Make or Break Your Options Trade

There are 2 factors that experienced options traders believe affects the success of any option trader - the strike price and the time to expiration.

Most beginners prefer to choose to buy the least expensive and out-of-the-money options (I will explain in a bit what this means), which expire one month later. The reason they prefer to do so is because of the low cost of this type of options. However, this is probably the worst way to trade an options because the majority of these type of options become “worthless” at expiration.

Out-of-the-money (OTM) options are options that are further away from the current market stock price. Let’s use Microsoft (Nasdaq: MSFT) again as an example. If MSFT is trading today at $30, a $40 strike price of a call option is OTM (remember a call option? If not, read my blog here: A $25 strike price is in-the-money (ITM), and a $30 strike price is at-the-money (ATM). Basically these terms represent how far the strike price is from the current market price.

When buying cheap, out-of-the-money calls, time is our fiercest enemy. Every day, even if the underlying stock is unchanged or up a fraction, the time premium is slowly slipping away. As time goes by, our fear of losing more money increases. That fear can cause sleepless nights and make us do odd things, such as selling the option to salvage what we have left just before it becomes profitable. Being right but losing money is one of the worst feelings an option trader can experience.

Almost all beginners, including myself, make similar mistakes. Novices usually end up losing money and sleep. Or they will act under pressure to sell some put options for a slight loss two days before the options reverses direction and could have handed us beginners a nice profit. The hard knocked education of losing money has changed the way I now play the options market.

I started learning from the professionals simple technical analysis of the underlying stock. Some of the simpler analysis includes determining the overall trend of the stock using 50- and/or 200-day moving averages, along with support and resistance levels (previous highs or lows, moving averages, retracement levels, etc.). I will talk more about these in future blogs.

The essence is to buy a call as close to support as possible, or buy a put as close to resistance as possible. That way, your risk is minimal because a break below support or above resistance gets you out of the trade with a reasonable loss.

Once I’ve declared my option strategy, choosing the strike price and time to expiration are paramount. Time erosion is one of my main concerns. So, I look at the options chain to determine which in-the-money-option with little or no time premium is closest to the price of the underlying stock.

Here’s an example taken from one of the newsletters that I subscribed to which perfectly illustrates the above example:

In late January, Safeco (ticker symbol: SAFC) triggered a sell signal and the RSI (relative strength) fell below 50. It then dropped below its 50- and 200-day moving averages. The stock could not make much headway after reaching its February lows, despite a strong showing by the Dow and S&P. So, I looked for a spot to buy some puts.

On March 19, SAFC traded up to its 50-day moving average and the RSI was close to the 50 line (bullish above, bearish below). The stock was trading at $52.70 and the April $55 put was $2.30-$2.60. Although I did pay a 30-cent time premium, the leverage was much better than buying the April $60 put.

The only problem with playing in-the-money options more than one month out is that the liquidity can be low. That can mean a large spread between the bid and ask. In cases like that, you may have to choose an option that is not ideal. All we can do is use the best strategy available.

Your exit point would be a break above $53.50, which would produce about a $1 loss. But if it reaches the target of about $49.40, it should produce more than a 100% gain. Author Resource:- Patrick Lim operates, a blog about his personal journey to take $50,000 to turn it into $1,000,000 in 5 years. He likes to share the strategies he uses to try to accomplish his goal and is now giving away a FREE article he wrote about how to make a quick profit during times of market volatility.

Join him on his journey and get FREE tips and strategies at:

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