Here’s one for you new and intermediate options traders (though frankly, I think traders of all experience levels can benefit by getting back to basics).
Want to know what I think are the four cornerstones of sound options investing? They aren’t complicated, yet they seem to be elusive too much of the time. They are…
- Invest in options that respond well to the underlying stock’s movement (high delta)
- Minimize time decay (the natural erosion of an option’s value over time)
- Buy enough time to capitalize on major moves (you don’t have to hold it the whole time)
- Minimize volatility (since volatility can shake up your confidence and your account balance)
Don’t worry – you won’t need a PhD in mathematics, nor will you need to be a seasoned options trading veteran, to apply these four principles. All you need is a little willingness.
1) Invest in options that move well with the underlying stock.
If you’ve ever heard the term ‘delta’ as it pertains to options trading, this is what they’re talking about. Delta is the degree to which each individual option changes with respect to every $1 change in the underlying stock’s price.
For instance, a call option with a delta of 0.30 (30 cents) would increase in value by 30 cents for every dollar’s worth of gain for the stock. That would be a relatively low delta. A relatively high-delta call option might move by 90 cents (a delta of 0.90) when the underlying stock gained a buck.
Obviously high-delta options are more desirable if you’re making a directional forecast for a stock.
(Note that the delta can change as an option moves deeper in the money or deeper out of the money, and as time passes. For our purposes though, you just need to understand the concept.)
2) Minimize your time decay right off the bat
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Have you ever noticed you pay a little more for options than they’re mathematically worth? For instance, a call option with a strike price of $30 on a stock that’s trading at $35 is intrinsically worth $5. However, you may have to pay $7 to own the call option.
That additional $2 is considered to be ‘time premium’. As time passes – even if the underlying stock’s price doesn’t change by a penny - an option’s time premium will sink. As expiration approaches, the time premium will eventually be whittled away to zero…meaning the option will eventually only have intrinsic value (or what the option is mathematically worth).
Option traders call this time decay ‘theta’. Needless to say, keeping theta to a minimum is critical to your long-term profitability.
