Are you looking to enhance your trading game? Let us dive into the dynamic world of options trading and uncover the 10 most useful rules that can guide your trading decisions and help you navigate the ever-changing market landscape. Some writers call them cornerstones. Others call them pillars.
By whatever name they are called the bottom line is that they are extremely useful in helping you make better options trading decisions.
Let’s jump in and see how they can help you trade more productively.
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
The idea that a trader is better off selling options when volatility is high is a common strategy in options trading. High volatility often translates to higher option premiums due to the increased risk associated with price fluctuations. By selling options in a high volatility market, traders can potentially gain from the inflated premiums. However, it’s important to remember that this strategy also comes with its own risks, as the price swing could go against the position. Therefore, like all trading strategies, understanding market dynamics and managing risk effectively is crucial.
3. Trade Small, Trade Often
The concept of “trade small, trade often” is a strategic approach in options trading. This principle encourages traders to make frequent, smaller trades rather than betting big on a few transactions. The idea is to minimize risk by spreading it across many trades while increasing the probability of profit over time. By trading often, investors can take advantage of diverse market conditions and mitigate potential losses that may arise from a single large trade.
“Probability never lies” is a fundamental principle in options trading. This statement emphasizes the importance of statistical probability in forecasting the potential outcome of trades. Traders who understand and apply this concept recognize that while individual trades may not always go as planned, over a large number of trades, the outcomes will generally align with the probabilities. Thus, it encourages traders to make decisions based on statistical analysis and probability, rather than on emotions or speculation.
5. Implied Volatility is overstated
The phrase “implied volatility is overstated” refers to a common scenario in options trading where the market’s expectation of future volatility, reflected in option prices, is higher than what actually transpires. This discrepancy can lead to inflated option premiums, providing an opportunity for options sellers who can potentially benefit when the implied volatility decreases, bringing the option prices down.
6. Take profits; give losers duration
“Take profits and give losers duration” is a valuable adage in options trading. This principle suggests that traders should not hesitate to realize profits when a trade is going well. On the other hand, if a trade is not performing as expected, instead of hastily exiting the position at a loss, traders should consider extending its duration, if possible. This approach provides the trade some time to potentially recover or even become profitable, thus potentially mitigating losses.
7. Passive investing is destructive to wealth
The statement “Passive investing is destructive to wealth creation” challenges the traditional belief in the effectiveness of passive investment strategies. This view posits that simply investing in a broad market index and waiting for returns over time may not always be the best approach. Critics argue that this strategy can lead to complacency, ignoring the opportunities for active management and strategic decision-making that could potentially yield higher returns. It suggests that being proactive, staying informed about market trends, and adjusting portfolios accordingly can be more conducive to wealth creation.
8. Active Investing works
The idea that “active investing works” promotes the practice of actively managing investments as opposed to merely holding a market index. This approach involves continuous analysis of market trends, investment diversification, and frequent balancing of the investment portfolio. Active investors believe that through careful research, analysis, and the strategic buying and selling of assets, they can achieve higher returns than those provided by passive investments. They argue that by actively engaging in the market, investors can take advantage of short-term price fluctuations and potentially increase their overall returns.
9, Trading is a skill that can be developed
Trading is a skill that can be developed over time. Like any other skill, it requires practice, dedication, and a willingness to learn. It involves understanding complex market dynamics, developing strategic trading plans, and making calculated decisions based on a variety of factors. Trading is not simply about making quick decisions, but rather about cultivating an in-depth understanding of the markets, learning from past experiences, and continuously refining your tactics. With time and experience, anyone can enhance their trading skills and increase their chances of success in the market.
10.Be mechanical with positions
Being mechanical with positions is an optional approach to options trading. This method involves setting predefined rules and sticking to them for every trade, irrespective of other factors. Traders following a mechanical approach may set rules for entry and exit points, position size, and other parameters, and strictly adhere to them. The main advantage of this strategy is that it removes emotion from the trading process, resulting in consistency and discipline. However, it may not always account for changing market conditions or unique opportunities that require flexibility. Thus, while being mechanical can bring stability and predictability, it is one of many strategies that traders can adopt based on their individual risk tolerance, financial goals, and trading style.
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