Options Advice

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Options tips

Evaluate the potential impact of volatility. Consider dividends. Manage your risk.

  • Fidelity Active Investor
  • – 05/09/2020
  • 1144

It takes knowledge and experience to trade options successfully. Here are a few tips to think about when considering your next options trade: Consider volatility, dividends, and manage your risk.

Assessing your options

Trading options is more complex than simply buying or selling a stock. Even the language of options—words like calls, puts, premium, and roll—can sound foreign at first. So, options may not be right for everyone. However, with education and experience, it’s possible to learn how these investments work, and in what ways they may help you invest the portion of your portfolio that you manage personally.

Every investment plan should include an assessment of your individual goals, risk constraints, time horizon, tax constraints, and liquidity needs. Options have unique characteristics and risks, and should be carefully considered within the context of your overall investing plan. Investors can trade options if they sign an options agreement and are accepted to trade options by a brokerage firm.

Before trading options, it’s particularly important to know how much risk you are willing to take. For many investors, and especially those just starting out with options, it’s vital to know what kind of investor you are. For instance, what type of risk are you comfortable with? And how thoroughly do you understand the way options work? The answers to these questions can help you decide if options are right for you, as well as the types of options strategies that might best align with your objectives and risk constraints.

Use volatility to your advantage

An often overlooked aspect of options trading by many new investors is the impact of volatility. Many options investors do not realize that, even if a stock for which you have bought or sold an options contract moves in the direction that you want it to, that option may not always reflect the stock’s move.

The reason is oftentimes a change in implied volatility. As it relates to options, implied volatility is the market’s expectation for future volatility. So, a stock might move in the direction that you want it to, based on your option position, but an increase or decrease in expected volatility that may have caused the stock to move could positively or negatively impact the price of the option—known as the premium.

You can help put yourself in position for success by getting familiar with how both implied volatility as well as historical volatility factor into the price of an option. Always remember to put an option’s current level of volatility in perspective. For example, be careful when buying an option with current implied volatility at the high end of its past range, as well as when selling an option with current implied volatility at the low end of its past range.

Moreover, implied volatility can help you find the right options contract among all of the available choices. One way to determine if an options contract is attractively priced is by evaluating implied volatility relative to past ranges.

The straddle is one of the more popular strategies that is designed to capitalize on the expectation for higher implied volatility and a relatively large move in either direction. A straddle involves buying a call and a put option with the same strike price; essentially, you are looking for an increase in implied volatility. This strategy offers limited risk and unlimited reward, and the breakeven is either the call strike price plus premium paid or the put strike price minus premium paid.

One tool that you can use to help generate investing ideas based on volatility is the Trading Ideas tab on Fidelity.com’s option research page.

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Look for dividends

One pitfall that some new options traders can fall prey to is focusing solely on their expectation for the direction that an underlying stock of an option will move. While that is of critical importance, the potential impact of dividends upon options is another one of those nuances that it’s important to be familiar with—especially when selling options.

What is time value?

Before initiating an options trade, know if the stock pays a dividend. If it does, you have to examine if the option is in the money (which is to say that it could be worth exercising) or close to it as expiration approaches. If the dividend is greater than the time value of the option (see What is time value? sidebar), then the stock could be assigned (meaning the owner of the option could exercise the option in order to earn the dividend payment, and you would be forced to sell the stock).

Fortunately, you may not necessarily get stuck with being assigned in this scenario. You may have a choice in advance of that dividend payment. You could wait and see if the stock will be assigned, or, you could close the position and roll it out to a later month to potentially avoid assignment. In fact, almost two-thirds of all options are closed out before they expire. This is one of the many ways that you can manage your risk with options.

Manage risk

When it comes to options, it can be particularly important to manage your positions actively and change course as needed.

“An options trade is an actively managed strategy, which is to say that you don’t want to set it and forget it,” says Greg Stevens, vice president at Fidelity. “When an options trade is open, there are several choices you may make throughout the life of the contract—including closing out the trade, letting the option expire, and if you still want to be in the position, rolling it out.” Of course, if you sell an option, assignment is out of your control.

  • Closing out a trade can involve taking an offsetting position. For example, if you purchased a call option, you could sell an identical call option to effectively close the trade out.
  • Letting an option expire is when an options contract reaches its expiration date without being exercised, and is possible if you purchase or sell a call or put.
  • Rolling out an option involves closing out an option that is about to expire and simultaneously purchasing a similar trade with a later expiration date.
  • Assignment can happen if you sell an option—meaning you might have to receive or deliver shares of the underlying stock.

Chart a path to trading options successfully

If you want to put yourself in the driver’s seat, consider making use of all the resources that are at your disposal. For some people, options appear too complicated. However, there are many tools and resources that can help you research options.

Making Your First Option Trade

Larry Washburn / Getty Images

You know what an option is and you believe that you understand how it works. Congratulations. But please demonstrate some patience before placing your money at risk. You are bursting with anticipation and cannot wait to begin raking in the money. However, it is not that easy. Money must be earned and please believe that no one gives it away. Here is a look at the pitfalls of buying options before you are ready to trade.

A Typical Example of Buying Call Options

Your favorite stock (FAVR) is currently $42.50 and you love its prospects. You just “know” that FAVR will be trading above $50 per share fairly soon. Based on that anticipation, you open a brokerage account and buy 10 FAVR call options. They expire in 90 days and are struck at $50 (i.e., the strike price is $50). You can hardly wait to see the money roll in.

So what happens? Most of the time expiration day arrives and the options become worthless. The once eager, new options trader (along with many experienced traders who should have known better), lost every penny invested.

The truly sad part is that your inclination was right on the money. FAVR did move higher, and 90 days after your option purchase, the market price was $46. The only problem is that you correctly predicted the price increase and still lost money. It is bad enough to lose when your prediction is wrong, but losing money when it is correct is a bad result. Yet, it happens all the time in the options world.

Unfortunately, this is a common result. So before buying options, please consider some things that you MUST understand about options. The purpose here is to make you aware of vital information. The details can wait until you have a better understanding of the basic concepts of options.

Earning a Profit

Many factors go into the price of an option. A trader cannot simply “buy calls” and expect to make money when the stock price rises. Much more is involved. The problem is that brand-new traders are unaware of all the other factors that affect whether the trade will earn a profit or lose money.

You expect the stock price to rise (i.e., you are bullish). Good. By how much do you expect the price to change? Is it reasonable – based on FAVR’s price history – to expect the stock to move to $50 (an increase of almost 18%) in 90 days?

A history of the stock’s average daily price change (volatility) provides a good clue to the correct answer. It is a poor strategy to buy (OTM) call options with a strike price of $50 if the average stock price move is $0.05 per day. However, it is a reasonable play when the average daily stock price change is $0.50 per day. Be aware of just how volatile the stock price has been in the past.

Strike Price

It is not necessary to buy OTM options, despite the fact that this is the choice of the vast majority of traders. They believe their prediction will come true and they want to buy the cheapest options. Why? Our best guess is that most under-educated option traders want to own “a lot” of options, rather than just a few.

It is similar to the thought process that makes someone buy lottery tickets. The odds may be terrible, but the possibility of a huge payoff is too much to resist. Based on volatility data, buy options that have a good chance to be in the money at a later date (before the options expire). Thus, it would be reasonable to buy FAVR calls struct at $40, $42.5 (if these options exist) or $45.

Deciding how much to pay for options requires some trading experience. However, you must be aware of several items.

  • Was the option price reasonable or was the implied volatility of this option too high?
  • Did buying these options at this price give you a fair chance to make any money – based on your expectation for the price increase?
  • Was the bid/ask spread too wide? Wide markets are more difficult to trade. Did you make the mistake of paying the asking price when you should always try to do better?

Holding Too Long

When buying options, do not plan on holding them until expiration arrives. Options are wasting assets and your plan should include getting out of the trade as soon as it becomes feasible. It is easy to fall in love with a profitable option trade and hold onto it, looking for a much larger profit.

Do not allow that to happen. Sometimes you earn the target profit. At other times it means giving up on the trade and selling the options while they still have value. If the stock price reaches your target (or gets near that target price), it is time to take your gains and sell the option.

The Stock Market

Was this a good time to make such a bullish play? Do you believe the stock market is headed higher? Most stocks do not move in a vacuum, and their rise and fall are dependent on the performance of other stocks. In other words, is the market bullish or bearish?

Did you consider all these factors? Did you consider any of them? The bottom line is that if you do not pay attention to each factor, then your chances of earning money become smaller, and the loss of your entire investment becomes the most likely result (especially when you purchase OTM options).

It is not enough to have a strong belief that the market will move higher or lower. When buying options, the option price has a large influence on the potential profitability of the trade and often matters more than a change in the price of the underlying stock. Thus, do not pay too much (based on implied volatility) for your options.

It is very important to recognize how easy it is to lose money when buying options. Most traders only think about “how much money can I earn?” Please avoid using options to gamble.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Traders Exclusive

Here’s some general advice about taking any stock options advice: Don’t.

More precisely, never take stock options advice from anyone without weighing it against your own criteria for an appropriate risk or trade.

Every investor has a trading and investing psychology that constitutes his beliefs, values, aspirations and gratifications about risk and wealth. No two investors have the exact same psychology.

Stock options advice is neither applicable nor credible without knowing an investor’s basic options trading strategy. Without context, the content of all stock options advice is meaningless.

Are you an investor or a trader? Are you a speculator or a hedger?

What are your basic values and your core beliefs about the nature of risk?

In general, all stock options advice carries an element of risk, and no one piece of stock options advice is suitable for all investors.

What kind of options trader are you? Are you systematic, impulsive, or scholarly?

For the cautious beginner, stock options advice should be tempered with risk-aversive strategies that automatically stop losses when conditions change.

For the circumspect journeyman, appropriate stock options advice can be more aggressive, perhaps addressing how to make money more consistently by letting profits run and cutting losses short.

For the strategic professional, appropriate stock options advice may include taking a more leveraged position.

Though specific recommendations can often be suspect, there are some general principles that all option traders should follow. Here is some general stock options advice that’s appropriate for all traders:

1. Whatever your tolerance for risk, don’t get into the game unless you are fully prepared.

2. Study, learn, make a plan, and follow it with discipline. In that order.

3. Always have an exit strategy for getting out of the market to curtail losses. Make this exit plan before getting into the trade in the first place

If you start your trading and investing activities by following this fundamental advice, you’ll build a solid foundation for all the more exotic and strategic stock options advice that will surely follow.

Five Mistakes to Avoid When Trading Options

(Especially since after reading this, you’ll have no excuse for
making them)

We’re all creatures of habit — but some habits are worth breaking. Option traders of every level tend to make the same mistakes over and over again. And the sad part is, most of these mistakes could have been easily avoided.

In addition to all the other pitfalls mentioned in this site, here are five more common mistakes you need to avoid. After all, trading options isn’t easy. So why make it harder than it needs to be?

MISTAKE 1: Not having a defined exit plan

You’ve probably heard this one a million times before. When trading options, just as when you’re trading stocks, it’s critical to control your emotions. That doesn’t necessarily mean you need to have ice flowing through your veins, or that you need to swallow your every fear in a superhuman way.

It’s much simpler than that: Always have a plan to work, and always work your plan. And no matter what your emotions are telling you to do, don’t deviate from it.

How you can trade smarter

Planning your exit isn’t just about minimizing loss on the downside if things go wrong. You should have an exit plan, period – even when a trade is going your way. You need to choose your upside exit point and downside exit point in advance.

But it’s important to keep in mind, with options you need more than upside and downside price targets. You also need to plan the time frame for each exit.

Remember: Options are a decaying asset. And that rate of decay accelerates as your expiration date approaches. So if you’re long a call or put and the move you predicted doesn’t happen within the time period expected, get out and move on to the next trade.

Time decay doesn’t always have to hurt you, of course. When you sell options without owning them, you’re putting time decay to work for you. In other words, you’re successful if time decay erodes the option’s price, and you get to keep the premium received for the sale. But keep in mind this premium is your maximum profit if you’re short a call or put. The flipside is that you are exposed to potentially substantial risk if the trade goes awry.

The bottom line is: You must have a plan to get out of any trade no matter what kind of strategy you’re running, or whether it’s a winner or a loser. Don’t wait around on profitable trades because you’re greedy, or stay way too long in losers because you’re hoping the trade will move back in your favor.

What if you get out too early and leave some upside on the table?

This is the classic trader’s worry, and it’s often used as a rationale for not sticking with an original plan. Here’s the best counterargument we can think of: What if you profit more consistently, reduce your incidence of losses, and sleep better at night?

Trading with a plan helps you establish more successful patterns of trading and keeps your worries more in check. Sure, trading can be exciting, but it’s not about one-hit wonders. And it shouldn’t be about getting ulcers from worry, either. So make your plan in advance, and then stick to it like super glue.

MISTAKE 2: Trying to make up for past losses by “doubling up”

Traders always have their ironclad rules: “I’d never buy really out-of-the-money options,” or “I’d never sell in-the-money options.” But it’s funny how these absolutes seem obvious — until you find yourself in a trade that’s moved against you.

We’ve all been there. Facing a scenario where a trade does precisely the opposite of what you expect, you’re often tempted to break all kinds of personal rules and simply keep on trading the same option you started with. In such cases, traders are often thinking, “Wouldn’t it be nice if the entire market was wrong, not me?”

As a stock trader, you’ve probably heard a justification for “doubling up to catch up”: if you liked the stock at 80 when you first bought it, you’ve got to love it at 50. So it can be tempting to buy more shares and lower the net cost basis on the trade. Be wary, though: What can sometimes make sense for stocks oftentimes does not fly in the options world.

How you can trade smarter

“Doubling up” on an options strategy almost never works. Options are derivatives, which means their prices don’t move the same way or even have the same properties as the underlying stock.

Although doubling up can lower your per-contract cost basis for the entire position, it usually just compounds your risk. So when a trade goes south and you’re contemplating the previously unthinkable, just step back and ask yourself: “If I didn’t already have a position in place, is this a trade I would make?” If the answer is no, then don’t do it.

Close the trade, cut your losses, and find a different opportunity that makes sense now. Options offer great possibilities for leverage using relatively low capital, but they can blow up quickly if you keep digging yourself deeper. It’s a much wiser move to accept a loss now instead of setting yourself up for a bigger catastrophe later.

MISTAKE 3: Trading illiquid options

When you get a quote for any option in the marketplace, you’ll notice a difference between the bid price (how much someone is willing to pay for an option) and the ask price (how much someone is willing to sell an option for).

Oftentimes, the bid price and the ask price do not reflect what the option is really worth. The “real” value of the option will actually be somewhere near the middle of the bid and ask. And just how far the bid and ask prices deviate from the real value of the option depends on the option’s liquidity.

“Liquidity” in the market means there are active buyers and sellers at all times, with heavy competition to fill transactions. This activity drives the bid and ask prices of stocks and options closer together.

The market for stocks is generally more liquid than their related options markets. That’s because stock traders are all trading just one stock, whereas people trading options on a given stock have a plethora of contracts to choose from, with different strike prices and different expiration dates.

At-the-money and near-the-money options with near-term expiration are usually the most liquid. So the spread between the bid and ask prices should be narrower than other options traded on the same stock. As your strike price gets further away from the at-the-money strike and / or the expiration date gets further into the future, options will usually be less and less liquid. Consequently, the spread between the bid and ask prices will usually be wider.

Illiquidity in the options market becomes an even more serious issue when you’re dealing with illiquid stocks. After all, if the stock is inactive, the options will probably be even more inactive, and the bid-ask spread will be even wider.

Imagine you’re about to trade an illiquid option that has a bid price of $2.00 and an ask price of $2.25. That 25-cent difference might not seem like a lot of money to you. In fact, you might not even bend over to pick up a quarter if you saw one in the street. But for a $2.00 option position, 25 cents is a full 12.5% of the price!

Imagine sacrificing 12.5% of any other investment right off the bat. Not too appealing, is it?

How you can trade smarter

First of all, it makes sense to trade options on stocks with high liquidity in the market. A stock that trades fewer than 1,000,000 shares a day is usually considered illiquid. So options traded on that stock will most likely be illiquid too.

When you’re trading, you might want to start by looking at options with open interest of at least 50 times the number of contacts you want to trade. For example, if you’re trading 10 contracts, your minimum acceptable liquidity should be 10 x 50, or an open interest of at least 500 contracts.

Obviously, the greater the volume on an option contract, the closer the bid-ask spread is likely to be. Remember to do the math and make sure the width of the spread isn’t eating up too much of your initial investment. Because while the numbers may seem insignificant at first, in the long run they can really add up.

Instead of trading illiquid options on companies like Joe’s Tree Cutting Service, you might as well trade the stock instead. There are plenty of liquid stocks out there with opportunities to trade options on them.

MISTAKE 4: Waiting too long to buy back short strategies

We can boil this mistake down to one piece of advice: Always be ready and willing to buy back short strategies early. When a trade is going your way, it can be easy to rest on your laurels and assume it will continue to do so. But remember, this will not always be the case. A trade that’s working in your favor can just as easily turn south.

There are a million excuses traders give themselves for waiting too long to buy back options they’ve sold: “I’m betting the contract will expire worthless.” “I don’t want to pay the commission to get out of the position.” “I’m hoping to eke just a little more profit out of the trade”… the list goes on and on.

How you can trade smarter

If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Don’t be cheap.

Here’s a good rule-of-thumb: if you can keep 80% or more of your initial gain from the sale of an option, consider buying it back immediately. Otherwise, one of these days a short option will come back and bite you when you’ve waited too long to close your position.

For example, if you sold a short strategy for $1.00 and you can buy it back for 20 cents a week before expiration, you should jump on the opportunity. Very rarely will it be worth an extra week of risk just to hang onto a measly 20 cents.

This is also the case with higher-dollar trades, but the rule can be harder to stick to. If you sold a strategy for $5.00 and it would cost $1.00 to close, it can be even more tempting to stay in your position. But think about the risk / reward. Option trades can go south in a hurry. So by spending the 20% to close out trades and manage your risk, you can save yourself many painful slaps to the forehead.

MISTAKE 5: Legging into spread trades

“Legging in” is when you enter the different legs of a multi-leg trade one at a time. If you’re trading a long call spread, for example, you might be tempted to buy the long call first and then try to time the sale of the short call with an uptick in the stock price to squeeze another nickel or two out of the second leg.

However, oftentimes the market will downtick instead, and you won’t be able to pull off your spread at all. Now you’re stuck with a long call with no way to hedge your risk.

How you can trade smarter

Every trader has legged into spreads before — but don’t learn your lesson the hard way. Always enter a spread as a single trade. It’s just foolish to take on extra market risk needlessly.

When you use Ally Invest’s spread trading screen, you can be sure all legs of your trade are sent to market simultaneously, and we won’t execute your spread unless we can achieve the net debit or credit you’re looking for. It’s simply a smarter way to execute your strategy and avoid any extra risk.

(Just keep in mind that multi-leg strategies are subject to additional risks and multiple commissions and may be subject to particular tax consequences. Please consult with your tax advisor prior to engaging in these strategies.)

Advice on options play for a beginner

I’m looking to buy a call on $MCD. I think their app is going beyond expectations and the new stores will drive more growth and I think they will pop after earnings. My real question is though, how should I play it? Calls expiring the week after earnings? Their earnings are Oct 23, first available options Nov 16, stock price is $161.74, lowest OTM call is $165 at $3.63. Should I wait to buy weekly options for the week of earnings? I know I should buy ITM calls (e.g. $150 call for Nov 16 is $13.65, only +1.18% for profit) but I don’t have the capital for that now. Should I buy further OTM ( $170 call Nov 16 for $1.92)? Thanks for any and all advice.

If you don’t have $1365.00 to buy that $150 call, I think you are too undercapitalized to be buying the $165 strike for $363. You are risking too much of your capital on a single trade.

Also, while I have not analyzed this specific trade, buying calls as an earnings play is a classic newcomer trap. Even if you are right and they get a pop after earnings, you’ve still got all that theta decay between now and Oct 23, and you are still vulnerable to IV crush.

If you must make an earnings trade on this underlying, why not wait until the day before earnings and write a put credit spread? This will put IV decline on your side, and if the stock gets a bump, you’ll be more likely to realize a profit. And if you’re wrong directionally, you have limited downside risk.

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