Perhaps the most difficult aspect of buying and selling options is self-discipline. If you do not set policies and trading rules regarding when to close a position, how to reduce risk, or what you hope to achieve then it will be difficult to profit from trading options.
A successful options trader is one who understands the importance of self-discipline and has the ability to open and close positions in accordance with predefined trading rules, even when tempted to do otherwise. The fast-changing nature of the options market, the steady pressure of ever-closer expiration dates, and the different factors that affect the time value of an option all require you to be aware of how time works for or against you in order to maximize your profits. You need to establish policies in two broad areas: First, know why you are using options, and second, know your exit point.
To begin with you should be clear on what your purpose is for trading options. Are you using options for leveraged speculation? If so, then you better have market timing tools that give you precise entry and exit points. Using options to get added income from your stock holdings? Then know which stocks have options with implied volatility levels high enough to make selling options worth the effort. Finally, are you using options to protect against losses in your investments? Then in addition to protective puts you should also consider the collar strategy, which is used for this purpose by institutions every day. In short, understand what kind of options trader you are.
The second most important area involves having a specific exit strategy. You need to think about possible scenarios and decide – in advance – when you will close a position. You could hold options until expiration day or exit the week prior. If you have bought an option, you should identify a profit point where you would sell as well as a loss level where you would bail out. You might determine to sell if you double your money (on the upside) or lose one-third (on the downside). Rules like that, no matter what the specific exit points used, need to define a specific event where you should take action.
Risk exposure is yet another issue to consider. For example, let’s say you are short calls and expiration day is near. The call option is one dollar out-of-the-money and the option is now worth only 10 cents. Should you wait for expiration and take the risk the stock will jump in price before the option expires? For a dime per contract, it might be prudent to just close out the position, just in case the stock did rise at the last minute.
Stocks and options should not be treated as separate parts of the portfolio, they should work together. You will get the greatest benefit from trading options when you learn to use them as part of your overall investment strategy. Without setting your rules in advance, and having firm standards for getting out, you will almost certainly fail. Follow your rules and resist the temptation to make exceptions, and you will have a better chance to be successful making money with options over the long term.