People often regret missing out on lucrative investment opportunities. However, the risks involved—and the money that can vanish in an instant—are seldom discussed. The allure of potential riches is simply too enticing.
Instead of risking your life savings on long-shot gambles, this guide will show you how to manage your risks effectively. You’ll learn to follow market trends rather than trying to beat the odds. While you may not become a millionaire overnight, careful trading in stock options could help you consistently add to your income.
Ultimately, the market always has the upper hand, and you may not profit every single time. However, by using these strategies, you can minimize your losses.
In this summary, you’ll discover:
- The difference between stocks and options.
- How to make money on a losing stock.
- Why trading options is not the same as betting on horse races.
Make Money Trading Options
Trading Stock Options: A Path to Lucrative Returns
Imagine you’ve just retired after a fruitful career in teaching. Over the years, you’ve diligently set aside portions of your monthly paycheck, depositing them into your retirement account. By now, your contributions have blossomed into a respectable nest egg of $150,000.
But here’s the thing: you have grand plans for your retirement. You want to travel the world, stay in luxurious hotels, and maybe even pay off your mortgage. So, how can you increase your income to make these dreams a reality?
Your first thought is to invest in stocks. Then you remember your nephew constantly raving about the money he makes trading options. It seems like he always wins. Why not give it a shot?
The key takeaway here is that trading stock options can be very lucrative.
Your nephew is right about one thing: you can make money trading options. However, like any investment, it comes with risks. To understand what’s at stake, let’s delve into the basics of stock options.
A stock option is a type of agreement known as an options contract. This contract gives you the right to buy or sell a stock at a predetermined price in the future without being obligated to complete the purchase.
You’re likely familiar with how stocks work. If you buy one share of Microsoft at $10, you own a tiny piece of the company. If the price of Microsoft shares rises to $15 and you sell your share, you’ll make a profit of $5. Conversely, if the share price drops to $1 and you sell, you’ll incur a loss of $9. If you initially bought 100 shares, you’d need $1,000 upfront. Should the market decline, you’d be out $900.
When buying options, you’re not required to purchase the actual underlying stock. Compared to stock trading, options trading requires less capital: one option contract controls 100 shares, and the cost (or premium) of this contract can be as low as a few dollars.
Let’s say you buy an option contract for Microsoft valued at $10 per share. If the share price reaches $15, you have the right to purchase 100 shares of Microsoft at the earlier, lower price (the strike price) and sell them at the higher market price. Instead of a $5 profit, you’d be looking at $500. If the price drops to $1, your loss would be limited to the premium you paid.
This sounds great—like a get-rich-quick scheme that really works! So, what could possibly go wrong?
Make Money Trading Options
Understanding Options: A Key to Minimizing Risk
In the previous scenario, quite a lot could go wrong.
Many novice traders, eager to make a quick buck, often confuse options with stocks. Instead of purchasing 50 shares, they might accidentally buy 50 options. Remember, one option controls 100 shares, so 50 options translate to a trade of 5,000 shares. While this could lead to significant profits, it could also result in a loss of several hundred or even several thousand dollars.
This highlights one of the greatest dangers of trading options. If you’re not careful and don’t understand how much money is at risk before entering a trade, you could lose a substantial portion of your savings in a matter of hours or even minutes.
Here’s the key message: understanding how options work is vital to minimizing risk.
When you buy and sell stocks to make a profit, your decisions depend on the direction in which you think the price is headed. Share prices can go up or down, and for each possibility, there’s a type of option.
Consider Apple announcing its new iPhone model. You’re confident it’ll be a hit, causing the price of Apple shares to skyrocket. But you can’t be 100 percent certain. What if a report exposes a technical flaw? That could be disastrous for the stock price.
Instead of risking your hard-earned cash, you buy a call option contract. If the new iPhone is flawless and the share price rises, you can buy 100 shares of Apple at the pre-announcement price or sell the option to someone else who wants to buy those cheaper shares. As the stock price increases, so does the price of your call option.
The second type of option, a put option, involves betting against the market. If you buy stock at $10 and the share value decreases to $1, you have limited choices: sell it and cut your losses or wait for the share value to recover.
However, if you anticipate that the price of shares will plummet, you can still make money by buying a put option. This gives you the right, but not the obligation, to sell Apple stocks at a certain price—say $5—even if the share prices drop to $1.
For our purposes here, we’ll focus on call options.
Make Money Trading Options
All Options Have Expiration Dates, Unlike Stocks
Now that you have a better grasp of call and put options, you might be eager to get started. It seems simple enough, as long as you don’t confuse shares with options and keep track of the money at risk for each trade.
However, there’s one more key difference between stocks and options that significantly influences your profits—or losses—over time.
When you buy a stock, you have the flexibility to keep trading or hold it long-term. For instance, you could buy 50 shares of Google and walk away. Take a vacation. Join a knitting club. When you return, as long as the company still exists, your shares will still be there.
Whenever you buy an option, however, the clock starts ticking. Unlike stocks, all options expire.
Life is fleeting, and so are options. The moment you buy an option, you decide when it will become worthless. Most options are set to expire on the third Friday of each month at 4:00 p.m. Eastern Time. You can also choose weekly or quarterly expiration dates.
Whichever you select, remember this: the farther away the expiration date, the more the option costs. As you approach this date, the price at which you can sell the option rapidly decreases. With less time for dramatic shifts in the stock price, the option becomes less attractive.
This is why some people lose money on options, even if they predict the market correctly. It’s risky to wait to sell—or exit—an option position just before it expires. Although the underlying stock price might be higher, the premium you receive could be less than what you paid.
Consider this scenario: the market price for one Netflix share is $20, but you suspect it will surpass $25 within the next couple of weeks. So, you buy one call option, set to expire in a month, and pay $10 for it. Your plan is to sell the option, giving someone the right to buy 100 shares at $20—the strike price. So you wait, watch, and listen.
Fourteen days pass, and Netflix is trading around $18. You’re losing hope. Then, two days before your call option expires, your prayers are answered: the share price reaches $25. Someone buys your option, but because it expires so soon, the premium has plunged to just $2.
Here, you made the right prediction but still ended up with a net loss.
Make Money Trading Options
Discover the Most Profitable Stocks Using the Test Trading Strategy
The risks and complexities of trading options can be daunting. However, if managed correctly, options can be an excellent way to increase your income or savings.
In some cases, like gambling on horse races, you’re not permitted to change your bet after the starting bell rings. You place a wager on the horses you think will finish in the top three. If you’re right, you win some money. If you’re wrong, you lose the money you bet. But what if you could avoid risking so much?
Imagine being able to place your bet partway through the race. You’d probably win more often, right? While this isn’t allowed in horse racing, you can do something similar when trading options using the Test Trading Strategy.
The key message? Identify the most profitable stocks with the help of the Test Trading Strategy.
You don’t need to be a fortune teller to succeed. Instead of predicting the future, you can use virtual trading tools to test theories about stock movements. Virtual trading, also known as paper trading, uses fake money to practice buying and selling stocks and options. Not only is paper trading a great way to learn, but it also helps you avoid real financial losses while practicing.
The Test Trading Strategy will help you prepare for the trading day, determine which stocks to watch, and decide which days to sit out, recognizing that not every day is ideal for trading.
First, you’ll need to set up a test trading account. If you already have a broker, they likely offer a simulated trading platform. If not, there are free options available, such as on the Investopedia website.
Once your test account is running, it’s time to create your Watch List. This list includes stocks and other securities, like ETFs (Exchange Traded Funds), that you’ll monitor daily on your computer or smartphone.
Your Watch List should include SPY, the stock market symbol for the SPDR S&P 500 ETF Trust, QQQ, the Invesco QQQ Trust, the Dow Jones Industrial Average (DJIA), and the Standard & Poor’s 500 Index (SPX or the S&P 500).
With these ETFs tracking general market trends, it’s time to add individual stocks to your Watch List. We’ll learn how in the next section.
Make Money Trading Options
Add Individual Stocks to Your Watch List and Start Test Trading
When creating your Watch List, it’s important to choose stocks that meet specific criteria. These are the companies whose stocks or options you’re considering buying and selling.
Ensure the stocks on your Watch List are priced at least $50 per share and are among the most actively traded on the market. Look for companies held by mutual funds, indexes, banks, and hedge funds. A robust Watch List might include highly successful companies like Apple, Amazon, IBM, Mastercard, Netflix, or Tesla.
Avoid including potentially risky investments and assets like American Depositary Receipts (ADRs), which can’t easily be converted to cash without losing significant value.
Once your test trading account is loaded with your Watch List picks, you can start making your first practice trades.
Here’s the key message: Add individual stocks to your Watch List. Then, start test trading.
Before the real market opens at 9:30 a.m. Eastern Time, take time to prepare your test trading account and adjust your parameters. Most trading simulators provide you with virtual money—ensure your account has at least $100,000 for ample buying power across different stocks.
About 30 minutes before the market opens, review the stock quotes on your Watch List to gauge market expectations. Has Mastercard’s stock moved up by a dollar or one percent? What about Tesla?
Remember, you can’t trade options until after the market opens. Instead, place a market order in your test trading account to buy 100 shares of each stock. This type of order executes at the current market price when your order is filled.
Whether you prioritize dollar movements or percentages is up to you; the goal is to identify winning stocks.
Be cautious of stocks that experience significant jumps in the pre-market—they may not sustain their gains once trading begins.
Once the market opens, monitor closely for stocks that change direction or fail to maintain momentum. Winners will start to emerge as the trading day progresses.
Make Money Trading Options
Identify Winning Stocks as the Stock Market Opens
At 9:30 a.m., the stock market opens and the race begins. By closely monitoring the stocks in your trading account, you can start identifying the winners in real-time.
Early morning brings fluctuating trends: some stocks surge, others plummet, and some remain stable. As the morning unfolds, the true winners emerge with sustained gains.
Patience is key at this stage, but knowing what to look for is crucial. What defines a winner?
The key message here is: Pick out the winning stocks once the stock market opens.
A common strategy in stock trading is to buy low and sell high, though timing such maneuvers perfectly is rare. Instead, through the Test Trading Strategy, focus on stocks showing consistent growth in the first hour. This approach allows for more modest gains by buying high and selling higher. If no clear winners emerge by mid-morning, it’s prudent to consider pausing trading for the day.
You should aim to identify one or two leading stocks pulling ahead of the pack, sometimes as many as six or seven on good days. Now, it’s time to start buying call options in your test trading account.
Let’s use a strategy called the five-call probe: for each winning stock, purchase five call options. Ensure these calls are priced lower than the current market price of the stock, which is known as being in-the-money. Monitor these calls along with their respective stocks to gauge continued momentum.
For any options that continue to appreciate, consider buying five more calls at-the-money, or at the current market price. If these calls also show profitability—typically ranging from $100 to $300—you’re ready to transition from your trading simulator to live call options in a real brokerage.
Make Money Trading Options
Implement the Five-Minute Rule for Risk Management in Options Trading
Before purchasing any call options in your real brokerage account, there’s one final check you must perform. Leaving behind the paper trading account means you’re now using—and risking—your own money. Failing to be thorough could lead to costly surprises, and while surprises can be exciting, losing significant sums of money is not.
This is where the Five-Minute Rule becomes crucial. By following the steps outlined in this method before each trade, you can ensure everything is in order before you hit the Enter key.
The best part about the Five-Minute Rule? It’s quick—taking only five minutes—so you won’t likely miss any significant market fluctuations.
The key message here is: Use the Five-Minute Rule to manage risks when trading real options.
For beginners, it’s advisable to limit yourself to one or two positions at a time. This helps in keeping track of your open positions effectively. Once you’ve decided on a position to open, it’s time to apply the Five-Minute Rule.
Firstly, carefully examine the option details such as the expiration date and strike price. This information can be found in the options chain. Many traders make mistakes here—entering too many contracts unintentionally—which can lead to issues.
Next, check the bid-ask price in the options chain. This is crucial because if the bid-ask spread is too wide, it indicates liquidity issues and makes profitable trading difficult.
The third step is to place a limit order instead of a market order. Unlike the test trading account where market orders were used for tracking, in a real account, using market orders is risky. A limit order allows you to specify the price at which you want to buy, typically between the bid and ask prices.
Lastly, review the stock charts once more to confirm your initial analysis remains valid.
Taking five minutes to go through these steps can prevent rushing into a trade due to a careless mistake, ultimately safeguarding your investments.
Make Money Trading Options
Continue Risk Management Post-Option Trade
At this stage, you’ve identified a promising stock showing upward momentum and purchased a call option. However, like any investment strategy, the Test Trading Strategy carries its own set of risks.
Even if a stock has passed all your tests and performed well under your five-call probes, there’s always the possibility it could reverse course unexpectedly. Even seasoned experts can misjudge stock movements at times.
While you hope for the best outcome, it’s crucial to prepare for potential setbacks.
Here’s the key message: Continue managing risks after trading an option.
Trading options requires a pragmatic approach. After acquiring a winning call option, it’s essential to have an exit strategy in place. This involves utilizing two key tools: time stops and stop-loss orders.
Many traders inadvertently lose money due to distractions post-trade. Setting a time stop allows you to pre-determine when to automatically sell your option, whether at a profit or a loss. This could be within a short timeframe or by the end of the day to secure gains or prevent losses from escalating.
Alternatively, a stop-loss order triggers an automatic sale once the option price hits a predetermined threshold. For instance, if you’re unwilling to endure more than a $50 loss on an option, a stop-loss ensures you exit the trade promptly, even if you’re away from your trading station.
The choice between a time stop and a stop-loss depends on your trading style and risk tolerance.
Once your safety measures are in place and your trade is active, the final step of your trading day arrives with the market closing. Take a few moments to review the day’s activities. Assess both successful trades and losses. What contributed to your successes? What led to losses? Keeping detailed records allows you to learn from each trade’s outcomes, improving your proficiency as an options trader over time.
Source
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