Options
Options Trading: Guiding Principles
There are three guiding principles that successful options traders always keep in mind. They are as follows:
- Make sure you trade with the market, sector, and stock.
- Before you enter into a trade, understand your exit strategy.
- Be aware of upcoming announcements.
Guiding Principle 1 - Trade with the Market, Sector, and Stock
Typically, when an investor is ready to enter a trade, they are completely familiar with the trend of the stock. They have probably been studying the trend for a period of time prior to deciding to purchase the option. However, understanding the trend of the underlying stock is not enough. An investor must also understand the direction of the general market and the market sector for the individual stock before they purchase a particular stock or an option based on that stock. The market and sector trends need to also be moving in a direction that matches the investor’s strategy.
Standard & Poor’s separates the market into 27 market sectors which are made up of 247 industry groups. Every publicly traded company in the U.S. is categorized into one of these industry groups.
The reason that it is important for an investor to be familiar with the entire sector not only the individual company is that the group performance, rightly or wrongly, can drastically influence the price movements of an individual stock. Because companies are grouped by the products or services that the offer to customers, often a group’s client-base is the same across multiple companies. Therefore, bad news from one company will tend to drive prices down for other companies in the same group.
An example of this situation was what happened in the utility group a few years ago. During the Enron scandal, healthy utility companies’ stock prices were affected just as badly as Enron’s once the discovery of questionable practices within Enron was made. The entire group suffered because investors no longer knew who to trust within the group. Even though the healthy companies were only being lumped with Enron and there was nothing to support any allegations within these companies, there stock price was also punished.
Therefore, it is important that before you enter a trade, that you check the trend of the general markets, the specific market sector, industry group, as well as the trend of the stock that you are interested in.
Guiding Principle 2 – Understand Your Exit Strategy Prior To Entering the Trade
It is difficult to think about, but you need to understand the detailed objectives that you are trying to achieve when you enter a trade. It is more than that you want to make money. You need to understand how much money you want to make – i.e. how will you recognize when you have acquired enough profits. In addition, you need to understand what actions you are going to take if the trade starts to go the opposite way to the direction you anticipated.
The reason that these guidelines are hard to establish is that some investors are never happy with their profits. They also do not want to think that their strategy could go wrong. However, as an investor, you need to have an exit strategy so that you do not become paralyzed by indecision when things do start to go against you. Also, you want to take your profits and run before the stock price begins to fall.
One way to develop an exit strategy is to analyze the stock’s patterns of support and resistance. For example, if you know that the stock tends to increase 10% before a resistance level is reached, then there is probably a good chance that the same thing will happen again. A good exit strategy would be to plan to exit near the 10% level.
If you want to take some additional risk with your investment, one possible strategy to follow is for you to sell half of your stock when you reach a comfortable level and let the other half stay in the investment until an appropriate exit point is reached.
Guiding Principle 3 – Be Aware of Upcoming Announcements
Although there are always surprises, such as company announcements, that may affect your investment, there are some announcements that you can plan for. Quarterly and annual reports fall into this category. They are easy to plan for. Often these announcements are planned far into the future. Even if the exact date of a reporting period is not know, it can be roughly worked out from the previous reporting date. Most companies will make investors aware of official announcements through an investor website or by alerting the financial media.
There are other types of announcements to be aware of though. For example, fiscal policy announcements from the Chairman of the Federal Reserve always have implications for market prices. As an investor, you need to understand how the market reaction is affecting your individual position. Do you want to exit because your holdings dropped in value as a result of his comments? Another option to considering is placing a stop-loss on your position prior to an announcement that might negatively affect your portfolio.
It is important for all investors to conduct a nightly review of their holdings. Investments cannot be ignored if you are going to create wealth in your portfolio. An investor should nightly check the stock charts and the market news concerning their holdings. Something in one of these could mean that you need to take action to sell your position. Also, review your stop-losses to see if they are still appropriate. It will only take 15 minutes each night to do a small amount of research to protect your investments.
There is no excuse for being uninformed about your stocks and not trying to follow strategies that allow you to protect your overall portfolio from unexpected news.
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