Chapter 7: How to Trade Options?

Step 1: Building/Developing a View

Most successful traders , plan their trades in advance just because they study the markets or the stock , dig deeper and develop a bias. Developing a bias is the first step towards any form of trading , as it forms the base to select which strategy is the best fit for the trader to begin trading.

Biases can be of 3 types:

1. A bullish bias could mean a trader is expecting the price of any asset or commodity to up.

2. A bearish bias could mean a trader is expecting the prices of any asset or commodity to go down.

3. A non-directional bias could mean a trader is expecting the prices of any asset or commodity to stay within a range and is expecting very less volatility or fluctuations in the of the underlying  prices.

Option sellers usually get the benefit of being non-directional as close to 90% of the strike prices become worthless at expiry.

Once a bias is developed, the next part is to create a trading plan. 

Step 2: Constructing a Trading Plan

A trading plan is a set of rules that a trader makes. This plan acts as a detailed guide that an options trader adheres to. A good trading plan should outline your trading goals, risk tolerance, and time commitment.

Defining your entry and exit criteria, profit targets, and maximum loss limits are also part of a trading plan. Having a well-defined plan will help you stay disciplined and focused.

The plan must also include what financial instruments to choose and which strategy to deploy based on the view and the current market conditions.

Not only this , but the trading plan should have key  insights  such as how much capital to deploy, when to enter and when to exit from the strategy and any other information that can help the trader to take an informed decision right from before entering into a trade and until the time to exit.

Key elements that a trader needs to keep in mind before designing a trading plan are:

• Taking action based on the current market scenario
• Following a structured method of entry and exit before entering the trade
• Having a proper risk management system based on your risk profile

Traders sometimes have to make instant decisions, in fact most of the time take decisions spontaneously as and when any opportunity  is spotted. 

Thus, it’s good to have a trading plan designed well in advance so that there’s no room for error for a trader in times when prompt action is required. 

Step 3: Finding and Deployment of a Strategy

Finding the right strategy could be challenging since there are thousands of strategies that can be deployed. 

Options trading can be both rewarding and complex, so it’s important to approach it with a solid plan. 

Here are some steps and ideas that can help you find the right strategy for you. 

1. Education and Research

Before diving into options trading, ensure you have a strong foundation in understanding how options work, including concepts like strike prices, expiration dates, implied volatility, and different option strategies. 

2. Risk Tolerance and Strategy Selection

Understand your risk tolerance and trading goals. Different options strategies have varying levels of risk and potential rewards.

Some strategies, like covered calls, are more conservative and income-focused, while others, like naked puts for example, can be more aggressive.

Knowing your risk tolerance can help you manage your risk. A trader should always choose the right strategy based on their risk tolerance. 

3. Market Analysis

Conducting a thorough market analysis to identify potential trends, volatility patterns, and underlying asset movements is something that a trader should immensely focus on.

This analysis can influence your strategy selection. Technical and fundamental analysis can be particularly useful in this regard.

4. Choosing the Right Strategy

Explore different options strategies based on your market outlook and risk profile.

Some common strategies include, Covered Call that is selling calls against a stock you own or Protective Puts, which is buying puts to protect a stock position.

Then there are strategies like Straddles and Strangles. They involve Buying both a call and a put (Straddle) or selling both a call and a put (Strangle) with the same expiration but different strike prices. Such strategies are used by traders who have non directional views.

In the coming Chapters we shall be explaining some of these strategies in detail.

However, it’s important to know that every strategy has a different risk to reward ratio and therefore a trader has to understand his/her own risk profile in order to choose the best strategy that suits their trading style. 

5. Implied Volatility Analysis

Paying close attention to implied volatility levels can be useful, as they can significantly impact option prices.

Strategies like selling options benefit from high implied volatility, while buying options benefits from low implied volatility.

6. Backtesting

Before deploying a strategy in a live market, consider backtesting it using historical data to see how it would have performed in different market conditions. This can give you a better understanding of the strategy’s potential risks and rewards.

7. Diversification

This is one of the most important aspects in trading. Avoid putting all your capital into a single strategy or trade. Diversification across different strategies, underlying assets, and timeframes can help manage risk.

Essentially, diversification helps you increase your longevity in the markets as a trader because you’ll be disciplined. And, as they say, never put all your eggs in one basket.

Not all strategies work at the same time. Some may work in stable market conditions while some may work when theres high volatility.

Thus, running multiple strategies can give traders an edge as they can have a higher probability of managing their positions in all market conditions and a better chance of being profitable. 

8. Trade Management and Exit Strategies

Defining a clear entry and exit criteria for each trade can also be super helpful.

Instead of having a random approach to managing your trades, having a plan for managing losing trades (stop-loss) and taking profits (target price) can help you be disciplined.

Sticking to your plan can be a great way to avoid emotional decision-making.

With this we come to an end of this Chapter. In the next Chapters we shall explore how to choose the right instruments for options trading!