To make money option trading it is absolutely vital you understand a few essentials. Firstly, option trading, while offering wonderful financial rewards thanks to the leverage on investment capital that they offer, can also be one sure way to wipe out an entire trading bank.
But it doesn't have to be like this!
Good traders are making consistent profits month after month and I'm about to tell you how.
Exchange traded options are superior to other leveraged instruments because options have limited risk. Providing that you're not short selling naked options without any long (i.e. bought) positions for protection, the maximum amount that you can lose is the amount you invest, or in some cases, the amount of margin required for the trade.
This leverage, combined with the limited risk in options, is what makes them so appealing as a trading vehicle. But along with these advantages comes one big setback.
All options expire at some point.
They are not like shares which you can theoretically hold onto until the price recovers. If your options are "out-of-the-money" at expiration date, they are worthless. So choosing your expiration date wisely may be an important piece of your trading strategy. We'll elaborate on this later.
If your strategy is to profit from options time decay then you would choose short dated options. If your strategy is to make money from favorable price movements in the underlying, then you may prefer long dated options.
To make money option trading you MUST have a risk management system in place that you stick to with disciplined resolve. Your financial life depends on it! You MUST accept the fact that not all of your trades will be profitable and need to factor this anticipation into your trading plan. In the end, the raw simplicity of trading success of any kind, is not just about being able to pick the right trades - it is all about management of risk.
These are four essential things you need to decide before you do anything:
1. How much of your entire trading capital will you risk on any one trade?
2. What is the minimum target profit you need to make on every trade?
3. What is the maximum amount you are prepared to lose on any one trade?
4. How many winners vs losers do you need to be profitable overall?
Once you have answered these four questions, from then on, to make money option trading, it is simply about sticking to your business plan.
Here's an example.
Let's say that you have answered three of the above four questions with the following:
1. I will risk a maximum 10 percent of my starting capital on any one trade.
2. My target profit for each trade is 50 percent.
3. I will accept a maximum 30 percent loss on any one trade. This is because 30 percent of 10 percent equals 3 percent of my entire capital that I am prepared to risk on any one trade.
Now that you clearly understand your trading parameters, to make money option trading you then need to determine how many successful trades compared to losing ones that you need, in order to realize an overall "business" profit.
So if you have adopted the above strategy and your starting capital was $10,000 then you would only risk a maximum $1,000 on each trade. With a 70 percent success rate and each trade providing $500 profit (50%), you would realize an overall profit of $3,500 after ten trades, minus $900 from your 3 losing trades, giving you an overall profit of $2,600.
After the first 10 trades, you now have $12,600 to continue with, so your investment amount for the next 10 trades will be a maximum $1,260. You continue to work your plan - and you gradually grow your account. Or, you may choose to withdraw the $2,600 profit as income and start again.
If your business plan assumes a lower level of winning trades, with lower profit targets, you will need to adjust your stop loss percentage for each trade accordingly.
On the other hand, if you had a system that provided 90 percent winning trades, then you can afford lower profit targets, should you choose to do so.
The Next Step
Now that you have first worked out your capital management plan, to make money option trading you must then combine it with an option trading strategy that will allow you to realize the required profits compared to anticipated losses.
For example, you may have decided to buy simple long calls and puts. Alternatively, you may have realized that by using vertical debit spreads, even though you sacrifice theoretically unlimited profit potential, you can reduce your exposure and increase your return on risk, which means that you're more likely to reach your profit targets.
You may be partial to option spread trading strategies such as credit spreads, calendar spreads and iron condors. Or you might be a more conservative covered calls trader.
On the other hand, your trading style may be to buy longer dated out-of-the-money option spreads with a minimum 100 percent return on risk and plenty of time to be right. If this is your strategy, then you may be also prepared to realize closer to 100 percent loss (you can't lose any more than this) on other trades, knowing that, as long as you achieve greater than 50 percent success rate you will profit overall.
The Right Mindset
If you really want to make money option trading you must adopt the mindset of a business person. Anyone going into business without first establishing a business plan is asking to fail. This is how it works in the real world and it is no different with option trading.
In a 'conventional' business, you make some good decisions, others bad. You try different things - some work, others don't. When they don't, you cut your losses and focus on where the profitable areas are. This is trading as a business. Some decisions will profit, others WILL not and you need to be psychologically ready for this.
The most important thing is your business plan.
The next important thing is matching your chosen business plan to an appropriate option trading strategy.
The final ingredient that separates the winners from the losers, is implementing your plan with consistency, persistence, self discipline and commitment to ongoing education and improvement.
Follow this advice and you will not just make money option trading - you will have a successful option trading business.