If you can master stock Option trading, they can be very useful in building income alongside other financial investments.
In this Option Trading Tutorial, we will equip you with the best practices and warn you of mistakes to avoid in your endeavor.
This will enable you to steadily make money from your option trades and thus get you a step closer to your financial objectives in the new decade.
Option Trading Tips: Know Your Opponent
Many people come to Option trading for different reasons.
One of the attractive part of options is the leverage they provide to those with smaller starting capital.
If you already have a big portfolio of stocks, you can use your assets to write options and generate income.
That is a given.
Our focus today is the activity of day and swing trading of options to generate a revenue that can be used later to acquire stocks if need be.
Option Trading Tips on Position Entry
This is the one area that is so important because everything flows from your entry into a trade.
We are going to assume that you have done your nightly and pre-market study and know exactly what you want to trade
All is left is to execute the trade.
This entry should ALWAYS be a Limit Order.
What does that mean ?
In other words, you tell the platform you are buying your option up to a certain limit price set on your entry form.
Now, how to set that limit price ?
Here is your first Take Away:
- Do Not try to enter any position it the first 10 minutes after the Opening of The Market
- Set your Limit Entry Price at 75% of the current Bid and Adjust is as Direction is confirmed after initial 15 minutes
Let’s talk about these two.
Why on earth would you sit around in the first 10 minutes when the markets are fresh out of the gates ?
You WILL fight the urge to follow the first recommendation. It is called Fear Of Missing Out (F.O.M.O) 🙂
We have our adrenaline flowing at the prospect of making “easy” money because we think that because a stock is bearish/bullish in pre-market it will exactly continue that way at open.
Beware of the first 10 minutes as they are known for price discovery and head fakes (make you believe the direction is one way while it will violently revert to the other direction or better yet start a back and forth psychedelic dance !
What better than showing you how this looks like. I do not even have to go search very far.
How convenient for me that as I am writing on this last day of the decade, SPY actually just went through this as shown below.
Each candle on the chart represents 5 minutes.
The Lowest value of that first 5 minutes candle is $320.15. The highest value is $321.
Quite difficult if you ask me during the Live session to determine the direction of SPY.
Don’t you think ?
Most inexperienced retail traders are convinced that they can only make money in the first hour of the session.
Consequently, they rush into trades and later wonder why they keep losing money.
Here is actually what is taking place.
THE AGE OF MACHINE LEARNING HAS ARRIVED
Retails traders are mostly trading against High Frequency Trading powerful computers known as Algos.
The word “Algos” comes from computer programming Algorithms. Meaning something a human programmed to accomplish a specific task.
Well, with the proliferation of Artificial Intelligence, Algos are becoming more and more Powerful.
How Powerful ? You May ask.
There is this a subsection of Artificial Intelligence called Machine Learning that consists of giving computers sets of basic instructions.
Then it is up to the computers to determine when presented with a variety of similar or not so similar environments to decide what to do.
How is this related to Trading ?
A group of High Frequency (meaning they can execute millions of orders very fast) computers can be assembled with the common objective to maximize their trading gains for the benefit of the people who own them obviously.
So these computers are smart enough to use what is called in Machine Learning as REINFORCEMENT LEARNING.
I will devote a full article on this in the future.
For now, we will remember that the computers will learn that for every action (buy or sell) they take, there is a reward (money being made or lost).
So to achieve the common goal which is to make the most money from their common trading, they can decide to “sacrifice” some of the computers individual gains to achieve the overall objective.
Some computers will show the rest of us that the market is going one way, while in fact the other computers are taking the opposite positions thus resulting in us who followed the “fake” machines losing.
The reinforcement part comes from the fact that once the computers figure out that performing that action creates their desired result (increase their common trading gains), they will keep repeating or reinforcing it !
This is why you will see many head fakes throughout the day.
The best security to observe this phenomenon on is SPY especially at Market Open.
Hence, now that you know this, you will bite your time not to fall prey to machine learning robots.
The second Tip may actually land you in fabulous trades.
By setting your Limit order so far away from the current Bid and Market, you will be the beneficiary of the head fake by entering your position at the cheapest price possible.
That is the dream entry as opposed to taking the “fake” direction.
There is nothing more demoralizing that entering a position and being down 50% within 10 minutes or being forced to cut your losses on your first trade of the day.
Option Trading Tips: Avoid Cult Stocks
From my observations, anytime a stock has a huge following with opined pundits and a large retail ownership, it becomes very difficult to predict and trade.
How to do you recognize such a stock ?
One is to look at the number of Followers on stocktwists.com or the messages on social media with that Ticker.
Let’s me give you the first one on the list : Tesla.
Have I made money trading Tesla Options, yes. Have I lost money on Tesla options ? Yes and Yes !!
Maybe it is just me but if you are to pull a chart of Tesla Stock (Ticker: TSLA) and scrutinize the ups and downs, the gaps up, the gaps down from The Chief Executive Officer tweets or the investigation on cars crashing in XYZ countries.
You name it, this company has drama all over it. And that will wreck you account if you are a beginner.
The next one to avoid is a newcomer: Roku
This stock gained over 355% this year alone as of the writing of this publication.
Yes, you are reading correctly. Feeling some F.O.M.O already ? 🙂
Most of the gains were through Earnings reports but after it reached $100, it became a nightmare to trade with head fakes in pre-market and during sessions.
At one point this year, there was no making sense of what was moving the stock.
On days when the entire market was red, Roku will gain 5% and when the market was bullish in December, guess it, Roku was slumping -5% or more.
The spread of its options become unattractive due to the constant volatility in the stock.
Even stock holders must have felt the impact. Except those who bought the stocks for below $50 maybe.
The rest of investors had tough decisions to make after it ran up from $70 to $170 and then retreated to $100 i just a couple of months !
Last but not least on this infamous list is: NetFlix
Everyone knows the popular of the streaming service not only state side but internationally as well.
Do not get me wrong. I use the product. I appreciate catching shows from other parts of the world just like the guy next door.
However, I do not let my personal views cloud my judgment in trading.
These stocks are just too erratic to lend themselves to safe options trading.
Also, you will come to find out that they are quite expensive to trade on a small capital.
When you just have a few hundred dollars and the average contract for not so far out of the money options is $300 or so, it can really be very challenging to safely trade these securities.
The one thing I have resorted to is maybe to just day trade them. I have actually enjoyed day trading NetFlix (Ticker:NFLX) this year more than before.
The other two, not so much.
When In doubt, Stay In Cash
There is this old saying I hear traders use all the time.
“You cannot go broke taking Profits”. As corny as it may sound, it is actually true.
It means that even the smallest of profit out of the market is an achievement by itself.
In the big scheme of things, I could add this other one.
“Leave to Fight Another Day”. It is quite alright to retreat instead of forcing trades.
That reminds me that I still need to share the article on Over trading with you guys.
We are not supposed to make money everyday so it is okay to cut the session short, go outside and enjoy life for a bit.
Recharging the batteries is a great coping mechanism to fight the gloomy ideas of trading.
Maybe I should have started with this one really.
Patience is spelled “PAYtience”. This means that those who are patient get paid. Always.
Hence, the utmost importance for you to know Your Paydays on Weekly Options.
Just like in baseball, Singles are okay Monday to Wednesday (except Earnings Seasons).
The big money tends to be made later on the week. I could well be starting on Wednesday if the market is moving.
However, typically, we have seen that Thursday and Fridays are the PAY days.
Make Momentum Trades Your Bread and Butter
Sometimes a stock will just have unexpected news during the day.
Rather than jumping in and try to trade it right away, it is better to wait for the dust to settle.
If the momentum is strong enough, this can provide you with easy trading opportunities for at least of a couple of days.
Such example was Qualcomm (Ticker: QCOM) Post Lawsuit settlement with Apple.
These trades are the ones you must be on because the risk of sideways trading is very small.
You can and should partially hedge in the opposite direction of the current move when carrying some contracts overnight.
Here is the basic Technique for Identifying Momentum in Pre-Market Analysis.
- Stock up 3% or more
- Relative Volume greater than 3 from Finviz.com
- Trading above VWAP
- No Long Term Resistance
These types of stocks are High of the Day Candidates.
The only obstacle is How to handle the trade in the adjustment window between 10AM and 10:30AM EST.
It is known that during this time (it is not exactly this very 30 minutes every day but you get the point), stocks that have be flying from the Open naturally must cool off.
Option Trading Tips for Earnings
After the first Day post Earnings, certain stocks may signal a strong direction.
This is known as momentum. It can be either on the downside or upside.
Identify those in your overnight study and plan to take advantage on the second and third day post Earnings Release.
These are relatively easy to trade opportunities that should help any disciplined trader generate enough monthly income to pay for subscription such as FlowAlgo or Finviz.com.
Option Trading Tips for SPY
In 2019, there was this one recurrent pattern for SPY.
We pointed that out in this recent article.
It was the behavior of this ETF at the beginning of each month.
By behavior, I mean the volatility or movement.
How can You and Me Leverage the information summarized in the chart below ?
The above chart is tracking the delta in percentage change between the current Day Low and the previous day closing price.
Which means that if the number is positive, SPY has gap up by at least that percentage change.
For the whole year, the average is 0.8%. That is 2.5 points at he current price of SPY.
The average in the first 8 months is 1.2% which equates 3.8 points.
May I suggest the following strategy on SPY for 2020 ?
- Strangle SPY 3 points up and 3 down in the first 3 days of each month
I am not suggesting that because the observation was true last year, it will be true this year.
But we know that the mighty High Frequency computers love their reinforcement learning.
Should they come up with something new, I surely will be the first to share that with you here 🙂
Until then, starting today December 31, I will be implementing this strategy and hope to live to share its outcome here.
Do we have a Deal ?
Losing in trading is not fun but each trader has to recognize from the beginning that it is part of the rules of engagement.
How you prepare yourself, manage the ups and down of your trading journey will ultimately determine your success.
These Option trading tips are meant to guide you and avoid the trials and tribulations so many have to go through.
I hope you found value in this discussion.
If you would like to increase your knowledge and further your understanding of these concepts, may I suggest this similar article.
If you would like see how we put this information in application to make money trading Options, click here.
Please leave us your thoughts, comments, experiences or questions about this content so that we can continue to tailor it to your needs.