Option Trading Tip #1

Consider Selling Options is Part 1 of a 4 part series on my top option trading tips.

Option Trading Tip #1 - Consider Being a Seller or Net Seller of Options

You basically have two choices when it comes to option trading - you can be a net buyer of options or a net seller of options.

Not to oversimplify, but when you are long options or you're a net buyer of options, you're essentially making a bet that a stock will do something specific by a certain date.

If you're right, you can be rewarded quite handsomely. And, of course, there are always techniques whereby you can mitigate some of the inherent risk of being wrong in exchange for giving up some portion of your potential gains.

But the point is, with net debit strategies, the objective is to take calculated risks which result in either high ROI gains or some form of loss.

With a net debit strategy, it costs you money to set up a position. And before the trade expires, your hope is that the value of the position increases so that you can close it out for a profit.

"Straightforward But Difficult"

Buying straight calls or straight puts is a pretty straightforward strategy, but it's probably one of the most difficult to consistently succeed with.

That's because it forces you to be right - not just on what a stock is going to do, but also when it's going to do it - or else you're going to lose money, potentially the entire amount of capital placed at risk.

Long calls and long puts on their own really are like little lottery tickets.

You can reduce the risk somewhat by buying your options in the money (at strikes below the current share price in the case of calls and at strikes above the current share price in the case of puts) as well as selecting a longer duration (i.e. expiration date).

And you can also tack on a short option component to reduce the cost a bit (in exchange for capping your max potential gains).

But at some level, you HAVE to be right or else you're going to suffer a permanent loss of capital.

Much Harder Than it Looks

To become adept at this type of trading, it really requires that you become proficient at technical analysis so that you - hopefully - can:

• Really time your entries
• Have a reasonable target in mind where you plan to exit if the trade works out the way you think/want it to
• Be able to identify as early as possible when the trade's not going to do what you want it to so you can get out early enough to limit the damage as much as possible.

Why I Prefer Selling Options vs. Buying Options

I personally prefer selling options or certain net credit strategies (providing you don't use the credit spread structure to overleverage and put your portfolio at serious risk).

Again, I'm not trying to oversimplify here, but when you're a net seller of options, when you intiate trades that produce net credits, you receive cash when you set up a position.

And while there may be some benefit from the underlying stock doing one thing or another, what you're really being paid for is the passage of time.

It's true that not all credit or net credit strategies are created equal. In fact, I'm not a fan of all such strategies (I prefer covered calls, naked puts, and calendar credit spreads over bull puts, bear calls, and iron condors).

But when you set yourself up to be paid - more or less - for the passage of time, then you've always got some kind of wind at your back.

Volatility vs. Risk

Of course, that's not all you're being compensated for. But when you choose a high quality underlying stock (and by that I mean a high quality business that isn't currently overvalued), in my experience it's not risk your assuming but volatility.

Why don't I consider volatility to be risk?

With a debit or net debit strategies, it's next to impossible to roll the trade or keep it alive until it works out in your favor.

That's not the case with net credit strategies like covered calls, naked puts, and calendar spread credit trades.

Structural Advantages of Selling Options

Two of the most important factors that I feel I owe my success to is that I've learned to treat my trades as a series or campaign of trades.

And the other is that I choose trades that have significant structural advantages built into them. And by that I mean that when a trade goes against me, the trades I employ enable me to roll and adjust and repair and keep them alive until things eventually turn around.

And most importantly, while I might not be generating huge and sexy mega returns, I typically manage to continue making positive returns.

This gets more into the whole Leveraged Investing (value investing with options) approach, but basically, all else being equal (i.e. assuming the stock market isn't in complete meltdown mode), by being a net seller of options (or at least certain strategies), I've learned to make great returns when I'm right, and good, decent, OK returns when I'm wrong.

And I find that to be a pretty good trade off.

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