As an active trader, I’m amazed more people don’t trade options. Options not only allow you to lower your risk but also allow you the opportunity to mimic a stock portfolio, but with a lot less money. Now, who wouldn’t want to make bigger profits and risk less of their money?
I take pride in outperforming the Wall Street pros every year and have learned not to get caught up in trading ranges or pending breakouts or breakdowns until they happen. In part, I attribute my success as an options trader to a few simple rules that I’m going to share with you today. No matter where you are in your trading career, adhering to these three key guidelines will help you collect more profits and increase your wealth.
Rule #1: It Takes Money To Make Money
The most important thing you will need is money. The best trading idea in the world is worthless unless you can execute on it. “How much do I need to start trading options?” is probably what I get asked most often and, while there’s no one-size-fits-all answer, I’ll give you my general guidelines.
A lot of people want to trade options with starting only $100–$1,000. You can start with this amount, but one or two bad trades will wipe you out… and, trust me, there will be trades that don’t work out. My philosophy is to build a solid foundation of wealth and then use some of that for your “riskier” investments. I suggest having at least $2,000–$5,000 to start your option trading account, which should also be separate from your longer-term investing account. If you start an options account with that $2,000 to $5,000 in place, you can easily double or triple that amount with the right trades. (Also, I hope this goes without saying, but I’ll say it anyway: don’t use money you need to pay for crucial expenses like food and housing.)
So, the next logical question is: How much should I put toward each trade? Let’s start with the maximum: For my options trading account, I do not risk more than $2,000 in any one position for my portfolio; more conservative traders might stick to $250-$500 per trade. You can even trade options for less than $250 per position.
With any trading account, it’s better to think in percentages. Do not risk more than 5% of your trading account on any single trade; as you’re getting started, consider not risking anything. Paper trading or practice trading options can help you gain confidence and avoid costly mistakes.
Once you see how options work, you’ll understand why they are the most powerful investment tool ever created.
Rule #2: It’s Good To Aim High
As with any journey, it’s important to understand where you’re going before you set out. I never make an options trade without knowing what I expect from the underlying stock and the corresponding option I choose to trade around it.
A lot of people buy a stock or make a trade based on a company or a product they know and like. This is often a good strategy because you know the company and its products. However, if you only trade stocks you “like,” then you’re also missing out on half the opportunities in the market.
Conversely, if you decide to take a bearish stance on a stock simply because you don’t like its products or practices, you may be setting yourself up for trouble. This is why I let my fundamental and technical analysis set the roadmap for me.
My goal for every option trade is to make a return of at least 100%. I often achieve that, but, just as often, I will take lower profits if the charts are telling me that the stock or the underlying market are about to change direction.
If your exit target is reached, you can sell half of the position and take all of the risk out of the trade because you will have earned your original investment back. Sometimes an option zooms past my 100% target and I ride it for even further gains. Once this happens, it is easy to set a stop to take you out of the position, you also have more room to play the volatility.
Another word of advice: Most traders get greedy and wait too long to take gains. This folly can turn profits into losses, and that’s why I always stick to the plan. While there may be a little more juice in the melon to enjoy, exit when the parameters of the trade have been met.
Whether you take profits just in the nick of time or you happen to take them too soon, never look back! What’s done is done and a profit is a profit.
Rule #3: Know When To Say Goodbye
Exiting a trade with a win is the goal, and I hit that goal most of the time. But losses happen, and any trader who tells you otherwise isn’t being honest.
I try to limit losses to 50% on options over $2 and you should too. However, I do not carry stops on cheaper options (those under $1) because you can often get “whipsawed” out of trades due to market volatility. This is why chart work is crucial and why I do the homework to decide if a position should remain open or if I should cut my losses.
What I tell traders is that all exit targets and stop targets are just that: targets. Oftentimes, I’ll use a stop limit in order to protect the profits I’ve already accumulated. If a position is up 125%, you want to protect that return by having a stop in place. Traders can get greedy if they see a return of 200%, and they will often give back a major portion of their gains by not having a stop in place.
Again, it all comes down to knowing what you expect from the trade on the upside, but being prepared to exit early with profits—or a loss—if the charts are telling you to do so.
While simple, these three rules can provide you with a foundation to help you gain control of your own trading strategy. I recommend you start following these rules immediately. Not only will you become a stronger trader, but you’ll also be a much more profitable one.
Note: This article originally appeared at Investors Alley. The author is Rick Rouse.