There are countless things that an option trade should pay attention to. It can be very overwhelming to keep all the important things in mind when trading. In this article, I will give you 11 free option trading tips. Make sure to always pay attention to these aspects when you are trading options!
1. Pay attention to Implied Volatility!
Implied volatility is paramount to the success of an options trader. Therefore, my first options trading tip is that you should look at implied volatility before even considering to trade options.
If you have gone through my free options trading courses, you should know what implied volatility is and how to use it. But for everyone else, here is a brief recap:
Implied volatility (IV) is derived from option’s prices and it represents the expected volatility for an asset over a certain time period. In times of high IV, options tend to be more expensive and vice versa.
Due to this, you should sell options in times of high IV and buy options in times of low IV. IV Rank compares the IV of an asset to past IV of the same asset and then displays a number between 0 and 100. If IV Rank is under 50, implied volatility is considered low and if IV Rank is over 50, implied volatility is considered high. So use IV Rank to find out if the current IV is high or low.
As implied volatility makes up a big part of option’s pricing, it is very important to take it into account when trading options.
Over the past decades, implied volatility has been overstating the actual volatility. Thus, historically speaking options have been too expensive. This gives option sellers an edge.
Here is a list of strategies profiting from decreasing implied volatility that should be entered in times of high IV:
- short calls
- short puts
- credit spreads
- short iron condors
- short strangles
- short straddles
Here is a list of strategies profiting from increasing implied volatility that should be entered in times of low IV:
- long calls
- long puts
- debit spreads
- long iron condors
- long strangles
- long straddles
To find out how much an option strategy gains or loses value from changes in implied volatility, look at the option Greek Vega. Vega shows the impact on an option’s price for a 1% increase in IV. So strategies with a positive Vega profit from increasing IV and strategies with a negative Vega profit from decreasing IV. Note that Vega changes together with other changing market factors.
To learn more about volatility, you could check out my article on historical volatility vs implied volatility.
2. Trade High Probability Strategies!
The next option trading tip is focusing on high probability options trading strategies. A very common mistake, especially amongst newer option traders is trading low probability strategies.
The great thing about options is that you can put the odds on your side and thereby, increase your success rate. However, if you only trade low probability, directional strategies like long calls/puts, you will have a hard time.
The more an asset’s price has to move in a direction for a strategy to become profitable, the lower the probability of profit for that strategy becomes. Therefore, try to focus on slightly or non-directional strategies.
The options Greek Delta indicates directional risk. So non-directional options trading strategies have a Delta near zero (e.g. iron condors).
Most good options brokers show you different probabilities of different options. Make sure that your option trades don’t have a low probability of profit.
The following image shows where all the different options trading probabilities are displayed inside of the broker platform tastyworks.
If you want to learn more about different important probabilities, read my article on options trading probabilities.
Here is a list of potential high probability strategies:
- short calls
- short puts
- credit spreads
- short iron condors
- short strangles
- short straddles
As you can see, all of the above-mentioned strategies are overall short strategies. This is not a coincidence. Buying options is a directional approach to options trading and thus, the probability of profit is relatively low for most long option strategies.
Most people that switch from stock to options trading start by buying options. This is because they think of options as special stock. Just like in stock trading, they try to predict moves in the underlying’s price.
A much easier approach would be to take advantage of implied volatility and time decay instead of trying to predict price movement. So instead of buying options with a low probability of success, you could trade high probability short option strategies that take advantage of time decay (and decreasing implied volatility).
3. Trade small!
In addition to the last two option trading tips, it is important to trade small. Sadly, way too many people trade too big. Trading small is one of the only methods to protect yourself against blowing up. This is especially true in the world of options because you can easily lose 100% or more of your initial investment with options.
As a rule of thumb, you should try to never risk more than 5% of your total account capital on a single trade. No matter how high the probability of profit on a trade is, you can always lose! Even with a 90% probability of profit, you will lose about 10% of the time.
If you risk all or too much of your capital at once, it is just a question of time when you will lose it.
Here is some evidence for this:
Let’s compare two traders that trade in different position sizes. Trader A risks 50% of his account capital per trade and trader B risks 5% of his account capital at once. Both trader A and B trade with a 60% probability of profit on every trade.
Trader A only needs two bad trades in a row to lose all his money. With 60% POP per trade, there is a 16% probability that two consecutive trades will end up losing (0.4^2). 16% is by no means very high, however, it is definitely possible. After enough trades, it is very likely that trader A will lose all his money.
As trader B only risks 5% of his account capital on a single trade, he needs 20 consecutive losing trades to lose all his account capital. With the same 60% POP per trade, there is only a theoretical probability of 0.0000010995% that you will lose all your money (0.4^20). Think about that for a second!
Hopefully, this really makes the importance of trading small clear!
4. Take Profits!
Furthermore, it is very important to take profits when trading options. The saying ‘let your winners run’ does not apply to options trading!
If you are trading overall short, defined risk option strategies, you shouldn’t always aim for 100% of the max profit. Different studies from tastytrade have actually shown that taking profits early actually increases your win rate and your overall trading performance.
Cutting profits improved your trading performance? This might sound counterintuitive. But if you think about it, it does make sense. Winning trades can always turn into losing trades unless you realize your paper profits by closing the position. In other words, closing a winning position makes it a guaranteed profit. Not taking the profit, however, still gives the trade a chance to turn around and become a loss.
That is why taking profits at profit targets such as 50% of max profit, actually increases your win rate.
Another benefit of taking profits early is that you thereby decrease the time in a trade. So instead of holding on to positions until the expiration date, you close them much earlier. This allows you to open new positions faster. Therefore, you can trade and profit more often if you take profits early.
Actually, trying to reach max profit will negatively impact your risk to reward ratio. This is best explained by a brief example:
Let’s say you enter a trade that has a max risk and a max reward of $100. So when you put on the trade, your risk to reward ratio is 1 to 1. The more the trade moves in your direction, the worse this risk to reward ratio becomes.
In the beginning, you are risking $100 to make $100.
Let’s say the trade starts out good and it shows a paper profit of $20. This means that you now only have $80 of potential profit left. The risk, on the other hand, has increased to $120. So now you are risking $120 to make $80.
If the trade now works out even better and the new paper profit is $80, you will only have $20 of further profit potential. This means, you now are risking $180 to make the last $20. This is a very questionable risk to reward ratio.
I hope you get my point. Often it is not worth it to wait for the last percentage of max profit. In terms of risk/reward, you shouldn’t always shoot for max profit.
In fact, the probability that an options trade such as a short iron condor will reach 50% of max profit sometime before expiration is usually higher than the probability that the same trade will be profitable on the expiration date.
The screenshot below shows the probability of profit (POP) and the probability of reaching 50% of max profit (P50) for a short iron condor. As you can see, the probability of reaching 50% is significantly greater. (POP: 54% vs. P50: 69%)
Generally, there is a wide variety of benefits in taking profits early. A good profit target for most options trading strategies is 50% of max profit. However, more aggressive strategies like short straddles can definitely be managed even earlier.
5. Don’t Cut Losses!
Yes, that’s right! When it comes to options trading, you shouldn’t always cut losses short.
If you are selling options, you have to give the price some room to move in. You shouldn’t close your position as soon as it shows a paper loss. Otherwise, your trading performance will suffer drastically.
The same principle of locking in profits can be applied to locking in losses. If you close a losing position, it is a guaranteed loss. However, if you leave the position on, it can still turn around and become a winner. So locking in losses actually decreases your win rate.
This does not mean that you should never cut losses and always hope that your losing positions will turn around. This only works with a certain options trading system, namely options premium selling. Not cutting losses does not work for simple options buying.
If you are selling high probability options, you should not close positions as soon as they go against you. Most short option positions will be tested sometime before expiration. This means that these positions will show paper losses. However, if you hold on to them, they can still turn around.
Actually, the probability that the underlying’s price will reach an option’s strike price normally is 2x the probability that the exact same option will expire In The Money (ITM). So even if you sell an option that has a 70% probability of expiring OTM, there still is about a 60% probability that this option will be tested by the underlying’s price sometime before the expiration date.
So make sure to give the price some room to move in before cutting losses if you are selling options.
Nevertheless, you should always define your risk before entering a trade, especially for undefined risk strategies.
Together with managing winners early, not cutting losses can improve your options trading performance dramatically.
6. Educate Yourself!
In my opinion, the most common reason why so many traders fail is the lack of education. If you don’t know what you are doing, you won’t be profitable. So make sure to prepare yourself as much as possible.
I look at trading as a profession. What do all professions require? Education!
For instance, if you want to become a doctor, you will have to go through years of studying, training, and preparation. The same is the case for almost every other job in existence. Now please tell me why this should be any different for trading?
Everyone wants to make loads of money in the markets but barely anyone is actually willing to do anything for it! Do you really think that so few people would be doing it if it would be that easy?
Don’t make the same mistake as so many other ‘traders’ and risk your hard earned money without preparing yourself beforehand.
7. Use The Greeks!
Option Greeks measure changes in an option’s price for changes in market factors such as time, underlying’s price, implied volatility… They are often considered the steering wheel and dashboard of options trading.
There is a reason why option Greeks exist and that reason is to help you! Greeks should impact your trading decisions when entering, adjusting and exiting positions.
I have a separate lesson on options pricing and option Greeks in which I thoroughly explain how all the Greeks work. I highly recommend checking it out if you aren’t completely familiar with the Greeks.
Here is a very short summary of what the different Greeks stand for:
- Delta: Delta measures changes in an option’s price for changes in the underlying asset’s price.
- Theta: Theta measures changes in an option’s price for time passing by.
- Gamma: Gamma measures changes in Delta for changes in the underlying’s price.
- Vega: Vega measures changes in an option’s price for changes in implied volatility.
- Rho: Rho measures changes in an option’s price for changes in interest rates.
Even though option Greeks might seem intimidating at first, they are essential to successful options trading.
8. Be Consistent!
Another huge options trading mistake is not sticking to your trading system. Consistency is huge in the realm of trading. If you want to have consistent results, you will have to trade with a consistent approach. If you trade randomly, your results will be just as random.
Trading consistently means that even if you have been experiencing some losses that you don’t just give up on your trading system.
Let me introduce you to the law of large numbers:
The law of large numbers states that the more you repeat an experiment, the closer its outcome will become to the expected outcome.
A great example to simplify this is that of a coin flip. If you flip a coin twice, the expected outcome is that the coin lands on heads once and on tails once because the probability is 50/50. However, if you ever flipped a coin, you should know that this isn’t always the case. Very often, the coin will land on the same side both times. In that case, the expected outcome would vary a lot from the actual outcome.
However, if you flip a coin 1000 times, it is very unlikely to see the same divergence between the actual and expected outcome. The expected outcome would be that the coin lands 500 times on heads and 500 times on tails. To have the same difference between actual and expected outcome as in the example with 2 flips, the coin would have to land on one side 1000 times. This is very unlikely.
The coin probably still won’t land on each side exactly 500 times. But it will likely come much closer to its expected outcome than in the example with only two flips.
The more you flip the coin, the more equal the actual and expected outcome will become. If you repeat an experiment an unlimited amount of times, the two outcomes should be equal.
So what does this have to do with consistency and trading?
The more you trade, the closer your actual outcome will get to the expected outcome. If you trade with a probability of 70% ten times, the expected outcome would be 7 wins and 3 losses. However, as ten trades aren’t much, it isn’t unlikely to have 5 wins and 5 losses or an even worse scenario. This does not automatically mean that there is something wrong with the trading system. The problem may just be that you haven’t traded often enough.
If you trade exactly the same way for 100 trades, the divergence between the actual and the expected outcome should be much smaller already. But it would still be possible to have 50 wins and 50 losses.
If you now trade even more and have a total trade count of 1000, this divergence should become very small. It is very unlikely to have 500 wins and 500 losses. The outcome probably won’t be exactly 700 wins and 300 losses (which is the expected outcome). However, it should be somewhere close to that.
The takeaway here is that you have to test your strategy over a big enough number of occurrences. You can’t judge a system after one or two months with a few trades.
Even if it might not seem to work in the beginning, you should give it some time and don’t give up immediately.
9. Be Mechanical!
The ninth options trading tip is to always stay mechanical. With that, I mean that you should keep emotions out of trading.
I recently published an entire lesson on psychology and trading which I recommend to anyone that is struggling with consistency and emotions in trading. In that lesson, I present multiple tips to stay mechanically when trading and how to develop a winning mindset.
Letting emotions influence your trading decisions should be avoided at all costs. The problem with this is that humans have an extremely hard time staying unemotional when hard earned money is on the line.
Some people even say that it is the mindset that separates winning from losing traders.
It is safe to say that emotions play a huge role in trading and it is very important to trade as mechanically as possible.
10. Focus On Liquidity!
If you have gone through some of my courses, you know that I can’t emphasize the importance of liquidity enough! Liquidity is probably the most important aspect of trading. If you currently are trading illiquid assets, you really are wasting a lot of money.
Liquidity describes the ease of opening and closing positions in an asset without having to change the price. Typical features of very liquid assets are:
- High Volume
- Tight Bid/Ask Spreads
- (High Open Interest For Options/Futures)
I won’t go over all the benefits from trading liquid assets in this article because that would take too long. However, I have a separate lesson about the importance of liquidity in which I show how you can save thousands of Dollars every year by trading liquid assets only.
Risks of trading illiquid assets are:
- Losing money from the Bid/Ask spread
- Being stuck in positions
- Long fill times
- Bad pricing
- Lower probability of profit
Just make sure to only trade liquid assets!
11. Always Have A Trading Plan!
This actually isn’t just an option trading tip, it is a general trading tip. No matter what you are trading, you should always have a trading plan!
Having a trading plan is one very important aspect of trading mechanically. It is very important to create your trading plan before you enter a trade as you will only be able to think completely rationally before you risk your money.
Here are a few key features that every trading plan should have:
- Risk/Reward ratio
- Exit point
- Entry point
- Position size
- Adjustment points
You will find it much easier to control your trading when you have a trading plan. Instead of having to improvise mid-trade and find a good point to cut losses or take profits, everything is planned ahead of time. So there is no chance that your emotions can tell you what to do.
Never deviate from your initial trading plan!
The trading plan should be as specific as possible. Leave as little as possible to emotions and improvisation.
Let’s recap all the option trading tips real fast:
- Pay attention to Implied Volatility!
- Trade high probability strategies!
- Trade small!
- Take profits!
- Don’t cut losses!
- Educate yourself!
- Use the Greeks!
- Be consistent!
- Be mechanical!
- Focus on liquidity!
- Always have a trading plan!
I truly hope this article helped you and that you learned at least one new thing.
Please let me know in the comment section below which of these 11 options trading tips was useful!