that just the passage of time will hurt any long option. If you were expecting a bullish price movement, and it is not happening, plus the option expiration is coming up in 2 or 3 weeks, you should probably take your loss and move on.

Conversely, if you are using a strategy that benefits if short options lose their value, the passage of time will help.

Now if your position seems to be working as expected, the difficult question is how to take profits. Remember the adage "cut your losses short, and let your winners run".

Check an option graph for your position, as well as any new expectations you may have about stock price movement. If the position looks like it still has a good chance to benefit from holding it longer, then resist the urge to take a quick profit. On the other hand, if a check of the option graph shows that holding longer most likely results in a loss of value due to the passage of time, then it might be best to take your gains while you have them.

The green line on the graph below shows a bull call entered 15 days ago, and now with 15 days to expiration let's say the stock has risen to $55. This is definitely a position that should be held until expiration if possible. Just the passage of time at this stock price will make another $180 or so. There are two things working for the position at $55: One, your expectation for stock movement was correct, and Two, time is working for you.

On the other hand, imagine the stock has fallen to $49 with 15 days to expiration. The passage of time is just going to make your losses grow. It would be best to take your loss of about $50 now, much less than the maximum possible loss, rather than waiting till expiration. There are two things working against the position at $49: One, your expectation for stock movement was wrong, and Two, time is working against you.

Bull Call Option Graph

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