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Financial Literacy

Four Essential Rules for Smart Options Trading

Options befuddle many investors. But those who understand them love them.

My father-in-law is in this camp. Whenever we visit him in the Keys, nine times out of 10 he’s waiting in the doorway with a big smile… ready to brag.

His most recent success involved a contract on NextEra Energy (NYSE: NEE), the utilities holding company that owns Florida Power & Light. It resulted in a tidy $5,000 payout. (Needless to say, grouper sandwiches were on him that night.)

But for every options evangelist, there are countless traders who’ve been scorched. For many, their contracts expired worthless, causing them to lose their entire investment. It’s just one of the risks you take with options.

Fortunately, there are ways to greatly improve your odds of success.

Simply follow the rules below and you’ll instantly be head and shoulders above your options-trading peers.

Rule No. 1: Not Sure What You’re Doing? PAPER. TRADE. FIRST.

A lot of readers are probably groaning right now. But listen, it doesn’t matter if you’ve been managing your own portfolio for 10, 20 or even 50 years…

You shouldn’t trade a single options contract until you’ve got some paper trades under your belt.

And even if you’re comfortable selling puts and buying calls, it’s a good idea to have some simulated trades going at all times. On paper, you can test different plays and strategies (like spreads and straddles) to see how they’d perform in real time.

The best part? Win or lose, it won’t cost you a single red cent.

Just one word of warning…

You may find yourself investing much more aggressively while paper trading than you would with actual money. For your portfolio’s sake, make sure you treat every simulated trade like it’s the real deal.

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Rule No. 2: Don’t Trade Options Unless You Have a Good Reason

Smart investors don’t call their broker unless they have at least an inkling that a stock is about to move upward (or it’s a great value play). This rule applies to most investments, but it’s doubly true with options.

Unlike stocks – where time is most often your ally – the moment you purchase a call option, the clock starts ticking. If your strike price isn’t hit by the expiration date, you can lose your entire investment.

There’s no way to guarantee this will never happen, but you can stack the deck in your favor. All it takes is a little due diligence.

One example is buying calls ahead of a big news release. This is something that comes up often in the biotech space. Just take what happened to Edwards Lifesciences (NYSE: EW) back in April…

The company, which Alexander Green recommended to his Momentum Alert subscribers, announced positive lab results for its patented aortic-valve replacements. As a result, shares of Edwards Lifesciences shot up to a new all-time high of $107.

And the May $97.50 calls Alex recommended? They shot up 284%.

Of course, test results are just one possible driver of gains. There are other factors to consider as well. To name just a few…

  • A new product launch
  • Increases in insider buying
  • An upcoming, high-profile meeting (think OPEC, the Fed, the FDA, etc.)

The bottom line? Do your research. Find a strong catalyst.

Rule No. 3: Reduce Your Risk by Splitting Your Position

When calls fly above their strike price, investors’ first instinct is usually to close their position and lock in those profits.

That’s a good defensive move, but it may not be the best choice in terms of securing the greatest possible return. Instead, consider splitting your position. That is, sell half of your contracts and let the other half ride.

For example, say you bought $500 worth of call options and they suddenly jumped 75%. You still have several months before your calls expire, so you have a choice to make. You could:

  1. Take your entire investment – now worth $875 – and walk.
  2. Sell half, instantly placing $438 – almost 90% of your initial investment – back in your pocket.

With option B, if your calls jump higher (remember, you were banking on this when you selected the strike price/expiration date), it will essentially be pure profit.

So if you were waiting for a big announcement (à la Rule No. 2), you can still capture any major gains. And if things don’t go your way? No worries. You’ve already recouped most of your original investment.

Rule No. 4: Make Things Easier for Yourself by “Doubling Up”

Since you’re reading this investment-focused e-letter, I’ll assume you own at least a few stocks. Heck, even the most hardcore options traders keep a portfolio of “plain Jane” equities. (And if not, they certainly should.)

Properly diversified and allocated, your stock portfolio should serve as the solid foundation upon which you build your wealth. But that doesn’t mean you can’t also use it to generate some big short-term gains…

Why not “double up” by trading options on companies you already own?

As we covered in Rule No. 2, it’s important to conduct your investment due diligence before buying call options. The information you uncover could be instrumental in determining an ideal expiration date or strike price. This takes that idea one step further.

After all, there’s no company you know better than one that’s currently in your portfolio. You’re among the first to know when an earnings call has been scheduled… or if all is not well with a certain initiative.

Let’s say you’re preparing for some disappointing news after a rough quarter. Maybe it’s not enough to make you want to sell your shares, but you’re expecting the stock to take a dip. You could take advantage of the situation by selling calls.

Conversely, if it’s good news you’re expecting, you could buy calls on an anticipated leap in share price.

Obviously, there’s a lot more to options than we could possibly cover in a single issue. If you’re interested in learning more advanced tactics, head over to the Investment U Bookstore and check out our Essential Options Manual.

And if there’s something you’d like to see us cover here in the future, leave a comment below or on our Facebook page here.

Good investing,

Alex


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