Lesson Objective: Making sure that your entry point in trading options is right.
It is not an overstatement to say that any options trade is doomed to fail if you fail to have a sound entry point i.e., clear of any obvious errors. If your entry point is well thought out, then you have a chance to be successful even if the market goes against you. No adjustments will save your trade if the initial entry is faulty, hence the need to be careful from the moment you start building up the strategy until the moment you hit the “execute” button.
Here are a few tips and things to check; you can obviously add to the list as you become more skilled in options trading.
- Have a plan – before executing any trade, you should have a clear understanding of your overall objective (income generation? Investing at a lower cost basis? Etc.), your profit target and loss limit if any, and any adjustment you are planning to make if certain conditions x, y, or z are met. Ideally, you should document your rules to help you formalize and clarify the steps because the devil is in the details. Your adjustments should also be laid out under the different scenarios contemplated as well as your exit plan.
- Stick to the plan – try to make no exceptions unless you have a very good reason to make one.
- Trade in limited size – we believe that no underlying should represent more than 5% – 10% of your entire portfolio at any time. Go back to lesson 15 for a detailed discussion on the importance of trade size.
- Anticipate the worst-case scenario before executing a trade and ensure you are ok with the outcome – will you have enough cash reserve to meet your obligations if your short puts are assigned? Can you afford being a long-term investor in a stock if the trade goes against you or will you have to sell for a potential loss?
- Make sure your portfolio is diversified according to your risk appetite and that such diversification is not jeopardized when entering a new trade – in other words new trades have to fit your portfolio. For instance, are you invested in a sector in which you believe and are ready to be exposed to? What about the geographical area and the option strategies in your portfolio?
- Make sure you have a benchmark and are able to assess performance ahead of trading – don’t just trade blindly. The benchmark doesn’t have to be perfect, but it should be a fair indicator of your portfolio’s performance. Analyze each trade even after they are completed/closed to see where you performed and where you need to improve.
- Before executing a trade, check that you selected all the intended parameters: Underlying? Number of contracts? Put vs. call? Expiration date? Strike? Price? How long will the order be valid for? Etc.
- Before executing a trade, check that the P&L chart is conform to your expectation: you should always have in mind a pretty good idea of what the P&L chart of a contemplated trade would look like. This will help you understand the risk/reward profile of the trade as well as pinpoint any gross mistake in your order.
- Check that there is enough liquidity for the underlying and the option: The underlying should trade at least 100,000 shares a day. In addition, if the bid/ask spread is tight in comparison to the overall premium then you will probably get a quicker fill and a better price. In the same vein, if there is enough volume, there is better liquidity generally speaking.
- Use limit orders to get better fills and be patient: you should always use limit orders rather than market orders whenever possible so that you can control the entry price and limit slippage.
- Use limit and GTC orders to systematize profit taking or loss limiting according to your plan: you should also use limit and GTC orders (“Good Till Cancel” – see lesson 20 on Types of Orders) to close your trades and create the exit order just after executing on the entry order. Say for instance that you have Sold To Open (STO) a put for $2 and your plan dictates a profit target of 50%. Right after shorting the put, you would send a GTC BTC (Buy To Close) order with a limit price of $1. This way, as soon as the price of the put moves down to $1 or below, the pending GTC order would automatically be executed, ensuring that you earn at least a 50% profit on the option. Another example: same scenario but instead of a 50% profit target, your plan calls for a 40% loss limit. Just after shorting the put, you would send a GTC BTC order with a limit price of $2.8. If the option’s price goes to $2.8 (or beyond), the GTC order would automatically execute and you should be able to limit your loss to about 40% (unless the option’s price gaps up).
- If you sell options, try to trade the underlying when IV percentile (rank) is historically high (above 50%) and vice versa: if you buy options, try to trade the underlying when IV percentile is historically low (above 50%).
- Use the right option strategy for your plan: g., if you cannot afford or are not willing to take too much risk, do not trade undefined risk options. You should never trade a strategy that you not fully understand and for which you do not have a clear understanding of the risk/reward profile. Refer to the lesson on risk/reward for a detailed discussion.
- Select the risk/return profile that meets your expectations and outlook: targeting for a higher return usually means a lower probability of success because you have to select strikes and expirations that are inherently riskier. Use your trading platform to gauge the probability of success and the probability of touch (probability at which the underlying stock price may test the strike during its life cycle).
- Accept to take losses when necessary, do not try to make up for sunk trades by doubling up: in other words, try to keep your emotions in check and never trade out of emotions or when you are angry, desperate, or otherwise emotionally impaired. More often than not, when a trade goes wrong, people are tempted to break their own rules and simply keep on trading the same option over and over again, “doubling up to catch up”. In the world of trading stocks, it can be tempting to buy more shares and lower the cost basis. However, “doubling up” on an options strategy rarely works because options are derivative instruments, so their prices do not move the same way as the underlying. It usually just compounds your risk. It is a much wiser move to accept a loss now instead of setting yourself up for a much bigger risk and potential loss.