Becoming a trader who consistently wins in the options market requires three key elements:
- A bargain-hunting instinct with the ability to identify undervalued and overvalued options.
A sound and well-designed game plan that provides consistent action over time and that works in all market conditions.
The discipline to follow the game plan.
In applying this formula for success in the options market, the first element is simple: You must always buy underpriced options and sell overpriced options. Most options investors don't follow this basic rule. Instead, they spend far too much time studying the underlying stocks and following the market, and base their option purchases only on these factors, ignoring the price of the option. If you do not buy underpriced options or sell overpriced options, you're going to lose eventually.
You must also create a good game plan. In the options market, the game plan is far more important than in other markets, because things happen so quickly that you must be prepared before you play. Then, you follow your game plan.
A good trading plan involves a gradual program for investing in the options market vs. the elephant approach, in which you take all of your money and invest it all at one time, all on one side of the market. In addition, your portfolio must be balanced, investing money in both puts and calls. As you become more familiar with the different trading tactics, you can further diversify among directional, sideways and delta neutral strategies. Also, be sure to diversify among different sectors over time.
Set aside a speculative fund for options, realizing you could lose everything because of the short-term expiring nature of these investment vehicles. Most important, this speculative cash must be money you can afford to lose. If you play in the options market with money you cannot afford to lose, your emotions are guaranteed to overwhelm you, and you'll be forced into bad trading decisions.
Finally, the most important part of your game plan is not how many positions to take and when to take them. Rather, it's when to take profits and when to cut losses once you are in a position. Here you must clearly define when to take profits or cut losses before you trade, or your emotions will force you to do the wrong thing at the wrong time. Try to be consistent. Don't keep changing the rules of your game plan in the middle of the strategy.
The last ingredient to success is ironclad discipline. You may think that this step is the easiest one to implement, but discipline can be difficult, especially during battle, when you may be incurring losses and have to make some tough decisions. If you don't have your trading plan written down on paper and instead decide in your head what moves will be made at each point, there will be no discipline when you need it. If you find yourself straying from your game plan, you're doomed. Without discipline, you will never win the options game.
Options traders lose because they follow the crowd, and the crowd feeds on emotions. To profit consistently, you must stand alone and act rationally. In the options markets, this means buying underpriced options, selling overpriced options, and having a well-designed trading plan -- one that beats your emotions, forces you to be consistent and keeps you with a balanced, diversified portfolio.
By Jeff Neal, contributing writer and options strategist at
Optionetics.com. Email him at