Revised November 18, 2021
Today I want to discuss the 10 Most Useful Rules in Options Trading. These ideas have been called various names by various sources. Some writers call them cornerstones. Others call them pillars.
By whatever name they are called the bottom line is their usefulness in helping you make better options trading decisions.
The 10 Most Useful Rules of Options trading
1. Liquidity is king of all.
According to the research team at tasty trade, liquidity is how easily an investor can buy or sell an asset without losing much value. The more an asset is traded, the more liquid it becomes. A trader should trade only liquid products because as a self-directed investor, you want to trade in the most efficient option markets. In addition, this allows you to get in and out of our trades at a fair price. If you stick to the most liquid products, you know you will give up a little edge getting in and out of your trades.
Now that you understand the meaning of liquidity, it is important to understand the criteria you should look for at order entry. You always want to be able to decide whether a product is suitable to trade. Stock and option volume is key in this regard. It is important to assess stock and option volume before placing a trade.
Since options are a derivative of stocks, if the stock has low volume, so will the options. In addition, the bid/ask spread will tell us how tight the markets are and represent the prices we know we can get in and out of our trades at.
Another important reason you want to trade products with extremely liquid options is because more liquid options have much more accurate probabilities (as calculated by the Black-Scholes pricing model).
2. Sell options when Implied Volatility is high
Implied Volatility is a term that refers to the current market price of volatility for a given option. While historical volatility is observable, future volatility is unknown. The current price of volatility (i.e. implied volatility) reflects the culmination of the market’s expectations for future volatility. Implied volatility is dynamic and fluctuates according to supply and demand in the market.
Implied volatility (commonly referred to as volatility or IV) is one of the most important metrics to understand and be aware of when trading options. Implied volatility in the stock market refers to the implied magnitude, or one standard deviation range, of potential movement away from the stock price in one year’s time.
3. Trade Small, Trade Often
5. Implied Volatility is overstated
6. Take profits; give losers duration
7. Passive investing is destructive to wealth
8. Active Investing works
9, Trading is a skill that can be developed
10.Be mechanical with positions
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