7 Things to Know Before Your First Options Trade

Welcome back to our Introduction to Options series!

By now we’ve covered:

1) The ABC’s of Puts and Calls

2) How Implied Volatility Works

3) Theta: The Options Trader’s Kryponite

4) 3 Simple Options Strategies Beginners Should Know

Today, we're going to close out our series with 7 key things you need to know before you place your first options trade.

These simple tips will help avoid common pitfalls that can destroy your profitability, so we hope you enjoy it!

1) Start with 1 Contract

Yes, you want to swing for the fences and make a big fat pile of cold hard cash with your first options trade.

But winning traders know that we're not in a spring. We're in a marathon.

We recommend that you start slowly.

So if you want to buy call options, just start with 1 contract, and carefully track your trade's progress.

Likewise, if you're interested in multi-leg strategies like bull/bear call spreads or iron condors, just use one contract for each leg of your trades.

A big part of your options trading education will come from actual trading — so make that education as inexpensive as possible!

It's very easy to make mistakes with options trading, particularly when it comes to order entry, and it's best to start with small dollar amounts and work your way up.

2) Be Careful Getting in the Pool Naked

Think twice before putting on naked short options positions.

A naked short position is one in which you are short call or put options without an offsetting trade that limits your risk.

The risk is astronomical and if the underlying stock makes a big move against you, your account will be damaged.

So before putting on trades, consider the risk-reward, and makes sure the odds are in your favor.

Shorting options can be very lucrative — especially in a volatile market when premiums are high — but you must be very careful.

We recommend getting the guidance of a more experienced options trader before considering such a trade.

Shorting options is especially risky ahead of earnings and other events.

Case in point: take a look at this chart of online retail giant Amazon.com (AMZN).

As you can see, it gapped up on 10/27/2017, the day after it reported a stellar third-quarter earnings report:

Let's say that when Amazon was trading around $980, you thought there was no way it could get above $1000.

Ahead of earnings, you could have shorted the December $1,000 calls for around $28.

So for each call you shorted, you would receive a credit of $2,800.

Let's look at what happened to this option's price after earnings.

The December $1,000 call closed at $25.15 on October 26 before the earnings report hit.

And after Amazon beat expectations and skyrocketed, the option opened at $70.80.

It then went over $100.

It's now trading at $131.

Let's assume you covered at $100 on the dot to keep things simple.

This means you:

• Went short at $28 ($2,700 per contract)
• Covered the short at $100 ($10,000 per contract)

That's a net loss of $71, or $7,200 PER CONTRACT.

A 3-contract trade would have put you out $21,600!

So please, know what you are getting into when shorting options.

And watch the calendar so you are aware of any stock-moving events.

3) Don't Go Overboard with Out-of-the-Money Options

In our last article on basic options strategies, we showed you this table explaining the differences between in-the-money options and out-of-the-money options:

As you can see, out-of-the-money options have a higher chance of expiring worthless.

But many new options traders love them because they have a lower up front cost.

Beginners especially love far-out-of-the money options because they look so darn cheap.

But there's a reason they look so cheap… it's because they're lottery tickets.

They don't cost much, and there's a low chance they'll actually pay off.

That's not to say they're inherently bad.

Just be aware that with out-of-the-money options, especially those that are far-out-of-the-money, you're rolling the dice.

Plus, be aware that far out-of-the-money options can be very illiquid.

It's not unusual to get in a position (often at a bad price, because market makers often jack up the prices on out-of-the-money options), and be unable to get out because no one is interested in buying your particular options.

It's just like the roach motel: you check in but you don't check out!

4) Be Careful with Your Entry Prices

Like stocks, options have a bid and ask price. (the ‘ask' is also called the ‘offer')

The bid is the price buyers are willing to pay.

The ask is the price at which sellers are willing to sell.

But if you are always  buying at the ask and selling at the ask, you're getting ripped off.

Let's look at red hot streaming media play Roku (ROKU).

With the stock trading at $45.27, here are the prices of the December $44, $45, $46, and $47 calls.

This is an extreme example so you can see just how easily you can get fooled by looking at the bid and ask.

Let's say we're looking at the $44 calls.

The market maker would LOVE to sell us those options at $6.80 (the ask). That's like walking into a used car dealership and taking the first price the salesman offers up.

Odds are we can actually get filled somewhere near the middle of the bid and ask. The midpoint of the $5.50 bid and $6.80 offer is $6.15.

So if we bid $6.20-$6.30 or so, odds are we'd get filled. Heck, we may even get filled at the exact midpoint of $6.15.

But let's say we got filled at $6.30.

That's a savings of $0.50, or $50 per contract.

On a 10-contract trade, that's a difference of $500.

This is an extreme example. Roku is a fast-moving new IPO. Options on tThese types of stocks typically have extremely wide-bid ask spreads.

But we want you to understand the importance of not blindly placing orders at the bid and ask.

Keep in mind that some online brokers  default to the bid or ask when you make trades, so be ready to make adjustments yourself.

With more liquid large-cap stocks, bid-ask spreads are much tighter, so you're less likely to get ripped off.

Take Apple (AAPL). Some of its options have spreads of mere pennies:

But why give away money when you don't have to?

5) Double Check Your Orders

Before you execute your options order, double-check it.

When dealing with options, you’re often looking at dozens or even hundreds of small numbers on a single computer screen:

It’s easy to make mistakes — ESPECIALLY with multi-leg strategies like calendars and butterflies.

You may fool yourself into thinking you’ve found an especially attractive calendar or butterfly spread when in fact, you fooled yourself.

Or maybe you'll buy 1000 contracts when you meant to buy 100.

So before you hit that buy or sell button, check your work!

6) Monitor the Calendar

Events like earnings reports, FDA decisions, product announcements, dividend payments, conference appearances, and economic data releases can have a tremendous impact on options prices.

So before you place your order, be aware of what’s on the calendar for the stock or ETF at which you're looking.

For example, if Alphabet (GOOGL) is about to report earnings, its options will tend to be very expensive in the days before the report.

If it's the day before a Fed rate announcement, options prices on bank stocks may get jacked up.

7) Make Sure You're Educating Yourself

Options are incredibly flexible, and only as dangerous as you make them.

Still, options trading can destroy your account if you don’t know what you’re doing.

So make sure you take the time to learn the fundamentals of options pricing, order entry, and market mechanics.

They’re not nearly as complex as you may think, and they'll help you avoid errors that cost traders billions of dollars a year.

*******

Thank you for taking the time to read our Introduction to Options Series!

If you missed the prior articles, check them out here:

1) The ABC’s of Puts and Calls

2) How Implied Volatility Works

3) Theta: The Options Trader’s Kryponite

4) 3 Simple Options Strategies Beginners Should Know